EMC: A Better Way to Own VMware

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Includes: DVMT, VMW
by: Bapcha's Stocks

What was cutting-edge back in the 1970s - in the days of mainframe computers and centralized computing - is new again. I am talking about virtualization. The current version of virtualization is significantly different in that the computing equipment need not necessarily be centralized. In fact, in its current iteration, distributed “clouds” of computers can be configured to work as a virtual server, or if there is an excess of centralized computing power, that can be fractioned into multiple servers. The only down-side of virtualization is that the administrator of the data center cannot go to a box, look at the status LEDs and monitor the console, kick it, whatever.

The most elegant solution to managing these “clouds” is already on the market care of the near-forgotten ex-manufacturer of software for mainframes, but now blazing a new trail for themselves - BMC Software (NASDAQ:BMC). But I will cover that in a following article.

When one talks about virtualization, or “cloud computing”, the first company that comes to anyone’s mind is - VMware (NYSE:VMW). VMW backs up its street cred with some amazing numbers [mixed with ample amounts of concern]. While sales growth was a torrid 25% yoy in Q4 2008, high margin license revenues grew only 10%. The fact that VMW guided lower going forward into calendar 2009 - is no surprise to anyone. Additionally, Microsoft (NASDAQ:MSFT) is planning an assault on VMWare by packaging virtualization-lite with Windows-7. In other words, virtualization is getting commoditized - which erodes VMW’s economic moat.

Analyzing VMware’s numbers raised one important question. The TTM tax rate is about 10%. Their tax rate in 2007 was a tad below 10%, but the 2006 tax-rate is 30.1%. The latest 10K of VMW’s clearly states that their tax rate is not too predictable, and can vary significantly from quarter to quarter. The question is - can the tax rate go back to 30%? The short answer is yes depending on the geographic mix of sales. In fact, a recovering US economy will mean a higher tax rate for VMW as their current US rate stands at 35%. In fact, their GAAP and non-GAAP earnings could decrease by up to 25% from current levels, and this is on top of lower projected revenues for calendar Q1-2009.

But, there is a better way to “own” VMware, and that is through EMC Corp. (EMC) - which owns over 80% of VMW’s outstanding shares, and more importantly, 98% of all the voting stock of VMW - effectively making VMW a “controlled company”. While Corporate Governance has not been a major issue until now, this explains the ease with which a former founder of VMware was let go. While EMC’s own business in the SAN world will shrink in 2009 - (like everyone else’s in recent times), they have been gaining market share from and earning double the profit margins than their next largest competitor - NetApp (NASDAQ:NTAP). In fact, EMC closed out calendar Q4 2008 and the year 2008 on a positive note - with quarterly revenues up 5% yoy to a little over $4 billion, and annual revenues up 12% yoy - to $14.88 billion [of course, these numbers *include* VMware's].

Looking at EMC’s valuation numbers, 2 Billion shares at $11.37/share ~ $23 Billion. Subtract cash, add in their debt, and the number drops to $19 Billion. EMC generates about a billion in cash flow every quarter [about three-quarters of a billion in FCF]. EMC has bought back about 300+M shares over the last several years, a billion dollars worth [of the bought back stock] was financed with notes yielding 1.75%. This is, in our opinion, a very efficient use of capital - since most of the shares were bought at or below $11.40/share.

But, EMC’s current valuation is significantly influenced by VMW’s numbers. In fact, moving forward, VMW’s sales and profitability will be significantly lower in 2009 [vs. calendar 2008]. But EMC’s sales and profits will erode at a much slower rate than VMW’s, affording us a discounted entry into either stock which would not have been possible if the two had been separate. In other words, VMW’s impending negative growth rate is weighing on both VMW and EMC.

At this point in time, each share of EMC controls a little less than a fifth of a share of VMW. Add to this EMC’s fundamentally sound business, and I see no compelling reason for buying VMware; I’d rather buy EMC.

In short,
1. Gross margins > 80%
2. Revenues growth rate of 30%
3. Owns the datacenter market.
4. Very little earnings hit from stock options.
BUT,
1. High margin license revenues grew only 10% [bad if you want a premium valuation].
2. EMC owns over 80% of common and 98% of votes making VMW a “controlled company” where the common stockholder has NO rights.
3. No independent directors.
AND,
4. Virtualization is getting commoditized.

Bottom-line:
When looking at a “controlled company” like VMware, one needs to analyze and determine if it is better to own the controlled company or the controller. In this case, since the sum of EMC’s parts far exceed what one pays for EMC, it is a better idea to buy into EMC than it is to buy into VMW.

Disclosure: No positions in VMW, EMC, BMC.