Should EMC Corporation Actually Sell its Massive VMware Stake?

VMware is important to EMC, but so is the amount of cash that EMC could create with a spin off.

Jul 24, 2014 at 12:30PM

A lot has been made in recent days about Elliot Management's pressure on EMC (NYSE:EMC) to force the company to completely spin off its holdings in the server virtualization company VMware (NYSE:VMW). While both sides of the argument are strong, one way clearly looks in favor of EMC shareholders, which indirectly includes peer NetApp (NASDAQ:NTAP).

Decisions, decisions, decisions
According to The Wall Street Journal, activist investment fund Elliot Management has invested $1 billion in EMC in hopes of convincing the struggling data storage company to divest its holdings in VMware.

VMware allows virtual computers to run different operating systems and applications, also known as server virtualization. While servers remain VMware's key business, it also has a growing presence in PC and mobile management as well.

EMC, on the other hand, is a market leader in disk storage systems, but works very closely with VMware to create new software businesses aimed at combating the rise of faster and cheaper cloud services, which are replacing many of EMC's core storage businesses.

With EMC owning approximately 80% of VMware, it has quite a bit of leverage in its partnership. For this reason, many think that spinning off VMware would be a bad idea for long-term investors. However, with VMware's $41 billion market capitalization and decelerating growth, others think that now is the perfect opportunity for EMC to significantly bolster its cash position.

What should EMC do?
Conveniently, VMware announced earnings on Tuesday and showcased revenue growth of 17.7%. However, in comparison to EMC, VMware's 12-month revenue of under $5.5 billion is relatively small. In other words, the real value for EMC has been, and still is, external and internal disk storage systems, a market that saw a 6.9% decline to $7.3 billion in the last quarter alone.

While EMC controls 22.4% of this market, its market share actually fell 50 basis points during the last quarter. Meanwhile, competitor NetApp saw its market share rise 50 basis points to 11.7%. The key difference in NetApp's gains is that it doesn't have the high exposure to a fast-falling high-end segment, which has given it an advantage in this industry.

Therefore, with EMC losing ground, NetApp gaining share, and significant cash opportunities in VMware's valuation, it might make more sense for EMC to divest and use the cash to focus on storage, or perhaps even use the proceeds to continue its new software projects.

Another option
With that said, if EMC can bolster its $8.2 billion cash position by adding another $30 billion divesting VMware, then it would have the capital to replace lost partnerships with research. It could also devote more energy and capital to the storage industry by either growing its market share or acquiring a company such as NetApp for under $16 billion.

Aside from an improving storage business, NetApp also has a research and development division that includes FlashRay, an all-flash array built from the ground up using NetApp's technology and research, with 20 times the performance of traditional hard disk drive storage systems. This is a technology in which NetApp has lacked a presence, and where EMC remains No. 1. Therefore, with NetApp choosing to develop, rather than acquire, its flash array will have complete synergies with NetApp products, something that cannot be accomplished with acquired flash array technologies.

As a result, investors are very optimistic about the potential for FlashRay, and the potential for this new technology to help catapult NetApp's revenue. With the product nearing its launch, EMC's interest in NetApp might very well be serious and growing.

Foolish thoughts
One thing is for certain: EMC has a lot of options when it comes to VMware. While investor opinions vary, taking the cash to focus on the storage space seems like the most fundamentally logical decision, plus possibly acquiring industry peers like NetApp, which would greatly improve the investment value of EMC shares by making the company more of a leader in the storage space.

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Brian Nichols owns shares of Apple. The Motley Fool recommends Apple and VMware. The Motley Fool owns shares of Apple, EMC, and VMware. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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