EMC: As Growth Begins To Accelerate, Shares Remain Undervalued

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Shares of EMC (EMC) have been battered over the past 12 months, falling over 18% as warnings of economic uncertainty and weak guidance at VMware (NYSE:VMW) created an aura of weakness around EMC. However, the events of the past few months (primarily EMC and VMware's Q4 2012 earnings) should not be seen as representative of EMC's long-term potential, a sentiment highlighted by CEO Joe Tucci at EMC's 2013 analyst day. We believe that EMC's best days are ahead of it, and that below $24, shares of EMC are meaningfully undervalued, and we lay out our bullish thesis below. For the record, unless otherwise noted, financial statistics and management commentary will be sourced from the following sources:

  1. EMC's Q4 2012 earnings release
  2. EMC's Q4 2012 earnings conference call
  3. EMC & VMware's 2013 Strategic Forum (the companies' analyst day)
  4. EMC's 2012 10-K
  5. VMware's 2012 10-K

Q4 2012 & Financial Review

For Q4 2012, EMC posted revenues of $6 billion (growing 8% year-over-year) and EPS came in at 54 cents per share, representing year-over-year growth of 10%. Operating and free cash flow also came in at record levels, with 2012 operating cash flow growing by 10% to reach $6.3 billion, and free cash flow rising by 14% to $5 billion. Operating margins also posted meaningful gains, expanding by 120 basis points year-over-year to reach 27.5%. However, despite posting record financial results for Q4 and 2012, as well as beating estimates on both the top and bottom line, shares of EMC have been pressured since the company's Q4 earnings due to weak guidance from VMware as well as below-consensus guidance from EMC; the company guided for 2013 revenue and EPS of $23.5 billion and $1.85, below consensus estimates of $23.6 billion and $1.90. However, there are several nuances to EMC's guidance relating to core growth at EMC. Given that EMC's 2013 guidance was below consensus, analysts immediately began questioning the company's management team, trying to discern the various moving parts embedded within the company's guidance. President & COO David Goulden explained that when VMware's forecasts are excluded, the company expects core EMC revenues to grow by 6% in 2013, versus historical growth rates of around 5%, driven by expectations of continued above-average growth in network storage, as well as EMC's continued product rollouts. And while EMC's growth relative to the market is slowing to 2x the market (6% growth at core EMC versus the company's 3% forecast for IT market growth), versus 2.5x the market in 2012 (5% growth versus 2% growth in the overall IT market), COO David Goulden also noted that this guidance was conservative, and that EMC hopes to beat those forecasts as 2013 progresses.

EMC's robust Q4 and full-year 2012 results have served to further fortify the company's balance sheet. EMC ended 2012 with $9.68558 billion in net cash & investments, and CEO Joe Tucci has pledged that EMC will continue utilizing its cash pile to acquire new companies and stay ahead of the competition. EMC will also be boosting its buybacks in 2013 by nearly 43% to $1 billion (versus 2012 buybacks of $700 million), and 50% of its cash is held in the United States, a notable contrast to many other technology companies that hold much of their cash overseas. EMC has pledged that it will continue to be an active dealmaker, and is reported to be one of the bidders for SoftLayer Technologies, with a price tag said to be at $2 billion. And although EMC is reported to be bidding against IBM (NYSE:IBM), the company does have a potential advantage. David Strohm, of Greylock Partners, sits on the boards of both EMC and VMware, and also sits on SoftLayer's board as well. And although Strohm has likely recused himself from an active role in negotiating any deal, it is highly likely that EMC has more knowledge of SoftLayer than IBM. However, M&A is but one of the ways in which EMC is set to deploy capital. CEO Joe Tucci has also pledged that a dividend will arrive in time, but that for the time being, EMC will focus on buybacks. When EMC does initiate its dividend, this will potentially bring in a new class of investors, thereby providing yet another catalyst for EMC's shares.

Long-Term Guidance: A Pivotal Re-acceleration of Growth

While some investors perceived EMC's commentary on its Q4 earnings call (as well as VMware's own Q4 commentary) as gloomy, the 2 companies sounded anything but gloomy at their 2013 Strategic Forum, which both EMC and VMware utilized to give long-term guidance. In our view, both EMC and VMware provided solid long-term outlooks, which, combined with the Pivotal initiative, should serve to reverse the decline in EMC's share price. We will break down the 2013 Strategic Forum (which we will refer to as EMC and VMware's analyst day) into its 3 main components: EMC, VMware, and Pivotal.

  1. EMC: For many legacy technology companies (given that EMC was founded in 1979 it certainly qualifies as a legacy technology company), shrinking addressable markets are a prime concern, especially at companies exposed to the PC industry. For EMC, however, this is not an issue. CEO Joe Tucci stated at EMC's analyst day that the company's current addressable market (defined as that of EMC, VMware, and Pivotal) of $99 billion is set to expand to $164 billion by 2016, driven by the continued growth of VMware's cloud markets, which are set to rise to $50 billion in 2016, up from $19 billion today. EMC's own addressable market is projected to expand by 27.94% to $87 billion. Of equal importance is the fact that EMC forecast annual revenue growth through 2017 of 9%, versus consensus forecasts of 8%. Furthermore, VCE, the joint venture 58% owned by EMC [35% is owned by Cisco Systems (NASDAQ:CSCO)] is on pace to "far exceed" $1 billion in 2013 revenue, according to CEO Joe Tucci.
  2. VMware: After providing what many thought was weak guidance for 2013, VMware's executive team soothed Wall Street by providing a robust outlook for 2014-2016. The company is calling for 15-20% annual revenue growth for those years, whereas consensus estimates called for growth of 15% in 2014. In addition, VMware is beginning to roll out products built around its takeover of Nicira. The company's NSX platform will launch in the 2nd half of 2013, and will merge together Nicira's Network Virtualization platform with VMware's existing vCloud product line. It is important to note that some of VMware's downbeat guidance for 2013 (2013 revenues are forecasted at $5.23-$5.35 billion, versus consensus estimates of $5.43 billion) can be attributed to its divestiture of assets slated to be included in the Pivotal initiative. A third of Pivotal's 1,250 employees are slated to come from VMware (which will own 31% of Pivotal; EMC will own the remaining 69%), and with Pivotal's existing businesses generating $300 million in revenues, the impact of the divestiture may be larger to VMware than EMC, given their size. However, VMware's executives said that the spinoff of Pivotal, which will incorporate EMC's data analytics division, Greenplum, and Pivotal Labs, could raise VMware 2013 operating margins.
  3. Pivotal: EMC and VMware will own 69% and 31% of Pivotal, respectively, and the venture is set to more than triple revenue to $1 billion by 2017, and Paul Maritz, EMC's Chief Strategist, believes that this target could be conservative. We share that view, for EMC has the financial firepower to invest meaningful sums into Pivotal ($400 million in investments is slated for 2013 and 2014), which will give Pivotal ample ability to invest in research & development at a pace that exceeds that of many of its competitors. In addition, Pivotal's ultimate corporate structure will likely resemble that of VMware: a publicly traded company majority-owned by EMC. EMC CEO Joe Tucci himself suggested that this would be the case, and an IPO of Pivotal would be beneficial to EMC, for it will allow investors to properly value EMC's stake in Pivotal. The likelihood of this outcome is further increased when one looks at the long-term effects of EMC's decision to partially spin-off VMware. Since the August 2007 IPO of VMware, its shares are up 42%, while shares of EMC are up by nearly 35%.

In our view, both EMC and VMware are poised for long-term success. The addressable markets of both companies are expanding, and EMC has the financial firepower needed to invest in all levels of its business. Pivotal's business is set to grow at a rapid pace through at least 2017, and a potential IPO of the venture will likely lead to profits for EMC investors.

EMC's decision to spin off VMware has proven itself to be a successful one, for it has allowed investors to place a more appropriate valuation on VMware than they would otherwise be able to had it remained a wholly owned subsidiary of EMC. But, this spinoff did not come without drawbacks. The continued growth of VMware, and the accompanying rise in its share price, has led to a dramatic undervaluation of EMC's standalone business, especially when compared to that of NetApp (NASDAQ:NTAP), its primary competitor.

The VMware Discount Factor

We have written about this issue before, and believe that it continues to be a meaningful issue, for EMC's outsized stake in VMware is depressing its standalone valuation.

Based on its 2,104,430,304 outstanding shares, and a stock price of $23.89, EMC's market capitalization currently stands at $50,274,839,962.56. But, EMC's 79.6%stake in VMware is currently valued at $26,902,024,000. Over 53% of EMC's value is based on its stake in VMware, and we do not believe that market value of less than $24 billion is representative of the true value of EMC's standalone business, especially when compared to the valuations of NetApp. The table below displays the undervaluation of EMC's standalone business (figures other than market capitalization are in thousands of dollars).

EMC Valuation Analysis

Consolidated EMC

VMware Within EMC

Standalone EMC

2012 Revenue

$21,713,902

$4,595,601

$17,118,301

2012 Pro Forma Net Income

$3,759,487

$597,461

$3,162,026

2012 Pro Forma EPS

$1.70

$0.270165504*

$1.429834496

2011 Revenue

$20,007,588

$3,762,854

$16,244,734

2011 Pro Forma Net Income

$3,380,542

$589,996

$2,790,546

2011 Pro Forma EPS

$1.51

$0.2635358354**

$1.246464165

2012 Revenue Growth

+8.53%

+22.13%

+5.38%

2012 Pro Forma Net Income Growth

+11.21%

+1.27%

+13.31%

2012 Pro Forma EPS Growth

+12.58%

+2.52%

+14.71%

Market Value

$50,274,839,962.56

$26,902,024,000

$23,372,815,962.56

Trailing 12-Month P/E***

14.05x

45.03x

7.39x

*15.89208847% of EMC's 2012 net income is from VMware, and VMware's EPS contribution is calculated by applying that percentage to EMC's consolidated EPS.

**17.45270433% of EMC's 2011 net income is from VMware, and VMware's EPS contribution for 2011 is calculated by applying that percentage to EMC's consolidated EPS.

*** Calculated by applying the implied values of each part of EMC and dividing it by the each part's 2012 net income.

As the table above shows (albeit with some complexity), EMC's standalone business is being valued at less than 8x earnings, a multiple we believe is far too low given the company's leading position in the storage market. And, that multiple becomes even more favorable when compared with that of NetApp, EMC's primary competitor in the storage market (data is sourced from NetApp's earnings releases).

NetApp Valuation Analysis (in Thousands of $)

Revenue

Pro Forma Net Income

Pro Forma EPS

Q3 2013

$1,630,100

$242,700

$0.665

Q2 2013

$1,541,200

$189,000

$0.513

Q1 2013

$1,444,600

$156,400

$0.421

Q4 2012

$1,702,500

$252,400

$0.661

Trailing 12-Months

$6,318,400

$840,500

$2.26

Q3 2012

$1,565,500

$216,000

$0.578

Q2 2012

$1,507,000

$235,000

$0.626

Q1 2012

$1,458,200

$222,300

$0.548

Q4 2011

$1,428,300

$236,700

$0.586

Prior Trailing 12-Months

$5,959,000

$910,000

$2.338

Trailing 12-Month Growth

+6.03%

-7.64%

-3.34%

It is true that NetApp's revenue over the past 12 months has grown by 6.03%, which is above EMC's standalone revenue growth rate of 5.38%. But, based on its March 28, 2013 closing price of $34.16, NetApp is valued at 15.12x its trailing 12-month EPS, more than double EMC's standalone valuation. And while EMC's standalone revenues grew 65 basis points less than NetApp's over the last 12 months, the business grew net income by double digits, even as NetApp's shrank. In our view, EMC's standalone business deserves a much higher multiple than it is currently getting. And EMC is taking market share. In the 4th quarter of 2012, EMC expanded its market share to 24%, and grew storage revenue by 7.3%, versus 6.3% storage revenue growth at NetApp. In our view, EMC's standalone multiple in no way reflects the company's true value, especially when compared to NetApp.

Conclusions

Despite offering investors double-digit growth in standalone EPS (and revenue growth only slightly below that of NetApp), EMC's standalone valuation is well below that of NetApp, a discrepancy that we believe will be remedied in the long run. We believe that EMC's best days are ahead of it, and that under $24, shares of EMC offer meaningful upside potential. EMC has been (and is) deploying capital aggressively, and both EMC and VMware have forecasted good growth over the course of the next several years. And the creation of the Pivotal venture, and its likely IPO, offer EMC investors yet another avenue to profit. These factors, and the likely initiation of a dividend, should lead to meaningful upside for EMC investors, and we believe that at present levels, a buying opportunity is at hand.

Disclosure: I am long EMC, CSCO, VMW. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.