By Michael Holt, CFA
EMC Corp. (EMC) has developed an enviable position at the heart of the storage and virtualization markets. We are confident that the company is on track to remain at the forefront of data center innovation and navigate the unknown challenges the industry faces as enterprises migrate to private and public cloud data center solutions. As EMC's share price falls into the mid-$20s, investors are presented with an opportunity to own one of the highest-quality firms in information technology.
Investments Provide a Foundation for Growth
EMC is wielding its balance sheet to remain at the forefront of innovation. The company continues to invest in its product portfolio, averaging $1.9 billion in research and development spending and an additional $2.1 billion in acquisitions during the past three years. Few competitors have the financial firepower to match EMC's investment in the storage and virtualization markets.
This investment is showing up in EMC's operational results and product pipeline. The company recently launched 42 new products. Many of these were incremental advances of varying substance, but others were prime examples of EMC's solid execution in product development.
Flash Is an Evolution of the Hardware, Not the Death of Storage as We Know It
Flash is an important evolution in storage that EMC is embracing, but not the end of disk. EMC is a leading player in rolling out flash to augment networked storage solutions. In a classic move, the firm is copying and acquiring the solutions as they gain market traction. For the foreseeable future, however, flash will remain a small percentage of the total capacity shipped in enterprise storage.
EMC is embracing flash and effectively using it to differentiate its solutions from the competition. Someday, flash may even become the dominant storage medium as Moore's Law drops the cost per gigabyte to below that of spinning disk. However, the industry is far away from that date. Solid-state drives accounted for just 1% of the capacity shipped for enterprise-class storage drives last year.
The mix shift to flash from traditional drives is interesting, but more important to the EMC story is the software that ties everything together. FAST (fully automated storage tiering) is EMC's software that moves the most active data to the fastest disk, enabling customers to boost performance by investing in a low percentage of expensive, high-performance disks and pairing those with a high percentage of cheap, high-capacity disks. EMC remains a software company, with fewer than 1,000 of its 16,000 engineers focused on hardware.
Cloud Computing Will Be Disruptive, but Also Creates Opportunities
Cloud computing is a threat, but also an important opportunity. There is little doubt that cloud computing is a disruptive force that will shake up the IT industry during the next decade. Instead of sticking its head in the sand, EMC is embracing the change, even though some of its traditional business will be cannibalized.
In the long term, many workloads that are currently run in on-premise (local for each company) data centers may be run in the cloud. If workloads are moved, customers focus more on choosing the software provider (for software as a service) or the service provider (for infrastructure as a service) rather than spending the time to build out and make individual technology purchasing decisions. This threatens to diminish the value of the customer relationships EMC has built during the past few decades.
The news is not all bad, as cloud computing is creating near-term and long-term opportunities. First, in the near term, the majority of workloads have not been moved off-site into the public cloud. However, cloud-type architectures are being adopted in the on-premise data centers. This is driving investment in the leading technologies where EMC is well positioned. Second, we believe the cloud computing movement will leave most companies with a mix of on-premise and public cloud applications because of network constraints, security concerns, and other reasons to retain some in-house control. We call this mixed model the hybrid cloud, and EMC subsidiary VMware is at the center of the cloud computing movement that will support the hybrid cloud model.
EMC is targeting technologies that will appeal to the buyers of infrastructure for the public cloud. Sure, Facebook and Google are building their own infrastructure, but that doesn't mean there is no place for the traditional hardware vendors in the public cloud. EMC has named Verizon, Rackspace, and several others as service providers that are using EMC's gear to run their public cloud operations. EMC is attacking this market with specific product bundles, such as the Symmetrix VMAX SP (for service providers).
EMC's Business Model Is More Bulletproof Than NetApp's (NTAP)
We are more comfortable with the long-term durability of EMC's business model relative to the model of rival storage vendor NetApp. Both are extremely well-run firms in a high-growth market, but we view EMC's diverse product line and best-of-breed approach as less susceptible to disruption as the era of cloud computing is ushered in.
Understanding the distinction between these two firms begins by recognizing that both are well-run leaders in storage, one of the fastest-growing segments in technology. Both firms have current product lines and excellent execution. Furthermore, both have been taking market share at the expense of other industry players in recent years, most notably from server vendors (Hewlett-Packard (HPQ) and Dell (DELL)) that have not always been strongly focused on storage. However, EMC and NetApp have extremely different approaches to the storage market.
NetApp has dominated midrange, file-based (network-attached) storage for many years. As file-based storage is growing faster than block-based storage, NetApp has delivered higher revenue and earnings growth, albeit from a much smaller base. The benefits of such a narrow focus are clear. NetApp's products span a large part of the addressable networked storage market and interoperate seamlessly because they are all based on the same operating system (excluding the recently acquired Engenio assets). Our concern is that if there is a disruption, whether from competitors (including EMC) or cloud computing, NetApp may feel the pain more deeply than a diversified competitor. NetApp has great technology, but it is appropriate to highlight the concentration of risk. In contrast, EMC has developed a broad portfolio of solutions, each with a specific target.
More important, EMC has proved that it can systematically adapt to emerging technologies, positioning its product portfolio around the technologies that are in demand. This can be seen in its acquisitions of Data Domain, Isilon, XtremIO, and many others. Internally, EMC has delivered FAST flash technologies in the array and at the server and scale-out storage-area network (Symmetrix VMAX).
Long-Term Threats to Monitor
There are two areas where we see threats that cannot be overlooked. First, integrated appliances from software providers such as Oracle (ORCL) could displace EMC. Second, as workloads migrate to the cloud, EMC will face a more concentrated and sophisticated customer base that may take advantage of greater negotiating leverage when deals are struck.
As software vendors deliver integrated appliances, can EMC be cut out of the loop? Oracle's Exadata is a great example of this phenomenon. EMC will tell you that the Exadata storage array doesn't measure up favorably to the full features and performance of the EMC gear. Over time, however, as Oracle improves its storage solutions, will it be able to leverage its position as the customer's database of choice to force out best-of-breed providers? Or will EMC be able to sustain enough of a technological lead on the storage side to minimize the threat?
The long-term trends for storage spending look healthy, but there is clearly going to be a shift in the customer base from corporate customers to service providers. This means EMC will be selling into a more concentrated purchasing base with greater sophistication and leverage. Even assuming that EMC successfully secures a comparable share of business in the new market from these service providers, will the economics of the deals be as favorable as the deals EMC has traditionally struck with its corporate base?
These are not questions that need immediate answers, but rather trends that investors should continue to monitor. Overall, we continue to be extremely impressed by EMC's positioning and execution.
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