The Search for EMC's Silver Lining

Analysts think the battered data-storage giant could regain its luster by beefing up product lines and cutting costs. That's a big if

By Olga Kharif

For storage giant EMC, it has been a year of bitter disappointments. As the economic downturn deepened and companies slashed tech spending, the data-storage market shrank 18%, from $31.2 billion last year to $25.5 billion in 2001, according to tech consultancy IDC. With corporate buyers looking more closely at price, high-end manufacturer EMC (EMC) , whose products store e-mail and documents on computer networks, bore the brunt of the downturn. Will 2002 be any better? Perhaps, but getting back on the growth track won't be easy.

EMC's woes became apparent in October, when the company reported third-quarter revenues of $1.21 billion, a 47% drop from the year-earlier quarter. It went into the red, recording a "pro forma" loss of $270 million -- 12 cents a share -- and announced it would lay off 4,000 employees, bringing its head count to 19,000. Coming from a company that posted double-digit growth in 2000, the numbers were shocking.

Perhaps even more troubling, EMC lost its crown as the world's No. 1 storage maker to rival Compaq Computer (CPQ) , according to IDC. IBM (IBM) and Hitachi Data Systems, a subsidiary of Hitachi (HIT) also took big bites out of EMC's pie, reducing its world market share from 18.8% to 15.6%. The company is taking steps to reverse the trend, but the near-term outlook remains uncertain at best.


  Analysts expect price pressure in the storage hardware market to continue. Demand could remain weak for another nine months, says Shaw Wu, analyst with Banc of America Securities. Considering the risks, most analysts surveyed by financial services firm First Call rate EMC stock a hold. Six investment banks, including Bear Stearns and A.G. Edwards, have downgraded it since late September.

Also, many analysts believe EMC's shares, which trade around $17, are still pricey. While they're down 82% from a 52-week high of $92, UBS Warburg thinks investors shouldn't buy the shares until they're down to around $7.

However, EMC can see a few glimmers of hope. On Nov. 28, Salomon Smith Barney raised its price target from $13 to $20 in anticipation of the success of a new software family called Auto IS, which EMC introduced on Oct. 29. On Nov. 27, Merrill Lynch expressed a similarly optimistic view based on these new products. "The worst is now behind them," says Brent Bracelin, analyst with Pacific Crest Securities. If EMC plays its cards right, it should land on top when the economic downturn ends, say analysts. Much remains to be done, though.


  The company has to enhance its storage architecture, further reduce costs, and continue to focus on software and services, rather than just hardware, to benefit from the expected market recovery of mid- to late-2002, say analysts. With hardware margins squeezed, expanding into software and services will be key to EMC's future growth. Hardware should account for 35% of its total revenues, instead of the current 70%, says Wu.

EMC says it aims to see software and services bring in half of its sales by 2003. The new Auto IS software line should help the cause. It allows better integration of software and hardware from different vendors and seems to have no rivals, according to Merrill Lynch. "We are probably at least a couple of years ahead of the competition," says Ken Steinhardt, director of technology analysis at EMC. To back up its commitment to diversify its business, EMC announced on Nov. 29 the creation of three business units focusing on software and services.

Its recent deals with other hardware vendors are another step in the right direction. On Nov. 8, EMC shook hands with Compaq on an agreement to cross-license each other's programming interfaces. The technology exchange will allow both businesses to develop applications capable of managing the other's storage systems. Customers increasingly demand such interoperability.


  EMC could soon agree to a similar deal with Hitachi Data Systems and IBM, believes Clinton Vaughan, analyst with Salomon Smith Barney. The bottom line is that EMC's programming interface is starting to gain acceptance. On Oct. 22, the company announced a partnership with Dell, which will resell some of EMC's products, widening the storage company's user base. Analysts have long grumbled about how EMC let similar deals with Hewlett-Packard (HWP ) and Sun Microsystems (SUNW ) slip away to rival Hitachi Data Systems.

Early next year, analysts hope to see EMC finally launch a new version of its Symmetrix hardware, which should allow for faster data transfers. The product has been late in coming, and a body of opinion sees EMC's wares as having lost their technological edge, says Andrew Neff, analyst with Bear Stearns. Counters EMC's Steinhardt: "Today, we have the highest performance in the market. We are totally on the leading edge."

Technology is crucial, but so are costs. EMC will have to cut them if it hopes to remain competitive. "It isn't that customers have stopped spending," says Bob Samson, IBM's vice-president for worldwide sales and operations in storage systems. "They are just spending their money more wisely." EMC Executive Chairman Mike Ruettgers insists that EMC is helping customers there, too: "We continue to drive components costs down, which is a major reason why customers can deploy new storage infrastructures for much less than it cost a year ago at this time."


  EMC has already reduced operating expenses, and its goal is to cut $800 million more by mid-2002. EMC should also try to cut the cost of its components and, possibly, consider changing its rigorous and costly testing process, says Banc of America's Wu, who adds that EMC might even want to consider more layoffs.

Ruettgers responds by saying "In terms of our testing costs, we've done a lot to reduce both the time and inventory required. But we refuse to sacrifice quality -- it's a major part of EMC's advantage." He adds that EMC won't "start rolling the dice" by going to random testing.

Analysts don't expect EMC to break even again until mid-2002. A First Call consensus estimate shows the company recording an 8 cent-per-share loss in the fourth fiscal quarter ending in December. For fiscal 2001, First Call estimates show it making 4 cents a share, then losing 7 cents in 2002 before earning 14 cents in 2003.

EMC insists that its strategy is sound. "What made EMC great is going to continue to make us great -- listening to our customers and bringing the products to the market faster than other companies do," says Don Swatik, EMC's vice-president for information sciences and alliances. Merrill Lynch rates the stock a buy long-term, which is probably the perspective most investors might want to take. The rest is in EMC's hands.

Kharif covers technology for BusinessWeek Online from Portland, Ore.

Edited by Beth Belton

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