EMC is a thirty year old company that essentially created the storage systems business as we know it today. The company began with humble roots selling memory for minicomputers. Through many failures, perseverance, vision and a take-no-prisoners culture, the company evolved into a storage industry powerhouse in the 1990′s with its Symmetrix high end disk array, unseating IBM as the dominant industry player. Interestingly, the first Symmetrix had 24GB of disk capacity, less than the flash storage of many smartphones today. Throughout the 2000′s, the company leveraged its early successes and via a series of acquisitions, re-invented itself, diversifying its product portfolio and focusing much more on software revenues. Incredibly, by virtue of its acquisition of VMware (completed in 2004) EMC is today positioned amongst the industry’s power players including IBM, HP, Microsoft, Oracle and Cisco in defining the future of enterprise IT. While much smaller than these firms from a market valuation standpoint, EMC is growing faster than the industry’s largest firms and is positioned to be the next big player in enterprise IT.

The thesis of this post is that EMC is undervalued. Despite recent increases in its stock price, the company’s core assets are still underappreciated by investors and have considerable upside potential in my view. DISCLAIMER: I’m not a financial analyst and the opinions in this post are highly speculative and based on rough calculations – so do your own research and go deeper before investing your hard earned money in this or any stock.

The Valuation Calculus

Last spring I read in Barron’s that EMC’s value had probably topped  out. The premise of the article was that VMware sentiment was peaking and because EMC owned approximately 80% of VMware, the value of EMC had considerable downside risk. I had just attended the New England VMware Users Group (VMUG) at Gillette Stadium earlier that year and I remember thinking “VMware sentiment was high and about to explode.” I guess that’s what makes markets.

In a move that had ramifications to customers, partners, competitors and investors, EMC spun out VMware in a 2007 IPO; however the company has maintained a roughly 80% majority ownership stake in the company. The decision to control VMware has defined EMC; and its actions are largely designed to exploit VMware and leverage the platform for competitive advantage. As a result, EMC’s valuation has been heavily influenced by VMware and in 2010, the value of EMC’s VMware holdings surpassed the value of EMC’s core business. What’s even more important and astounding is the value of EMC’s core business actually dropped (see chart).

*Assumes an 80% VMware ownership

*EMC has a 98% voting share of VMware, making it a controlled company

Here’s what’s happening. Investors have rewarded VMware with a high earnings multiple but have in my view penalized EMC’s core business in an effort to hedge the VMware risk inherent in EMC’s stock price. By comparison, VMware’s share value in 2010 soared more than 110% while EMC’s jumped roughly 33%. Both of those figures are impressive, but when you look further, from March to December of last year, the non-VMware portion of EMC’s valuation dropped by nearly $2B in 2010. [Note: I’m sure the data from Jan-Dec are the same but March data was more readily available for this analysis].

This is an astounding fact considering that in 2010 the S&P 500 and Dow were up 13% and 11% respectively and the value of other storage companies rose  considerably, boosted by an economic recovery and a run on storage M&A (e.g. 3PAR, Isilon and Compellent); meanwhile, that same year, EMC:

• Grew non-VMware revenue approximately 18%
• Generated more than $3B in free cash flow (FCF)
• Increased gross and operating margins considerably
• Exited with $10B in current assets on the balance sheet
• Integrated Data Domain and picked up strategic growth assets including Greenplum and Isilon

Tucci’s Reaction to this Anomaly

I recently had the chance to ask EMC Chairman and CEO Joe Tucci to comment on this trend, specifically asking, what are his thoughts on EMC’s core value decline in 2010 and is there anything he can do about it?  Tucci responded in his straightshooting style and we captured it on video:

To summarize Tucci’s comments:
• Both VMware and EMC shareholders were nicely rewarded in 2011 with share price increases of 110% and 33% respectively, higher than the industry at large
• Some investors will choose to play both sides of the equation and arbitrage the delta
• VMware is clearly part of the EMC family and it’s a consolidated company—you need to look at EMC/VMware as a whole
• We’re not splitting off VMware, the strategy makes sense and in general people are buying the story
• EMC’s consolidated P&L considerably outperforms the really big IT companies from a price to earnings standpoint
• Of these really big IT companies – EMC is the smallest of the big – implying EMC has more headroom for valuation growth
• I’m not going to argue with the market – “it is what it is.”

Wikibon is certainly not the first analysis group to focus on VMware’s influence on EMC’s share value. Seeking Alpha has written about EMC as a better way to own VMware, and Motley Fool has published on this interesting trend in the past. But in my January 1, 2011 predictions post I believe I was one of the first to point out that EMC’s core value had actually declined in 2010 and I predicted a reversal in 2011. Notably, since my predictions post on 1/1/2011, EMC’s core value has increased approximately $5.7B while its VMware holdings have stayed essentially flat. I attribute this not only to my incredibly insightful analysis but also to the wakeup call that came in the form of EMC’s January 25^th 2011 earnings announcement where the company crushed the quarter and the full year; and was extremely upbeat for 2011.

EMC Still has Upside Potential

While EMC’s core value (due to its January 2011 run) has finally surpassed its early 2010 number, both EMC and VMware in my view have considerable upside potential. VMware is the new enterprise IT economy with an incredibly robust ecosystem. It represents the new Wintel of the enterprise in my opinion. Meanwhile, the EMC cash machine keeps chugging along with its core business making consistent and profitable moves forward.

But Tucci and the EMC Board are not standing still. The company has set out to pave a new path through acquisitions, picking up several high growth assets in the past two years including Data Domain, Greenplum and most recently Isilon Systems. These moves in my opinion are starting to pay off in terms of stock value for EMC’s core business as EMC is positioning for growth as well as consistent performance, leading many (including me) to believe the firm is currently undervalued. Others feel EMC is fairly valued because of the inherent risks of its large VMware ownership.

As always we should look at risks to these scenarios and there are several, including:

• VMware adoption – it faces serious competition from Microsoft and others – if it slows,  EMC’s value will take a big hit
• Execution – EMC’s product portfolio continues to become more diverse – integration is getting harder
• Cloud service providers are changing the economic game in storage  – CSPs could  put  downward pressure on pricing as models shift from purchase to rental
• Lack of quality acquisitions going forward – EMC is largely relying on growth through acquisitions and needs a feeder system
• Difficult 2010 comparisons – the market rocketed in 2010, raising the bar on 2010

I can criticize EMC’s products saying that the microdode on its core storage products was invented in the 1980’s/1990’s and that its product line is fragmented and that its new entry level products came seven years after Compellent, 3PAR, LeftHand, et. al invented all the cool stuff…and  I can say EMC doesn’t innovate any more, rather it relies on acquisitions. I can say some of its acquisitions such as Documentum, Legato and RSA haven’t panned out the way EMC expected, etc, etc, etc. But the fact is that despite these challenges, EMC’s sales channel and execution ethos have powered it through all the minefields. AND the company owns the trump card – VMware.

EMC’s risk factors are imminently manageable in my view. EMC/VMware has an outstanding management team. Tucci is perhaps one of the best CEOs in the industry and Maritz, Gelsinger, Tod Nielsen (VMware’s COO) and others compliment EMC’s strong existing management team. As far as integration of a diverse portfolio – that’s what VMWare brings; an ability to hide EMC’s vast complexity. I do worry about the disruption of CSPs but I expect EMC will court CSPs as an important channel. On the acquisition front, look for EMC to start acquiring more “Big Data” software companies like Greenplum – they are out there believe me. As to difficult comparisons, EMC has put forth its expectations for 2011:

• IT spending up 5-7%
• EMC’s TAM up 8-10%
• EMC’s growth at 15% to $19.6B

EMC is becoming very good at hitting and exceeding expectations. In my view these numbers are reasonable to slightly conservative. My expectation is that through a combination of organic growth and acquisitions, EMC will hit $35B in revenue by 2015 and its market cap will approach $100B; roughly double where it is today.

The wind is at EMC’s back and the company is well-positioned to take advantage of two mega trends that I’m watching closely:

• The adoption of cloud computing, VMware in mission critical apps and IT-as-a-Service overall – will the cash follow the hype?
• Big Data. Big data is not like traditional enterprise data. It’s unstructured, often distributed, running in the cloud on dirt cheap storage.

The bottom line on these trends is making money is all about software. Competitively, EMC is in as good a position as anyone in this business, including IBM and Oracle. EMC’s acquisition of Greenplum is very interesting and the move to pick up Isilon is an attempt to replicate Data Domain’s success. The story right now for EMC is not perfect but it’s quite good.

What are your thoughts? Is EMC undervalued or does the inherent volatility in a high growth VMware asset appropriately suppress EMC’s valuation – I’d love to hear your opinion?

[Cross-posted at Wikibon Blog]