EMC's Data Domain Acquisition: A Sign of Desperation

At the turn of the century, EMC Corporation (NYSE: EMC) was marked out as a company that would dominate the tech landscape thanks to its towering presence in storage networks.

It followed a model made successful by Cisco Systems (Nasdaq: CSCO): multiple tuck-in acquisitions in related areas and technologies to increase scale and addressable market size. It achieved considerable success over the last five to six years using that strategy.

Revenue and Operating Profits from 2003-08

Source: Gridstone Research

As tech spending increased at a healthy pace, an increased addressable market meant better top-line and bottom-line growth thanks to operating leverage. But, as with any strategy, the true test is when the chips are down.

Revenue and Profits - Last Twelve Quarters

Source: Gridstone Research

Revenue in the last two quarters has been below or at 2007 levels and revenue growth has been hard to come by. The saving grace for EMC is that with its increased installed base of products, services revenue was growing despite a fall in product revenues over the last four quarters.

Revenue and Profit YOY Growth - Last Twelve Quarters

Source: Gridstone Research

This is not sustainable as only more product sales will beget more service revenues since EMC's service revenue streams - maintenance, installation fees etc. are not recurring revenue streams in the long-term.

In its defence, the acquisitions were to diversify revenue by not depending solely on storage box sales and related services. EMC's game plan was to move from only box sales to increasing its share of the dollars that went into managing storage networks that were becoming bigger and more complex.

It does sound nice on paper but this goal has also been only partially achieved as storage sales continue to be a dominant chunk (~70%) of revenues. All technologies and product areas which sounded promising a year or two back, like content management, faced growth pressures in the last two quarters.

Segment Revenues - Last Twelve Quarters

Source: Gridstone Research

As seen below, none of the segments have grown at an impressive pace in the last two quarters. In fact in June 2009, storage revenue had had better sequential growth than other segments.

Sequential Segment Revenue Growth -March 2007 Until June 2009

Source: Gridstone Research

Moreover, EPS has tracked operating income indicating that the product sales decline and resulting decline in net operating profits will have telling effect on EPS if things don't improve.

Operating Income and EPS -September 2006 Until June 2009

Source: Gridstone Research

It's not that only total profits have declined but margins have also declined consistently (on a YOY basis) over the last three quarters, showing that whatever expense reductions that EMC boasts of are still not helping at the EPS level.

Operating Margins: YOY Change in BPS - March 2007 Until June 2009

Source: Gridstone Research

From the above charts, it becomes evident that the only way EMC can please investors is to add more revenue streams and allow the after-effects to find its way to the operating income and EPS level. Margin/profit expansion on the same set of revenue streams seems a tough ask for EMC. Though the the past acquisitions have clearly fizzled out in helping EMC sustain profits, EMC has little options in this front but to acquire and grow.

But what is perplexing is the target - Data Domain (Nasdaq:DDUP) - and the lengths to which EMC has gone to acquire the target. At its offer price of $33 per share, the offer was seven times sales (revenue per share for DDUP was ~$4.9 in March 2009) and clearly on the expensive side. Also, EMC came into the fray post NetApp's (Nasdaq: NTAP) initial offer. The acquisition price seems even more ridiculous when we look at DDUP's margin profile in the last 5-6 quarters

DDUP - Revenue and Margins in Last Six Quarters

Source: Gridstone Research

While I do understand that the de-duplication technology that DDUP possesses has great potential, and don't disagree with EMC's claims that DDUP will help them to be leaders in "next-generation archiving", DDUP's recent quarter results do not promise scorching growth rates beyond a year or two.

Just to give a perspective, EMC paid ~$613M in January 2004 to acquire VMWare (VMW) which roughly added $387M of revenues and $131M of operating profits to EMC's kitty in 2005. In 2004 itself (the year of the acquisition), VMWare added $218M to EMC's topline - a acquisition price to sales multiple of ~3X. Compare that to the 7X multiple for DDUP, a company which churned out $16M in operating profits in 2008.

What is even more perplexing is that EMC trades at a P/E multiple of ~27 (as of the July 27 close price of $15.13) when there are question marks as to whether EMC can sustain long-term growth in EPS at even double digits. Add a pricey acquisition to that and it a clear sign that desperate times called for desperate measures from EMC.

Is the market expecting EMC to make more pricey acquisitions and then do a 'VMWare' (windfall profits through stake sale) to all these acquisitions? Other than that, there could be no justification for EMC's current market price

Disclosure: No positions

Comments

[tkane90]

This analysis needs to be done in a way that compares other players in the industry over the same time period. For the past twelve months we've been in a gobal recession (hello!) and most companies in the tech sector are struggling regardless of the business strategy. The real question is about how well placed EMC is today versus competitors to take advantage of a spending upswing when the economy rebounds. Any thoughts on that?
-tk

2009 Jul 28 08:55 AM

[Naveen Selvaraj]

I agree. But making expensive acquisitions is not the way out,especially during a downturn. So, my argument is that EMC should acquire -but not at any cost.

On Jul 28 08:55 AM tkane90 wrote:

> This analysis needs to be done in a way that compares other players
> in the industry over the same time period. For the past twelve months
> we've been in a gobal recession (hello!) and most companies in the
> tech sector are struggling regardless of the business strategy.
> The real question is about how well placed EMC is today versus competitors
> to take advantage of a spending upswing when the economy rebounds.
> Any thoughts on that?
> -tk

2009 Jul 28 03:39 PM

[doodoo]

What was EMC supposed to do with their billions in cash just set on it and do nothing.If they can make money by buying a co. then why not do it?Emc did a pretty good job when they bought VMW for $600m.That purchase is now worth $13b but you write that now they are desperate and must buy to survive.Don't understand your thinking.EMC is building a strong stable of products and thats what all co. should be trying to do.You figure it out.

2009 Jul 28 03:46 PM

[yyovel]

I think there is a sent of desperation here. De-duplication technology is an important piece of optimizing storage capacity. it has been around for a while, and is being offered by other companies. Risking over-simplification it can be viewed as a "feature" of a backup platform or a primary storage system. Data Domain made a storage company out of that "feature" and targeted mid-size businesses with an all-in-one backup appliance (and then primary) storage offering.

EMC and NTAP competed not only for the technology but also for the company DNA: building a lightweight, cost-effective storage platform for the mid-market that companies love to love. Is it worth going into a bidding war for? I would say not, EMC and NTAP obviously think otherwise.

2009 Jul 28 06:10 PM

[dstorm]

EMC is projecting the deduplication market to grow to $10B/yr. Data Domain had an estimated 50% share of the target-based deduplication market. It seems to me that EMC believes their projection and wants to own that space. If they can own 20%-30% of the future $10B/yr. market and make decent margins, then they will see good growth and a return on their DD investment.

2009 Aug 05 02:49 PM

[ranco]

While I agree with some of you and disagree with others, I am an EMCer, and live in the belly and see how things are changing internally. While the Author has an angle and your responses make sense too, I would share with you some of the insights,...

EMC had no choice but to acquire DD since NTAP jumped and wanted to close the deal. DD for EMC was the last piece of a long chain of complemented products, which is now complete. EMC line of products, in my humble opinion, are complete. I am part the delivery team, and I see a tremendous increase in our PS (prefessional services) delivery driven towards packaged deals (Storage, Virtualization, and DDUPing all in-one).

Thats the positive part, the negative part is, I am seeing a slow down in sales. No sales means less delivery, means less revenue, means less profit, and so on. I am seeing more consolidations services, than expansion services (PS delivery), and I am seeing more downsize than upgrades POs (DMX to CX platforms). This is where I agree with the Author a little. The move to spent an extreme amount of cash just so that EMC does not lose DD as its last piece of the chain, is a sign of extreme need, but hold on a minute here... a need that is much wanted! DD products will actually fix if not terminate the "not so good" EMC deduplication product, which has a bad reputation all over the market, and does not have an appeal, once it is presented during a pitch meeting.

Bottom line, EMC now has a golden opportunity to strive in the DDUPing industry and will operate in an almost MONOPOLY like market, where competitors will be seriously a little minority..

The questions is: will EMC sell stakes just to make out the cash spent in recent years? again in my humble opinion, I think that would be a mistake. While the economy is down, EMC must now take adavantage of the market and begin pushing even harder (sales) and refine some of its existing products, and keep bringing enhancements while competitors are either recovering or busy competing.

-EMCer

2009 Aug 09 07:55 PM