EMC (EMC) recently announced that it has signed a major partnership with personal computer maker Lenovo. The agreement will be targeted at key markets of corporate, IT, servers and data storage. This replaces its partnership with Dell (DELL) after the company became a rival when it entered the storage market. This could be bad news for corporate IT players such as Cisco (CSCO), IBM (IBM) and Hewlett-Packard (HPQ), as the partnership creates a formidable player in the corporate information technology space.
The impact of this partnership appears long-term as there will be no immediate impact on the company. Under the agreement, both companies will collaborate on innovation and additional research and development in the server and storage markets. The partnership creates efficiency from the respective companies supply chains. Lenovo Chairman and CEO Yuangqing Yang said that the total value of the partnership will be measured in billions of dollars over the coming years. Moreover, the deal will also boost EMC's efforts to expand its presence in China and other developing and higher growth markets globally. Over the last three years, EMC has invested more than $1 billion in the Chinese market. This is a win-win situation for both companies. Lenovo will gain server capability, while EMC will improve its current market penetration in China.
This will be a good test for EMC as it plans to move into other locations within the region. The Asia Pacific market will offset the weakness in demand from the euro zone. EMC's revenues in the Asia Pacific market have experienced double digit growth over the last three years. It has a compounded annual average growth rate of 15% for the period. This accounts for 13% of 2011 sales, higher than the previous year's contribution of 11% of sales. In the last quarter, Asia Pacific contributed 14% of sales. Although it does not disclose its China revenues publicly, I expect that the Asia Pacific market contribution to group sales will be higher on strong Chinese sales.
Over the past several years, EMC has used its strong financial position to cement its spot in the storage space. It continues to spend $1.9 billion in research and development and an additional $2.1 billion in acquisitions. This yields to massive investments in the storage and visualization markets few competitors can match. It recently launched 42 new products, which signals EMC's solid execution in terms of developing its own products. This strong competitive advantage translates into strong financial results. Over the last five year period, the company has grown its earnings by 12% per year. This translates to an improvement in operating margins from 10% in 2006 to 17% in 2011. Its return on equity has increased from 10% in 2006 to 13.5% in 2011.
Dell's storage business has also significantly improved. Service revenues have grown from a $5.3 billion business in 2009 to a $7.6 billion business in 2011. The robust revenue growth is attributed to its small business segment. But Dell's revenue growth is at 1.52% for the last five years. Its operating margins have slightly declined from 7.8% in 2006 to 7.1% in 2011. Return on equity is higher at 41% based on its lean business model.
Cisco's storage business is lumped under the New Products Segment. It has also grown from sales of $9.8 billion in 2009 to $13.02 billion in 2011. For the last 5 years, Cisco has grown its revenues by 8% a year. However, I am concerned with its operating margins. Operating margins have declined from 24% in 2006 to 17% in 2011 as competitors have taken market share from this technology giant. Returns on equity have also declined from 23% in 2007 to 14% in 2011. Separately, IBM has also gaining traction in the storage business. Average growth of its storage business is at 11% a year and has also gained momentum against EMC and Hewlett-Packard.
Finally, the majority of Hewlett-Packard's business comes from enterprise business (i.e., which includes storage solutions). Overall, HPQ sales have increased by 6% a year for the 5-year period. Its operating margins have been erratic. It has averaged 7% to 9% for the same period. This translates to returns on equity of 17% in 2011, lower than the return on equity of 16% in 2006. The company's woes comes from lack of focus rather than cut-throat competition.
Trend towards Partnership
Technology firms are expected to join forces to pool their resources in the coming years. This model is a cheap alternative to acquisitions. This is not new territory for EMC. It has partnered with other players like Cisco, VMWare and Intel to create a virtual company that will produce new-generation converged cloud infrastructure systems. As mentioned above, it had a 10-year partnership with Dell after the latter became a competitor.
The Lenovo partnership has created a flexibility that could rival IBM, given that Lenovo's business lines were acquired from IBM. EMC now has solid access to tier one clients for its enterprise markets. Another positive feature is that there is no overlap with any of EMC's primary partners in the enterprise space. Lenovo has no exposure to the storage or networking space. The long-term effect is positive for EMC as it ventures toward other products and services. Moving forward, EMC can use this partnership model to mirror IBM's all-in-one technology umbrella model.
At current price levels, EMC is trading at 22.2 times earnings. This is slightly lower than its 5-year multiple of 23.8 times earnings. From a growth perspective, the stock trades at reasonable levels at 1.1 times earnings. I believe that the premium valuation is attributed to its strong competitive position in the storage space.
EMC's peers are trading lower, as most technology firms are facing several headwinds like lower corporate IT spending from global economic uncertainties. Cisco trades at 13 times earnings, lower than its 5-year price earnings ratio of 17 times. On price earnings over growth ratio, the stock is valued higher at 1.7 times. IBM is valued at 14.5 times earnings and price earnings over growth of 1.2 times. On the other hand, Hewlett-Packard trades at 7.6 times earnings, lower than its 5-year multiple of 13.1 times.
The long-term trends for storage appear positive. But there is a shift in the client base from corporate clients to service providers. The key to outperformance will be its ability to sustain its technology needs over time. Investors should monitor EMC's success in executing its strategy. I believe the stock will trade higher over the next few quarters.