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This article is part of Our Top 5 Tech Stocks for 2011 series.
If you're like me and spend most of your time scouring technology stocks but find stocks with a strong presence in cloud computing a bit too pricey, I think I've got just the right play into the field. EMC (NYSE: EMC ) stands to benefit from explosive data storage trends, but it also has a powerful cloud computing kicker thanks to its massive stake in VMware (NYSE: VMW ) . While cloud computing stocks trade for nosebleed levels, EMC on its own isn't terribly expensive. However, after considering its stake in VMware, it's downright cheap.
EMC stands as the kingpin of networked storage, the kind of storage that's growing in popularity along with virtualization. However, It's not alone in the space, battling such large competitors as IBM (NYSE: IBM ) , Hewlett-Packard (NYSE: HPQ ) , and Dell (Nasdaq: DELL ) in addition to smaller storage peers like NetApp (Nasdaq: NTAP ) .
Get ready for the storage rocket ride
One only needs to look at the headlines to see how hot storage is. Between these massive players, deals are flying left and right, with the most recent buyout being Dell's $820 million offer for Compellent (NYSE: CML ) yesterday. There are a couple reasons for the buyout mania sweeping the industry:
- The amount of data being created is outstripping our ability to store it: The Economist estimates that the amount of information created each year is growing at a 60% compounded rate. What's even more impressive is the divergence between information created and the available storage capacity. While the two largely tracked each other up through 2007, information is now being created at an exponential rate that should be more than double the available storage by 2011. As EMC proudly points out, information is expected to grow 44 times over the next 10 years thanks to these consistent high rates of growth.
- The nature of storage is changing: While storage used to be defined by hard disks serving very specific purposes, today's storage is at the center of cutting-edge technology. Areas like virtualization and scale-out storage allow for better utilization and overall capacity, while other technologies shift necessary data between faster (and inherently more expensive) drives and cheaper drives for performance gains. Companies that fail to develop in key areas need to buy smaller players to fill in their product portfolios.
While this kind of extreme innovation can sound daunting, the important thing to remember is that EMC has not only some of the best foundational software in storage, but it also has several different software components that become vital to data centers buying from EMC. Also, after a couple of recent purchases, EMC has the most filled-in storage portfolio of all the major players.
While the moat here might not be as wide as a company like IBM that controls end-to-end facets of data centers, EMC's focus on storage's emerging growth areas has allowed it to take market share from larger players like HP and Dell while those companies consolidate across other segments of the IT industry.
What really gets me excited
At this point, EMC might not sound terribly exciting. It's the leader in a growth industry that should see compounded double-digit sales growth through mid-decade, but it trades for a P/E approaching 30; hardly the kind of skintight P/E to get your heart racing.
However, a key component to the EMC story is its history in virtualization. You see, in early 2004 EMC completed its acquisition of virtualization pioneer VMware for $625 million. Since then, EMC has spun off a portion of VMware, but it still maintains close ties and an 80% stake in the company.
When you consider that VMware is now worth more than $37 billion, that means EMC's stake in VMware comes out to nearly $30 billion. Since EMC itself only has a market share of $46 billion, that means its business is only worth about $16 billion after netting out its VMware holdings.
Given the outsized value of its VMware holding, you'd expect EMC to soar along with VMware's stock, but a wide gap has actually broken out between the two companies. In the past year, VMware more than doubled while EMC saw 27% gains. That's a respectable rise, but it clearly shows that investors aren't giving the EMC full credit for its vast holding in VMware.
Source: Capital IQ, a division of Standard & Poor's.
More to the point, EMC's most direct competitor, NetApp, trades at multiples well above its larger rival. To be sure, NetApp has navigated the economic downturn strongly and has executed well in a number of growth areas, but the company still trades for nearly 22 times trailing cash flow. Compare that to EMC -- which after netting out its VMware stake and removing the results of VMware from its financial results -- trades for less than 10 times cash flow. Yet, as you can see from the chart below, NetApp has run far above EMC in recent months as well.
Source: Capital IQ, a division of Standard & Poor's.
Top-shelf storage on sale!
The bottom line here is that even if you only give EMC credit for half of its VMware stake, it's still trading at a steep discount to its closest peer despite being an industry leader. That's a compelling deal, even if VMware were to suddenly fall from its seemingly never-ending climb.
While I personally find many cloud-computing stocks overvalued, EMC gives a way for investors to get exposure to the fast-growing segment while still hanging on to an industry stalwart like EMC that should be stable and continue to excel in the years ahead. Best of all, if you find VMware overvalued, you can always hedge any potential cloud computing collapse by either buying put options on VMware while purchasing EMC stock -- or for the truly brave -- short VMware while buying EMC.
With options aplenty for buying EMC no matter your view of cloud computing, it's time to give EMC a try for your 2011 tech portfolio.
Do you agree? Share your thoughts in the comment box below.
To access the full list of Our Top 5 Tech Stocks for 2011, click here.