Is EMC a target for takeover?

Possible merger partners circle as storage industry woes point to consolidation.
In an industry where executives like to name their products Thunder, Lightning and Shark, competition has always been treacherous.

But predators may be particularly keen on circling EMC--the largest independent provider of storage systems and a company once thought to be immune to recession. Some storage veterans are betting on a deal linking EMC and IBM--longtime rivals whose executives revel in insulting each other.

While there is no consensus among analysts or industry executives that EMC is bound to be part of any merger--either as a buyer or a seller--the storage industry is facing the type of downturn that often results in significant consolidation.

A protracted slump in PC sales led Compaq Computer and Hewlett-Packard to determine that one combined company is better than two. A severe decline in telecom-equipment spending also resulted in Lucent Technologies and Alcatel talking marriage, although the planned union was later abandoned And some speculate that companies are sniffing around Web portal Yahoo, which has fallen on hard times.

Now some Wall Street analysts are wondering whether EMC can weather the economic slowdown as a standalone company--especially after a suspected slowdown caused by the terrorist attacks of Sept. 11. They are bracing for underwhelming financial news from the company during a third-quarter conference call Oct. 17.

Though rumors about an EMC-IBM deal have been percolating for weeks, the notion of a megamerger in the storage industry heated up last month when HP announced its $25 billion deal to acquire Compaq. Many predicted the event would spark a rash of consolidation in the broader tech industry.

Representatives at IBM and EMC refused to comment on whether they are in negotiations, and any deal would face daunting financial, technological and cultural complexities. But speculation has reached such a pitch that analysts at Aberdeen Group recently drafted a report declaring an EMC-IBM merger a "win-win" for both the companies and their customers.

"We typically ignore the Wall Street rumor du jour," said Tom Willmott, chief executive of Boston-based Aberdeen. Willmott noted that while he had no inside information that such a merger was imminent, "this one made so much sense, for so many reasons, that we had to examine the information and educate our clients about our conclusions."

Why it makes sense--and why it doesn't
According to merger advocates, the deal would give IBM access to EMC's Symmetrix lineup of storage systems--multimillion-dollar hardware and software packages that companies use to send data such as credit card information or customer lists between servers. EMC is the acknowledged leader for both products and support services.

EMC could also benefit from a merger: It struggles to integrate its storage products with networking equipment and software from companies outside its control; an IBM deal would simplify that process.

Within IBM, EMC engineers could steer changes in software such as Big Blue's DB2 database. With IBM's vast range of products, customers could rely on a single company instead of many.

Proponents say the deal would also give EMC access to IBM's deep pockets--a major consideration as EMC shares hover near a 52-week low. The stock trades around $12.61, down more than 80 percent so far this year.

"In the past, EMC would have thought such a merger unthinkable and would have resisted with the tenacity for which it is well known," according to Aberdeen's report. "Thinking through the benefits for its customers, employees and investors, EMC may well now believe that it would be a good thing."

But many analysts brush off the merger rumors as wishful thinking by burned investors. IBM, they note, has not shown a taste for multibillion-dollar acquisitions. Although many analysts are aware of the rumors, few have joined Aberdeen's position that it would be a win-win for both groups.

The storage industry is unlike the personal computer niche or other segments where consolidation seems more logical during a downturn. Storage is still a relatively specialized field where companies have loyal followings; simply merging two long-standing rivals would not necessarily improve the combined company's chances of success.

Toni Sacconaghi, an analyst at Sanford Bernstein, agrees that IBM could pick up its chief rival and a large customer base for a fraction of what EMC would have cost a year ago. But EMC's customers might not be loyal to IBM after a merger; many EMC customers want a neutral storage provider to collect data from Sun Microsystems, HP, IBM and other servers.

"I'd be surprised by it," Sacconaghi said of a merger. The stumbling block, he said, is that the deal would not be good for EMC. "EMC loses this Switzerland independence that it has."

"Stick a fork in 'em"
An EMC-IBM merger--however unlikely today--would have been an absolute impossibility even a year ago.

Hopkinton, Mass.-based EMC builds the computerized vaults that companies use to hold electronic data such as customer credit card information or detailed pricing charts. With 23,600 employees worldwide and products ranging from software and networks to services, EMC is by far the largest independent provider of storage systems.

EMC, along with database software seller Oracle, server seller Sun and networking hardware maker Cisco Systems, was one of the vaunted "four horsemen of the Internet" in the mid-1990s. During the headier days of the Internet, start-ups and traditional companies flocked to these companies, believing their products the best choices to quickly set up Internet operations.

EMC and its leaders became known as much for their dominance of one of the most esoteric branches of the tech industry as for their macho bravado. Executives continually flouted the competition.

At an analyst conference in Boston in August, where EMC executives donned identical uniforms of black sweater-vests, Chief Executive Joe Tucci said Santa Clara, Calif.-based Hitachi Data Systems spouted "downright lies" about rival products' capabilities. Senior sales executive Frank Hauck also blasted Sunnyvale, Calif.-based rival Network Appliance by saying, "Now stick a fork in 'em. They're done."

Historically, EMC has had reason to be smug. As recently as January, when the rest of the tech sector was reeling from depressed stock prices, spending slowdowns and defeated morale, many analysts and venture capitalists insisted EMC and the storage industry were relatively recession-proof.

Regardless of what the broader economy was doing, they reasoned, companies needed to store their increasingly large files of electronic data somewhere. Storage, they said, was not a discretionary business expense like office masseuses or company cars--despite the fact that even middle-range storage systems cost more than $1 million.

EMC epitomized the recession-proof attitude with an extraordinary reluctance to admit that growth was sputtering. In the beginning of the year, Chairman Mike Ruettgers said he did not see a slowdown in the first half of the year for the data-storage segment. EMC maintained confidence in its goal of $12 billion in revenue for fiscal 2001.

Shortly after the fourth quarter of 2000 ended, Chief Financial Officer Bill Teuber said EMC would increase sales in the mid-30 percent range in 2001. In February, the company said it would still meet its $12 billion revenue target for 2001, but it warned that it would only increase sales 25 percent to 35 percent for the year.

Two months later, EMC lowered revenue growth estimates to 20 percent, and Ruettgers proclaimed that forecast "realistic." In July, Teuber warned that slowing international sales would slash profit and backed away from previous goals.

The back-stepping shattered what confidence remained for EMC on Wall Street; at the same time, the broader storage industry was skidding. Dot-com and telecommunications customers were collapsing, and hard-hit retailers went with lower-priced storage products. According to a report from Gartner Dataquest, the storage sector grew 16 percent last year but is expected to be flat this year at $30 billion.

As the dominant player, EMC had the most to lose when the sector stumbled. Competitors, mainly IBM's Shark and Hitachi's Lightning and Thunder, heated up their attack against EMC's Symmetrix and Clariion. HP expanded its storage products--a quiet but significant move that translated into even more competition for EMC.

The Sept. 11 terrorist attacks worsened the outlook. On Thursday, Thomas Mancino of Pacific Growth Equities reduced his rating on EMC from "strong buy" to "buy," based on the expected business spending slowdown from the atrocities as well as on market share growth of competitors including Hitachi, IBM and Network Appliance.

Mancino reduced his 2001 and 2002 revenue estimates for the second time in almost three weeks. Wall Street expects EMC to report revenue on Oct. 17 of $1.35 billion for the third quarter ended Sept. 30. That's 25 percent less than the $1.8 billion EMC said it needed to break even.

"Given the fluidity in the current situation at the company, we would wait until the quarterly conference call before making anything but trading commitments to the shares," Mancino wrote.

Market caps and Happy Meals
Despite the sharp decline in EMC shares, merger mongers could be in for a disappointment. EMC still has a market value of about $27 billion--more than many potential buyers could swallow.

At that price, even Big Blue would have trouble absorbing EMC. At last week's closing price of $98.02, IBM would have to issue more than 295 million shares--which would increase shares outstanding by about 17 percent--just to cover EMC's current market cap, let alone any premium.

IBM and EMC would also face enormous challenges dropping swords after years of warfare; EMC executives show little humility and no deference to Big Blue--or vice versa.

At the Boston conference, CEO Joe Tucci compared IBM's strategy for selling Shark systems to the McDonald's Happy Meal--a popular but bland fast-food kiddie plate. He said IBM peddles its software and other products as its "burgers and fries" and passes out Sharks like the plastic toys that accompany meat and potatoes.

"In their Happy Meal, they're giving away a Shark," Tucci told scores of analysts and investors gathered at the event.

The comment enraged executives at IBM's headquarters in Armonk, N.Y. Storage chief Linda Sanford introduced dramatic enhancements to the Shark in December. The product was finally picking up new customers and stealing market share from EMC.

"Shark--the product EMC insiders once foolishly likened to a McDonald's Happy Meal toy--has been eating EMC's lunch," one IBM employee quipped in an e-mail.

Bitter blood aside, EMC's management has taken a hard-line, independent stance for years, and any major acquirer could face daunting hurdles, said Brion Tanous, analyst with Wells Fargo Van Kasper.

"I would imagine if they could ever pull it off, IBM would want to buy EMC, but I think EMC would do everything in its power to keep that from happening," Tanous said.

Some analysts and insiders say EMC's most likely option is not to be acquired but to embark on a series of strategic partnerships, joint ventures and smaller deals. Such deals are becoming increasingly common throughout the storage sector.

EMC and Dell Computer began talking last month regarding a deal for the computer maker to resell some of EMC's storage hardware and software. In April, Sony cut a deal to use EMC's lower-end storage products as part of computing equipment it sells to broadcasting companies needing to edit videos digitally. Sony said it would sell EMC's Clariion products re-branded with its own logo as part of its XPRI editing system.

In August, Sun announced plans to resell Hitachi Data Systems' high-end storage setup--a deal that puts pressure on EMC, whose Symmetrix storage systems can attach to all the major server companies' products. About a quarter of EMC revenue comes from attaching storage to Sun servers, and Sun wants some of that revenue back.

The Sun-Hitachi deal added steam to Hitachi's campaign to convert from a mainframe company to a storage company and compete directly against EMC. As a result of increasing competition, EMC has been cutting prices aggressively to retain market share--dissolving profit margins and subsequently laying off employees to compensate.

EMC, which ended the July quarter with cash and short-term investments totaling almost $2.6 billion, could decide to continue down a path of minor software company acquisitions. EMC has bought seven software companies in the last 20 months, most recently snagging privately held performance-monitoring software company Luminate Software for $50 million cash.

EMC eventually might even be willing to sell parts of its business, said Robert Montague, analyst with Dain Rauscher Wessels.

"Often in tech cycles...the hardware in time commoditizes and provides the infrastructure for software to provide the value," Montague said. "Strategically, EMC is trying to become more of a software and services company."

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