By David Sterman
Looking over the most recent short-interest data, a very unusual company jumped out at me: EMC Corp. (EMC). Short-sellers are increasingly convinced the storage giant is headed for a fall.
In the last two weeks of April, they boosted the short position in EMC by 18% to 83 million shares. That makes EMC the seventh-most shorted stock on the New York Stock Exchange. Said another way, the percentage increase in short interest is the largest of any company in the Nasdaq 100.
Trying to figure out why so many investors are bearish, I turned to Wall Street analysts. That didn't help. I read nearly a dozen reports and almost every single analyst appeared very bullish on EMC's prospects, with almost all of them predicting shares will rally higher as the year progresses. Turns out, we've got a battle of bulls vs. bears.
Let's look at each case.
The Sell-Side Frenzy
Wall Street analysts, known as sell-siders, repeatedly take note of the fact that EMC operates in one of the hottest areas for high-tech spending - storage. Many enterprises are buckling under the weight of all the data they must harness, and they keep adding more and more storage servers to handle the load. EMC is considered to be the "best of breed," meaning its products are pricier - but more robust - than storage products sold by larger vendors such as Hewlett Packard (NYSE:HPQ) and Dell (NASDAQ:DELL).
By Wall Street's logic, overall tech spending will grow by single-digits in 2011, demand for storage could grow about 10%, and EMC, thanks to market share gains, can grow at least 15%. Sales had grown at an average annual rate of about 9% in the past three years. "We're beginning to think aloud if EMC's most robust opportunity actually lies in front of it," wrote analysts at Brean Murray in a January 2011 report.
That robust opportunity? Cloud computing. An increasing amount of corporate data is being placed at Internet-connected data centers where EMC's specialized hardware and software help keep the massive volume of information flowing. EMC's 80% stake in VMWare (NYSE:VMW) surely helps. The two firms, in conjunction with partner Cisco Systems (NASDAQ:CSCO), have seen their Virtual Computing Alliance (VCE) attract considerable buzz among IT executives.
A monthly survey conducted by Goldman Sachs in April that looks at IT spending plans found that "EMC is the standout gainer," adding that "EMC's gains were notable across storage and hardware." This means whatever IT spending funds are available in 2011 could well include EMC as part of the program.
Legions of Doubters
Yet it's that IT spending outlook that may actually prove to be an Achilles Heel for EMC investors. The nuclear crisis in Japan, the economic crisis in Europe and signs of an emerging economic slowdown in the United States have tech watchers concerned that the industry has already crested and is due for a reckoning.
Just this week, Hewlett Packard shaved its 2011 revenue forecast by $1 billion. HP may not be as strong a player as EMC in storage, but both firms share the same global customer base. "There's concern about a slowdown in economic growth. If that is the case, it will not only have an impact on a company like HP. It will affect the broader market," said Robert W. Baird's market strategist Bruce Bittles in an interview with Bloomberg. Can EMC really match the consensus forecast of 16% sales growth in 2011 if IT spending is upended?
EMC's detractors also take note of a few other issues. For starters, they note that more than half of the company's value is reflected in its 80% stake in VMWare. That firm, which admittedly has considerable momentum, is valued at more than 10 times projected 2011 revenue. That's an awfully high multiple for a company that has already grown quite large. So why not short shares of VMWare directly? Because very few shares are actively-traded, due to EMC's controlling stake, and it's much easier to short shares of the more liquid EMC stock and bet that both entities will drop in value.
Even Goldman Sachs' analysts, who highlighted positive survey responses for EMC, inject a note of caution. Their April survey generated a reading of 68.0, down seven points from the March survey. "Looking ahead, we believe IT spending expectations will have to balance secular growth drivers against an easing cycle recovery, tougher annual comparisons, and weaker key macro data," they wrote in a mid-May report.
Other short sellers suggest EMC's growth rate is bound to slow, simply due to the law of large numbers. Indeed, Merrill Lynch forecasts EMC's per share profits, which rose 40% in 2010, will grow 24%, 15% and 13% in 2011, 2012 and 2013, respectively. And that forecast assumes a robust outlook for storage spending. If the global economy weakens, EMC's growth rates would be notably lower than Merrill's forecasts.
Click to enlarge
Click to enlarge
Shares of EMC powered higher through the winter and have held their own in the spring, even as other tech stocks have started to stumble. Short sellers are betting that the stock's surge, which has pushed it up to more than 20 times trailing earnings, is simply too rich for such a sober current environment for tech spending. In the next few quarters, we'll get a clearer sense of who will emerge victorious in this battle between bulls and bears.
Although EMC looks like the best house in a bad neighborhood, a real case can be made for a slowdown in tech spending. The company may be hard-pressed to keep growing at the fast pace that many Wall Street analysts expect.
Disclosure: Neither David Sterman nor StreetAuthority, LLC hold positions in any securities mentioned in this article.