Description

I recommend the purchase of EMC outright.  Its Federation of data center businesses (EMC II, VMware, and Pivotal) seems well positioned to survive and thrive as the world switches from internal data centers to hybrid cloud and cloud offerings.  The EMC stub (long 1 EMC short .1719 VMW) has re-rated down to $11 from about $16 at the beginning of the year since the company announced its intention to keep the Federation together and a tough Q1 where currency was a big headwind, but Elliott Management’s standstill agreement ends in September and I think investors will again be forced to focus on the value hidden beneath all the complexity that is the Federation.  

EMC Corporation and its affiliated companies refer to itself as the “Federation.”  For the duration of this write-up I am going to refer to the “Federation” as the “Empire” because that is what they should have called it and I think the Empire is going to be creating value under pressure from the (activist) Force by the time Star Wars: Episode VII is out.

EMC Stub Overview

EMC Corporation is a leading provider of external data center storage with about 30% market share according to IDC.  The company has been built on numerous acquisitions over the years starting with the acquisition of Data General in 1999 which provided it with the Clariion mid-range line (since renamed the VNX).  The company acquired a little company called VMWare in January of 2004 for $625 million.  VMWare dominates the market for virtualization software which allows one to carve up physical servers into numerous virtual machines (VMs).  The software essentially allows people to fully utilize their servers by putting 4-5 virtual machines on each physical machine, reducing capital costs substantially.  As Edward965 pointed out in his short write up on VMW from 2012 (worth reading before getting involved in this), VMware seems to be able to capture much of the savings with its pricing. EMC IPO’d 20% of it in 2007 and today EMC’s ~81% stake in VMware is worth about $29.8 billion.

EMC’s core data storage business, like a lot of data center infrastructure businesses, is “in transition.”  The days of a company building its own walled-off data centers containing its own servers and storage managed by its own employees appear to be numbered.  Instead people are shifting to “the cloud” where they rent servers and storage from the likes of Amazon, Google, Rackspace, etc.  Now not everyone is making a clean break (you don’t just want to throw out an old data center), so there is also a “hybrid cloud” developing where people manage some of their own storage and server infrastructure and then use cloud providers at peak times or as their business grows.  However, the main point is that EMC used to be able to sell its customers monolithic boxes like the VMAX (high end, high performance) and VNX (mid-range) over and over as data always grows at enterprises (40%+ per year).  It was a very good business.  However, the cloud providers tend to use their own cheaper (and marginally less reliable) custom designed storage solutions or buy at huge scale when they don’t go proprietary, so growth slows for EMC’s core data storage business as customers shift their spending to “the cloud.”

In addition, there is another technology change going on from spinning disk drives to “solid state” NAND drives.  Basically, the performance of the solid state drives is much better and well suited for big data situations in particular, while other data can be migrated to commodity cheap disk.  Flash is squeezing out the high end disk market.  EMC was a little late to the flash party, but quickly acquired their way into a prime position with XtremIO and DSSD.  EMC has successfully acquired bolt on technology and then pumped it through their fantastic enterprise sales force numerous times over the years and solid state drives appear to be no different.

There is a lot of growth around solid state storage, but it is mostly cannibalizing the old disk business.  A wiser investor than me once said, “Good technology companies always obsolete themselves or someone else will do it for them.”  EMC has been very good about investing in new technologies and not keeping sacred cows.  The bottom-line is that EMC is investing heavily in keeping its core storage business competitive, but the market is going to be slower growth than it used to be.  Mid to low single digit is probably about the right long-term growth rate over the next several years and EMC should be able to grow at least as fast as the market (historically they have grown faster).

The EMC stub also owns the cash cow that is RSA security.  It only does $1 billion in top-line compared to $16 billion for the information storage business, but it could probably be spun out and get a pretty high multiple given all the excitement around security these days.  It grew revenue at a ~12% CAGR for the last decade since EMC acquired it, but recently growth has been mid-single digit.

The stub also has a ~62% interest in Pivotal.  Pivotal is a start-up that EMC/VMWare launched to focus on cloud/big data markets.  VMWare owns 28% and GE the final 10%.  Pivotal is focused on big markets but is still pretty small and seems like a disparate portfolio of solutions to date.  It did about $227 million in revenue in 2014.  It is most certainly losing money right now.  I’d view it as a call option, more than a sure thing at this point.  The plan is for EMC to get it to scale and then IPO it like VMWare, but the business model seems to be shifting to subscription from a licensing/services model early on so I think the jury is out on whether or not it will work.    

VMware Overview

VMware continues to dominate the market for server virtualization and management software with about 85% share of x86 virtualizations.  Open-source Openstack has not made meaningful inroads into the marketplace yet, and where it has it has been with VMware leading the push with VMware supported Openstack (instead of RedHat).  I think the primary driver of this is VMware’s high level of customer service and the fact that much of what is going on in the data center whether it is on premise or in the cloud (or a hybrid solution) is mission-critical.  No one ever got fired for buying VMware.  It works and it supports every configuration imaginable.  

VMware is also trying to expand its reach.  It has moved into cloud management (i.e. automating the provisioning and management of cloud resources) with vSphere and now has penetrated 15% of its installed base with the product.  Instead of focusing on just virtualizing server loads they are also working to virtualize the entire data center including servers, storage (vSAN), and networking (NSX).  It should be noted that networking is the last truly untouched frontier in the data center as storage has been virtualized within the monolithic boxes for a long time already.  Will NSX take all the smarts that usually sit in a Cisco switch and just turn it into a dumb (cheap) box?  It is a definite possibility.  VMWare also acquired Airwatch which manages mobile device and app deployments for enterprises.  It is also fast growing.

It is hard to say for sure, but it looks like VMWare can grow top-line at 10%+ annually for the next few years and EPS should grow faster given the leverage inherent in the software model.

Valuation/Comps

VMware – the valuation here is a little tricky.  The stock is trading at $87 and the company has about $9 per share in net cash fully taxed for repatriation.

Non-GAAP EPS estimates are $4.00 for 2015 and $4.54 in 2016.  The stock looks reasonable at 19x and 17x ex cash.   But those include exclude $1.00 in options expense and $1.10 respectively.   I guess I am old school as I view those as a real expense.  So the real numbers are closer to 26x and 22x.  Hard to say those are cheap.  But given the opportunity set ahead of VMware this doesn’t seem wildly overvalued (certainly not relative to the multiples people used to pay or peers get).  I wouldn’t really want to be short VMware here even if it is a little expensive.  It definitely isn’t cheap on an absolute basis, but the comps will show you it is pretty reasonable on a relative basis.

VMW Comps (Cap IQ numbers all exclude SBC i.e. these are higher if you account for options)

CY ‘15 P/E CY ‘15 EV/EBITDA CY’15 PEG LT Growth Est from PEG

RHT 44.3x 23.6x 2.9x 15%

CTXS 18.4x 10.6x 1.4x 13%

CERN 32.5x 16.5x 1.8x 18%

ADSK 52.6x 29.2x 2.9x 18%

INTU 36.6x 19.2x 2.7x 14%

ADBE 38.4x 23.0x 2.1x 18%

VMW 21.8x 13.9x 1.3x 17%

I tried to pick mid-sized software comps that dominate their niche for this comparison.  It is hard to say VMW isn’t cheap (very cheap) on a relative basis to any of these companies.  Like I said, the absolute value doesn’t seem great to me, but the whole software sector is wildly overvalued based on a look at these.

EMC Stub – The valuation here is much easier.

If you back out VMWare’s cash and contribution to EMC’s consolidated results, you are left with a stub that has a market cap of $22 billion, FCF of ~$2.5 billion and Net Income of ~$2.0 billion.  This looks cheap absolute and relative to me.

EMC Stub comps (Cap IQ numbers)

CY 2015 P/E (Cap IQ) CY 2015 EV/EBITDA (CapIQ)

NTAP 16.5x 6.1x

TDC 15.4x 8.4x

CSCO 13.2x 8.3x

ORCL 15.2x 10.2x

EMC Stub 9.6x 5.1x

Note:  I exclude HP and IBM here as I view them as much more challenged than the players listed above since VMWare’s software has crushed their server businesses especially.

HP 9.2x 5.4x

IBM 10.8x 8.6x

This all suggests to me that EMC stub is being undervalued by nearly 50-60% and should be worth $16-$18 as opposed to $11.

Conclusion

Since I think VMW is relatively cheap and EMC stub is absolutely cheap I think I’ll choose to pay the “discount for control” of VMW and hold EMC outright instead of creating the stub by hedging out .17 shares of VMW per EMC share. In aggregate I think there are multiple ways to win here (VMW re-rates towards software peers or stub rerates to stub peers).  Plus you get a call option on Pivotal and the potential to create an entity that gets stupid silly multiple like you see on DATA, SPLK, HDP (all north of 15x TTM revenues with real profits nowhere to be seen) in the next couple of years.   I think if the stub re-rates you are going to have a $32 stock.  If VMW rerates you could get a much higher number like $40 per share.   Hopefully what has been a Deathstar of value will finally be blown into multiple more valuable pieces.

Risks

• There is some risk that EMC will buy in the piece of VMWare they don’t own.  You would want to own VMW, not EMC, if this happens.  I don’t think it will.  A tax-free spin of VMW to EMC shareholders seems a lot more likely to me especially with Elliott minding the shop.

• My thesis on EMC II is that it will continue to be a slow grower instead of going into decline like the HP server business did.  I could be wrong on this and then the stub would bleed value.

• VMware has pretty much penetrated their core virtualization market.  They need to expand their market to the total data center to continue to grow.  So far it looks so good on that front, but the bear case is that revenue growth grinds to a halt and VMware’s expansion into the broader data center fails.

P.S. I apologize in advance.  I have never once gotten the tables to format right here on VIC.  They need to post a tutorial video on it or something.

Catalyst

• Activism - Elliott’s standstill agreement ends in September.  When they signed the agreement they put two members on the EMC board.  The stock is still around $26 which is about where they got involved per 13Fs.  I bet they aren’t going to be happy.  You can bet the pressure will increase if the stock isn’t up by September.  Just as a reminder Elliott’s tech activist activities are well known.  Here is a nice profile of Jesse Cohn who leads the tech activist group there: http://www.forbes.com/sites/nathanvardi/2014/02/03/the-33-year-old-hedge-fund-investor-shaking-up-silicon-valley/  I think it is safe to say that Elliott is a “force” that management is going to have to reckon with again given the lack of performance in EMC stock since the last round.

• The Emperor retires.  Joe Tucci has said he plans on retiring soon (he has been CEO since 2001).  He is working without a contract.  Maybe Joe wants to go out with a bang and do something big before he retires to go out on top.  But, even if he doesn’t, whoever comes in as the new CEO is going to take a hard look at ways to create value and if the Empire isn’t getting it done, my suspicion a potential VMW spin and or other break-up may end up being on the table again.  I’d expect management to turnover within a year.