What's EMC Without VMware?

An intrepid reader raised this interesting quandary on Friday:

I have held VMware (NYSE: VMW) for over a year and time and again I decide to sell them and buy EMC (NYSE: EMC), yet whenever it comes to the crunch moment of hitting the SELL button I chicken out. Comparing the market caps ($40:50 billion), the P/E ratios (130:30), knowing that EMC hold 80% of VMware's shares means that the rest of EMC's business if a freebie, so why do I not do the obvious and swap shares?

Ezlington has since gone with his or her gut and moved some funds out of the virtual computing veteran and into its storage-giant mothership. But the question is still worth answering.

As you already know, EMC owns 80% of VMware's shares, keeping the smaller company in a perpetual state of being half-separated from the parent. That makes EMC's stake worth about $31.6 billion at today's share price. VMware has a very clean balance sheet with $2.9 billion in cash equivalents and only $450 million in debt. Let's say that EMC holds $30 billion or so of VMware assets, all told.

That is indeed a hefty 61% chunk of EMC's own $48.8 billion market cap, or 67% of its $44.9 billion enterprise value. Does that match VMware's importance to EMC's financial health at all?

Currently, $2.6 billion of EMC's $16.2 billion in trailing sales comes from VMware. That's a 16% finger in EMC's revenue pie, ignoring minor considerations like minority interest stakes and the lunar aspect. Both companies sport net margins in the 10%-11% range, though VMware squeezes nearly twice as much cash out of every dollar of sales as EMC does.

Take out everything VMware brought to the table over the last four reported quarters, and you'd get EMC trading for 12 times trailing earnings and 1.4 times sales. You don't quite get the storage business for free, but that's a steep discount to VMware's stand-alone valuation ratios or EMC's with VMware included.

EMC's VMware stake gives the company a healthy dose of instant diversification without becoming a tech conglomerate in the style of IBM (NYSE: IBM) or Hewlett-Packard (NYSE: HPQ). VMware's leadership in virtual computing is also an advantage that none of those giants can match today. Buying EMC's stock gives you less exposure to the growth of VMware -- but also less of the risk. If main virtualization rival Microsoft (Nasdaq: MSFT) kills VMware tomorrow, as it has been trying to do for years without much success, an EMC investor will suffer grievous damage, but a VMware owner is dead in the water.

In my eyes, both stocks are attractive but for different reasons. Rule Breaker high-rollers will prefer the risk-reward profile of VMware, but more risk-averse investors will prefer EMC. Which vehicle you choose for your own portfolio will tell you something about your own risk tolerance.