Data virtualization company VMware (NYSE:VMW) went public August 14, 2007, as a spin-off of information infrastructure giant EMC (NYSE:EMC). VMware's technology essentially allows a single computer to operate as if it were several, improving information efficiency. Its IPO raised close to $1 billion, selling 33 million shares at $29 with an overallotment of 4.95 million additional shares, which the underwriters exercised. It was a 2007 success story, closing its first day of trading up 76% at $51. Unfortunately, the honeymoon wouldn't last.
We Told You So
At the end of August 2007, just days after VMware's special day, Investopedia ran an article detailing the reasons why parent EMC was appropriately valued despite Barron's assertions otherwise. Barron's felt the share price at the time was too low and that the true value was more like $22 to $23. Given the turn of events for the markets in 2008, anyone who read our article and refrained from buying is probably breathing a heavy sigh of relief. The price of EMC stock on August 31, 2007, was $19.66. Today, it sits around $10, nearly a 50% drop in 14 months. This compares with a 40% drop for the Dow Jones Wilshire 5000.
One of the major arguments in the Investopedia article for EMC being fairly valued was its price-to-sales ratio, which at the time was 3.21, more than double that of competitors Hewlett-Packard (NYSE:HPQ) and IBM (NYSE:IBM). (You can read more about evaluating this figure in Use Price-To-Sales Ratios To Value Stocks.)
A secondary argument was that the hype in the VMware IPO created an artificially high valuation of EMC. In essence, a rising tide lifts all boats. But that didn't happen. Within two months of VMware's IPO, its stock price jumped over the $100 mark, only to come crashing back to earth over the next 52 weeks, wreaking havoc on EMC's stock.
Have Things Changed?
I believe they have. EMC's price is more in line with the valuations of both IBM and Hewlett-Packard. The company expects fourth-quarter sales of $4 billion and GAAP EPS between 23 and 24 cents. This translates into sales of $14.86 billion and GAAP EPS of 74 cents for the entire year. More importantly, its price-to-sales ratio is 1.38, half what it was in 2007. Its Q3 was the 21st consecutive quarter of double-digit year-over-year revenue growth, up 13% from the prior year to $3.7 billion.
EMC believes it can continue to prosper in difficult economic times because its products and services help companies maximize their information infrastructure. While that's true, I think the real reason it will absorb some of the recessionary storms is its well-balanced sales. In Q3, all regions experienced year-over-year growth, including 7% in the U.S. - that's amazing in itself - and 19% from the rest of the world, which accounted for 46% of total revenue. Anytime you can achieve a 50/50 split between domestic and international sales, you're properly diversified.
Stock's True Value
Putting a price on EMC's stock is truly a vexing question. Where do you begin? EMC holds 326.5 million shares of VMware, 84% of the total outstanding. At VMware's October 24 price of $22.13, that's a value of $7.2 billion. Now, add to that EMC's cash and short-term investments, which were $5.86 billion at the end of September. This gives us $13.06 billion. Now back out VMware's sales from estimated 2008 revenues - $14.86 billion minus $1.88 billion - and you get sales of $13 billion, or $6.37 per share. Ignoring its majority ownership position and large cash hoard for a moment, its current price-to-sales ratio is 1.38, giving it a share price of $8.58 based on current operations. Then add in another $6 a share for its VMware stake and cash stash, and I come up with a value near $15. That's not too far off intrinsic value, which is $17.83. (See how an investing sage uses intrinsic valuation at Warren Buffett: How He Does It.)
Since 2004, EMC's stock has challenged its $10 low twice, rebounding both times. It's doing it a third time at present, and although I'm not a big believer in technical analysis, I do know that history repeats itself. Given this fact, along with the valuation presented above, I see EMC as a much better opportunity than in 2007.