Trade: Long EMC Current price: 26.75 Expected price: 33 Upside: 23% Time: 1 year
Cheap valuations, EMC on a stand-alone basis (stripping VMware) is significantly mispriced, huge cash pile, share buybacks,market leader, taking market share from competitors, sticky business, focus on innovation, smart acquisitions with power to scale them, strong distribution network,faster growing latest emerging storage offerings, growth in virtualization and hybrid cloud.
EMC Corporation (EMC) is the world’s largest provider of data storage systems offering products, services and solutions to assist customers with every phase in their IT infrastructure. It helps clients in managing and safely securing large quantities of increasingly complex information. It offers data storage, back up and archive, content and infrastructure management, information security, analytics, virtualization, cloud computing, and other services that enable companies to store, manage, analyze and protect data.
Every organization needs data management and hence EMC’s clients are very diverse ranging from financial institutions, social networking, media, manufacturers, healthcare, internet service providers, telecommunications operators, airlines and transportation companies, educational institutions, public-sector agencies, etc.
The company generates revenues from five segments: two being the major: information storage (69.5% of the revenues as of FY13) and VMware (VMW) virtual infrastructure (22.2% of the revenues as of FY13).
As of 31 December 2013, EMC owned 80% controlling interest in VMware (VMW) and held approximately 97% of the combined voting power of VMware’s outstanding common stock.
1. Public cloud: Public cloud, which is growing at an exponential rate, is a threat to EMC and VMware. In public cloud, data is stored and managed by the cloud application provider. This has advantages (especially to start-ups) as the cloud application user has no initial network infrastructure and maintenance cost, all it needs is the internet connection. Public cloud service providers offer storage and computing to organizations as and when needed and how much they need it, as compared to the traditional way of buying storage and systems from EMC (or NetApp) and essentially paying for extra, unneeded capacity (at least initially) and hence they are seen as a large threat to EMC’s traditional business model. It also allows enterprises to get their applications up and running faster, with improved manageability and less maintenance, and enables IT to more rapidly adjust resources to meet fluctuating and unpredictable business demand. Simply put, public cloud reduces enterprise hardware needs which is a threat to EMC and VMware. Also, some of these public could providers (such as Amazon web services (AWS)) are not using EMC and VMware products and services which takes away the growth aspect. Most cloud customers are startups and small and medium-sized businesses. However, public could providers such as AWS and Google are expected to shift focus to large companies soon, heading right into EMC’s and VMware’s sweet spot, which could be a big threat.
Analyze: EMC’s management very well understands that public cloud is a threat and are taking very aggressive measures to mitigate the revenue loss in information storage segment by launching new emerging storage offerings. Also, to compete on the public cloud front, VMware has recently launched vCloud Hybrid. Hybrid cloud is a system that combines public cloud with a compatible private cloud. The private cloud holds crucial data and applications, while the public cloud offers scale and superior pricing.
Though start-ups and even smaller and medium business IT departments are moving towards subscription based public cloud services to save cost the larger enterprises, especially those that have long established investments in on site infrastructure are not. Main reasons why public cloud hasn’t been able to penetrate in larger organizations are:
To transform and improve business, CIOs have to find efficiencies in their current IT environment. EMC supports the vast majority of enterprise customers contained in these environments (is a market leader) and hence is well positioned to help customers optimize and modernize their current IT needs by transitioning from existing exchange-servers to emerging technologies such as converged infrastructure, software defined data center and private cloud.
Lastly, EMC and VMware have launched Pivotal, which will provide enterprise-class cloud-computing platform and infrastructure and big data for VMware customers.
2. Open source virtualization software’s: Some companies and public cloud service providers are gravitating towards free and open source virtualization such as Citrix’s (CTXS) XenServer and not VMware’s virtualization software.
Analyze: Though Citrix’s (CTXS) XenServer is freely available its market share in the segment is very small and has been declining. Support, service and maintenance are very important for IT departments which VMware is good at. VMware is a leader with 55% share of the virtualization market.
3. Increasing competition and declining market share for VMware: Market share of VMware has been constantly declining over the last few years (declined to 55% in 2013 from 65% in 2008). Comparatively, Microsoft’s share in the market has gone up from around 20% at the end of 2008 to 28% in 2013.
Analyze: Competition has been increasing with companies like Rackspace, Microsoft, Google, Amazon, and others entering the market. Though VMware’s market share has been declining with increased competition, overall server virtualization market is growing and is still expected to grow 18% annually. VMware has grown its revenues by 23% cagr in last 5 years and growth in FY13 was 13%. VMware is still the market leader with 55% market share and its new internal and acquired technologies should further boost revenues and market share.
4. Majority of the revenues come from information storage segment which is a declining business: Information storage segment makes up 70% of revenues and virtualization 23% of revenues. Information storage business is in a secular decline.
Analyze: Overall enterprise information storage market is growing at a very small pace (1% to 2%) in dollar terms. Though the need for data is unstoppable and is growing exponentially, the slow growth has been mainly due to reduced pricing, database appliances that manage more in-memory computing and fast growing adoption of cloud offerings and software-defined storage that reduce enterprise hardware needs. Hardware market has stagnated at current levels as price declines offset most of the growth in unit shipments. That said, EMC is the market leader and has been taking market share from competitors. Its information storage revenue (70% of total revenues) increased by 4.5% in FY13 and its market share in the storage hardware segment increased to 33% in 4Q13, which is double IBM (second in the list) and triple its nearest competitor, NetApp (NTAP). The company is gaining market share because of its strongest and most complete portfolio, aggressive focus on R&D and innovation along with right acquisitions leading to outstanding new emerging technologies and solutions and excellent service. Also, storage software is growing and is expected to achieve a 7% growth in the next two years. EMC is the market leader in both storage hardware and software with a 34.2% and 23.6% share in them respectively.
1) Sticky business: EMC operates in a very stick business as it has long-term relationships with its customers and the solutions are sold through multi-year enterprise license agreements. Also, it takes a significant amount of time and effort to set up the networks and servers which makes it difficult for existing customers to move.
2) Faster growing latest emerging storage offerings: Though the overall growth in information storage market is stagnant, EMC has been growing its information storage segment revenues (70% of total revenues) by approximately 5%. The growth isbeing driven by smaller, but much faster growing emerging storage offerings. These latest emerging storage solutions like Isilon (network attached storage), Atoms (cloud storage), VPLEX (virtualization and private cloud) and XtremIO (all-flash storage array) are growing exceptionally well: up 54% in FY13 recording a revenue of USD 1.5bn. In less than two months of availability, XtremIO has already taken the market-leading position and combined product sales for Atmos and Isilon more than tripled in FY13. Also, new products such as ViPR, software-defined storage solution, significantly speed up performance. ViPR got off to a very strong start in 4Q. In September 2013, EMC also launched the new VNX Series, which delivers up to four-times the performance of the previous generation. These latest emerging storage offerings have had y-o-y growth of 73% in 4Q13 and 66% in 3Q13. Although this sub-segment (emerging storage) only contributed about 10% of the USD 16bn information storage segment, the momentum and the growth in these emerging storage offering could boost storage business. EMC intends to focus on emerging storage going forward.
3) VMware is growing: EMC owns 80% of VMware (VMW), which has the largest market share in providing virtualization to enable enterprise customers to deploy private clouds. Medium-sized enterprises are still in the early stages of deploying a server virtualization and this market is expected to grow 18% annually. VMware is uniquely positioned as i) it offers solutions which run on industry-standard desktop computers, servers and support a wide range of operating systems, application environments and networking and storage infrastructures and ii) it is 80% owned by EMC and hence has access to the massive EMC clientele and relationships. VMware has been growing its revenues and FCF by 23% and 29% cagr in last 5 years (13% and 32% in FY13), respectively.
Also VMware is attempting to become a cloud management provider, which is a transformation from offering primarily server virtualization solutions. VMware only recently released its vCloud Hybrid Service and made it available in the US in September 2013. It will roll out this service in other regions throughout 2014. The hybrid cloud service has gained tremendous popularity and despite competitive environment the company’s management tools for cloud are selling very well. Also, its vCloud Government Service is expected to be available in 2H14.
Just like EMC, VMware is also focused on innovation. In November 2013, VMware launched desktop as a service (DaaS) offering, with the goal of simplifying the delivery of cloud-hosted desktops, to any device, anywhere. DaaS is a cloud-based desktop service that delivers virtual desktops running on VMware’s vCloud Hybrid Service. It gives customers the ability to blend public cloud desktops and on-premise VMware private cloud desktops. VMware is also adding virtualized GPU (vGPU) by bringing Nvidia GRID technology to its DaaS platform. This gives VMware 30 million potential users: designers, project managers, engineers, and power users. GPU helps delivering a quality interactive visual experience and has been increasingly used even in mainstream Microsoft Office 2013 and rich HTML5 content on internet.
Lastly, VMware acquired AirWatch, the leader in enterprise mobile management and mobile security, providing software tools required by IT organizations to manage, monitor, and secure mobile devices in their enterprise. This helps organizations empowering the mobile workforce.
Apart from growing virtualization market, VMware will be able to pace the delivery of all these services and solution (DaaS, vGPU, AirWatch) through its network of over 11,000 VMware service provider partners further accelerating its top-line growth.
4) Relationship with existing clients: Vast majority of enterprise workload is supported by client-server era, in which EMC is the market leader. With EMC’s massive clientele and long term relationships and VMware’s seamless integration with EMC products, EMC is better equipped to help customers bridge the gap as they transition from the client-server to cloud computing, big data, mobile, and social networking.
5) Integrated with most big enterprise applications and technology alliances: During 2013, EMC continued to deepen the level of integration between its data protection hardware and software products, as well as with enterprise applications from Oracle, SAP and Microsoft and virtual infrastructure from VMware and Microsoft. This integrated approach to delivering solutions helps users address challenges associated with exponential data growth, physical-to-virtual migration and cloud computing initiatives. EMC also engages in numerous alliances with other technology companies for interoperability, seamless integration and hence improved the total customer experience. In 2013, EMC delivered significant technology integration and new solutions for SAP, Cisco, Brocade, Citrix, Microsoft, Oracle and VMware to help accelerate customers’ journey to private, public or hybrid cloud. It also expanded its partner ecosystem with global and regional technology and solutions providers.
6) Strong distribution network and sales force: One of the EMC competitive advantages is its massive direct sales force and distribution network. EMC markets its products and services through direct sales (in North America, Latin America, Europe, the Middle East, South Africa and the Asia Pacific region) and through multiple distribution channels (including value-added resellers and distributors, cloud service providers, systems integrators, outsourcers, independent software vendors, and original equipment manufacturers). EMC and VMware have demonstrated to be market leaders by continuing to dedicate significant resources towards expanding their product scope organically and through acquisition and then maximizing those investments by leveraging their significant distribution capabilities.
7) Focus on innovation with massive R&D expense: The current need for innovation is extremely important as the IT infrastructure market is going through the biggest and most disruptive (and opportunistic) transition. Withinternal annual R&D expense of USD 2.7bn and 15,000 engineers, it is difficult to beat EMC on innovation. Investment in R&D and new technologies and solutions is reflected in numerous innovations, refreshes and successful product launches in 2013. The company continues to develop a product portfolio with customers’ current and future needs in mind.The company continues to make major investments in new business areas including NSX, DCHS Pivotal, ViPR, ScaleIO, XtremIO and Project Nile.
8) Smart acquisitions with strong sales force help reach the product to its massive client base: EMC acquired eleven companies in FY12 and five in FY13. It has a track record of making smart acquisitions and have generated very attractive ROIs on them. Examples include VMware, Data Domain and Isilon. EMC’s strong sales force and partner network help reach the product to its massive client base which creates such attractive returns.
9) Top-line growth faster than it shows: Growth in EMC’s unearned revenues has been much faster than the actual growth in the top-line revenues. Revenue growth was 8.5% and 6.9% as compared to growth in unearned revenues of 22% and 19%, in FY12 and FY13 respectively. This shows the growth has been faster than actually depicted in the revenues.
10) Capex cycle: Cash on companies’ balance sheet is at its all time high but investment in technology has dropped to a near-15-year low as a share of overall investment. Average age of equipment is 7.4 years, the oldest since 1995. Average age of even quickly-depreciating assets like software and information processing equipment is at historical peaks. IT spending could increase significantly with an upturn in the capex cycle.
11) Pivotal: Large volumes of complex data generated by increasing use of smart devices have initiated the need for big data. Smart phones, tablets and new PC form factors are only the beginning. This trend will accelerate as sensors are built into almost every imaginable product that will collectively throw massive amounts of data. The world’s data is expected to expand at a cagr of almost 40% from 2013 to 2020. This data is stored in new clouds quickly and affordably. New and powerful cloud infrastructures provide technology that organizations can use to mine through massive quantities of data and enable them to use their findings to identify new business opportunities, trends and to make better and faster customer-focused decisions by understanding client needs and behavior while improving their operational efficiencies. Pivotal (launched in April 2013 and 84% owned by EMC) is a USD 1bn initiative, offering Platform-as-a-Service (PaaS) to target next-generation cloud and Big Data, as well as agile development tools. It is spun out of VMware, and backed by EMC and GE. The total investments to Pivotal are expected to be USD 400m, most of which will be coming in 2014. Pivotal is predicted to see exceptional growth with potential to exceed revenue of USD 1bn by FY17. A recent IDC forecast shows that the Big Data technology and services market will grow at a 27% cagr to USD 32.4bn through 2017. Pivotal currently contributes just 1.3% of total revenues and could be a huge growth engine for the company in the future.
12) Share buyback and potential shareholder activism: EMC continues to spend more cash on share repurchases. It repurchased USD 3bn, USD 685m and USD 2bn of its common stock from the market in FY13, FY12 and FY11, respectively. In FY12 it also repaid USD 1.7bn of long and short-term debt. In FY13 it issued USD 5.5bn of debt at a weighted average interest rate of 2.4%, taking advantage of the low interest rate environment. Most of this money will be used for stock repurchases and dividend payments. The company expects to spend another USD 2bn on EMC share buybacks in 2014. As per the company, combined payouts of dividends and share repurchases are seen around 50% of free cash flows. With strong annual free cash flow of USD 5.5bn and a massive USD 17.6bn of cash on balance sheet (31% of the market cap) buyback could only increase and the company could be a target for shareholder activism.
i) Multiples: EMC is trading at 10x Enterprise Value (EV)/FCF and 8x EV/EBITDA, about lowest historically (even lower than 2009). This is an extremely low valuation for a net debt free technology company, growing its revenues and FCF by 13.6% and 21% on average. In FY13 revenues and FCF grew by 7% and 10%, respectively. The company operates with average FCF margin of 22% and a consistent roce of more than 60%. Assuming a 5 year cagr of 2.8% in top-line and reducing FCF and EBITDA margins by 50bps each year, at current price, EMC trades at a future FY18 multiple of 7.3x EV/FCF and 5.1x EV/EBITDA, as modeled. This also assumes approximately USD 1.6bn (almost 30% of FCF) is used for acquisitions every year. These are extremely low multiple even at a very conservative growth rates. The company expects much higher growth and margins to improve slightly. Twice these multiples (100% appreciation) would be a minimum justification for a market leader in this segment.
ii) DCF: On average EMC’s FCF has been growing by 21% for last 4 years and grew by 10% in FY13. Assuming a conservative growth rate of 3% for next 5 years, a terminal growth rate of 1%, and a discount rate of 10% gives a stock price 20% above its current trading level. This clearly depicts an undervaluation even at minimum growth rates.
iii) Sum of parts:
VMware has had a 5-year average growth of 23%, 26% and 32% in revenues, EBITDA and FCF, respectively. Last year (FY13) revenues grew by 13%, EBITDA by 18% and FCF by 32%. Assuming a 10% growth rate for next 5 years, a terminal growth rate of 1.5%, and a discount rate of 10% gives a stock price trading at approximately current levels.
Standalone EMC: However, EMC on a stand-alone basis (stripping VMware), is trading at extremely cheap multiples (5.4x EV/FCF and 3.6x EV/EBITDA). The core EMC (stand-alone) seems significantly undervalued considering it is a market leader, has been growing its top-line by 5% and taking market share from competitors. Its competitor for stand-alone business NetApp (NTAP), trades at 7.5x EV/FCF and 6.6x EV/EBITDA. Valuing at those multiples suggest an approximate 80% upside on the core EMC (stand-alone) and an approximate 30% upside on the consolidated EMC. Valuing EMC (stand-alone) using a -1% growth rate in FCF for next 5 years, -1% terminal growth rate, and a discount rate of 10% gives a stock price approximately 70% above current trading levels, and a 23% upside on the consolidated EMC. These assumptions are really conservative as revenues from the EMC (stand-alone) grew by 5.2% and 4.5% and EBITDA by 10.1% and 3.7% in FY12 and FY13, respectively.
Even under such conservative assumptions EMC (stand-alone) is significantly undervalued. These valuations remind me of hard disk drive (HDD) manufacturers, WDC and Seagate. In mid 2012 WDC was trading at EV/EBITDA of 3.5x. The rationale behind such low multiples was that HDD manufacturers will not survive as solid state drives (SSDs) are the future. Since then WDC stock has almost tripled. HDDs are still sold and are very much alive.
Conclusion: EMC is trading at a discount even on a very conservative basis and the market is ignoring its competitive advantages including quality, breadth of offerings, strong distribution (sales force and channel partners), after sales service, scalability, interoperability, time-to-market enhancements and expertise in acquiring new emerging technologies with power to scale them. Furthermore its huge cash pile (31% of the market cap), high roce, 10% FCF yield and growing emerging segments are also overlooked. The stock has been down 8% in last 2 years as compared to a 32% gain in S&P on fears of client-server and data storage systems being obsolete with emergence of public cloud. In those 2 years EMC has recorded an average top-line growth of 7.7% and FCF growth of 11.7%.
EMC is taking very aggressive measures to mitigate the revenue loss in information storage segment and so far has been very successful in doing the same. It is well positioned to benefit from the current growth segments of IT: big data, cloud, virtualization, storage, security, and software-defined storage.
Disclosure: Long EMC, NTAP
Disclaimer : This is not an investment advice. DO NOT make any investments based on this article. Please read the disclaimer in detail.