EMC May Be Stronger Than It Looks

By Stephen D. Simpson, CFA | July 25, 2013 AAA

So far, this is looking like a quarter where the IT hardware space is still in rough shape, but not quite as bad as feared. That's good news for EMC (NYSE: EMC), as storage equipment budgets generally follow the overall space. It also looks as though VMware (NYSE:VMW) may be recovering faster/better than expected, and it's worth noting that EMC delivered an in-line quarter even though the launches of the new VNX2 products have slipped into third quarter. All told, while this wasn't a quarter worthy of a victory dance, the idea that EMC's performance is improving seems realistic and the stock's valuation still looks attractive.

In-Line Good Enough For Now
Most of the excitement for EMC's quarter is going to come from the fact that VMware seems to be rebounding both stronger and faster than expected. And while it's true that EMC's Info Intelligence and Security businesses were weaker than expected, I think the solid result in the core Storage business shouldn't be overlooked.

SEE: A Primer On Investing In The Tech Industry

Revenue rose 6% from the year-ago quarter, or 4% on a sequential basis and was pretty much bang in line with sell-side expectations. Storage revenue grew 4% (with 3% product revenue growth), with emerging products (which includes the company's flash efforts) up 39%. Info Intelligence revenue declined 6%, while security improved 4%. VMware was the real surprise though, as revenue improved 14% (with product revenue up 4%) on 9% license growth.

Margins support the idea that things are getting better. Although gross margin was still down a half-point from last year (on a big decline in security, but also declines in Info Intel and storage), but up more than a point sequentially. It's worth mentioning that on a non-GAAP basis, gross margin was down 10bp from last year. Operating income rose 8%, and the GAAP operating margin expanded by 40bp from the year-ago period.

Storage Gaining Share, And Likely To Re-accelerate
It's becoming old hat to mention this, but EMC (and NetApp (Nasdaq:NTAP)) continue to take share in the storage market from traditional competitors like IBM (NYSE:IBM) and Hewlett-Packard (NYSE: HPQ). Whether or not those company's executives would acknowledge it or not, this is likely to continue as they simply aren't investing the resources necessary to stay relevant with EMC and NetApp in the market.

Even apart from share gains, though, I believe there's a case to be made that EMC is likely to see improving growth in the second half of the year. More than a few sell-side analysts thought that EMC would miss the quarter due to delays in launching the new VNX2 and VNX2e products (the older versions of which contribute about 15% of revenue). These new products are likely to get a good reception from the market (offering better integration of HDDs and flash), and for EMC to make numbers even without their contribution, I believe that points to good pent-up demand for the second half of the year.

SEE: EMC Strengthens Security Portfolio

I also see the company continuing to build the business for long-term success. EMC has been seeing good interest in its Xtrem line of SSD/flash products, and the acquisition of ScaleIO improves the company's position in virtual SAN storage and continuous a theme of “self-obsolescence” by allowing customers to use heterogenous equipment and avoid “locking in” with a single supplier. Not only does this seem to match a similar move from Fusion-io (NYSE: FIO) with ION Data Accelerator, but if ScaleIO really takes off, I would think the reduced need for fabric switches would be a bad development for Brocade (Nasdaq: BRCD).

The Bottom Line
EMC has a winning formula of coupling strong internal development with as-needed acquisitions to stay on the leading edge of technology and customer needs in storage. I see no reason that that will change, as EMC has the resources to acquire or build whatever it believes clients need. As such, the biggest risks I see are the possibility that management badly misreads the future evolution of the storage market (including the risk of outsourcing to companies like Amazon (Nasdaq:AMZN)) and/or gets too aggressive with its M&A.

For now, though, I continue to believe this is an exceptionally undervalued stock. I'm looking for long-term revenue growth of 5% (against a trailing 10-year growth rate of 15%) and free cash flow growth of less than 6%. Even with a slight penalty to my estimated S&P 500 discount rate, that works out to a fair value of more than $38 per share. For today's price to be fair, you have to assume zero future growth, and even with the long-term risks facing IT hardware and VMware, that seems too conservative. Accordingly, I continue to believe this is one of the best long-term buys in tech today.

Disclosure – As of this writing, the author owns shares of EMC.

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