From Barron's on EMC :
The Terabyte Warriors
Abandoned by investors, storage giant EMC soldiers on. Recovery ahead?
BY BILL ALPERT
Eight prospective buyers used to visit EMC's Hopkinton, Massachusetts, computer lab on an average day. But visits halted after September 11, and since then the sales tours have returned to just half their historic frequency. The weak foot traffic through the facility reflects the computer industry's stalled sales. EMC's products -- essentially high-tech filing cabinets for vast amounts of corporate data -- had been the favored way to store vast amounts of data on various large corporate computer systems, as evidenced by the names on the machines on the supermarket-size floor of the lab: "Compaq Alpha," "IBM" and "Sun."
That popularity powered EMC's explosive sales growth, and made it the New York Stock Exchange's best-performing stock of the last decade -- of any decade, in fact, in the Exchange's 200-year history. But the terrorist attacks of September 11, coming amid a wintry recession in the computer industry marked by desperate competition, have combined to clobber EMC sales and profit margins. Operating losses and restructuring charges topped $1 billion for the September quarter, and EMC shares are down from 100 to 12.
Tucci (left) and Ruettgers: Reinventing the company once again.
Wall Street analysts who recommended the stock at 90 now shun it. Many doubt EMC will ever again see the happy circumstances that sent its shares up 80,000% during the 'Nineties. "Large IT [information technology] shops were buying so much ahead of plan," says Peter Bell, whose Storage Networks is an EMC customer. "CEOs were afraid of getting 'Amazoned' in any way, shape or form."
But if data-storage sales have paused, data growth has not. EMC Executive Chairman Mike Ruettgers believes that when buyers return to the market for data storage, EMC will retain its commanding market share. Gross margins will recover, he hopes, when sales volumes return and EMC increases its sales of new software products. Deep cost-cutting should also hasten the return of operating profits. Until then, EMC has $5 billion in cash -- about $2.25 a share -- on its balance sheet.
At the top of corporate To-Do lists
The aftermath of the destruction of Wall Street data centers on September 11 provided a powerful endorsement for the company's data replication systems. EMC customers didn't lose data they'd backed up on EMC systems in remote locations. After protecting employees, says Ruettgers, protecting data has jumped to the top of the To-Do lists of American business and government.
EMC has reinvented itself before. Just over 10 years ago, before EMC perfected the first disc-drive arrays for IBM mainframes, the company sold add-on memory for minicomputers. IBM customers had been paying through the nose for IBM proprietary hard drives. EMC introduced the Symmetrix, a cabinet filled with personal-computer components (microprocessors, memory and an array of hard drives). The redundancy and speed of disc arrays powered EMC's share of the mainframe storage market from 5% in 1992 to a market-leading 40% by 1995. Then EMC added arrays for UNIX computers (from the likes of Sun Microsystems) and for computers running Microsoft's Windows NT. Sales grew to $8.9 billion in 2000 from $260 million in 1991, while earnings soared to $1.8 billion from $11 million.
Around this time last year, Ruettgers recalls looking at industry forecasts of 19% growth for 2001. Fans were forecasting that EMC could do $12 billion in sales this year, with perhaps $15 billion in 2002 and $20 billion in 2003.
Revenues for the March quarter were on track for $12 billion in 2001, but demand showed signs of slowing. By April, it became clear that the $12 billion figure wouldn't materialize. "In the first quarter, our departmental customers could sign off on a $5 million order," says Ruettgers. "By the second quarter, their bosses had to sign off."
By the third quarter, the customers' CEOs had to sign off on orders. Price competition got ugly. Hitachi Data Systems was the first concern to discount deeply, then IBM. In some bids, says Ruettgers, IBM offered storage nearly free, as part of a bundle with mainframe processors and consulting services.
Even with such bids on the table from IBM, EMC won deals, including a contract for more than 100 terabytes (or a trillion words' worth) to MasterCard. But Wal-Mart chose IBM in a deal for more than 50 terabytes. "We like your stuff," Ruettgers recalls Wal-Mart saying, "but we can't overlook a price difference like this," as he spreads a thumb and forefinger as wide as they'll go.
Performance improvements in the storage offerings of IBM and HDS have certainly narrowed EMC's commanding technology lead, according to Peter Bell, who worked for EMC before launching the Waltham, Massachusetts-based network for online data storage called Storage Networks. But a more important change in product lineups -- the disappearance of all competition in the manufacture of IBM-compatible mainframe computers -- may have taken place altogether outside the category of data storage. With Hitachi, Fujitsu and Amdahl out of the sector, IBM has the pricing power to use its mainframe profits to subsidize low-priced sales of storage.
EMC's September quarter was worse than anyone expected. Gross margins, in particular, surprised analysts who'd watched them climb toward 60% over recent years, even as disc drives -- EMC's raw material -- got cheaper. Morgan Stanley analyst Gillian Munson, for one, had braced for a drop in gross margins to 40% in the September quarter.
Instead, on revenues of $1.2 billion, EMC earned gross margins of 30% (before special charges). Those margins were down sharply from 47% in the June quarter and 58% in the September 2000 quarter. EMC argues that most of the recent quarter's margin crimp resulted from costs that couldn't be absorbed by sales so far below the June quarter's $2 billion. Only five of the 17 lost percentage points in gross margin resulted from price competition and the mix of products, according to EMC's figuring.
Wherever the margins went, EMC is taking drastic actions to bring down costs. On top of $270 million in after-tax operating losses for the September quarter -- 12 cents a share -- the company took $675 million worth of restructuring charges, adding another 31 cents to the quarter's loss.
A 23% reduction in headcount and curbs on R&D spending will enable EMC to break even at an annual sales rate just above $6 billion, says Chief Executive Joe Tucci. Another cost-cutting step: the reliability testing cycle on disc arrays will be halved to 14 days.
EMC will push its mid-size storage line, Clarion, more aggressively in response to competition from low-entry cost systems after having preached the lower "total cost of ownership" of its large, expensive Symmetrix line. In August, Network Appliance beat out EMC in a deal with Deutsche Telekom. Mark Santora, marketing VP at Network Appliance, says his firm proposed a network of devices at 82 locations, while EMC proposed five large data centers where data would be stored on giant Symmetrix arrays. The EMC strategy of big, expensive systems reminded Santora of the erstwhile supercomputer maker, Cray Research.
Clarion -- as well as Network Appliance -- has seized on market uncertainties over the future of Compaq Computer's storage with the latter's plans to merge with Hewlett-Packard. Clarion boss Joel Schwartz chortles at Compaq's latest storage product introduction, where Compaq is offering purchasers 110% of their money back if the new product line doesn't survive the merger with H-P. Helping Clarion to knock heads with Compaq and NetApps will be Dell Computer, which agreed last month to resell EMC storage products. Dell will also help EMC increase sales of Microsoft systems, which are gaining share in data centers at the expense of UNIX systems from the likes of Sun.
Increasing sales of software is a big part of EMC's strategy to rebuild revenue and profit margins. Last week, the company announced a raft of new products aimed at automating the operation of storage systems so as to get around the acute shortage of skilled data-center personnel. And Chief Executive Tucci emphasizes the software's "openness" -- it works with storage and network products from EMC's rivals.
"Our competitors never thought we'd open our software to this extent," says Tucci. Will that software's compatibility with rival systems hurt EMC's own hardware sales? A bigger risk, says Tucci, would arise from ignoring customers' pressure to manage their data-center diversity. He hopes to increase software sales from 20% of EMC revenues to at least 30%.
Still, EMC's most heroic software products will continue to run only on EMC hardware. Foremost among these is SRDF, or Symmetrix Remote Data Facility. This is the product that instantly switched Wall Street firms over to backup copies of their data on September 11.
That was a wake-up call, says Chairman Ruettgers, that moved data security from the bottom of many corporate checklists right to the top. As the Pentagon recovers from its own terror losses, federal and state agencies are also examining and reviewing their ability to survive attacks on their data centers.
Value play?
EMC executives aren't yet ready to say that demand has bottomed. Investor relations head Polly Pearson says money managers had almost desperately been inquiring whether the nadir is near. The phones stopped ringing in early September, but she reports that calls have since picked up, and from a cross-section of investors who include "value" types, along with EMC's traditional growth-stock fans. Ruettgers is going on the road, meanwhile, to talk up the stock.
Brokerage-firm analysts, for their part, remain dour on EMC's prospects of returning to its former sales growth and 50% gross margins. Munson of Morgan Stanley is typical in seeing no demand recovery until 2004, when she estimates that EMC could earn all of 15 cents a share on sales of $7.4 billion. That estimate assumes 42% gross margins. In a happier case, with sales at $11 billion and gross margins at 52%, Munson reckons 2004 earnings might climb to the range of 35-50 cents a share. With those prospects distant, and EMC shares at 12 currently, she wouldn't urge investors to chase them.
But Ruettgers happily points to the company's $5 billion cash hoard, which will give his troops time to reinvent themselves as they wait for demand to return. Outside the company's Hopkinton software-development facility, the parking lot's overflowing. Whether or not EMC customers are buying today, the world's data continue to grow at nearly 50% per year. Eventually, they'll need more places to store it, and it's a good bet many of them will return to EMC. |
