EMC (EMC) has delivered outstanding top and bottom line growth in the previous years. However, the growth slowed down significantly in the recent quarters, and forward estimates are not much higher. EMC's share price did not make much headway since early 2011, even though the stock's valuation is way down, making it look cheaper than it was more than two years ago. However, the picture might be distorted with the above mentioned growth slowdown, and there are other negative factors that need to be considered.
Growth slowdown and improving operational efficiency
EMC was delivering double-digit earnings and revenue growth until the second quarter of 2012. Since then, revenue has grown between 5% and 9%, while adjusted earnings growth was between 4% and 12%. At the same time, the company's operational efficiency was gradually improving, with non-GAAP gross margin expanding from 60.3% in 2010 to 64.5% in 2012 and non-GAAP operating margin improving from 22% to 24.9% in 2012.
The growth slowdown can be attributed to the weak economic recovery and other headwinds that will be addressed later. EMC seems to be reaching a mature stage, with steady and slow growth seen ahead, and with its size making it harder to grow at a faster rate. In the chart below, you can see that the company's valuation has been adjusting to its growth rates. While earnings and revenue were growing more than 20%, EMC had a P/E ratio north of 30. Since early 2011, the market has been discounting the company's growth slowdown, and giving it a lower valuation along the way. EMC's current valuation may seem compelling, with a 12.5 forward P/E, but we should be interested in the stock's upside potential, which seems limited due to the company's lower growth rates.
EMC P/E Ratio TTM data by YCharts
Competition is getting tougher
The competition seems to be getting tougher for EMC. Morgan Stanley's analyst Scott Davitt asserted earlier this year that Amazon.com's (AMZN) Web Services is an "emerging IT mega vendor." Amazon Web Services will likely grow through the combination of greater scale of services and lowering prices, pressuring other competitors. Slower storage revenue growth is to be expected than it was in recent years, while the virtualization market could also be negatively affected, with VMware (VMW), which is majority owned by EMC, and Red Hat (RHT) at threat. This latest notion seems to be turning out to be true, as Red Hat reported lower than expected August quarterly billings and provided weak revenue guidance. Red Hat's share price was sharply lower following the earnings report, and did not manage to recover as of this writing. EMC's share price was down too on that day, with Barclays downgrading the stock, citing the stock being close to its price target and indicating that storage demand faces long-term headwinds.
EMC's management is upbeat
In the second quarter report, EMC's management was optimistic and satisfied with VMware's and Pivotal's progress. The creation of Pivotal was my reason to get more optimistic on EMC's future in mid-March. The stock performance since then was mixed, but the price is higher than it was in mid-March. Both Pivotal and VMware are delivering double-digit revenue growth. VMware is doing well, with its growth accelerating, and the company beat earnings and revenue estimates in the second quarter.
Pivotal and VMware announced in late August that they are partnering to co-develop Pivotal CF, a commercially supported hybrid Platform as a Service (PaaS) based on the Cloud Foundry Platform. The platform will be made available later this year. This platform will enable customers to use PaaS technology to accelerate time to market for new applications deployed on-premises. The two companies will continue with their efforts to expand the options developers have for its use. So, it is not all bad news, and EMC has two great projects (Pivotal and VMware) that are still delivering double-digit revenue growth, and should help EMC to try to grow more in the future.
EMC's growth is slowing down and it is driving the valuation down. With earnings growing in single digits, the upside seems limited. I don't see the stock trading more than 10% to 15% in the next six to twelve months. The downside seems limited, as the stock is pretty fairly valued, and EMC will probably trade in a tight range in the intermediate term. Things need to get much better for EMC to get past its long-term resistance around $30 any time soon, or to turn much worse for the stock to break down precipitously.