EMC Corporation (EMC) sold off following the release of third quarter results in October that disappointed investors as the federal government shutdown weighed on results of operations. While shares are down over the last three months and returns have trailed the S&P 500 YTD, I view this as justified.
Specifically, I think there are better investments; investments that will yield a higher return. I credit the company with revenue growth, strong cash flow from operations, and a strong competitive position. But I see limited upside looking into 2015 and 2016. I think rallies are an opportunity to harvest profits for reinvestment in higher yielding assets.
I agree with the hedge funds who are shorting this stock; there could be significant downside potential.
- A $0.10/share dividend was declared, which is a forward yield of 1.69%. I expect a dividend increase during C14 to $0.11-$0.13/share, increasing the payout ratio into the 30%-40% range.
- Hedge funds are short shares of EMC; I'm thinking that sentiment emanates from a belief that cloud will adversely impact EMC's core operations.
- Third quarter results missed expectations as a decline in high-end storage offset gains in flash and scale-out storage. IDC said Q2 total disk storage systems sales fell 5% Y/Y. The quarter was adversely impacted by federal, Internet giant, and cloud infrastructure provider demand.
With more than $10B in cash and equivalents and more than $5 billion in free cash flow, EMC has more resources than smaller competitors to pursue new technologies through acquisition and internal development. Rival NetApp (NTAP) generates just over $1 billion in free cash flow. Western Digital (WDC) and Seagate (STX) each generate about $2 in free cash flow. EMC has a tremendous scale advantage relative to the aforementioned organizations. But EMC faces stiffer competition from IBM (IBM) and HP (HPQ) because of their scale.
Cloud service providers are a threat to EMC's market share position. The largest CSPs often build their own storage systems. If they begin to account for a larger portion of enterprise storage, then EMC could lose market share. But EMC does provide infrastructure to some of these firms.
EMC's competitive advantages are rooted in its massive installed base. The firm's storage systems support an organization's mission-critical applications, and the operational disruption and risk associated with migrating data storage platforms typically make it difficult to switch to a competing vendor's offerings. These high switching costs have allowed EMC to expand its gross margins over the past several years.
Some analysts and investors view software-defined storage as a threat to EMC's core operations. Management views this as a myth. The way they think about it is that they have been adding value to their hardware through the software component for years. The way to think about it is that they use industry standard components, which anyone else can use, but they combine those components with their differentiated apps. These apps may eventually be sold as a stand-alone offering.
China is a revenue growth opportunity. EMC is less established in China, but its working relationship with Lenovo should make its offerings more competitive in the market. China can be accretive to net revenue.
Pivotal should see significant growth in the coming years, with potential to exceed revenue of $1 billion by 2017, according to S&P Capital IQ. The total available market for Pivotal is expected to expand from $8 billion to $20 billion in five years. While CEO Joe Tucci informed investors that this new platform could eventually reach IPO status, I think that remains years away and is unlikely to occur until at least the 2016-2017 time frame.
EMC should be capable of creating wealth for investors during calendar 2014. But rising interest rates and tighter monetary policy could eventually weigh on the company's valuation. I think it is best to use an intermediate-term rally to distribute shares of EMC in favor of a higher yielding investment.