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EMC Corporation (EMC) is diversifying into the emerging business of security software in a bid to mitigate the risk of its core data storage business. Its strategic planning, aimed at benefiting from both organic and inorganic growth, will enable the company to maintain its high growth. EMC's operating cash flows have been continuously increasing for the last 10 years and have risen by 200% since 2004.

Analysts expect its earnings to grow by 15% for the next five years. The stock is currently trading at a forward P/E multiple of 13.3x. Based upon its recent acquisitions, the transformation into a security business, strong cash flows, low valuations and future growth through acquisitions, the company is a good buy.

EMC Corporation is engaged in supporting, developing and delivering information technology. The company is operating in two segments, namely VMware Virtual, and Informational Infrastructure. The Informational Infrastructure segment enables the company to build, develop, protect, manage and analyze data with the help of different data centers. VMware Virtual helps clients transform IT resources according to their specific needs. They can integrate different servers, resources and data storage infrastructure to bring operational efficiencies. Cloud computing and business intelligence enables corporations to better utilize data to make effective future decisions.

Due to the economic turmoil in Europe, the company's revenues from the continent decreased by 1% in the last quarter. But, on the positive side, its revenues from emerging economies like India, Brazil and others rose by 20%; a 14% increase was witnessed in both the Asia Pacific countries and North America, respectively.

The company is trying conglomerate diversification to mitigate the risk of its slowly growing hardware storage business. EMC COO David Goulder reiterated that the company was interested in purchasing security software companies. In the second quarter, the company's security software sales increased by 13% YoY.

Furthermore, the company has also recently acquired Syncplicity to strengthen its bond with enterprise customers via a highly efficient management integrated system. The company also recently acquired Pivotal Labs to bring improvements in software development tools and services. The company has decided to invest in the Lab's R&D to further improve innovation. Moreover, the company's takeover of Watch4net illustrates that EMC is opting for vertical integration to bring about more efficiency in its operations.

Along with its organic growth and conglomerate diversification, we have seen inorganic growth through concentric channels. The company acquired XtremIO, an Israeli-based flash storage pioneer company, to enhance the portfolio of its storage products. This acquisition, worth $430 million, will enable the company to enhance its storage performance capabilities and capture the maximum market share from this segment.

The company is aiming to utilize $5.65 billion in cash to generate greater returns. EMC is planning to spend this cash on its security software business, to bring about growth from this emerging market. Corporations are concerned about the security of their networks and databases, and are willing to spend to protect their computer networks. According to Cekerevac, the emerging demand for security software in the technology space will provide great earning potential for companies engaged in the security, management and tracking of corporate data. EMC's future potential target companies involve Palo Alto Networks (PANW), Check Point Software Technologies (CHKP) and Fortinet (FTNT).

EMC's business relationship with Cisco Systems (CSCO) is now turning into rivalry. The companies used to help each other in cross selling different products, and also targeted customers as partners. But EMC's recent acquisition of Nicira poses a direct threat to Cisco's business and profitability. In response, Cisco, in its management discussion, decided to move into the storage market by acquiring one of EMC's competitors.

Financial Analysis

EMC's revenues grew by 10% over the last one year. A major increase of 18% in revenues was witnessed in the services segment. The company posted double-digit revenue growth for the 10th consecutive quarter. Its operating income and net income have substantially increased by 27% and 19% from 2Q2011 to 2Q2012. The company's profits have surged by 19% to $650 million in the second quarter. The significant increase in margin growth is depicted in the company's cost-effective strategies. Moreover, its interest expense has decreased significantly by 60% over the last one year. In its capital structure, the company's debt financing has considerably declined from 68% to 58% from 2Q2011 to 2Q2012. However, the important thing to consider is that the company has only $88 million in long-term debt. Furthermore, due to the company's acquisitions, it's restructuring and acquisition-related charges have increased by 30% in the year.

Direct Competitor Comparison

EMC

NTAP

BRCD

ORCL

SAP

Gross Margin (TTM)

62%

59%

61%

79%

72%

Operating Margin

19%

11%

10%

38%

31%

Qtrly Rev Growth (YoY)

10%

-1%

-1%

1%

18%

EMC's R&D expenditure increased up to $655 million from $538 million last year. The company has decided to invest $100 million in R&D in Brazil in the next five years to strengthen its innovation and manufacturing capabilities. The company's gross and operating margins of 62% and 19% are above NetApp's (NTAP) and Brocade Communications Systems' (BRCD) margins, and below Oracle Corporation's (ORCL) and SAP AG's (SAP) margins, as depicted in the table given above. Moreover, the company's operating cash flows and free cash flows are $1.24 billion and $958 million, respectively. There has been a significant increase in operating cash flows and free cash flows of 16% and 36% in the last quarter, which portrays the company's financial strength. Moreover, EMC invests its idle cash in long-term investments, which increased from $4.5 billion to $5.2 billion in the last six months.

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The stock has showed an upside of 22% YTD. Whereas, its main rival, NetApp, has been down by approximately 5%, while SAP and ORCL have followed the same trend as EMC. BRCD has been trading 10% above its year-starting price. Despite the fluctuations in the market, the stock remains above its competitors, as reflected in the graph given above. The bullish sentiment is reflected in the company's strategy to expand into the unrelated profitable business of security software.

Valuation

Comp Sheet

EMC

NTAP

BRCD

ORCL

SAP

EPS

$1.21

$1.42

$0.29

$1.96

$3.75

PEG (3-yr expected)

0.88

0.98

1.06

0.81

1.15

P/S

2.63x

2.01x

1.2x

4.1x

4x

Forward P/E (Dec 2013)

13.35x

13.98x

9.67x

12.03x

18.29x

The stock is currently trading at forward P/E of 13.35x, as compared to NetApp, Brocade Communications Systems, Oracle Corporation and SAP AG , whose forward P/Es are 13.9x, 9.6x, 12x and 18x, respectively. The stock is trading at cheap valuations as depicted in its 3-year expected PEG ratio of 0.88. Its P/S of 2.63x are undervalued when compared to ORCL's and SAP's 4.1x and 4x, respectively, and overvalued when compared to NTAP's and BRCD's 2x and 1.2x, respectively.

Going forward, we believe the company will execute its planned acquisition strategies, much like it has in the past. Its strong financial position, along with the growing demand for security software, will help the company sustain its high growth. The company's recent partnership with Lenovo to establish data storage products and market servers will enable it to broaden its reach in China. The company's continual growth, with increasing profits and high earning capabilities make it a good buy.

Source: EMC's Renewed Focus On High Growth Markets Makes It A Great Buy