Every so often, an investor will find a company that has a winning combination of attributes. It is exposed to secular trends that go beyond the economic cycle. It is the leader in its markets. It has a strong balance sheet. And its stake in another public company leads to the rest of its business having a significant discount, one that we feel is unwarranted.
EMC (EMC) is the world's leading storage company, with over 20% of the storage market. We have written about EMC before, arguing that it is a solid company that will grow despite economic uncertainty. Today, however, we would like to highlight another reason why we think EMC will outperform: its relationship with VMware (VMW).
EMC and VMware: An Overview
VMware is the leader in the virtualization market, just as EMC is the leader in the storage market. And in 2004, EMC, seeing the potential of VMware, bought the company for $635 million. In 2007, VMware went public, selling around 20% of itself, with EMC keeping a stake of almost 80%. Since the IPO, VMware has dramatically outperformed its parent, which is unsurprising given that VMware itself is growing much faster than EMC as a whole.
We do not believe that the markets are properly valuing EMC, specifically in regard to its stake in VMWare, and we lay out the mathematics below.
EMC and VMware: The Parts Should Be Worth More Than the Whole
VMware spells out EMC's ownership in its SEC filings. As of March 31, 2012, EMC owned all 300 million shares of VMware's Class B common stock. Based on the latest Form 4 filing, EMC also owns 38,626,026 shares of VMware's Class A common stock, and all Class B shares (or 300 million). Based on VMware's overall outstanding shares, EMC has a 79.2% economic interest in the company and has 97.2% of the voting power, which it derives from its Class B stock (those shares have 10 votes). Based on where VMware stock closed on June 22, 2012 ($92.45), EMC's stake in the company is worth $31,305,976,103.7. EMC itself, with its 2,099,710,476 outstanding shares, was worth $51,883,845,861.96.
To us, this signals that EMC is undervalued. The market is valuing EMC's standalone business at $20,577,869,758.26. While that still means EMC is a multibillion-dollar business, its valuation, while already low relative to the broader high-growth technology sector, becomes even lower. Because of the 20% of VMware that it does not own, EMC breaks down its income between VMware and standalone EMC. In the first quarter of 2012, EMC posted net income of $586.842 million, representing growth of 22.99% over the previous year. Of that, VMware contributed $152.006 million, or 25.9%, of EMC's overall income.
To calculate the valuation the market assigns to EMC on a standalone basis, we calculated EMC's standalone, trailing 12 months earnings, which we lay out below.
EMC Earnings, Trailing 12 Months
|Consolidated EMC Net Income||VMware Net Income||Standalone EMC Net Income|
|2011 Net Income (Diluted EPS)||$2,461,337,000 ($1.10417776)||$589,996,000 ($0.2646774749)||$1,871,341,000 ($0.8395002851)|
|Q1 2011 Net Income (Diluted EPS)||-$477,148,000 ($0.2112884242)||-$103,441,000 ($0.0458052552)||-$373,707,000 ($0.165483169)|
|Q1 2012 Net Income (Diluted EPS)||+$586,842,000 ($0.2665121963)||+$152,006,000 ($0.0690329815)||+$434,836,000 ($0.1974792148)|
|Trailing 12 Month Net Income (Diluted EPS)||$2,571,031,000 ($1.1594015321)||$638,561,000 ($0.2879052012)||$1,932,470,000 ($0.8714963309)|
|Trailing 12 Month P/E||21.31271981x||49.02581915x*||10.64848083x*|
*P/E Ratios are based on values calculated above for EMC's VMware stake and its standalone value.
Our analysis of EMC's financials shows that the market is currently valuing EMC's standalone business at under 11 times earnings, a number we think is far too low. NetApp (NTAP), EMC's primary competitor in storage, has less than half the market share of EMC, and yet is valued at over 19 times earnings. Critics may say that NetApp deserves a premium because it is growing much faster than EMC. That would make sense, if NetApp was growing much faster than EMC. The data above show that EMC grew its standalone storage income by 16.36% in the last quarter. In NetApp's latest quarter, net income grew by 12.52%.
We see no reason why EMC's standalone business should have a lower valuation than that of NetApp, given the fact that it is not only more than twice as large as NetApp's, but also growing faster than NetApp.
EMC: What Is Market Leadership Worth?
Given that EMC's storage business is growing faster than NetApp's, and is more than twice as large, we believe that EMC's storage business should be valued at a premium to that of NetApp. Assigning a multiple of 17 to the business (we deducted 2 points to account for increased uncertainty in the markets, even if we think that EMC will not be materially affected by macroeconomic issues) yields a value of $32,851,990,000 for EMC's standalone storage business. Adding back the company's VMware stake gives a total value of $64,157,966,103.70. On a per-share basis, that values EMC at $30.55, representing upside of 23.63% from current levels.
We believe that the market is not valuing EMC's business properly. As our analysis has shown, EMC's standalone storage business is valued at less than that of NetApp, despite being more than twice as large and having more growth. Analysts agree, and the Reuters average price target for EMC currently stands at $33.05. In particular, Argus (a Buy rating and $36 price target) notes the following:
In our view, the current multiples [of EMC as a whole] are distorted by the VMW [VMware] holding and meaningfully undercount the full value of standalone EMC. We recommend that investors take advantage of the relative discount in standalone EMC created by the rising VMW value to buy EMC shares at current levels.
EMC is undervalued, and we believe that investors will profit by adding to or initiating positions in EMC at this time. The company is the leader in storage, and is solidifying its position. And EMC owns almost all of the world's leading virtualization company, giving it another avenue for future growth. That stake, however, has led to investors discounting EMC's standalone business, something that we see no reason for. EMC is growing on all fronts and, in time, we believe that the shares will rise to reflect the true worth of this company.
Disclosure: I am long EMC.