Shares of EMC Corporation (EMC) have declined 10% from their three-month high of $28, recently achieved in September. I believe the plunge presents a great opportunity to load up on this quality stock at a discounted price. In this article, I will elaborate on the analysis that supports my view.
EMC is priced attractively based on the company's financial performance relative to that of its peers (see comparable analysis table below). Analysts on average predict EMC's revenue, EBITDA, and EPS to grow at two-year CAGRs of 8.9%, 19.2%, and 17.9%, respectively, over the current and next fiscal years. Those growth estimates are considerably higher than the average estimates of 3.2%, 6.0%, and -0.4%, respectively, for a peer group consisting of EMC's primary competitors in the data storage field.
In addition, EMC's EBITDA margin is forecast to expand decently by 4.6%, compared to the peer average of an only 1.2% increase. On the profit side, EMC's various profitability margins are all above par. However, the company's capital return metrics such as ROE and ROIC are below peer averages. EMC assumes a very low leverage as reflected by the firm's lower debt-to-capitalization and debt-to-EBITDA ratios. In terms of liquidity, EMC's trailing free cash flow margin at 21.4% is significantly above the peer average of just 9.9%. Due to the higher profitability and the lower debt level, the firm was able to maintain a very healthy interest coverage ratio. Both EMC's current and quick ratios are below par, reflecting a mediocre corporate balance sheet.
Click to enlarge images.
To summarize the financial comparisons, EMC's strong growth prospects, above-average firm size, and robust profitability and free cash flow should substantiate a large premium valuation for the stock. Nevertheless, the current stock valuations at 8.0 times forward EV/EBITDA, 11.0 times trailing EV/FCF, 13.5 times forward P/E, and 0.91 times PEG represent an average valuation premium of only 7.8% over the peer-average trading multiples, suggesting a cheap valuation (see comparable analysis table above).
Moreover, both EMC's trailing EV/EBITDA and P/E multiples are currently trading at 18.6% and 24.8% discounts, respectively, to their three-year historical averages (see chart below). In addition, the stock's forward P/E multiple has underperformed the same multiple of the S&P 500 index over the past 12 months and is now trading consistently with the index multiple (see chart below). I believe the stock should easily command an above-market valuation given that EMC's estimated long-term earnings growth of 14.9% is substantially higher than the average estimate of 7.9% for the S&P 500 companies.
Comparing EMC's valuation to that of NetApp (NTAP), the nearest comparable company, the stock's forward P/E and PEG multiples of 13.5 times and 0.91 times are fairly in line with NTAP's 12.9 times and 1.03 times, respectively, despite the fact that EMC's growth prospects, profitability, and free cash flow generation are considerably better (see table below).
The ongoing trend of weak corporate IT spending appears to be the primary drag on EMC's valuation. However, a group of analysts, led by Kulbinder Garcha at Credit Suisse, wrote in their recent research note:
We continue to believe that within the various subsegments of IT hardware, storage remains higher priority and maintains one of the most attractive secular growth profiles. While near-term macro trends have impacted overall IT spending, our recent survey shows the continued prioritization of budget dollars toward storage spending. With over two-thirds of our survey respondents listing storage among the top two priorities within customers IT budgets. Storage demand is largely driven by growth in unstructured data as a result of the explosion of digital content, server virtualization, and expanded regulatory and compliance requirements across verticals. Overall, we expect the storage hardware market to grow at a CAGR of 9.3%, between 2011 and 2015, with the networked storage market growing even faster.
According to a chart shown below, EMC's growth is partially driven by the heavy acquisition records as the company spent the free cash flows primarily in takeovers and share buybacks. Over the past decade, EMC's free cash flow has grown substantially to almost $6 billion on a LTM basis as of September 2012. With the current cash position of $5.5 billion, the company has an ample capacity to continue making tuck-in transactions and staying at the forefront of the technology curve.
From a technical perspective, EMC is now trading slightly above a technical support level that helped in mitigating a downward price trend in mid-2012 (see chart below).
Bottom line, I believe EMC's solid margin of safety -- which is supported by the cheap valuations and the promising growth prospects -- should warrant a buy decision. Assuming that the stock's forward multiple would trade at 10% premium above the current multiple of 13.7 times the S&P 500 index, and supposing that EPS would grow to analysts' average estimate of $2.23 by FY 2014, this base-case scenario implies a target stock price of $33.6, representing 33% upside.
The comparable analysis table was created by author. All other charts are sourced from Capital IQ, and all financial data is sourced from Morningstar, Thomson One, and Capital IQ.
Disclosure: I am long EMC.