Brocade, McData Send Mixed Messages

Two key storage area networking (SAN) vendors have made a key reseller the battleground for a dramatic faceoff.

Within hours of each other, Brocade Communications Systems Inc. (Nasdaq: BRCD) and McData Corp. (Nasdaq: MCDT) reported dramatically different news.

And in each case, reseller EMC Corp. (NYSE: EMC) plays a role.

Here's the story: Last night, McData reported fiscal first-quarter 2001 revenues of $83 million, up 6 percent sequentially and 76 percent year to year. Earnings per share are expected to be 8 cents, up 33 percent year to year.

This morning, Brocade predicted an earnings shortfall for the quarter set to end April 28. The company now expects net revenues to be 30 percent lower than they were the preceding quarter. Diluted net income per share for this quarter is expected to be 5 to 6 cents on revenues of $115 million, compared with diluted net income per share of 13 cents on revenues of $165 for the first quarter of fiscal 2001.EMC's business is key to both accounts. "Brocade and McData are at each other's throats over EMC," says Mark Kelleher, senior analyst at First Albany Corp.. To see why, let's consider each company separately.

McData is heavily reliant on its former parent company, EMC, which accounted for 68 percent of total revenue this quarter. A second OEM, IBM Corp. (NYSE: IBM), accounted for 14 percent of McData's quarterly revenue.

For its part, Brocade has a wider range of OEMs. While the company did not reveal EMC's contributions to this quarter's revenues, its SEC forms indicate that for 2000, EMC accounted for at least 10 percent and, together with Compaq Computer Corp. (NYSE: CPQ), contributed 49 percent of Brocade revenues.

So questions arose this morning as to whether McData's news last night signals that Brocade is losing business to McData at EMC. Was Brocade's loss really McData's gain?

No, says Brocade. "We did not lose any revenue traction at EMC through the quarter," CEO Greg Reyes asserted to analysts on a conference call this morning. He said Brocade has no leftover inventory at EMC and that he saw Brocade's share of business gain there, while that of competitors went down. (Indeed, technically, the percentage of McData's revenues accountable to EMC business has dropped a couple of percentage points.)EMC declines to acknowledge any market share fluctuations amongst its partners.

Indeed, a substantial analysis of both companies' prospects requires a look at more than their OEM relationships. The upsides and downsides of their respective market positions also need to be considered.

McData owns at least 90 percent of the market for SAN directors -- switches with more than 32 ports that interconnect multiple Fibre Channel SANs. This is a fast-growing market, which Brocade only recently joined with the announcement of the SilkWorm 12000 (see Brocade Unveils Big SAN Switch).

On the downside, right now the director market is still comparatively small, accounting for 10 percent or less of the overall SAN market (which is estimated to be $3 to $4 billion annually at present).

There's also evidence that McData's good news of last night may not continue unabated. Gross margins are down: They were 45.7 percent for the quarter, compared to 53 percent at the same time last year. Growth for this quarter is expected to be good, but substantially lower year over year compared with growth in the first quarter. Further, pro forma fully diluted EPS is expected to be 4 to 6 cents next quarter, down from 8 cents this quarter.As for Brocade, there are many upsides: Despite its earnings shortfall, Brocade said its gross margins will stay in the 60 percent range this quarter. Further, the company will have no layoffs and will continue to hire on a limited basis, and annual revenues for 2001 are expected to grow by 58 percent year over year.

Brocade also owns 60 percent of the overall SAN market, and 80 percent of the market for Fibre Channel switches of 8 to 16 ports. What's more, as noted, it has a wide range of OEMs and resellers.

On the downside, Brocade is a ways away from delivering its first high-end switch. What's more, Brocade's heavy reliance on the Fibre Channel market could be a liability if that market slows down, as some analysts seem to think it will (see Finisar Lowers Guidance