What is EMC?EMC is the largest data storage company and biggest player in the virtualization space through its 80% ownership of VMWare (VMW). Companies and governments around the world utilize EMC's data storage solutions as more and more records are retained electronically and advanced databases are needed to manage content effectively. The Information Storage unit accounts for 76% of EMC's 2009 revenues. While this line of business saw a cyclical downturn in '09 as lowered spending in IT dragged down EMC's sales, the long-term story is quite bright. Another 10% of revenues are derived from the content management and information security divisions.
Virtualization is the exciting piece of EMC's business line and the company wisely spun off 10% of VMWare (VMW) to unlock value in 2007. EMC acquired VMWare for $635 million in 2003; VMW now boasts a market capitalization of $32 billion. After spinning off the unit at nearly the top in the equity market in August 2007, VMW has still returned shareholders 46% since inception. Virtualization allows companies to get more out of less. By using the software VMWare creates firms can efficiently split up their servers allowing them to run multiple applications from one server. This helps reduce total hardware costs for firms that previously would be required to invest in greater numbers of individual servers.
Capitalizing on a secular trend
Cloud computing has been the hot sector in 2010 and despite last week's sell-off in many cloud-related names, the secular trend is in tact. The high momentum behind these businesses has carried their stocks to extreme levels and the sell-off last week brought some of the stocks' valuations back to earth. Yet, the cloud is an extremely attractive option for many businesses across the spectrum promising an easier, cost-effective way to manage IT. Growth in this industry is likely far from over even if the valuations are a bit overheated.
The electronic storage of information is a long-term growth story with exponential growth opportunities as more companies adopt online databases and the content itself dramatically increases in size: think streaming movies as an example. EMC invests roughly 11-12% annually in research and development giving it sustainability in cutting-edge innovations.
A modest valuation given potential
EMC sells for 29 times trailing but based on analyst expectations sells for a relatively cheap 14.6 times forward. Smaller rival NetApp, Inc. (NTAP) garners a PE of 37 in the market and a forward PE of 22 even though 5-year analyst growth expectations are nearly inline with EMC. EMC has a 5-year sales growth rate of 12.5% and an astounding 82% gross margin. The company has an impeccable balance sheet holding only $3.1 billion in long-term debt against its $41.7 billion in equity market capitalization. And, with $6.7 billion in cash on hand EMC has the flexibility for future strategic investments.
EMC has guided $1.18 for the FY 2010. I believe EMC conservatively can increase earnings by 20% in 2011 given the recovery in IT spending with the global economic rebound and the secular trends in cloud computing driving exponential growth in storage needs. EMC would produce $1.42 in earnings per share with 20% EPS growth. With a PE of 21 by the end of 2011 EMC would sell for $30 per share, a 40% gain from current prices.
Risks to target
Shares of EMC are inherently volatile with a beta of 1.65 creating large divergences in returns based on timing of purchases and sales. EMC can also suffer as competitors such as IBM (IBM) and Hewlett-Packard (HPQ) encroach on the data storage space. The recent bidding war for 3Par (PAR) that drove HPQ's bid to $33, a valuation of 125 times 2011 earnings, is a prime example of the strong desire to break into the cloud arena. Also, while companies have record amounts of cash and IT investments are expected to rise, a sluggish economic environment or lack of clarity on future demand may suppress IT spending and stall EMC's growth.
Brandon R. Rowley
"Chance favors the prepared mind."
*DISCLOSURE: Long EMC.