Over the past few years, technology companies have dramatically increased the amount of cash that they return to shareholders as dividends. Cisco Systems, Inc. (CSCO) recently boosted its dividend by 75%, and Apple Inc. (AAPL) has reinstated its dividend. And Dell Inc. (DELL) has yielded to pressure and initiated a quarterly dividend. But there is one large company that remains conspicuously absent from the list of technology leaders that pay a dividend. And that company is EMC Corporation (EMC). EMC is the world's largest storage company, and over the past year, the stock has outperformed both the S&P 500 and NetApp, Inc. (NTAP), its chief rival.
And while EMC is buying back stock, with $700 million in buybacks scheduled for 2012, we do not think it is enough. EMC's financial profile, in our view, means that the company has ample flexibility to initiate a dividend, and we break down our thesis below.
A Strong Balance Sheet, Strong Cash Flows, and Flexibility on Acquisitions
EMC ended the second quarter of 2012 with $9.195812 billion in net cash & investments on its balance sheet. And $3.7 billion of that cash is in the United States. EMC has 2,098,719,769 outstanding shares, which gives the company a net cash position of $4.38 per share. Based on the company's closing price of $26.68 on August 24, EMC has 16.42% of its market capitalization in cash. And we believe that some of that cash needs to be returned to shareholders.
EMC's cash flows are more than sufficient to support a dividend, continued buybacks, as well as acquisitions. In Q2 2012, EMC posted free cash flow of $958 million, up 36% from Q2 2011, as continued growth across EMC's business lines brings more and more cash in the door. EMC's current free cash flow "obligations" include $700 million in stock buybacks for 2012, and so far in 2012, EMC has spent just under $260 million on buying back its own stock.
In our view, a dividend would do nothing to thwart EMC's buybacks (in any case, dividends and buybacks are both a way of returning capital to shareholders; any cash EMC intends to allocate towards increased buybacks could just as easily go towards a dividend). Year-over-year, EMC reduced its diluted share count by 2.59% in Q2 2012. EMC has been returning capital to its shareholder's but it should do more. And it can, without endangering its ability to acquire new companies, which is essential for EMC.
EMC operates in a fiercely competitive market, and it needs to be able to acquire startups and other companies in order to stay ahead of its competition, especially NetApp. Though NetApp has stumbled of late, due in part to EMC, it remains a formidable competitor and should not be underestimated. However, in recent weeks, a potential new competitor has emerged: Cisco Systems.
When VMware, Inc. (VMW) (which is majority owned by EMC; more on that later) bought Nicira, sources told Reuters that VMware outbid Cisco for the networking startup. According to those sources, there is increasing tension between EMC and Cisco, which threatens their VCE (Virtual Computing Environment) joint venture, which was created in 2009. VCE is designed to bundle together networking gear from Cisco, software from VMware, and EMC's storage technologies into one package, thus making it easier for customers to manage their IT purchasing.
But, as EMC and Cisco move closer and closer into outright competition, their relationship seems to have frayed. On Cisco's last earnings call, CEO John Chambers surprised analysts with how blunt he was about this issue. Chambers said that while the partnership with EMC is strong, Cisco stands ready to be a very tough competitor. Cisco has already struck a deal to sell memory from Fusion-io, Inc. (FIO), and many analysts don't think that it is a stretch to assume that NetApp will be taken over by Cisco.
While this may look like a negative for EMC on the surface, we believe that the net effect of this will be a wash. The VCE joint venture is currently unprofitable, and we fail to see how folding NetApp into Cisco and replacing EMC's technology with NetApp's will fundamentally alter Cisco's competitive position. And in any case, EMC is not a company to back down quietly, as we saw back when EMC outbid NetApp for Data Domain.
And if NetApp is indeed for sale, it is certain that EMC will be at the table. The company has billions in net cash and investments, a good balance sheet, and a stock and management team that has the support of Wall Street. Though EMC's market cap of around $56 billion may be much less than Cisco's almost $103 billion, we think that investors should not underestimate EMC's financial strength.
The Dividend Math
If EMC is to initiate a dividend, where should it start? We believe that a yield of 2% is a good starting point. Dell, the most recent technology company to initiate a dividend, has a yield of over 2.8%. For the sake of conservatism, EMC can start at 2%. Based on the company's closing stock price on August 24 of $26.68, a 2% yield would require a payout of 54 cents a year (the actual yield is 2.02%), or 13.5 cents per quarter. At that rate, this dividend would cost EMC $283,327,168.80 million each quarter, hardly an exorbitant sum.
Based on EMC's Q2 cash flows, EMC would have over $499 million in remaining free cash flow each quarter, giving the company ample room to beef up its war chest of cash & investments (to say nothing of its existing $9.195812 billion in cash & investments). In addition, EMC's remaining free cash flow could be used to rapidly pay down any debt needed to finance a sizeable acquisition. Or, EMC could use its remaining free cash flow to rapidly buy back any stock issued for an acquisition. Simply put, we see no reason that a dividend needs to stand in the way of EMC being able to buy the companies it needs to stay competitive.
EMC does not need to simply have cash pilling up on its balance sheet, and we believe that the stock can see a significant rise if the company were to initiate a dividend. But, excess cash is not the only reason that EMC should initiate a dividend. There is a second reason. And that reason is VMware.
The VMware Factor
EMC and VMware have a truly unique arrangement. VMWare is a public company, yet almost all of it is owned by EMC. VMware's latest 10-Q (for Q2 2012) indicates that EMC controls 79.3% of VMware's stock. EMC's ownership consists of 38.664 million shares of Class A common stock (which is publicly traded) and every single share of Class B stock (300 million shares). EMC controls 97.2% of the votes at VMware thanks to its Class B stock.
Since EMC floated a potion of VMware on the NYSE back in 2007, VMware has outperformed its parent, rising almost 66%, compared to a rise of almost 51% for EMC.
Based on VMware's closing price of $92.21 on August 24, EMC's stake in its virtualization subsidiary is worth $31.22820744 billion, or 55.77% of EMC's own $55.99384343692 billion market capitalization. Our last article on EMC focused extensively on how EMC's VMware stake is leading to a dramatic mispricing of the company's core storage business. At the time the article was written (June 22, 2012), EMC's core storage business was being valued at just 10.65x trailing 12 month earnings, compared to a P/E ratio of almost 25 for NetApp (EMC's overall P/E ratio stands at just over 22, but that is distorted by the company's VMWare stake). NetApp's valuation relative to EMC would be justified if NetApp was set to grow faster than EMC, which is projected to grow EPS by 13.91% in 2013 and by 14.53% in 2014.
What about NetApp? Isn't that company set for even faster growth. Not so. NetApp's earnings are actually expected to shrink in 2012, due to intensifying competition from EMC. Earnings at NetApp are set to fall by 4.55%, before rebounding by 16.67% (to be fair, we see potential catalysts for NetApp as well, which we cover in our latest article on that company).
In our view, EMC's true value is being distorted by its control of VMware, and given the fact that a spin-off of VMWare has not only been refuted by that company's executives, but would not make sense from a strategic standpoint, a dividend is the next best way for EMC investors to unlock value from the company. And we believe that there is plenty of value to be unlocked.
VMware is causing to EMC being undervalued, and at under $27, EMC's shares are not reflecting the company's full potential. Should the company choose to initiate a dividend and unlock value for its investors, we think that shares of the world's leading storage company can rise even more than they already should, given EMC Corporation's financial strength, strong competitive position, and solid growth opportunities.