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Wednesday, January 27, 1999

An Investment Opinion
by Louis Corrigan

The EMC Effect?

It's hard to look at a company trading at 69 times trailing 12-month earnings and say, "What a bargain!" Yet, as Michael Ruettgers, CEO of data storage giant EMC Corp. (NYSE: EMC), suggested in Tuesday morning's conference call, that's what investors perhaps should say. To provide some perspective, Ruettgers offered up some comparison valuations. The average S&P 500 stock trades at an earnings multiple that's 4 times its earnings growth rate. Leading tech names like Cisco (Nasdaq: CSCO), IBM (NYSE: IBM), and SAP (NYSE: SAP) trade for over 3 times their earnings growth while Microsoft (Nasdaq: MSFT) and Lucent (NYSE: LU) trade for more than 2 times their growth rates. Then there's EMC. At $101 13/16, it sells for about 53 times the consensus FY99 earnings estimate of $1.93 per share, a number that assumes a 30% growth rate that should prove conservative.

Such managerial chutzpah is more commonly seen with micro-cap outfits where management is looking to push up its stock price to sell some shares before the bubble bursts. It's not so common with major technology names. Yet EMC is known for its hard-driving salesmanship: The company likes to hire former college athletes for its sizable direct sales force because they're so aggressive. And that aggressiveness pays off when you've got the products to back it up. Simply put, EMC has become so consistent at delivering spectacular results that perhaps it deserves a big-league premium over and above the 145% return its shareowners have enjoyed since the October dip and the 20% gain recorded so far this year.

Fourth quarter results announced yesterday show a company gaining market share and boosting already high profit margins in an industry benefiting from exploding data storage needs triggered, partly, by the Internet. Sales grew 36% to $1.19 billion for the quarter while net income soared 54% to $256 million, or $0.48 a share. That was two cents ahead of estimates. For the year, revenue increased 35% to $3.97 billion, pumping net income up by 47% to $793 million, or $1.49 per share. Over the last five years, EMC's revenues have grown at an annualized rate of 38.4% while net income has soared by 44.2% a year on a compound basis.

According to research firm Dataquest, EMC's share of the $10.1 billion market for stand-alone data storage systems shot up to 32% from 28% in 1997 while IBM's market share fell to 20% from 24%. And IBM is the only other player with more than a 10% market share. Eighty percent of EMC's sales came from products introduced during 1998. Strong demand for these products is reflected in the sharp increase in gross margins to 53.6% in Q4 versus 47.4% a year ago. For the year, gross margins rose to 51.5% from 46.5%. Net margins came in at 21.5% in Q4 versus 19.5% a year ago. Net margins rose to an even 20% for the year, up from 18.3%. Planned increases in selling, general, and administrative expenses (SG&A) and R&D mitigated some of the gross margin gains.

The higher margins followed, in part, from a benign pricing environment (not exactly what you hear these days from the tech sector) and a trend toward larger system configurations, as EMC's Fortune 100 clients consolidate more of their storage needs. Also, software is becoming an increasingly crucial element of EMC's value proposition and margins story. Indeed, enterprise storage software sales were $164 million in Q4 and $445 million for the year, gains of 175% and 152%, respectively. Already the fasting-growing major software company, EMC expects software sales to increase by 50% this year as more than 60% of its storage systems now ship with EMC software versus 40% at the beginning of 1998.

Generally speaking, EMC's business is being driven by increased demand for data storage solutions that are dependable, flexible, and responsive as the rise of e-commerce, data warehousing, and sales automation mean that the largest corporations have become data hogs. Though EMC was once mainly a mainframe computer firm, its Symmetrix product family, which works with different operating systems, is now the meat of the company.

E-commerce and the Internet should continue to drive EMC's sales, as 8 of the 10 largest Internet service providers already use EMC storage solutions. Still, the exploding demand for Windows NT will also play a significant role. An EMC-sponsored study showed that 63% of information technology executives plan to move so-called "mission critical" applications to the NT platform this year. While UNIX isn't disappearing, NT server sales should outpace UNIX sales 7 to 1 in 1999, according to a Dataquest study. Many industry analysts think that the proliferation of NT servers will create the need for "storage area networks" (SANs), or a centralized storage architecture that makes databases readily available to multiple servers without delays or glitches and with reduced network management demands. EMC is devoting 80% of its R&D dollars to software partly because SANs should shift value-added data management tasks from the servers to the storage network.

The impact from NT probably won't be pronounced until 2001. Still, sales of storage systems with Fibre Channel connectivity, which allows multiple servers to hook up with a single Symmetrix port, increased 192% to $286 million in Q4. As Ruettgers noted, "We think this broad demand for Fibre Channel is a precursor to the widespread implementation of the EMC Enterprise Storage Network," which is EMC's name for its SAN.

While margins will decline a bit over the seasonally weaker first half of the year, EMC expects a 100 basis point increase in gross margins for the full year. EMC has also signed a reseller deal with Japan's NEC. By the second half of the year, NEC's sales staff should be up to speed on EMC's offerings. The deal should help the firm improve on the recently disappointing sales results for the Asia-Pacific region, particularly Japan.

Ultimately, Ruettgers has set a target of $10 billion in revenue by 2001, a figure that requires 36% annualized revenue growth. Assuming earnings increase at merely this same rate (and they should grow faster), then EMC would deliver FY 2001 earnings of $3.75 per share. So the company would now trade for 27 times earnings three years out. That may not entice your basic value investor, but it's not bad for a genuine Internet stock. Investors mapping out their own Internet strategies should take a closer look at EMC.

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