EMC Opening Its Wallet And Bracing For The Next Evolution Of The Market

By Stephen D. Simpson, CFA | May 30, 2013 AAA

These are busy times for EMC (NYSE:EMC). It may not look like it, given the sleepy state of the IT hardware market, but like a duck moving across a pond there is a lot of activity going on below the surface. EMC is looking to position itself to not just withstand but prosper from changes in its core storage business, while also sharing more capital with its shareholders. Although big capital returns are often a sign of fading prospects in the tech space, I do believe EMC is undervalued on its long-term prospects.

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Will Amazon Kill The King, Or Just The Footmen?
In relatively short order, Amazon's (Nasdaq:AMZN) Amazon Web Services (AWS) has emerged as a major force in IT – essentially allowing companies to offload their hardware, software, and management needs to a cloud service with minimal upfront costs. If companies decide that they no longer need their own data centers and storage hardware, that cuts to the heart of what EMC does as a business (and it's potentially even more serious for EMC's high-margin majority-owned subsidiary VMware (NYSE:VMW)).

EMC isn't taking this lying down, and is positioning ViPR and Pivotal as answers to Amazon's efforts. ViPR is effectively EMC's entrant into “software-defined storage” and manages storage infrastructure and data. Interesting, EMC has designed ViPR to support third party hardware and software, including rivals/competitors like NetApp (Nasdaq:NTAP), Microsoft (Nasdaq:MSFT), and OpenStack. This willingness to “self-obsolete” is one of the things I've always liked about EMC, and I believe it is why EMC has managed to stay on the leading edge of its markets.

SEE: Analyzing An Acquisition Announcement

Pivotal is a bit more confusing. This company, which combines bits and pieces from EMC and VMware, will target big data analytics and allow businesses to create Amazon-like clouds without locking into those providers. EMC believes that its hardware and software can enable private clouds that are considerably cheaper than what Amazon offers (one-third the cost) with better service. Suffice it to say, there is ample disagreement on this point. In any case, Pivotal will be structured and run as an independent company, shared between EMC, VMware, and General Electric (NYSE:GE) (which kicked in $100 million for a 10% stake), much the same as VMware was before its IPO.

Sharing The Wealth
Although EMC has never been shy about using M&A to acquire the technology management thinks it needs (and couldn't develop internally), $12 billion is probably more cash than the company can realistically use. To that end, EMC is answering the wishes of many analysts and investors with an expanded capital return program. In addition to establishing a $0.10 per share dividend (equivalent to a 1.7% yield based on the price before the announcement), the company will be upping its buyback substantially – targeting $6 billion in buybacks before the end of 2015 (with as much as half coming this year).

SEE: A Breakdown Of Stock Buybacks

I have mixed feelings about this. As an EMC shareholder, I'm happy to collect a dividend and I don't think the company needs all that cash (not to mention, interest rates are low now and the company can borrow whatever its ample free cash flow generation can't provide). On the other hand, capital returns haven't helped tech companies like Microsoft change the tone on their stocks, and I fear some analysts/investors will point to this as an “ah ha” moment that somehow proves EMC no longer sees itself as a real growth company.

The Bottom Line
There is no doubt that the world has changed around, and because of, EMC. Dell (Nadaq:DELL), Hewlett-Packard (NYSE:HPQ), and IBM (NYSE:IBM) have faded as threats to EMC's core business, while Amazon and Oracle (Nasdaq:ORCL) have emerged as new rivals. EMC has historically been good at adapting to changing markets and customer needs, and I have confidence that they will navigate this change as well. Of course, change means risk and by no means should investors ignore the potential that EMC will find itself increasing marginalized, looking around in a few years and wondering what exactly happened.

I am looking for 5% long-term revenue growth for EMC, which is probably on the higher end of the future growth range for the traditional enterprise storage market. I'm likewise looking for about 5% free cash flow growth as a heavier mix of software and advanced products (like flash) should boost margins. It's worth noting as well that these estimates assume that Amazon does not utterly undermine the traditional hardware market and that VMware can reignite its revenue and maintain margins.

If these projections are valid, fair value EMC is around $38.50 – well above the $30 or so average of sell-side price targets. That makes EMC substantially undervalued in my mind, and a hardware company that investors should consider for their own portfolios.

At the time of writing, Stephen D. Simpson owned shares of EMC.

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