The Purpose Of EMC's Equity Games

| About: Dell Technologies (DVMT)


It's true that the pieces are worth more than the whole.

Spinning off the pieces loses the synergy that gives them long-term value.

EMC is presently the cheapest cloud play there is for small investors.

Elliott Management wants EMC (EMC) to spin out VMware (NYSE:VMW) in the name of "shareholder value."

But that's not the same thing as the best interests of shareholders. Or the best interests of EMC.

Right now EMC owns 80% of VMware. The two companies also hold, along with GE (NYSE:GE), stakes in the Pivotal Initiative, which is commercializing a cloud platform called Cloud Foundry. EMC owns 62% of that venture, VMware 28% and GE has 10%. While the group was originally focused on enabling languages for cloud applications - that's what a cloud platform is, as opposed to infrastructure - they're now also focused on creating cloud scale for Internet of Things.

Internet of Things would take sensor data from jet engines, car engines, factory equipment or even your home refrigerator and schedule maintenance when it's convenient and before a catastrophic failure. As with your own preventive health care, the idea would be that owners would save money and pay for that service.

But it takes a lot more data to run a jet engine, or an airliner, or even a small fleet of cars than the jabbering you see at, say, Facebook (NASDAQ:FB). Fortunately the data flows and analysis can be highly automated, and that automation can also drive service scheduling.

Right now, Pivotal is taking cash from all three partners, although GE's original investment of $105 million provides a cushion. Cloud Foundry itself has been turned into an open source project, so financially Pivotal looks weaker than it is. In reality the concept is new, powerful, and could be very strong.

But it won't be strong if Wall Street vultures like Elliott start squeezing the parents for ready cash. They don't care about the long-term vision. They want money now.

EMC can accommodate them, at the expense of other shareholders. Doubling the float on VMware would still leave EMC with 60% of the equity. The present company has a valuation of $40 billion, so figure about $8 billion could be turned into stock buy backs through the equity sale. EMC has an equity value of $57 billion, so an $8 billion buyback would reduce the float by about 15%. This would support the stock and let Elliott take a profit.

The problem is that EMC is itself vulnerable to cloud market trends. EMC makes the huge hard drive packages used by cloud service providers. Over time, these are being replaced by chip-based storage, which is faster and cheaper to maintain. (Hard drives have moving parts that take a lot of electricity and can break down - your tablets and phones don't have them for that reason.) More importantly, the work done inside an EMC stack can be done by software like Inktank Ceph from RedHat (NYSE:RHT), or its GlusterFS software-based storage server.

Everything EMC is doing with VMware, with Pivotal, and with its RSA Data Security unit, obtained in 2006 for $2.1 billion, is aimed at milking the EMC cash cow and creating new software businesses that can take on that load over time. The plan is working. But it's not going to keep working if vultures like Elliott are able to blackmail EMC into payouts aimed at their short-term gain at the expense of the long-term vision.

EMC's "federated" business model is fairly strange, and it can be argued that it minimizes the short-term value of the pieces by keeping them together. But the cooperation lets them operate with a long-term vision, which tech companies need, and to operate fairly autonomously, which they also need. It looks like a kludge, but it works on both a financial and technology level.

By buying into the weak "parent" company, EMC, Elliott hopes to engineer a break-up of the whole that could leave the parts either worthless, or as small pieces in other companies, within a few years. It's pure Wall Street greed at the expense of shareholder vision.

If Elliott should succeed in convincing CEO Joe Tucci, who is due to retire next year, to break up his company, sell your shares as soon as you can. Right now, the play is to buy more because EMC is the cheapest stock in the business of arming the cloud. Compare their present price-earnings multiple of 22 to Red Hat's 59.

If you're going to see a major transaction around EMC, it is more likely to be a sale to IBM (NYSE:IBM), with its $193 billion market cap, or to Microsoft (NASDAQ:MSFT) with its $371 billion market cap. It's true the whole is worth less than the sum of the parts, but breaking up the whole at this point would be stupid, and reduce the long-term value of the parts.

Disclosure: The author is long GE, GOOG, GOOGL. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.