What Will Help EMC Grow?

| About: Dell Technologies (DVMT)

In its recent third quarter results, EMC experienced a mere 5% growth in total revenue year over year. The U.S. government cutbacks severely impacted the company. EMC Corporation (EMC) receives almost 10% to 15% of its revenue from the federal government. The fall in government spending will also affect the overall 2013 fiscal year estimates. It was the revenue contribution from VMware (VMW), which grew by 17% compared to the same quarter last year, offsetting the setbacks from the federal cuts.

VNX2 to boost future storage sales

The demand for its lower-end variants, VNX5200 AND VNX5400 have been so high that EMC faced production shortage, due to which the shipments were delayed. Initially, the product shipments for September were shifted to Mid-October, and now to December. In order to counterbalance this shipment delay to customers, EMC offered around 19% discount on the selling price to customers. This move helped EMC in not losing customers. Since the shipments started from end of September, I believe the VNX2 system will experience order growth from this year's last quarter onwards.

On the other hand, some customers are still opting for the older VNX system, as EMC is offering it at 30% to 50% discounted prices. The reason for this discounting is that EMC aims at clearing the inventory. Despite this cut in prices, EMC registered 35% of the VNX orders for VNX2 in September, which is a positive sign for the success of the product. EMC expects this figure to reach 50% by December this year. Due to this launch, I expect the VNX sales to reflect the best results in the last quarter of this year, compared to the previous quarters this year.

EMC will experience revenue re-acceleration from this product by the first quarter of 2014. Also, it should impact the topline significantly since the VNX product line contributes approximately 30% of the storage product sales of EMC.

Support from VMware, Pivotal show secured growth prospects

VMware alone contributes almost 24% of EMC's total revenue. In the third quarter, VMware experienced a 17% rise in revenue to $1.28 billion year over year. VMware's maintenance revenue supported this increase. It clearly indicates customer satisfaction and sustained growth in the coming quarters for the company. In the third quarter of this year, VMware posted $725 million in services revenue, which grew 13% year over year. This was mainly due to growth in contract renewals, also including contracts sold with new licenses. Overall, I expect consistent revenue contribution from VMware in the coming quarters, citing no such major headwind situation in the near term. Based on the above data and its continued no. one position in the virtualization and cloud systems market, it will continue to grow its revenue-contributing share in EMC.

Revenue from Pivotal also posted impressive results; it grew 21% year over year in the same quarter. It was launched on Nov 15th, through which EMC will enter the cloud computing market. Through this service, it will allow enterprises to shift their data centers to cloud servers, which are run by companies like Amazon (NASDAQ:AMZN), VMware, and OpenStack. Post this launch, I expect this segment of EMC to expand at a higher rate, given the growing significance of cloud computing and big data. This year will be considered a transition period for Pivotal, with improved results expected from the first quarter of 2014 onwards. Also, the announcement by Joe Tucci, CEO of EMC, regarding an IPO of Pivotal, lends further confidence for the growth prospects of this business.

R&D Intensity to improve further

Lenovo (OTCPK:LNVGY) recently announced its expansion plans regarding R&D centers in Brazil. It will be opening a center in Sao Paulo, Brazil, costing around $100 million. Through this center, Lenovo will provide 100 vacancies, which will concentrate on enterprise software, high-end servers, storage, and cloud technologies. Since Lenovo has a joint-venture with EMC for the storage segment, I anticipate EMC to benefit from this new center.

It will have a direct impact on the R&D to sales ratio of EMC, which is currently at 12.38%, while its peer companies like VMware, and IBM posted 20.64%, and 6.19% respectively. Of the three companies, VMware impresses the most as tech companies are known for benefiting from spending more on R&D. As evidence, in the past two quarters VMware's revenue grew consistently by an average of 4% quarter over quarter. On the other side, both EMC and IBM have maintained their R&D intensity at 12.38%, and 6.20%. Also, both companies have posted a decline in revenue of 1.34%, and 4.83%, when compared to their previous quarters. Considering the R&D spending, I believe VMware is the only company from the above three that has strategized its expenses well, leading to sustained revenue growth.

EMC has a better free cash flow yield side

One of the most impressive figures from the third quarter results of EMC was its free cash flows, which have significantly increased by 26% to $3.7 billion year-to-date, when compared to the same nine-month period of 2012. In this year's third quarter results, EMC, VMware, and IBM have posted free cash flows of approximately $1.42 billion, $543 million, and $2.2 billion respectively. Although IBM posted the highest free cash flows, it's necessary to find out the free cash flow yield in order to get a clearer picture, as these companies vary in terms of market capitalization. Henceforth, the free cash flow yield of EMC, VMware, and IBM are 2.89%, 1.56%, and 1.13% respectively. This paints a different perspective, as EMC posts the best figures, followed by VMware, and IBM being the lowest. For further assistance, I considered the debt levels of these companies, which were $7.1 billion, $450 million, and $36.1 billion. Overall, due to low debt and high free cash flows, I believe EMC will continue a similar performance in the coming quarters also.

Share buyback on its way

EMC is known for its share repurchase plans, as in the past five years it has repurchased almost $1.5 billion worth of shares every year on average. Furthermore, it will continue its cash distribution strategy by conducting share buyback activity over the coming seven months. This will be valued around $3.5 billion, which is almost equal to 147 million shares, based on its present stock price of around $24. This will remove almost 7% of the outstanding shares from the stock market, which is equivalent to its share trading volume for nine days. This will also lead to improved EPS from the second half of next year onwards.

Buy for long-term gains

EMC has immense support from VMware's business. Based on its present performance, I expect it to grow at a similar rate in the coming quarters. Post the U.S. government cutbacks, the business is expected to normalize from this quarter onwards. This will add additional upside, as it was one of the reasons for EMC's lower than expected results. On the valuation front, EMC has a low price to book ratio of 2.19x. The industry average is 4.9x, making EMC an undervalued stock. Based on its present low stock price, EMC proves to be an attractive investment opportunity for long-term returns.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.