Dell surprised many observers last week when it said that it plans to buy storage start-up EqualLogic for around $1,4bn in cash.
One reason for the surprise is the price it is paying for such a small company, which although very fast growing still only has an annual revenue run-rate of around $140m. Another is that the purchase will take Dell into the realm of technology development for the very first time.
Dell has highlighted the fact that EqualLogic's disk arrays are iSCSI devices. Importantly, the devices can only be attached to storage networks or servers by iSCSI, and this means that Dell is betting $1,4bn that iSCSI will eventually develop beyond its current status as a minority technology.
But iSCSI is far from their most distinguishing characteristic of EqualLogic's products. Every major storage vendor including Dell and its OEM partner EMC has been supplying iSCSI-attached disk arrays for some while.
The most significant quality of EqualLogic's technology is their use of disk virtualisation software to provide much simpler management and scalability that conventional disk arrays. EqualLogic's technology and architecture is similar that which start-ups such as 3PARdata, LeftHand Networks, Pillar Data Systems and Xiotech have used to create businesses within a consolidating storage market.
Dell's planned purchase makes it the first tier-one supplier to own such technology.
In the short term, Dell's move does not have strong potential to significantly alter the revenue that the company earns for EMC. But in the long term, it will seriously alter its relationship with EMC, by turning Dell into a competitor with EMC.
Founded in 2001, EqualLogic brought its first product to market in 2003.
The cheapest of the company's disk arrays carries an all-in list price of $22 500 for a 2 TB set-up. The typical sale is around $50 000, and the largest single implementation spans over 120 TB and cost over $500 000, according to EqualLogic.
The start-ups arrays feature iSCSI front-end ports, a multiple controller architecture, and sophisticated virtualisation software.
Ease of both management and scaling are the most important qualities of EqualLogic's gear, according to Curtis Preston, vice president at storage consultancy Glasshouse Technologies, who described the devices as 'very impressive'.
By this summer EqualLogic was claiming 2500 customers worldwide.
The start-up's revenue has been growing correspondingly quickly, moving from $30m in 2005 to $68m last year. Based on those numbers and what the company has declared so far this year, revenue for 2007 is likely to be around $120m to $160m.
In its S-1, EqualLogic says its revenue for the first quarter of 2007 was $24m, with a net loss of $1m.
Assuming an EqualLogic revenue run-rate of say $140m per year, Dell has agreed to pay a price equal to around 14 times revenue.
That might seem a shockingly high multiple to some. As a comparison, EMC paid around six times revenue when it bought VMware. Despite the fact that VMware like EqualLogic was then doubling its annual revenue, some thought EMC had paid over the odds.
Time told differently. EqualLogic may never grow to the size and importance of VMware, but Dell might have calculated that it was cheaper to agree to buy EqualLogic before the start-up completed the IPO for which it filed an S-1 registration this summer.
After the IPO or stock market debut, Dell would have had to pay whatever market capitalisation EqualLogic reached, plus a premium of around 20%. As an example of storage start-up market valuation, Data Domain which has a revenue run-rate of around $120m - is currently valued at $1,9bn.
The price that Dell paid for EqualLogic may very well have been inflated by competing bids or interest real or feigned - from other suppliers such as EMC or Hewlett-Packard.
A lever against EMC
Storage currently only accounts for around 4% of Dell's revenue.
But that was enough to make Dell the fifth largest external disk array providers during the second quarter, and give it an 8% share of global revenues, according to IDC.
Most of that revenue came from the sale of products originally designed by EMC. The fact that EMC is Dell's only major OEM supplier of disk arrays does not fit well with Dell's business model, part of which involves developing multiple sources for components or products in order to squeeze the best prices from suppliers.
But it was not obvious how Dell could introduce a second source of disk arrays that would be sufficiently distinct from its EMC-originated devices to avoid confusion for its customers and sales force.
If, for example, Dell had taken on products from LSI or DotHill to compete with its mostly mid-range EMC-originated disk arrays, Dell would have ended up with two lines of non-interoperable but functionally very similar devices in its portfolio. (The array technology that Dell OEM's from LSI is limited to a low-end device that carries list prices starting at only $5000).
No two vendors' disk arrays are interoperable, and EqualLogic's devices are also non-interoperable with EMC's arrays. But because of the virtualisation software, and their lack of Fibre Channel front-end ports, they are quite distinct from EMC's disk arrays.
How much of EMC's revenue is at risk?
Since 2001 when EMC and Dell struck their re-branding and re-selling deal, the proportion of EMC's revenue that has come from Dell has been inching up. By the third quarter this year it had reached 16%.
Now much of that revenue is at risk, because Dell will want to sell more of its own EqualLogic-originated gear than EMC's equipment.
It is not the entire 16% Dell revenue that is at risk however, because EqualLogic's gear cannot compete with all of the EMC products that Dell sells, which includes EMC's VMware software and Symmetrix high-end disk arrays.
What is at risk is only the revenue that comes from Dell's sale of EMC-originated Clariion mid-range disk arrays. EMC does not break out the numbers needed to calculate how much revenue that is, but one informed source claimed that it is only around 5% to 6% of EMC's total revenue.
Limited short term threat to EMC's revenue
In the near term, Dell's ability to persuade customers to stop buying Clariions and start buying EqualLogic boxes will be limited by the fact that there are barriers to adopting new disk array suppliers such as the lack of interoperability between different vendors' devices, and the expense of training staff to use new equipment.
That momentum will guarantee that no matter how attractive EqualLogic's gear, Dell will be selling EMC's mid-range storage for quite some while yet.
There is also the issue that the EqualLogic gear features only iSCSI front-end ports. Although EqualLogic and other analysts and consultants including GlassHouse insist that iSCSI is capable of serving most applications, not every customer will agree. Many in any case will want storage that they can easily connect to their existing Fibre Channel storage networks.
The longer term threat
Momentum does not last forever, and in the longer term, wider developments will help Dell persuade more customers to switch to EqualLogic's gear.
The first will be the increasing acceptance of iSCSI as a storage networking protocol. iSCSI-connected storage is still only small beer compared to the overall market for networked storage, but it is approaching the critical mass at which its take-up should accelerate sharply.
According to IDC, revenue from the sale of iSCSI-connected external disk arrays totalled just $191m in the second quarter, or 6% of the combined SAN and NAS market.
But that figure was up nearly 60% year-on-year, and does make credible a claim by EqualLogic that iSCSI disk sales will total $1bn this year.
IDC has already predicted that from 2006 iSCSI sales will show 61% CAGR to reach $6bn in 2011.
There are caveats. IDC has been wrong about iSCSI take-up in the past. 10 Gbit Ethernet over optical fibre is still very expensive, and even the Ethernet Alliance marketing organisation is currently describing 10 Gbit Ethernet on copper as a 'bleeding edge' technology.
But iSCSI will certainly continue to be taken up, and Dell's backing for the technology in itself will help accelerate that process.
The second factor in Dell's favor will simply be market exposure to the benefits of disk virtualisation. Like iSCSI, storage virtualisation has been slower to achieve market acceptance than expected. But it has also been the technology that has allowed EqualLogic and a handful other start-up disk array makers such as 3PARdata, Pillar Data Systems, Xiotech and LeftHand Networks to claw themselves a share of what was otherwise a consolidating market in which the biggest five suppliers have been slowly increasing their grip.
A channel extension
Dell will also gain the 500-plus resellers that EqualLogic has signed up. It remains to be seen how many of these will actually continue to sell EqualLogic's gear and risk a relationship with Dell that could allow the server giant to step into their customers' accounts and steal their business.
Early reports suggest that some resellers are very wary, and one of EqualLogic's start-up rivals told ComputerWire that it is confident that it can benefit from defections to its camp.
One source told ComputerWire that despite Dell's relationship with EMC, Dell is still not able to close large storage deals without the help of EMC specialists. If that is so, Dell may feel under a lot of a pressure to try to hold on to as much of EqualLogic's channel as possible.
Dell is not saying how it will handle EqualLogic after the acquisition is completed, and there is a possibility that EqualLogic will be left to run as an independent company, kept at arms' length in order to keep resellers on board.