EMC (NYSE:EMC) has finally gotten some positive attention and investor interest, but only because of the possibility that an activist investor will push management in a strategic direction it has already said it does not wish to go. Second-quarter results showed sequential improvement and share gains in the core storage market, but EMC still has work left to do in convincing investors that it has the right solutions for the next wave in the market, and that VMware (NYSE:VMW) is a critical part of the model.
A small beat amid tough times
EMC continues to find itself mired in a sluggish market for core enterprise storage products. During its recent EMC World event, management highlighted that customers were holding on to equipment longer (four to five years instead of two to three), but public cloud vendors like Amazon (NASDAQ:AMZN) and Google had significantly changed the internal planning and discussion processes over new storage installations.
Still, EMC continues to gain share. Consolidated revenue rose 5% in the quarter for a modest beat versus sell-side expectations. Upside was led by the storage business, where revenue rose 1% year over year and 8% sequentially, despite a less accommodating environment for traditional rivals like NetApp, IBM, and Hewlett-Packard. High-end storage product revenue was down 14% as customers deferred purchases ahead of a product refresh.
Other revenue line-items were less exceptional. VMware revenue was up 17%, but slightly below expectations, while info intelligence was up 4% and security was up 7%, but about 7% below expectations. Pivotal is off to a good start, up 29% year over year and 10% quarter over quarter, but still a tiny part of the total. Gross margin declined a half-point from the year-ago period, but improved about one point, sequentially, and matched expectations.
New products and emerging opportunities
May's EMC World event wasn't thesis-changing, but it gave management an opportunity to clarify its strategy and view of the storage market. EMC has added features to its software-defined ViPR platform and expects revenue opportunities to materialize starting next year.
Regarding the cloud, EMC now refers to "Project Nile" as Elastic Cloud Storage, and management reiterated its belief that this alternative to Amazon and Google public cloud storage offers a significantly lower total cost of ownership (approximately 10%-30%). Management also acknowledged that it views Amazon as a primary competitor, but believed public cloud storage was having more of a psychological effect on the market than a dollars-and-cents effect.
It seems that the availability of the Amazon/Google option is slowing the decision-making process and giving enterprise clients more to think about, but it's not fundamentally changing final storage decisions. That might be a bullish view of the market, given the ongoing sluggishness in storage demand at EMC and NetApp.
Management continues to build out its array of offerings. Around the time of EMC World, the company acquired DSSD, a rack-scale flash storage provider with expertise in I/O-intensive applications like social media and cloud. Recently, the company released the latest high-end VMAX (boasting a 50% lower cost of ownership and increased performance) and announced the acquisition of TwinStrata, a software developer that helps migrate storage to cloud environments.
Should VMware stay or go?
EMC shares recently popped on news that activist Elliott Management had taken a 2% stake and would push for management to spin off the remainder of VMware and return more cash to shareholders. This is not the first time the subject of divesting VMware has come up, and management has been adamant about its reluctance to take such a step.
EMC management continues to believe there are meaningful marketing synergies between the two businesses. Management also believes that its ownership of VMware is a critical part of owning all the components needed to be competitive in this emerging third generation of storage, which includes flash, software-defined storage, and cloud. Pivotal or ViPR could not have come around without the input of VMware. There is also a real risk that, if EMC lets go of VMware, a competitor like IBM, Hewlett-Packard, Oracle, or perhaps even Amazon could acquire it.
If anything, EMC should consider more acquisitions. Past investments in Nicira, Airwatch, Pivotal, and ScaleIO should start paying off over the coming years, but EMC would do well to bulk up its security offerings even further -- perhaps not on the level of acquiring a large, established player like Check Point, but with a focus on the needs of data center and cloud clients.
EMC continues to look undervalued in some respects, but it's closer to fair value in others. A discounted cash flow methodology that assumes 4% FCF growth suggests potential into the high $30's, while a ROE/PBV approach suggests that EMC is not so significantly undervalued and that a positive rerating is tied to improvements in net margins. EMC is following in the same steps as companies like Cisco, Oracle, and Intel with this prolonged period of lackluster performance. But, underlying potential still makes this a name for value and GARP-type investors to consider.