What Will Finally Close The Gap Between VMware And EMC?

I am running out of adjectives to describe the runaway rally in VMware (VMW). The virtualization software company is up another $5.46, or 5.1%, to $112.50, which gives the company a market cap of $43 billion. The stock has now nearly quadrupled since its $29 IPO in August.

To put that in perspective: Yahoo (YHOO) has a market cap of $38 billion; Adobe (ADBE) is $26 billion; Autodesk (ADSK) is a little under $12 billion. And think about this: SAP (SAP) has a market cap of $67 billion; in other words, VMW’s market cap is about two-thirds that of SAP, while SAP is expected to have 2007 revenues 12x higher than VMware.

Meanwhile, EMC is finally picking up steam, as analysts grapple with the valuation divergence issue between the two stocks. Previously, I noted that Pacific Crest thinks the issue has the potential to trigger acquisition interest in EMC from companies who might see EMC as a way to gain control of VMW on the cheap.

Thursday, Clay Sumner of Friedman Billings Ramsey raised his price target on EMC to $25 from $17; he only has a Market Perform rating on the stock, but says the shift today reflects “the reality of VMW shares trading at $107” (that was Wednesday’s reality).

Sumner says he sees core EMC worth $11 a share. He writes that he had previously assumed a price for VMW of $43, and notes that “clearly, the market disagrees with our assessment of VMware’s value.” He notes that the persistent spread in the price of VMware’s shares and EMC’s shares “should increase the pressure on EMC to spin off some of its VMW shares to EMC holders in a tax-free distribution.” As Sumner points out, EMC has 98% voting control of VMW, a position it could maintain with far fewer shares.”

EMC Thursday is up 91 cents at $23.48, which gives the company a market cap of $49 billion. EMC owns about 86% of VMW; ergo, its current stake is worth about $37 billion; that implies the rest of EMC is worth about $12 billion, or about $6 a share. But as noted, he thinks it is actually worth about $11 a share; and that is a conservative view; Pacific Crest’s Brent Bracelin put the value of core EMC at $34.5 billion, or more like $17 a share.

Again, something has to give here; either EMC shares ought to move up to narrow the valuation gap, or VMW shares ought to come down.