Everybody Wants to Eat EMC's Lunch

Rivals are rushing into its market, and margins are shrinking. Will a new focus on software save the day?

It's a humdrum office park 27 miles west of Boston. But through the '90s, the Hopkinton (Mass.) home of EMC Corp. (EMC ) was the global capital of the soaring data-storage market. EMC's stock rose from a split-adjusted 7 cents to $101, making it the top performer in the Standard & Poor's 500-stock index during the '90s. The world was bursting with digital information, and EMC's massive disk-drive machines, regarded as the best of breed, gave companies around the world a secure place to store every last bit. Naturally, it came at a premium price. One competitor joked that "EMC" stood for Excessive Margin Co.

Those margins are shriveling fast, as legions of competitors, including IBM (IBM ), Hewlett-Packard (HPQ ), Dell Computer (DELL ), and dozens of upstarts, rush into the market. They're not all building the refrigerator-size machines that EMC made famous. These days, even startups and midsize companies want storage, and they're demanding cheaper machines--all of them linked to networks. The key is no longer simply to save the information but to manage and retrieve it faster.

That's why on Aug. 20, Cisco Systems Inc. (CSCO ) made a play to grab a bigger chunk of network storage. It announced an agreement to purchase Andiamo Systems Inc., a maker of storage switches. For now, Cisco is angling for leadership in the $1 billion switch market, which is off EMC's turf. "But Cisco may have grander ambitions," says Steve Duplessie, founder of The Enterprise Storage Group Inc., a consultancy in Hopkinton. "Then it could get ugly for EMC."

EMC already has all the competition it needs. Its stock price has withered to a mere 7% of its 2000 high, and HP, strengthened by its Compaq Computer Corp. (HPQ ) acquisition, has raced ahead in market share, with 25.6% to EMC's 17.3%. The question now is whether EMC CEO Joseph M. Tucci can lead the $7 billion company through a wrenching transformation to software and services--without succumbing to a takeover. To do so, he must match former IBM Chairman Louis V. Gerstner Jr., who pulled off a similar makeover in the '90s. That was a Herculean task. What's more, analysts say, EMC, a far smaller company than IBM, with a market capitalization of $16.8 billion, could get even cheaper, becoming irresistibly bite-sized as it struggles to remake itself in a merciless market. "Their window [to change] is closing," says Ashok Kumar, senior research analyst at U.S. Bancorp Piper Jaffray.

Who would buy EMC? Now that storage is growing in corporate networks, practically every big tech company is pushing into the business. They all want to sell a complete suite of digital offerings to their customers, and EMC, despite its bumps and bruises, is still at the front of the class in storage hardware and software. This would make the former highflier a juicy target not only for IBM and HP but also for newcomers to storage such as Cisco and Dell. Bear, Stearns & Co. analyst Andrew Neff predicts a possible HP-EMC merger. Of course, HP, fresh from its Compaq purchase, won't likely be in a courting mood for a year. Still, the deal has a certain logic: EMC would provide HP with its own top-of-the-line offering, Neff says--while breaking up EMC's increasingly chummy relations with Dell. HP officials declined to comment.

EMC's ability to remain independent hinges on software. The big challenge is to come up with a program that stitches together today's crazy quilt of storage systems. The typical data center has several types of storage boxes on its floor that can't talk to one another or share storage space if one gets overloaded. The magic bullet for them would be software that connects them all and automates management, taking much of the manual labor--and cost--out of the process.

EMC engineers are racing to come up with just such magic. A program called AutoIS promises to let corporate managers store and retrieve data no matter what machine it resides on. Trouble is, rivals are following suit--and AutoIS isn't complete, though a big piece is due in October. "The AutoIS vision is compelling, but we need to see delivery," says Paul J. Gaffney, chief information officer at Staples Inc., who buys storage from EMC, IBM, and HP.

Tucci doesn't downplay the immense job ahead. He blocked out 14 days for vacation this year but has managed to slip away for only two. He's too busy mapping out a plan for his specialty business to survive in a world of giants. The strategy: EMC, in the fashion of Japan's keiretsu, teams up with a group of service partners, including Accenture (ACN ) and Electronic Data Systems (EDS ), to sell and install the systems. And an eventual merger? "I don't spend a second worrying about it," he says.

He has more immediate concerns. Hardware makes up 56% of his business, and prices are plunging at least 30% a year. This is likely to help drive down revenue from $7 billion last year to $5.7 billion in 2002, while earnings tumble from last year's $168 million, excluding restructuring charges of $825 million, to a net loss of $84 million, predicts Neff of Bear Stearns. Even with revenue shrinking, Tucci is resisting temptations to slash spending on research and development. He's holding it nearly flat at $800 million, or 14% of revenue.

Much of it is going into software. But here, Tucci's proposed keiretsu threatens to punish his margins. The reason is simple: If EMC's partners sell its software, they hold on to a piece of the profits. Sanford C. Bernstein & Co. analyst Toni Sacconaghi estimates that EMC's 85% margins for direct software sales in the midrange market will plunge to 55% in the Dell partnership.

Tucci remains confident that he'll be able to bolster margins in other ways. Over the past year, he has attacked costs by trimming inventories, reducing manufacturing and testing time, and cutting staff. For growth, he concluded a key deal in October with Dell to sell co-branded products. This gives EMC entrée to thousands of new customers in the midrange storage market dominated by HP, which has a 41% share to EMC's 6%. But competitors call it a desperate move, one that benefits Dell more than EMC. "EMC's business model is no longer relevant," says Howard Elias, senior vice-president of HP's storage division.

EMC and Dell also are crafting a plan for Dell to make a low-end storage box designed by EMC. Royalties from the deal, Tucci says, will boost margins. He predicts that overall gross margins will return to 45%-plus from 38.3% now--still down from a peak of 59%.

Software will be the key to fatter profits, and EMC currently has the edge. It leads its rivals with a 30.4% market share; its closest rival, Veritas, has 19.8%. But EMC's efforts to come up with programs to interpret all of its competitors' software could still be a year away, analysts say. Meantime, EMC seeks technical help from competitors to make its software work with their boxes. But bringing these long-warring factions together is no easy task. IBM and EMC have yet to agree to an exchange of technical specs. Tucci says he has made an offer and is still waiting for Big Blue to respond. IBM says EMC has been resistant to open standards.

Such difficulties are typical of an industry rife with bad blood after a decade of EMC's dominance. But EMC's easy years are history. Now the onetime storage king has to do whatever it can to keep standing on its own feet.

By Faith Keenan in Boston, with Spencer Ante in New York and Cliff Edwards in San Mateo, Calif.

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