Following the much-hyped initial public offering (IPO) of VMWare (NYSE:VMW) by EMC Corporation (NYSE:EMC) an interesting series of events took place.

There was the usual IPO excitement and VMWare's share price shot up. Then, investors remembered that EMC still holds owns 85.9% of VMWare. Chatter began to spread that possibly EMC was undervalued given the good things happening with its offspring.

Barron's Online came out with an August 20 article titled "An Unloved Store of Value" contending investors don't fully appreciate the value VMWare provides to EMC. At $18, the stock was undervalued the article contends, "EMC will benefit directly from VMWare's rising profits and will also enjoy gains in sales of storage-area networks, thanks to virtualization's growth. It could be a $22-$23 stock."

However, EMC has three other important business segments on top of the VMWare value. These businesses must be included in any EMC valuation, and, as we'll see, when everything is taken in as a whole, perhaps EMC is not undervalued, after all.

VMWare's Value
On August 14, 2007, 10% of VMWare's shares were sold by EMC through an initial public offering (IPO) at $29. This gave EMC $1.1 billion in cash before fees to the investment bankers. Since then, the price of VMWare's shares has risen to the $60 level, generating a very nice unrealized profit for all who owned shares in the company.

In July 2007, shares of VMWare were sold to Intel and Cisco. Each company was able to acquire their shares at a price lower than the IPO price. The primary purpose of these sales was to enhance the relationship of these companies in the virtualization software business, the mainstay of VMWare. It also turned out to be a good investment for Intel (Nasdaq:INTC) and Cisco (Nasdaq:CSCO) as shown in the table below.

Many articles, including the one from Barron's, claim investors are not fully realizing the value of EMC with VMWare in the market place. After the IPO, EMC still owns 85.9% of VMW. And management has indicated that it will take a long-term view on VMWare and not simply capitalize on its current value. This can be interrupted that they intend to help VMWare to grow its business. If it works, the value of VMWare should continue to increase over time.

EMC's Value
If we assume a $60 price for VMW, then the unrealized market value of EMC's investment is $19.5 billion. On August 21, 2007 the market capitalization of EMC was $37.2 billion meaning the market valued the rest of EMC at about $17.6 billion.

So, what is the valuation of EMC if VMWare were not part of the company? Sales for the three other business segments for the second quarter were $2.8 billion. As we calculated above, the market is valuing the three EMC segments at approximately $17.6 billion. This gives us a forward looking price to sales ratio of 1.56. I am assuming sales will remain flat for the year, which is not realistic, but more conservative. For reference, EMC's current price to sales ratio is 3.21, Hewlett-Packard's is 1.26 and IBM's is 1.57. Using this simple analysis, to factor out VMWare from EMC, it looks like the market is valuing the rest of EMC fairly when compared to other large growing technology companies.

Looking at EMC's second-quarter performance shows that the other business segments are performing well (despite a temporary problem for Content Management). RSA Information Security was acquired less than a year ago so actual comparisons are not yet possible. However, when compared to its results prior to the acquisition, revenue grew by 21% in the latest quarter. Content Management is expected to get back on track with new product releases along with renewed sales. In other words, this part of EMC isn't likely to cause the company's valuation to jump up dramatically from the current level.

EMC Generating Plenty of Cash
Another way to understand the potential of a company is by examining how much cash it generates. EMC is generating a lot of cash which gives the company several options to enhance shareholder value. As of the end of the second quarter, EMC had $4,591 million in cash and short-term securities. Add to that the cash generated from the VMWare IPO, plus cash generated in the third quarter, and EMC could have almost $7 billion in cash and cash equivalents on its books by the end of the current quarter.

So, what could EMC do with this cash? According to management about half of the cash is either committed to VMWare or is located outside the United States, making it a little more difficult to easily access. Still $3.5 billion is a lot of cash. Assuming EMC needs $1 billion for ongoing operations that leaves $2.5 billion that could be used for stock buybacks, dividends or acquisitions. I expect management to deploy the cash to complete additional stock buy backs and acquisitions. If acquisitions can add to the growth of the firm then it will benefit shareholders. Any stock buyback will also be advantageous.

The company's free cash flow for the latest quarter was $1 billion, up from $617 million in the same period in 2006 and significant when compared to $1.2 billion for all of 2006. This indicates management is doing good job managing the assets of EMC.

The Bottom Line

The VMWare IPO is contributing to the higher valuation of EMC. Much of the hype surrounding VMWare implies that EMC should be rising faster in value as well. VMWare is important to investors in EMC and it is helping to push up the price of the shares. However, EMC is more than VMWare and any valuation of the company must consider all the business parts.

In that light, EMC is probably reasonably valued with the expectation that is will continue to grow and generate a lot of cash that can be used to enhance shareholder value. Investors should look to acquire shares of EMC by considering the whole of the company, not just its fastest growing segment. With this perspective, buy on dips in price to participate in the growth of the whole company, not just the price appreciation of the VMWare shares trading on the open market.

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Tickers in this Article: EMC, VMW, INTC, CSCO

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