EMC Corporation's Transition Issues Have It Stuck in a Value Trap

These are not particularly enjoyable days to be an EMC (NYSE: EMC  ) shareholder. While the company's market share in its bread-and-butter storage offerings is quite strong, and EMC has launched numerous products/platforms with good long-term growth potential, the storage market itself has seen a lot of change and turbulence. With that, the Street seems virtually indifferent to the company's good margins and strong cash flows and is focused instead on short-term revenue growth concerns. EMC looks exceedingly cheap on a DCF basis, but readers thinking of buying today need to be prepared to ride out the transition issues of 2014.

Growth a valid talking point...
EMC's recent performance has made questions about its ability to continue to grow pretty relevant. The first three quarters of 2013 saw single-digit revenue growth, despite double-digit growth at majority-owned VMware, with only the fourth-quarter results moving back into the double digits. A refresh of the mid-range VNX line has helped, but high-end VMAX sales have been sluggish as the overall enterprise storage market has weakened.

Management's guidance for first quarter 2014 revenue didn't help matters, with the target coming in about 7% below Street expectations. Some of this is due to a deliberate change in manufacturing policy designed to smooth operations (and likely improve margins by reducing costs tied to expediting orders at quarter end), but it does nothing to counter the arguments that storage is no longer a growth market and that, as the market leader, EMC is going to suffer as a result.

...but there are growth opportunities here
EMC's core storage market has slowed. Some of that is due to database appliances that manage more in-memory computing. Some of that is also to do increased adoption of Infrastructure as a Service (IaaS) offerings from Amazon (NASDAQ: AMZN  ) and Google that reduce enterprise hardware needs. Last, and not least, I would think some of it is also due to buyers simply waiting to see how new alternatives like all-flash arrays and software-defined storage play out.

The good news is that EMC has not run out of growth opportunities. "Emerging" storage products like Isilon and XtremIO are growing exceptionally well (up 73% in the fourth quarter and 66% in the third quarter), and the RSA storage business is likewise growing by double-digits. A newly refreshed mid-range VNX line-up is going to give NetApp (NASDAQ: NTAP  ) and Hewlett-Packard plenty to handle, as these new systems incorporate multi-core processors, virtualization, and flash at attractive price points.

There are also brand new businesses to drive EMC. The ViPR software-defined storage solution allows users to view object-oriented storage as if it were file-based, significantly speeding up performance. This is basically a management-layer offering that will enable companies to set up hyperscale data centers. I don't think it's too much of a stretch to say that, with ViPR, EMC is looking to do with storage what VMware (of which EMC still owns 80%) did for servers by pooling heterogenous systems and arrays and automating (and centralizing) the management of them.

EMC also has Project Nile. This is a web-scale storage solution that offers familiar hardware (likely VNX) and new software tools (including ViPR) in a more elastic and scalable fashion. I don't think the name "Nile" is coincidence, as this directly targets part of Amazon's AWS service offering. With pricing similar to the services offered by Amazon and Google, EMC management believes that it can offer a total cost of ownership that is half of that of Amazon or Google.

Amazon's AWS is widely seen as a large threat to EMC's traditional business model as it purports to offer enterprises the storage they need "as they need it." By comparison, the traditional way of buying storage requires multiple system purchases from EMC (or NetApp) and essentially paying for extra, unneeded capacity (at least initially). Given the security concerns that go with external service offerings, this could be a significant boost to EMC's efforts to compete with Amazon AWS by offering a viable, cost-competitive private cloud option.

A tough battle before the cavalry arrives
Nile might be a powerful factor in EMC maintaining its historically strong position in storage against the new service offerings of Amazon and Google. ViPR might be a VMware-like opportunity in storage virtualization. The all-flash XtremeIO might be EMC's gateway into the next generation of faster, more efficient storage systems. Pivotal (in which EMC owns 63% stake, partnering with VMware and GE) could be a multihundred million dollar opportunity that touches on major growth markets like Platform as a Service (PaaS), Big Data, and Cloud apps.

Despite all of those "may's," the reality is that 2014 is going to a battle. IBM, Dell, and Hewlett-Packard may have lost traction in enterprise storage (largely due to under-investment), but NetApp has been stepping up its game. Not only has NetApp been more aggressive in seeking partners, it has moved faster in incorporating flash into its products. NetApp's ONTAP cluster-mode architecture is complex, but it does offer very strong performance (compared to EMC's Isilon). Last and by no means least, NetApp has made ease-of-use and affordability bigger priorities – EMC systems may be more powerful and feature-rich, but they're expensive and not necessarily the easiest to manage.

Longer term, NetApp may have more to lose from the changes in the storage market (migration toward software-defined storage, cloud services, etc.), but they are a tough competitor today. EMC has basically acknowledged as much and is stepping up its marketing efforts as a result. Combine that with sluggish underlying market growth and I can appreciate some of the worries.

The bottom line
Value really doesn't cut it with tech stocks. Even though it takes less than 4% annual free cash flow growth to support a price target near $38, it takes a long time for slow-growing tech stocks to get there due. That puts even more pressure on strong ongoing growth at VMware and RSA, strong adoption of XtremIO, ViPR, and Nile, and converting the attractive potential of Pivotal into real reported revenue.

I am still bullish on EMC. My DCF-based valuation model suggests a fair value of $38, while an ROE/BV analysis suggests undervaluation in the neighborhood of 20%. All of that said, investors will need to be patient. The first quarter will hopefully mark a trough for the cycle, but these shares are not likely to break out higher until the market's worries about the health and growth of the storage market are put to rest.

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