Not Even EMC Is Immune To Tech Headwinds

By Stephen D. Simpson, CFA | October 24, 2012 AAA

Data storage had been one of the strongest and most predictable segments of tech, but with EMC's (NYSE:EMC) earnings in hand, it's pretty clear that even this market has stalled in the face of more cautious IT spending. On a positive note, EMC continues to gain share in the market and refresh its offerings with new releases. I believe EMC remains one of the best-positioned tech companies today and a good stock to accumulate.

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Third Quarter Results Come in Soft
EMC doesn't miss very often, but the company fell victim to the same weakness that has hit other tech companies, such as IBM (NYSE:IBM), F5 (Nasdaq:FFIV), and Microsoft (Nasdaq:MSFT). While it sounds like some potential third quarter deals were pushed into the fourth quarter, I wouldn't necessarily assume that there's going to be a rebound in growth, as there has been little in the way of encouraging guidance from the tech sector lately.

Revenue rose 6% from last year and fell 1% from the second quarter, leading to a 3% miss relative to sell-side expectations. While storage was up 3% and network storage was up 2%, both saw meaningful contractions in growth from the second quarter. One bright spot for EMC was in high-end storage, where the company not only saw 5% growth, but acceleration from the second quarter growth rate. As previously announced, majority-owned VMware (NYSE:VMW) saw 20% growth this quarter and makes up more than 20% of EMC's reported revenue.

EMC also experienced some negative margin leverage with the sluggish revenue performance. Gross margin did improve from last year by about 70 basis points, but slid a similar amount from the second quarter and missed estimates. Product gross margins were lower, however, falling about 60 basis points from last year. Operating income was likewise unimpressive, up less than 2% from last year and down 5% sequentially, though the non-GAAP operating margin was better than the average analyst's estimate.

SEE: Analyzing Operating Margins

Continuing to Gain at Other's Expense
Although storage has weakened this year, EMC continues to gain share. Based on reported results, company guidance, and various surveys published by sell-side analysts, it looks like IBM, Dell (Nasdaq:DELL), Hewlett-Packard (NYSE:HPQ) and possibly NetApp (Nasdaq:NTAP) all continue to lose share to EMC.

Considering where EMC is in its product cycles, more share gains could be on the way. The company's new high-end storage products are fueling good growth, and a new version of Isilon's operating system, Maverick, should be out by year-end, offering better integration with VMware and better management of unstructured data. While the company's weakness in mid-range systems (flat this quarter, versus 10% growth in the second quarter) was disappointing, it looks more like a pause than a change in the market.

Longer term, I continue to expect EMC to benefit as customers consolidate around fewer vendors (and choose those with more complete/comprehensive offerings). While I do see some risk from solid state enterprise storage products from LSI Logic (NYSE:LSI) and Fusion-io (NYSE:FIO), the high cost of these systems is a meaningful obstacle today and I believe EMC will be able to increase its presence in flash as prices come down (EMC's current product, VFCache, is more expensive and management acknowledged that its cost has been an obstacle for customers). Still, with NetApp and Cisco (Nasdaq:CSCO) allied with Fusion-io, I don't dismiss them as a rival.

SEE: Great Company Or Growing Industry

The Bottom Line
I've generally been more bullish on EMC than most analysts, at least from the standpoint of fair value. While EMC remains a relatively popular pick among sell-side analysts, the average price target seems to imply compound free cash flow growth of just 4 to 5%. In contrast, I expect the company to deliver mid-single digit revenue growth and incremental free cash flow margin improvement; enough so that my growth rate is about 2 to 3% higher.

Oddly, this seems to flout what most analysts project in terms of operating margin improvements and VMware's contributions, and may be a byproduct of the fact that cash flow modeling is a secondary consideration for most analysts. Either way, EMC looks undervalued today. Whether you go with the consensus implied growth rate of 4 to 5% (and the resulting fair value of around $32) or a rate in the higher single digits (pointing to a fair value in the high $30s), EMC continues to look like an attractively-priced play on one of the healthiest tech markets.

At the time of writing, Stephen D. Simpson owned shares of EMC since September 2012.

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