EMC: Retooling for a Rebound
By Richard Stice, CFA
Following a period of incredible growth in the late 1990s, EMC (EMC ) has fallen on hard times over the past 18 months. While many difficulties facing it are related to macroeconomic factors beyond its control, EMC has made things worse by not reacting quickly enough to the changing environment. Faced with declining revenues, pricing pressures, and a bloated operating structure, EMC finally realized it needed to take drastic steps to maintain its standing within the computer-storage industry and to reposition itself once info-tech spending recovered.
From 1997 to 2000, EMC's sales nearly doubled, to $8.9 billion. Two major trends fueled that growth. First, the Internet-fed explosion of information forced companies to increase spending on storage-related products in order to house ever-expanding amounts of critical data.
Second, the Y2K phenomenon pushed many businesses to purchase excess amounts of storage equipment in an attempt to avoid potential glitches associated with transferring information into the year 2000. Growth rates during this period were impressive, but they weren't expected to last.
Few people, however, anticipated the unraveling of demand experienced in 2001. A weakening economy, the bursting of the Internet bubble, and the terrorist attacks left customers more cautious about spending. Many technology companies were caught off-guard by the abrupt shortfall. EMC was no exception. It believed that even if technology spending were curtailed, allocations toward storage products would not be significantly affected.
However, the severity of the corporate IT spending reductions had a profound impact on storage. Moreover, pricing pressures rose as competition heated up for fewer projects, which hurt margins.
These factors were reflected in EMC's 2001 results: It lost 23 cents per share, compared with earnings of 79 cents in 2000, on a 20% decline in sales.
DEALING WITH DELL.
As a result, EMC decided to streamline its operations to lower operating expenses and help offset the weaker sales levels. To begin with, it announced plans to reduce its headcount to 19,000 employees by the end of June, from nearly 25,000 a year earlier.
In the fourth quarter of 2001, EMC entered into a five-year alliance with Dell Computer (DELL ) that made Dell the largest reseller of EMC's CLARRiiON midrange storage product line. The deal made sense for both, as EMC was able to reduce its costs for sales and marketing, and Dell was able to fill a missing piece of its product line. The success of this initial endeavor has led to an expanded relationship, with Dell agreeing to manufacture EMC's forthcoming lower-end storage offerings.
At the same time, EMC launched its Automated Information Storage (AutoIS) software strategy. This program enables customers to centralize the management of their entire storage infrastructure in a single, unified, and consistent manner, regardless of the storage system's manufacturer.
This thrust into software has several potential benefits. First, it adds diversity of its revenue base (EMC's goal is to have software sales reach 30% of its overall total by the second half of 2004).
Second, software margins tend to be much higher than those achieved by selling hardware-related products. Lastly, the production of software is much less labor-intensive, so operating expenses can be kept in check.
In the end, the Dell deal and the software launch should help EMC improve profitability by allowing it to lower operating expenses and at the same time offset current sales declines in other product areas. We see EMC turning profitable in the third quarter ending in September.
Although EMC was late to the game in realizing the economic slowdown's severity, we at Standard & Poor's believe the steps taken to shore up the cost side strengthen its chances to capitalize on future growth opportunities. In addition, EMC has maintained a dominant position within the data-storage sector, and it continues to make significant investments in research and development (more than $900 million in 2001, and an additional $800 million anticipated for 2002).
Plus, EMC's balance sheet remains solid, with cash and investments exceeding $5 billion.
However, on a valuation basis, the shares trade at a forward price-earnings-to-growth ratio of 1.6, a premium to its peers and the broader market. Moreover, we do not see any near-term catalyst that will propel demand. As a result, we have a 3-STARS ranking -- a hold recommendation -- on the shares, and we expect them to perform in line with the broader market over the next 6 to 12 months.
Analyst Stice follows computer storage stocks for Standard & Poor's