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EMC Corporation (NYSE:EMC) released its third quarter results before the market open on Tuesday. The results were quite soft and missed consensus estimates. Yet the sell-off, combined with the after-hours spike in shares of VMware (NYSE:VMW) on Monday, might offer investors a unique opportunity to apply relative arbitrage.

The drop in EMC's shares and jump in VMware's shares implicitly means that EMC's legacy assets trade at a 33% discount in pre-market trading on Tuesday. This is based on a 10% jump in VMware's shares to $91 per share and a 4% sell-off in shares of EMC, at around $24.25 per share.

If one can execute at these levels, an arbitrage spread to buy EMC and sell VMware might be extremely profitable in the short to medium term.

Third Quarter Results

EMC generated third quarter revenues of $5.54 billion, up 5.0% on the year before, but quite badly missing consensus estimates of $5.80 billion.

Operating income rose by little less than a percent to $907 million. As a result of notably higher interest expenses, net earnings fell by 6.4% to $586 million.

As a result of modest share repurchases over the past year, earnings per share fell by just a penny to $0.27 per share. Non-GAAP earnings of $0.40 per share, missed consensus estimates by $0.05 per share.

CEO and Chairman Joe Tucci commented on the performance, "We leveraged the unique power of our business model in the quarter to expand our technology portfolio, strengthen our partner ecosystem and extend our leadership in cloud computing, Big Data and trusted IT. Despite our disappointment with our quarterly results, our confidence in the success of our strategy over the long term has never been stronger."

Looking Into The Results

Revenue growth over the past quarter was mostly driven by services. Service revenues were up by 8.2% to $2.37 billion as product revenues rose by just 2.6% to $3.16 billion. Operating income rose by just 1% as EMC saw cost increases outpace revenue growth, notably in the cost of services as well as selling, general and administrative expenses. As a result, operating margins fell a full 66 basis points to 16.4% of total revenues.

Outlook

For the year of 2013, EMC now sees consolidated revenues around $23.25 billion, up 7.0% on the year before. GAAP operating income is seen around 18% of total revenues, or around $4.2 billion. Revenues missed the previous guidance of $23.5 billion in annual revenues and consensus estimates at $23.44 billion.

GAAP net earnings are seen around $2.9 billion, with non-GAAP earnings seen at $3.9 billion. As such, GAAP earnings are seen around $1.33 per share, as non-GAAP earnings could total $1.80 per share.

Previously, EMC guided for full year non-GAAP earnings of $1.85 per share, as consensus estimates had risen to $1.86 per share.

Valuation

EMC ended its third quarter with $10.6 billion in cash, equivalents and short-term investments. The firm operates with $7.2 billion in total debt, including $1.7 billion in convertible debt, for a net cash position of around $3.4 billion.

For the first nine months of the year, EMC generated revenues of $16.54 billion, up 5.5% on the year before. Net income advanced slightly to $2.00 billion.

Factoring in losses of 4% on Tuesday, with shares trading around $24.25 per share, the market values EMC at roughly $50 billion, or operating assets around $47 billion.

This values operating assets of the firm around 2.0 times annual revenues and 16 times annual earnings. EMC pays a quarterly dividend of $0.10 per share, for an annual dividend yield of 1.6%.

Some Historical Perspective

Long-term holders in EMC have seen great returns and they should thank EMC for that by acquiring VMware back in 2004. Shares roughly doubled in 2007 alone to highs of $25 as the company sold a portion of its stake in VMware through an initial public offering. Shares fell back to levels as low as $10 by 2008 and 2009 to see a steady recovery to levels around $20-$30 in recent times.

Between 2009 and 2012, EMC has managed to increase its annual revenues by a cumulative 55% to $21.7 billion. Net earnings rose by some 150% to $2.7 billion in the meantime. Note that both revenues and earnings are expected to increase further into 2013 following EMC's full year guidance.

Investment Thesis

Interestingly enough, VMware itself reported its third quarter results on Monday after the close. For the first nine months of the year, VMware generated revenues of $3.72 billion on which it net earned $679 million. At the same time, VMware fetches a market capitalization of nearly $40 billion in after hours trading, as shares are trading with gains of 10% in after-hours trading.

Given that EMC still holds a 79.5% stake in EMC, its stake alone is worth around $32 billion. Given the 10% jump in VMware's shares, the value of EMC's stake alone would have increased some $3 billion on the back of the news report. It is therefore really interesting to see shares of EMC fall by 4% pre-market, reducing the market capitalization of EMC by some $2 billion to $50 billion.

That means that the gap between EMC's and VMware's market capitalization has narrowed to just $11.5 billion overnight, down from some $17 billion on Monday's close. This seems insane given the fact that EMC guides for full year revenues of $23.2 billion on which it expects to earn $2.9 billion. Now even if we subtract 100% of VMware's contribution from these numbers we still end rather favorably.

VMware could generate annual revenues of $5.2 billion this year on which it could earn roughly $1 billion in earnings. This means that EMC's legacy businesses, notably the infrastructure business would generate revenues of $18 billion this year, on which it could earn around $2 billion. Note that I arrive at these numbers by simply subtracting VMware's revenues and earnings from the full year forecast of EMC. As such, the current $11.5 billion valuation seems incredible cheap.

Therefore, the $6 billion buyback program, being authorized by the board, should run at full speed on Tuesday. The current valuation, in the light of the earnings releases of both companies heavily favors EMC over VMware.

This invites potential investors to initiate a long EMC, short VMware spread, to "lock" in the valuation of EMC's legacy assets. The recent initiation of a dividend, leaves the potential for further dividend hikes given the low payout ratio. The sizable share repurchase program, which should be sufficient to retire 11-12% of EMC's shares, will furthermore work in your advantage.

Depending on Tuesday's price action, and the relative valuation of EMC's legacy assets I might initiate a long EMC, short VMware position.

Source: EMC - Tuesday's Correction Offers Great Relative Value Arbitrage Vs. VMware