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EMC Corporation (NYSE:EMC)

Q3 2013 Earnings Conference Call

October 22, 2013 08:30 AM ET

Executives

Joseph M. Tucci - Chairman and CEO

David I. Goulden - President and COO

Tony Takazawa - Vice President, IR

Analysts

Kulbinder Garcha - Credit Suisse

Brian Marshall - ISI Group

Ittai Kidron - Oppenheimer

Brian Alexander - Raymond James & Associates, Inc.

Aaron Rakers - Stifel Nicolaus

Maynard Um - Wells Fargo

Keith Bachman - BMO Capital Markets

Alex Kurtz - Sterne Agee & Leach

Lou Miscioscia - CLSA

Operator

Good morning and welcome to the EMC Third Quarter 2013 Earnings Conference Call. All parties are in a listen-only mode until the question-and-answer portion of the call. As a reminder, this conference is being recorded. If you have any objection, you may disconnect at this time.

I’d now like to introduce your host, Mr. Tony Takazawa, Vice President, Global Investor Relations of EMC.

Tony Takazawa

Thank you. Good morning. Welcome to EMC’s call to discuss our financial results for the third quarter of 2013. Today, we’re joined by EMC Chairman and CEO, Joe Tucci and David Goulden, EMC President and COO.

David will begin with a few comments on our results and provide a bit more detail and color around the factors contributing to our results. He will also discuss our outlook for the year 2013. Joe will then spend some time discussing his view of what is happening in the economy and IT, EMC’s vision and strategy and our results this quarter.

After the prepared remarks, we’ll then open up the lines to take your questions. We are providing you with our updated projected financial model for 2013. This model is out all of the key assumptions and discrete financial expectations that are the foundation of our outlook this year. We hope that you find this model helpful in understanding our assumptions in context and in ensuring that these expectations are correctly incorporated into your model. This model is available as background in today’s slides available for download in the IR sections of emc.com.

Please note that we’ll be referring to non-GAAP numbers in today’s presentation unless otherwise indicated. The reconciliation of our non-GAAP comments to our GAAP results can be found in the disclosure in today’s press release, supplemental schedules, and the slides that accompany our presentation. In addition, all financial comparisons will be on a year-over-year basis unless otherwise indicated.

As always, the call this morning will contain forward-looking statements and information concerning factors that could cause actual results to differ can be found in EMC’s filings with the U.S. Securities and Exchange Commission.

With that it is now my pleasure to introduce David Goulden. David?

David I. Goulden

Thanks, Tony. Good morning everyone and thank you for joining us today. By now you all have seen our financial results for the quarter. Q3 was very much a tale of two cities. On the positive side, we achieved almost all our strategic and operational goals in the quarter and there is a lot to like. But on the less positive side there were two big challenges we couldn’t overcome, which had a direct impact upon our financial results for the quarter.

Third quarter 2013 revenues were a little over $5.5 billion and earnings per share was $0.40. This revenue was below our expectations for the period by approximately $250 million, principally driven by two major factors both of which impacted storage product revenue. The first was a very late timing of orders in the quarter. The second was U.S Federal Government’s spending. I will walk you through each of them.

For the past several quarters we’ve seen cautioning customer spending, leading to increased scrutiny and extended close cycles and this continued in Q3. The result was another very backend loaded quarter. Specifically more storage products than we expected came in on the very last day of the quarter, which as you know was a Monday making fulfillments to these orders in Q3 extremely difficult. As a result storage product orders we received that we didn’t ship in the quarter were $100 million higher than we expected.

Now turning to the second factor. Many storage product orders from the U.S Federal Government that were expected to close in the last weeks of the quarter did not, due to less than expected year end budget money and unexpected reprioritization of these year end budgets ahead of the federal government shutdown. This accounted for approximately $120 million of revenue shortfall against our expectations. To put some perspective around this, after relatively flat first half storage spend with us by the U.S Federal Government, Q3 spending was down significantly year-on-year on what is the biggest and most important quarter for U.S federal spending.

Together these two factors accounted for the vast majority of the Q3 revenue shortfall versus our expectations and this revenue shortfall directly impacted our EPS results for the period. While we’re disappointed with our reported results in the quarter, our confidence in the success of our strategy over the longer term is as strong as its ever been.

You might be asking what was driving this confidence. Well there are number of things. First was the trend in our storage product bookings growth rate, excluding U.S federal storage product bookings growth accelerated in Q3 to the high single digits, the highest rate we’ve seen all year. This was through globally as well as for each of the Americas, EMEA, and APJ. This positive development in demand bodes well not only for EMC, but for the storage market as a whole. There is also what we accomplished in the quarter.

Key strategic areas of our business including our emerging storage business, our service provider partner program VCE and VMware all had accelerating year-on-year growth once again in Q3. Pivotal continue to execute well on its roadmap, collecting Whitehouse wins and preparing the launch of Pivotal 1 this quarter.

On the successful launches of ViPR, our new Data Domain platforms and our next generation VNX in Q3 further enhance our value proposition for our customers.

Finally, we are confident simply because of what our customers are telling us. We stay close to listening to our customers and they’re demanding ever greater value from their IT spend. The good news is our technology goes a long way towards making customers more efficient and their response to our relentless focus on continuing to deliver this value.

This dedication to customer success is a whole mark across EMC, VMware and Pivotal teams indispensable to our strategy and a key driver of our market share gains, which we believe continue in Q3. The takeaway is that while global IT spending continues to be lackluster and the situation with the U.S government has not made things easier, our portfolio of offerings combined with our business model put us in an advantage position to help customers transform their IT to fully optimize cloud, Big Data and trusted IT.

Looking at our results in more detail, year-on-year revenue growth in the quarter was 5% to $5.5 billion and 6% in constant currency. In spite of this quarter’s challenges our information infrastructure and information storage businesses grew and growth of Pivotal and VMware accelerated. All four of our major geographies grew as well, with North America up 3%, EMEA up 8%, its highest growth rate this year, APJ up 8%, 12% ex-Japan and Latin America up 13% from last year’s third quarter. Our BRIC+13 emerging markets grew at 19%, also its highest growth rate for the year.

Our storage product revenue shortfall in Q3 hurt our gross margins. On a consolidated basis, gross margins were down 40 basis points from Q2, the higher mix of VMware revenue in a quarter helped, but not enough to offset the impact of reduction in volume from last quarter.

Non-GAAP operating expenses were flat versus Q2. We continue to invest in key areas across the federation, including ViPR and XtremIO and EMC II, the software defined data center, VCHS, end-user computing of VMware and building the platform for next generation application developments at Pivotal.

Our tax rate was slightly lower than in Q2 effectively offsetting the impact of non-operating expense or non-GAAP EPS which came in at $0.40 for the quarter. Free cash flow in Q3 grew 26% year-on-year to $1.4 billion bringing our year-to-date free cash flow to $3.7 billion, up 6% against a comparable period last year.

Free cash flow is an important driver of our shareholder returns and in May we enhanced our capital allocation framework to enhance our returns to shareholders by directing half of our U.S.-based free cash flow at VMware to dividends and buybacks, returns to shareholders grow as the business grows over time.

As part of this new framework we were pleased to pay our first ever quarterly dividend in Q3. We also repurchased $1 billion worth of EMC stock in the quarter and this brings our buyback to $2 billion for the first nine months of the year, more than halfway to our $3.5 billion share repurchase target for the 18 months ended June 30, 2014.

We also spent approximately $400 million on acquisitions in the quarter and in Q3 with $17.5 billion in cash and investments, $8 billion of which is in the U.S. excluding VMware. 1.7 of this will be used to settle our remaining [ph] convertible bond in January.

Looking across the federation to get a better understanding of what happened in the quarter, let's begin with the EMC II business starting with storage which grew 1%. While we expected growth in our high end storage business to moderate in the second half of this year as we annualized the refreshed VMAX. The disruption to our federal government business added significantly to this headwind. VMAX continues to present unique value proposition to customers and added net new customers yet again in Q3.

Year-to-date, we've added more new VMAX customers down for the comparable period last year. The 10-K and 40-K continue to exhibit the strongest results and Flash penetration on new systems continues to climb reaching 70% in Q3. Our innovations on VMAX make a difference with customers such as a large telecom provider in Europe. This customer was looking to consolidate on the best-of-breed infrastructure for their storage as a service offering and selected VMAX to displace two competitors and serve as a platform of choice for their customers.

As this example illustrates the reason for selecting VMAX are as compelling as they've ever been, scaling mission critical workloads with the best reliability and availability VMAX meets requirements that other offerings cannot.

Our unified and backup recovery portfolio grew 3% in Q3 impacted by the fact that this significant majority of this quarter's higher than expected un-chipped orders were in this business. Our unified storage business benefited from the very successful global launch in September of our next generation VNX. The press, industry analysts and most importantly our customers and partners received a new VNX with enthusiasm. This was evidenced by their rapid transition to the new systems where almost 35% of the new VNX ordered in September were for the next generation VNX and by the end of the quarter, this mix had reached about 50%.

This rapid uptake is not surprising as the new VNX represents a breakthrough in unified storage delivering over four times the performance of its predecessor across file, data base and virtualization workloads. Key to this breakthrough is the new NCX software which enables the VNX controller to take full advantage of Intel multi-core processing power. By uniformly distributing data services across all cause, customers avoid controller bottlenecks that can hamper the performance of other mid-tier systems.

This is especially important for maximizing the potential Flash in the array and the new VNX is optimized for Flash which is clearly important as approximately two-thirds of the new gen VNX is sold in the quarter including Flash drives. This is a significantly higher rate than the previous VNX family.

Our backup and recovery system business did quite well in Q3 despite a higher than expected level of un-chipped data domain orders existing the period. BRS growth was driven by our data protection suite together with our recently refreshed line of mid-tier data domain products which accounted for approximately 75% of mid-tier data domain orders in the last week of the quarter.

EMC is the world's largest data protection company and we believe we continue to gain share because we have the broadest, best-of-breed portfolio of products. The new data domain systems are four times faster, 10 times more scalable and almost 40% lower costs than a prior generation enabling customers to consolidate all backup and archive data onto a single protection storage platform.

This is why one New Jersey based health insurer looked beyond the longtime backup software vendor to EMC in Q3. The incumbent could not scale to complete backups for their virtual machines within the schedule backup window. EMC data protection suites combined with data domain not only got the job done during the backup window but did so with integrated solution that lowers the customers total cost of ownership.

Our Emerging Storage business grew 66% in Q3 demonstrating how EMC is innovating in ways to enable customers to quickly and easily derive value as they build out their cloud and big data environments. With Emerging Storage, Isilon continued strong growth in Q3 and had the record number of new customers in the quarter. Isilon continues to expand in its established verticals as well as in broader enterprise used cases that are beginning to leverage scale-out NAS architectures.

For example, demand in health care and financials grew well over 50% year-on-year in Q3 for Isilon. Also of note in Q3, Isilon saw triple digit growth in big data analytics mostly for enterprise [indiscernible] implementations where Isilon scale and architecture is a natural fit. Several of these wins were achieved by teaming with Pivotal, an early sign of power of authoritative model. For example, a large mobile service provider in Southeast Asia was looking to capitalize on its customer usage demographics.

The majority of this day was unstructured but needs to be analyzed alongside CRM and back office data. This drove the customer to seek infrastructure that could offer both performance for [indiscernible] analytics as well as enterprise grade data services with Pivotal analytics and iPhone for the storage, the customer will now be able to create an enhanced personalized experience across their mobile services. As this example illustrates, iPhone's enterprise features are a growth driver and will be adding more enterprise class features with our next generation of OneFS which is on track for release this quarter.

Atmos also contributed to growth in the Emerging Storage group in Q3. Atmos is an object storage system that is being increasingly used by large web-scale providers and next generation application developers for its simple, scalable, globally distributed architecture. In fact it was with a web-scale customer that Atmos won its largest deal ever shipping almost half an exabyte to this single customer so far this year.

In Atmos, EMC offers one that few commercially available object storage systems and we believe our share in this market far exceeds our block and final market share. In 2014 our next generation Atmos systems will come to market as part of our Project Nile which we discussed in some detail September launch events.

Revenue from VPEX continues to grow a well over 50% year-on-year as it has done for the last several quarters. The global major businesses today and the drive to maximize system utilization are increasingly dictating a need for continuous operations around the world. This is exactly what VPEX often in combination with RecoverPoint delivers. Using this combination, businesses can now run mission critical classifications in truly active data center configurations enabling better utilization of information infrastructures.

Our storage business continues to benefit from our differentiated strategy leveraging Flash technology across the entire storage infrastructure. Flash has a significant role to play in our hybrid storage systems which are increasingly optimized to take advantage of Flash. For many workloads, hybrid arrays offer rich data services, low latencies and the most economical price points.

Our recently announced next generation VNX is an outstanding example of this. However, some workloads require sustained low latencies regardless of whether the array is idle, busy, empty or full. This is the domain of all Flash arrays and the reason why last year we acquired XtremIO. XtremIO is architected in a fundamentally different way than both hybrid arrays and any other old Flash array. These differences include true multi-controller scalar architecture delivering consistent and particular performance for any workload with any level of array utilization over any period of time.

Deduplication that is always on and always in line. Metadata that’s always stored in memory to minimize rights and allow near instantaneous cloning a virtual machines and flash optimized data protection which is both faster and dramatically more efficient than traditional RAID. I want to be clear that XtremIO is the only all-Flash array architecture with all these mind and this represents a key advantage for EMC and our customers. XtremIO will GA this quarter and we’re confident it will be very successful.

My review over last few minutes of EMC’s storage offerings illustrates the broad spectrum of technology required to run a set of highly diverse workloads. It also speaks the complexity of the underlying storage infrastructure, and this is why we search sites about ViPR which GA last month. EMC ViPR delivers software defined storage and consists of two distinct components, the ViPR Controller, and the ViPR Data Services. The ViPR Controller reduces complexity in today's storage environment by abstracting and standardizing the management of EMC and non-EMC arrays. Because of this the storage infrastructure can be highly automated and accessed through a self-service portal enabling IT departments to offer simple, public cloud like experience for application owners.

ViPR Data Services provide new storage functionality in software on top of existing EMC arrays, non-EMC arrays and early next year commodity storage. Initially ViPR provides a new object storage software implementation supporting both Atmos and Amazon S3 interfaces. We believe large web-scale content depots our next generation application developers will increasingly rely upon object storage because with simplicity, cost and globally distributed nature. Object storage will also play a major role under these big data analytics systems based upon our dupe and for this reason we’ll be adding [HDFS] access to the ViPR object storage later this year.

Turning now to security. Our RSA security division grew 11% in Q3 benefiting from year-in-year revenue expansion in both major lines of business. Within our identity and data protection business to secure IT return to growth, revenue growth accelerated for our security management compliance business with growth coming from both Archer and our security analytic suite. As customers begin to allocate more of their security budgets beyond static prevention and towards intelligence driven security based on context and analytics, RSA is well positioned to meet these needs.

Revenue from our Information Intelligence Business declined in Q3 as a number of deals were pushed out of the quarter. When budgets are tight, spending on business process improvements and collaboration become less of a priority. We did see continued progress in the quarter with our vertical solution sets; energy plant and facility management and life scientists in particular. We also continued to see momentum for the Syncplicity sync and share SAS business. We acquired Syncplicity about a year-ago as a very early stage company and we’re seeing dramatic growth in customers large and small. Syncplicity was recently cited as a leader in the farthest of wave and was recognized as one of the top 10 most secure apps in the cloud by NetScope.

VMware’s revenue growth accelerated again in Q3 as customers transformed to the mobile cloud era computing. Customer’s uptake of non-standalone vSphere solutions expanded with over 40% of VMware’s license bookings in the quarter coming from areas beyond standalone vSphere. Management and automation license bookings were once again VMware’s strongest growing product category in Q3. VMware is later focused on delivering unique customer value in three strategic growth areas to software defined data center, hybrid cloud and end user computing.

In Q3, VMware announced three new and key technologies, vCloud Hybrid Service, Virtual SAN Storage and the NSX Network Virtualization Platform. It also announced an entire refresh of its industry leading vCloud suite and announced a new desk top of the service offering uses a technology from a Desktone Acquisition. Record attendance of VMWorld in August in San Francisco and in Barcelona last week of more than 30,000 people combined speaks the broad and growing appeal VMware offers to customers wanting to transform their environments for the mobile cloud era computing.

Pivotal our new company continued to make significant progress in Q3 towards its goal of building a new application development platform comprising next generation data fabrics, application fabrics and a cloud independent platform as a service. Pivotal’s recent acquisition of Xtreme labs adds an important dimension to it's efforts as Xtreme labs advantage in mobile application developments are highly complementary to the expertise of Pivotal labs the agile development services unit within Pivotal. Xtreme labs list of clients is impressive in including several new web-scale companies as well as organizations like Deutsche Telekom, Viacom and the NFL.

Enterprise customers are seeking a data-centric and modern development platform on which to build their next generation applications for both web and mobile. Pivotal’s first version on this platform Pivotal One is on track for availability before year end. Pivotal’s leading efforts in this space are capturing the interest of many. Their inaugural Cloud Foundry Conference last month was sold out an attractive five times the number of attendees it had targeted. Additionally, large household organizations including GE and IBM are lining up to collaborate or co-innovate on the Open Source Cloud Foundry project.

As we look across our federation of businesses we see a number of benefits to our model. First and foremost this model is best for customers. It offers our customers horizontal solutions and more choice than they get from others to prepare them for the third platform of IT. Second, this approach fosters excellence and leaves each business free to focus and build the products, go to market capabilities and ecosystems necessary to win. Finally with all three businesses together within one federation interests across them are aligned. As part of the single entity our businesses share a vision to leverage Cloud, Big Data and trusted IT to maximize control, efficiency and choice.

Since 2009 we’ve been promoting the main virtues of cloud infrastructures and because of this long standing conviction today we offer some of the industry’s leading technology to support cloud deployments. Over the last several years we’ve also been developing innovative go to market model to optimize the delivery of these technologies and accommodate a variety of customer preferences. These initiatives are proving to be very successful.

Let’s start with converged infrastructure and VCE. Demand for Vblocks in the period grew well over 50% and had a higher rate than in Q2 outpacing the market for converged infrastructure which is one of the fastest growing areas in IT. Customers seeking speed to deployment, ease of operations and reduced complexity turn to Vblocks. This was validated by our recent report from IDC which indicated that compared with (indiscernible) components, VCE customers realized five times faster deployments in new services and the 96% reduction in downtime while a shrinking annual data center cost by up to 50%.

VCE is setting the pace in some of the technology leadership as well. This quarter the company launched two new Vblocks specialized systems targeted a high performance data base and virtual desktop environments as well as new Vblocks incorporating our new VNX platform. There is another large segment of customers who value simplicity, agility and speed to deployment and off the choice provided by reference architectures instead. This was evidenced by the continued strong growth of VSPEX. We expanded our base of in-store VSPEX by over 45% in Q3 bringing the total number to more than 5200. This is excellent progress for a solution that’s only been in the market for a year and a half. Partners love it because it offers them another way to add value and customers love it because it's easy to purchase, deploy and operate.

Finally a growing number of customers are opting for off premise solutions to augment their current IT investments. For more than a year now service providers have been our fastest growth vertical market segments and this trend continued in Q3 as the revenues from this program were up well over 50% year-on-year. This rapid growth comes from the expansion of the program to include new partners as well as from existing partners as early partnerships continued to gain traction. A great example is our alliance with Atos which we first announced early last year. This alliance structured around that canopy cloud services company has been so successful that we recently expanded our partnership. Atos will continue to standardize the majority of their cloud and managed services hosting platforms on EMC, VMware and VCE Technology.

In summary, taking into account the market leading assets within our portfolio built around the mega trends of cloud, big data and trusted IT as well as the energy and innovation with which we deliver in these technologies to our customers, we are confident that our long-term strategy is the right one.

Turning now to our outlook for the full year, we do not expect to recover the Q3 federal shortfall in Q4, so this flows through to our outlook for the year. We also are slightly revising our demand outlook for Q4 taking into account recent reductions in GP and IT spending forecast for 2013 and the ongoing uncertainty around U.S. federal spending. Of course we do expect a solid increase in Q4 IT spend relative to Q3.

For the full year we now expect EMC revenue to grow 7% to $23.25 billion and non-GAAP EPS to grow 6% to $1.80 per share. We continue to expect free cash flow to grow by 10% to $5.5 billion. Our confidence in achieving these results comes through a number of factors including last quarter's $109 in higher than expected backlog that we've already shipped.

Our increased storage product bookings momentum, a full quarter's effect of the new VNX, ViPR and data domain products, the general availability of XtremIO, VMware's continued momentum and the success of our ongoing market initiatives including VCE, VSPEX and our SC [ph] partners. Going forward we're confident that we'll continue to grow and gain share because we have the right vision and strategy. We have an enviable market position of portfolio. We have a leadership role in important new technologies and across the federation, we have the team to make it happen. All of this together puts EMC in an unique position to help customers and partners transform their businesses and be successful.

With that, I'll turn it over to Joe. Joe?

Joseph M. Tucci

Thank you, David. My welcome and thanks to everyone joining us for today's call. I have very mixed feelings and emotions about our Q3 results. To be clear and for the record, I am disappointed that we missed our Q3 revenue and EPS expectations and I assure you that the EMC management team shares my disappointment.

On the other hand, I feel extremely good about our strategic position, about our products and service offerings and with the way our customers and new prospective customers are giving us permission to play in our target markets, in cloud, big data and trust.

We are focused on building a platform for new cloud, big and fast data applications, delivering on the promise of the software defined data center for a new cloud era. Dividing our customers' portfolio of information storage and protection solutions with unparallel depth and breadth and we are focused on ensuring we deliver trusted IT.

We feel good that we continue to grow faster than most of our larger IT peers. As David said, excluding federal, demand in bookings growth accelerated across the major parts of our business. In particular, our newer high growth businesses did extremely well. In Pivotal our developers pass CloudFoundry is attracting an impressive and growing community of partners and Pivotal's big data analytic solution shows strong momentum and growth.

Growth also accelerated in VMware and within RSA security, our security analytics and our Archer GRC suite grew over 35% year-on-year. And our VCE joint venture year-on-year growth exceeded 50% an acceleration over Q2. And our Emerging Storage offerings; Isilon, Atmos, VPLEX and Flash grew over 65%. Going forward we will also include our software defined storage offering ViPR and our new all-Flash array XtremIO in this category starting now in Q4.

By the way Q3 marked the 15th consecutive quarter in which we posted year-on-year organic revenue growth. I would like to thank my talented colleagues in EMC, VMware and Pivotal around the world for their hard work and dedication.

David explained our shortfall this quarter and I would like to give you my perspective on the two factors he discussed. First was a higher level of storage product backlog than expected. To provide a little color and more detail, on the last day of the quarter we initially expected to receive approximately $100 million in storage product orders. In actuality we received almost three times that amount.

We were able to process and ship some but not all of these orders. This resulted in the backlog that was $100 million greater than planned and thus the corresponding $100 million Q3 revenue shortfall. Clearly we worked hard to get orders in earlier and I assure you our sales teams were incented accordingly. But customer caution and their scrutiny of IT purchases continued and more orders than expected were released to us on the last day of the quarter. The good news of that in total we did get the storage product awards we expected in Q3 with a notable exception of those from the U.S. federal government.

Moving on to our U.S. federal business, I would like to point out that the vast majority, approximately 70% of our federal storage product revenues are transactional in nature which means they are booked, built, shipped and billed within a quarter. In other words our federal business is mainly project based and transactional in nature as opposed to being more a multiyear program based.

With the government dealing with the budget impacts from the sequester and the effects of a pending shutdown, these types of transactional orders were the ones most negatively impacted in Q3. To put a number around this impact, our U.S. federal storage product business was down over 40% year-on-year in Q3. By the way normally because of the federal September 30 fiscal year end, Q3 represents several times the order volume of any other quarter.

The good news is that the demand for these storage infrastructure products did not go away nor was it lost to another IT vendor. But because of uncertainty around the federal government's funding this new fiscal year, it is unclear when this pending demand will result in actual orders to us.

As we look forward we now believe that overall IT spending growth for 2013 will come in a little below 3% with a solid increase in IT demand in Q4 versus Q3. Against this backdrop we expect consolidated EMC to grow at 7%, 5% excluding VMware this year which will put us in good stead relative to many of our large cap IT competitors.

Thank you for joining us and I would now like to turn it back to Tony to moderate the Q&A portion of today's call. Tony?

Tony Takazawa

Thanks, Joe. Before we open up the lines for your questions, as usual, we ask you to try and limit yourself to one question including clarifications. This will enable us to take as many questions as possible. We thank you all for your cooperation in this matter. Evan, can we open up the lines for the first question please?

Question-and-Answer Session

Operator

Yes, sir. (Operator Instructions). Our first question today comes from Kulbinder Garcha with Credit Suisse. Your line is open.

Kulbinder Garcha - Credit Suisse

Thanks. I just want to clarify a couple of points. David, first of all on the revenue sequentially in the fourth quarter if I take VMware out of it, you're guiding for 25% sequential growth which is I think the strongest sequential growth you would have seen in a decade ex the VMware business. And just to be clear, is that just all because of the orders that have been pushed out in Q3, Q4 and you're not really assuming anything much in the end environment with your customers to actually improve? That's one question. The second question I have is kind of linked to it. The gross margin relative weakness versus expectation this year has meant the information storage segment of your business isn't expanding gross margins anymore. Has that story about your ability to both increase share and expand gross margins there largely played out now and you can't do both – how can you convince this in being more structural, whether it's cloud related otherwise isn't pressurizing that business maybe more than you would have thought six or nine months ago? Many thanks.

David I. Goulden

All right, Kulbinder, thank you. I think that qualifies as two questions, I'll take both of them. So the first one, Q4, yes, you're right to point out that obviously from a reported point of view that's going to be a fairly increased sequential growth rate. There are two factors to come into account. First of all we are giving you our best estimates of Q4 and as you know from our full year guidance, because we will benefit from the $100 million of backlog coming out from Q3, we've essentially taking a little bit off top of the Q – the prior Q4 guidance reflecting a slightly weaker economy that we're seeing. The important thing is the factor that impacted us in Q3 do not impact us in Q4. Specifically in Q4, the federal government business is a very low percentage of our total bookings unlike Q3 and also the backlog factor is less, in fact it's almost a non-issue in Q4 because we carry larger backlog out of Q4 just because of the nature, the size of Q4. We don't optimize our factories to try and ship all the Q4 backlog. So if you normalize Q3 for the facts that did impact this in Q3, the backlog and if you normalize for what would be a more normal federal performance, the seasonal progression from Q3 to Q4 is much more in line with seasonal norms. And of course we still expect these from budget cycle in Q4 with IT spending seasonally ahead of Q3 and that we also mentioned that we’re expecting to see a continued strong storage product booking to support that number.

We talked about the fact that we’ve seen our storage product bookings growth rate accelerate in Q3 an d in Q4 on top of that benefit of the run rate we’ve coming out of Q3. We’ve got the additional benefits of things like a full quarter of the new VNX, the full quarter of the new DD and the first quarter shipping XtremeIO. So those are all the factors that come into the Q4 numbers.

In terms of gross margin, obviously the gross margins were most impacted by the shortfall in storage product revenues this quarter. As we mentioned, 220 of the overall 250 [indiscernible] were directly related to storage product revenues, of course carry a very high incremental gross margin because all our fixed costs are already covered and the impact of $220 million less of a storage product revenue on our entire income statement is fairly meaningful.

So if you normalize I understand that’s a normalization calculation, but if you normalize our gross margins for storage, for EMC infrastructure for consolidated -- for the $220 million would be roughly flat quarter-on-quarter, roughly flat year-on-year and the operating margins in fact will be up in both cases. So we don’t think there is anything structural happening to our business. We’re still very pleased about the potential for continued expansion in the gross margin and the operating margin in storage as we go forward.

Kulbinder Garcha - Credit Suisse

Thank you.

Tony Takazawa

Thanks, Kulbinder. Next question please.

Operator

Our next question comes from Brian Marshall with ISI Group. Your line is open.

Brian Marshall - ISI Group

Great. Thanks, guys. Obviously there is nothing you could do about the weakness in the Fed and I didn’t actually realize 70% of your business was transactional in nature there. So that’s an interesting statistic, thanks. But with respect to the inventory situation, if you look at it, 1.4 billion up both sequential and year-over-year, can you talk about how that jives with the fact that you did have a lot of orders coming in at the end? I’d anticipate you guys could probably pre-build a lot of those orders and prep for a pretty big backend loaded quarter and orders coming in at the last day. So can you talk about how you can pre-build and if that was the case and you shipped a couple of hundred million in the last day of the quarter, why inventories went up as well? Thank you.

David I. Goulden

Yes, Brian, let me take that as well. Yes, obviously we were able to ship a large number of the orders we got on the last day. But as we explained, not all of them and we had planned our inventories for essentially $100 million less backlog and we planned to have the inventory for the federal orders that didn’t come in. So those directly impact our inventory. We also of course were playing around some product transitions both on the VNX and on the Data Domain sides where we’re covering our position a little bit on product transition. We didn’t have any issues with product shortages, which is good because we were able to plan around those transitions. So the manufacturing inventory and the situation kind of tied directly to how we saw the quarter and play out. And then the final piece is the overall inventory picture as we’ve a little bit of a build up in engineering or R&D inventory and support some of the new products that are in the pipeline.

Brian Marshall - ISI Group

Thank you.

Tony Takazawa

Brian -- Evan, can we go the next question please.

Yes, sir. Next we have Shebly Seyrafi with FBN. Your line is open.

Shebly Seyrafi - FBN Securities

Yes, so a clarification and a question. On the clarification, what was the VNX and Data Domain growth rates during the quarter? And the question I have is on the high end you declined 8% year-to-year following the growth at rates of 10% to 5% the prior two quarters. What do you think is going on the high end? Is it just the secular shift away from the high end to the mid range or this was just -- was it impacted mostly by the federal and what do you think the high end growth rate should be secularly going forward?

David I. Goulden

Yes Shelby, let me take that one as well. The biggest impact compared to our expectations in the high end this quarter was the reduction or the lack of federal orders, and that had a direct impact upon the high end growth rate a little bit of the backlog or the orders that we didn’t ship was is in the high end, but the biggest factor was the federal which is why it was below our expectations for the quarter. Now you can see that obviously the high end is very much a function or very much impacted by product cycles to your early point we had a very strong first half and the high end as we were still in the first year of the product cycle, Q3 was the first year we had a kind of lapping or an annualization of the new VMAX, so we expected some softness in the second half relative to the first half. We still think that the opportunity is there for the high-end to grow in the range that we talked about at the form, which is then -- at the 1% to 3% range and nothing we’ve seen recently would change our viewpoint on that.

And then relative to the first part of your question you asked about the growth rates of VNX and DD. And the growth rate in VNX picked up during the quarter with the transition into the new part. The growth in DD remained strong and both of those were impacted by the additional or as we couldn’t shift. So the prior question we can do much more pre-building of the Symmetrix orders than we can pre-building of mid tier orders, they tend to come in with less define configurations mainly through the channel partners. So the majority of the build up of the un-shift inventory, the majority of the $100 million impacted the [indiscernible] mid tier bucket and absent that we would have been very pleased with the growth rate.

Tony Takazawa

Thank you, Shebly. Next question please.

Operator

Next in queue we have Ittai Kidron with Oppenheimer. Your line is open.

Ittai Kidron - Oppenheimer

Hello, thanks. Last night VMware gave little some color about 2014 outlook. I know it's a little bit early and you tend to do that mostly in your January conference call, but Joe is there any chance you can give us some of your initial thoughts about how, what's the framework we should think about from a macro standpoint towards spending some of the opportunities in risks that you see in that timeframe?

Joseph M. Tucci

I hate to tell you what everybody knows. But obviously the Federal Government we take the can down the road to January and early February. And I think a lot is going to depend and I could tell you I’m traveling around the world, as a matter of fact as I finish this call I am heading on the plane to go to China. As I head around the world, I can tell you that all eyes are on the U.S. So if you can answer that question for me I’ll give you my best guess.

Ittai Kidron - Oppenheimer

All right. Very good.

Tony Takazawa

Thanks Ittai. Next question please.

Operator

Our next question comes from Brian Alexander with Raymond James. Your line is open.

Brian Alexander - Raymond James & Associates, Inc.

Yeah, a question on the bookings acceleration that you saw in the quarter David, up high single digits I think you said. If you can talk about how the bookings linearity compares to what you normally see in the third quarter and whether the acceleration is more a function of easy comparisons from last year which Q3 was weak, but whether you’re really calling for more of an inflection point in storage demand and if the latter what change that’s driving the acceleration?

David I. Goulden

Yeah, sure Brian. Obviously number of parts to that question. Now relative to the acceleration as I mentioned, the good news whilst that’s again, we had to take federal out of our picture because that was the kind of one area where we did not meet our expectations from a bookings point of view. But if we exclude Federal and you look at the storage product bookings we saw the highest growth rate we saw during the quarter in both The Americas, in EMEA and in APJ; so we felt strong about that. Obviously a little bit of that was again say a compare, but to see that pick up in all three field as we saw as a very encouraging sign.

Relative to the calendarization, it was a backend loaded quarter as we mentioned similar in total in terms of the calendarization to what we saw in Q1, Q2 of this year obviously with it being a Monday as opposed to a Sunday close. In the prior couple of quarters we’ve planned to kind of get more of the orders in the final week and less on the last Monday, obviously the numbers of all as we got on the last Monday were more than expected were probably -- were less than we would have gotten on if you like a Thursday or Friday of the prior quarters. So those are the factors.

In terms of the overall pick up I think what we’re seeing a lot is the strength of our portfolio. Obviously we are doing well. We think relative to the market in all the sectors that we play in. We talked about what was impacting the high end. We feel good about our transition in mid-tier. Then you’ve also got to look in kind of the really exceptional growth we’re getting in that new emerging storage bucket, 66% is I think higher than anybody else out there. Also bare in mind that’s now fairly a large chunk of revenue close to $400 million in the quarter, it's growing at 66%. And the fact we have that break to portfolio is enabling us to go to customers and talk to them about all the different workloads in their business and say we have a portfolio that can actually handle all off of including your second platform apps and your third platform apps. And that story really resonates well with enterprises, it resonates well with service providers and it also resonates well with the cloud scale companies.

Tony Takazawa

Thanks Brian. Next question please.

Operator

Next in queue we have Aaron Rakers with Stifel Nicolaus. Your line is open.

Aaron Rakers - Stifel Nicolaus

Yeah, thanks for taking the question. Going back to the backend loaded linearity in the quarter and for that matter the last three quarters. Can you talk a little bit about the initiatives that you’re putting in place or more recently have put in place to try and diminish that backend loaded quarters which has clearly been an impact on the margin trajectory particularly in the storage business?

Joseph M. Tucci

Yes. So Aaron there are always things that we can do to improve that linearity and we are all over it and specifically I and my team are working this very aggressively. We are going to be facing midweek quarters for a few quarters going forward now less of an issue obviously for Q4 because what I mentioned in terms is not a backlog that we carry but will be, something we're going to look at going into 2014. And the way we're going to address that is a number of different areas one of which is really spending a lot more time with our customers to explain the neutral benefit of getting orders in just a few days before the end of quarter as opposed on the very last day, but we'll continue to work the opportunity.

Tony Takazawa

Thanks, Aaron. Next question please.

Operator

Next in queue we have Maynard Um with Wells Fargo. Your line is open.

Maynard Um - Wells Fargo

Hi. Sort of in line with that, how should we think about working capital in light of the economy and the product launches because if you've had very backend loaded quarters, specifically what can you do on the working capital side in this environment? Should we actually think about a new normal in the various metrics of the cash convergence because of the environment we're in? Thanks.

David I. Goulden

Yes. Maynard, obviously there are a number of things going to working capital, the famous one is our cash convergence cycle and our collections we're really very strong this quarter. We collected over $6 billion and you can see that reflected in our DSOs down to 49 days. So that's the biggest thing we can do for cash convergence cycle. There will continue to be some pressure on inventories as we manage through the quarter and we manage through the transitions. As I've said, we're looking at those opportunities as well. We continue to optimize in terms of how we're building out the factory processes, we continue to optimize our engineering, labs in terms of shared surge [ph] and things like that. So we have continued programs that will be driving very aggressively into business to optimize the working capital cycle. But again I'll come back to my first point collection is the biggest factor.

Maynard Um - Wells Fargo

I'm just wondering if you changed any of your target metrics or metrics within DSOs or turns or things like that, just given the environment and how we can think about that?

David I. Goulden

Specifically we still are targeting DSOs around that 50-day level, obviously some quarters are a little bit higher, some quarters are a little bit lower. We're still targeting inventory turns in the 6 to 7 range and again we have a lot of promos [ph] in place to make sure we can achieve those. There are still things we can do to optimize in the factories despite the backend loaded quarter and there are some things we can still do to optimize the amount of inventory we keep in our development labs.

Maynard Um - Wells Fargo

Great, thank you.

Tony Takazawa

Thanks. Next question please.

Operator

Next in queue we have Keith Bachman with BMO Capital Markets. Your line is open.

Keith Bachman - BMO Capital Markets

Hi. Thank you. David, for you please, ending the year based on your 2013 outlook with upper income about 25% which is up about 10 basis points year-over-year, a little bit more than 10 basis points. Can you provide some perspective on how we should be thinking about that number in particular as we're looking at 2014? And then just a clarification, could you also just tell us how much federal government was for set of revenues and for the September quarter? It just seems like a pretty material shortfall, just wondering what it was in the September quarter. Thank you.

David I. Goulden

Sure, Keith. Let me handle both of those. So relative to your second question and obviously the impact of the federal government was most prevalent in storage for our bookings. So when you put it in that context because obviously we do all our things with the federal government including VMware and there are some services lines in there as well, but for the whole year if I look at the federal government it represents less than 5% of storage for our bookings. But as Joe said, Q3 represents a multiple of any other quarter during the year. So obviously it represents a fair amount over the 5% in a Q3 and a fair amount below the 5% in any other quarter, which is kind of where you get the impact you saw in Q3. Relative to your question on the income statement, you're right. We're now projecting to have operating margin improvement in 2013 of about 10 basis points. Obviously that's directly impacted by the less storage program when we were calling a quarter going out as I mentioned has a high incremental gross margin which is why you see the margin profile coming down from 25.5 points to 25 points. Within that margin picture for the year, we expect gross margins to be relatively flat again impacted by the fact that we are – don't have that 220 plus issue of storage for our revenue. We expect to pick up most of our leverage this year from operating margin line. Going forward next year we think there is opportunity for improvements in both lines.

Tony Takazawa

Thanks, Keith. Next question please.

Operator

Next in queue we have Alex Kurtz with Sterne Agee. Your line is open.

Alex Kurtz - Sterne Agee & Leach

Yes. Thanks guys for taking the question. David, just thinking about Q4 again and the increase in the sequential growth rate; Q4 from what I can understand is always a very backend loaded quarter, so I was just wondering how you discounted that into your guidance here knowing what just happened in Q3 and maybe how you think about that across different geos [ph], maybe it's going to be less pronounced in the U.S. for whatever reason and you feel more confident about hitting that sequential growth rate, but just any more color on the backend loaded nature and sort of how you base that into your guidance?

David I. Goulden

Yes. Sure, Alex. Again when we look at Q4 and fundamentally we haven't changed it very much at all from what we're calling last time, there has been a very minor change but fundamentally let's say there's no material change. And then to put that into context of what happened in Q3, let me just remind you the fact that the impact just in Q3 are not a factor in Q4 and let me just explain why. So we just explained on the last question, thank you, Keith, for the question that the U.S. federal government is actually a very small part of our Q4 expectations. As Joe said, we're not factoring any kind of budget flush out at the end of the year or any significant revival into our Q4 expectations from what didn't happen in Q3 but there's always some potential. Right now nobody knows what's going on down in Washington relative to federal government spend. The other factor that impacted us in Q3 relative to our expectations was the backlog coming out of Q3. As I mentioned, that's not a factor in Q4 either because we carry higher backlogs going out of Q4. So even if Q4 became more backend loaded and we expected from an order point of view that wouldn't impact us. So basically the things that impacted us in Q3 are not impacting us in Q4 and the reason why we feel confident about our Q4 guidance is when we look at the opportunity out there, we kind of look at what the sales teams are forecasting, the amount of pipeline we're looking at, we look at the venue box cycle, fundamentally we're saying we're broadly on track for Q4 as we expected and the fact that they hurt us in Q3 aren't a material factor. We have, as I mentioned in my comments, brought the Q4 guidance down by a little bit excluding the backlog and it's really related to the macro. If you look at the June, July quarter for example, consensus economic forecast for U.S. GDP growth 1.9%. Now there are about 1.6% and that's having a bit of an impact upon IT spending forecast. And because of that we've taken a little bit of our expectations out of the Q4 budget flush. But having said that we're still expecting a strong budget cycle in Q4, we're expecting IT spending to be seasonally ahead of Q3. So hopefully that gives you a feel, Alex, and those are the factors that go into it.

Alex Kurtz - Sterne Agee & Leach

That helps. Thanks, David.

Tony Takazawa

Thanks, Alex. We have time for one more question and then we'll have some concluding comments from Joe.

Operator

Our final question today comes from Lou Miscioscia with CLSA. Your line is open.

Lou Miscioscia - CLSA

Okay. Joe, you mentioned you're actually getting on a plane, I guess, tomorrow and heading over to China. Maybe if you could comment on how you all are doing out there, some other companies it seems like might have been impacted for a number of reasons and I believe your China business is actually smaller. Has it grown well and then if you could also comment on the possible, I guess, pullback from the government on U.S. IT companies because of security issues, that would be helpful?

Joseph M. Tucci

Yes. We don't break out China separately but we are growing nicely in China. And as David said in our [indiscernible] which is basically our emerging markets group the companies that we track and this is a little bit more than 13 companies, we just started that kind of [indiscernible], we grew 19% year-on-year in Q3. So we're doing quite nicely and China is doing well for us. You asked a comment about the security aspects faced in China and there's nothing really to add there you don't know. I mean obviously there's concerns both ways and I think rational people are having discussions and we got to – it's an opportunity for us with our security business and it's not something I want to specifically comment on.

Tony Takazawa

Thanks, Lou.

Lou Miscioscia - CLSA

Thank you, Joe.

Joseph M. Tucci

With that, I want to again thank everybody for being with us today. We really do appreciate it. I want to emphasize that we are definitely disappointed that our revenue and non-GAAP EPS didn't meet our expectations. That said, as you can detect from our comments, we’re very excited about our future. As evidenced by the fact that excluding federal, our bookings rate in Q3 accelerated across EMC, Pivotal, VMware and gave us we believe proof that our strategic focus on cloud, Big Data, and trusted IT is right on.

I’m blessed to be surrounded by a terrific leadership team. We have more than 61,000 talented, dedicated professionals around the globe that are charged up and deeply believe in our vision and mission. And most importantly, customers are rooting for us. You can feel that when you speak to customers and when I -- as I travel and they’re giving us a broader, more strategic seat at their IT table.

So again thank you for being with us today and we look forward to continuing our dialogues with you on an ongoing basis and we’ll be with you. Thank you.

Operator

This does conclude today’s conference. You may disconnect at this time. Thank you.

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