Buyouts are generally supposed to produce upside for the shareholders of the company being acquired, but that hasn't been the case for EMC (NYSE:EMC) since the company announced its merger agreement with Dell back in October of 2015. While it has indeed been a lousy market for a few months now, EMC's 12% drop since the time of the deal is worse than the performance of the Nasdaq, as investors have grown increasingly worried about the weak performance of EMC's storage business, the poor performance of VMware (NYSE:VMW), and concerns that the deal may not go through at all.
I believe that the deal gets done, but even if it does not, I believe EMC would walk away with at least $4 billion in cash in its pocket and an underestimated PaaS business in Pivotal. I wouldn't expect EMC's reported storage results to improve much until mid-2016, but with a stand-alone value above today's price and very low implied value to VMware, I believe there's still upside in these shares that is worth the risk that the deal unravels.
Weak Results As Customers Stay On The Sidelines
There's not much to celebrate in EMC's fourth-quarter reported results. As I mentioned in a recent piece on F5 (NASDAQ:FFIV), investors aren't fond of techs with weak growth ("value investing" doesn't often work well in the sector) and EMC has that in spades.
Revenue was flat on a reported basis and up 3% in constant currency, a slight miss relative to expectations. Revenue from the Info Infrastructure operations (the core storage business) was down 4% as reported, with a 4% decline in storage, a 6% decline in Info Intelligence, and a worse than expected 10% decline in the RSA security business. Pivotal was the best grower (up 28%), but still an insignificant revenue contributor (about 1% of the total), while VMware's 10% growth was a little better than expected (EMC owns 80% of VMware).
Gross margin was down about 180bp and a little weaker than expected, but EMC has started seeing the benefits of its cost-cutting efforts. With that, the 13% decline in adjusted operating income was basically as expected.
Not surprisingly, EMC management pointed to weak demand in major emerging markets like China, Brazil, and Russia. More importantly, the over tenor of demand for security wasn't great in the quarter, with management talking about customers holding off on purchasing (buying "just enough", "just in time") as they figure out their needs relative to the evolving technology options. IBM (NYSE:IBM) reported a 7% decline in storage sales for the fourth quarter. Both NetApp (NASDAQ:NTAP) and Hewlett Packard Enterprise (NYSE:HPE) are on a different financial calendar, but their recent results support the overall notion of weak storage demand for traditional vendors, while Pure Storage (NYSE:PSTG) and Nimble (NYSE:NMBL) have been reported meaningfully better growth.
Will The Deal Go Through?
Investors have been nervous about the Dell-EMC deal pretty much from the moment it was announced. Would EMC shareholders approve it? Would Dell be able to raise the money needed to fund the cash portion? Would the IRS nail Dell with a potentially prohibitive tax bill for the VMware tracking shares? Would the tracking shares really be worth all that much given the generally dicey history of past tracking stocks?
Dell and EMC managements have been saying all the right things in their attempts to reassure investors about the deal. EMC management addressed it on the call, pointing to the fact that Dell has firm commitments from banks for the financing. I don't believe there has been a formal determination from the IRS on the tax status of the tracking stock, but this isn't like an inversion deal and I think it's a reasonable assumption that a lot of high-end tax attorneys have examined this issue and reassured the companies that the IRS will go along with the companies' interpretation.
The tracking stock value issue is a legitimate one, as tracking stocks have a pretty mixed track record on Wall Street. The bigger concern is that expectations for VMware's revenue growth are now in the single digits and management has not made a convincing case to the Street that there's real long-term growth potential in the core VMware operations. I happen to disagree with that viewpoint, but VMware's lower guidance after fourth quarter earnings doesn't help the argument, nor does the weakening bookings growth for the core vSphere product.
When it's all said and done, I believe the deal goes through. If Dell nixes the deal, they will owe EMC a $4 billion break-up fee and that is strong incentive to make it work out. I want to be very clear that I'm not a lawyer; the terms of the deal as filed with the SEC would suggest to me that Dell is not excused from the $4 billion even if they get an adverse tax opinion, but lawyers may have a different opinion. While the weakness in VMware and EMC may prompt a renegotiation of certain terms, I don't believe EMC will have to concede too much (if anything) should such an event occur.
On It's Own, There's Still A Future For EMC
If the worst comes to pass and the Dell deal collapses, I don't believe EMC is doomed. EMC remains the leader in the enterprise storage space and all of the talk from up-and-comers hasn't changed that. What's more, I think EMC has done a better job of evolving with the times than the company's stock would reflect.
EMC will be launching its new DSSD platform, a rack-scale flash storage architecture that will serve ultra high-end needs. The company will also be launching flash-optimized VMAX (high-end) and VNX (mid-range) products in the first half of 2016, and these will include a new architecture designed for the needs, demands, and quirks of flash systems. That said, these introductions will likely do little to quell the debate around whether EMC is truly keeping up with smaller rivals like Pure Storage or Nutanix.
Beyond that, there is also the potential of EMC's Pivotal business and its plans to be a major player in the evolving enterprise Platform as a Service (or PaaS) market. As Oracle's (NYSE:ORCL) Larry Ellison observed in commenting on the Dell-EMC deal, EMC's business may still be centered around "last generation" technology, but it throws off buckets of cash that can be reinvested into growth opportunities (something that EMC has historically been pretty good at).
Recalculating The Value, Whether The Easy Way Or The Hard Way
At a 0.11 per EMC share weighting, VMware's share price doesn't swing an overwhelming amount of influence in the value of the proposed Dell deal. Based on the current VMware price, EMC ought to be trading at close to $29/share, but even if VMware's shares were to get cut in half from here, EMC would still be undervalued by about $1 on the terms of the deal. With that, I don't think it's unfair to suggest that $28 is a pretty conservative fair value for EMC shares on the basis of the deal going through (as it allows for further erosion in VMware's share price).
On its own, I believe EMC is worth more than $28 per share. I calculate that on a long-term revenue growth rate of under 3%, with EMC growing around 2% as next-gen storage and PaaS offset erosion in the traditional disk-based storage business. I'm looking for about 4% long-term growth from VMware in this scenario, but dropping that to 2% would only take about $1/share out of the fair value. In the standalone scenario, I expect EMC's free cash flow margin to erode with time due to margin erosion at both VMware and EMC; such a projection gives management no credit for potentially reducing operating expenses to maximize cash generation from the legacy business. At the end, this model produces a long-term free cash flow growth rate in the mid-2%'s and a fair value of $28.50; adding in the $4B break-up fee would be upside to that figure.
The Bottom Line
One way or another, I think EMC shares are worth around $28 to $30 today, and I'm content to sit tight. Owning a tech value story is a frustrating exercise, but I do believe that EMC can survive a breakdown of the Dell deal and a future as a standalone business. Although there are still some risks in the Dell-EMC deal that have to be addressed, Wall Street's pessimism over the deal seems excessive today.
Disclosure: I am/we are long EMC.
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.