VMware IPO Adds Luster to EMC
The highly anticipated initial public offering of VMware has placed the spotlight on its parent, EMC (EMC; recent price, $17.72). The offering is scheduled to begin trading Aug. 14 on the New York Stock Exchange (NYX), according to press reports. The company will still hold 89% ownership in VMware after the IPO.
In our view, the VMware IPO will add appeal to EMC shares, which we think are already attractive on a fundamental basis. EMC shares carry Standard & Poor's highest investment recommendation of 5 STARS (strong buy).
We think EMC has the product portfolio in place to become the dominant player in the information management business. The company's information life-cycle management (ILM) approach to data management allows it to leverage its leading share of the external disk storage systems market in the areas of data security and virtualization, through its RSA Security and VMware units.
We believe new products aimed at enterprise and small and medium-sized businesses alike, along with key partnerships with Microsoft (MSFT) and Cisco Systems (CSCO), enhance EMC's position as an IT vendor. We also see the growth in virtualization adding to EMC's cachet, with the IPO of VMware emphasizing its importance.
Founded in 1979, EMC addresses the information infrastructure (management, security, and availability) needs of businesses of every size, by developing, delivering, and supporting information technologies and solutions worldwide through four operating segments: Information Storage; Content Management and Archiving; RSA Information Security; and VMware Virtual Infrastructure.
The Information Storage segment offers networked information storage systems to be deployed in a storage area network (SAN), networked attached storage (NAS), content addressed storage, or direct attached storage environment. In addition, the segment provides platform-based software controls and enables functions, such as replication, optimization, and data movement, and multiplatform software to store, protect, optimize, and leverage information in complex IT environments.
To augment these products, the group provides a suite of accompanying services ranging from consulting, assessment, implementation, integration, and operations management, to support, maintenance, education, and training services.
The Content Management and Archiving segment offers content management software to optimize business processes, as well as to create, manage, deliver, and archive information from documents, discussions, e-mail, Web pages, images, XML, reports, records, rich media, and application data. This segment also provides input management software for conversion, indexing, and processing of paper-based information to digital formats.
The RSA Information Security segment's security product and service portfolio provide tools to collect, monitor, analyze, and report on security event-related activity throughout the IT infrastructure. Products and services include enterprise identity and access management products, consumer identity and fraud protection solutions, encryption and key management software, and security knowledge and expertise.
The VMware Virtual Infrastructure segment offers virtual infrastructure solutions and services used by enterprises for server consolidation and containment, disaster recovery and business continuity, capacity planning and development, enterprise desktop hosting, test optimization, and software distribution.
EMC has grown organically and via acquisitions, with the most notable being RSA Security in June, 2006, and VMware in December, 2003. In addition, EMC has invested 11% of revenues in research and development over the past three years, resulting in a strong record of product development.
We believe a partnership strategy that includes major information technology industry players like Microsoft and Cisco positions EMC at the front end of technology change affecting information infrastructure. In our view, these strategies have enabled EMC to increase its revenues 15.4% in 2006 to $11 billion, and we see a further rise to $14.5 billion in 2007, excluding any further acquisitions.
Research firm IDC expects the storage systems market to continue its steady growth and reach $31.4 billion by 2011, driven by a number of factors, including increased investment in data protection and data recovery plans, fast growth of fixed content (i.e., digital images or video), e-mail and archival data stored on disk-based storage systems, and data being stored for prolonged periods on disk-based storage tiers before (if ever) being moved to tape or optical storage.
EMC leads the external disk storage systems market with a 21.2% revenue share, according to estimates from IDC. EMC continues to maintain its leadership in the total network storage market with a 26.9% revenue share.
In the Open SAN market, EMC was the No. 1 vendor with a 25.1% revenue share. The NAS market grew 10.9% year over year, led by EMC with a 33.3% revenue share, while the iSCSI SAN market continues to show strong momentum, posting 68.6% revenue growth compared to the prior-year quarter. EMC has the No. 2 position in this space with a 14.6% share. In the total worldwide disk storage systems market, EMC maintained the No. 3 position with a 14.8% revenue share of this over $6 billion market, which grew 7.2% in the 2007 first quarter.
The storage virtualization market, widely viewed to be in the early stages of growth, presents tremendous opportunities for storage systems and services suppliers, in our view. EMC, with its ownership of VMware, together with its partners, is well positioned to address this growth opportunity, by our analysis.
Our 12-month target price of $24 combines two metrics. The first, a relative price-to-earnings measure that allocates EMC a slight premium to its peers, reflects an expected p-e multiple of 26.7 times our 2008 EPS estimate of 90 cents. EMC recently traded at about 30 times per-share earnings for the past 12 months, making it less expensive on that basis than its smaller peer, Network Appliance (NTAP), which had a price-to-earnings ratio of 32. Our forward multiple is lower than historical averages for EMC as well as the peer group (to be conservative based on the current environment).
However, we believe EMC deserves a premium multiple to the S&P 500 Computer Storage & Peripherals subindustry group based on the company's recent outperformance vs. peers in a weak enterprise spending environment; its information life-cycle management approach; its leadership in the growing virtualization market; new product announcements; and the pending VMware IPO, which we think could add about 25% to enterprise value.
Our discounted cash flow (DCF) analysis for EMC indicates an intrinsic value of about $23.
Overall, we view EMC's corporate governance policies favorably and believe the company compares well in this regard relative to peers. We view the following factors as positives: The board is controlled by a supermajority (greater than 75%) of independent outsiders; the nominating and compensation committees are comprised solely of independent outside directors; all directors with more than one year of service own stock; all stock-based incentive plans have been approved by shareholders; the audit committee is comprised solely of independent outside directors; and the company has not restated financial results for a prior period or been subjected to an enforcement action due to backdating of options during the past 24 months. In addition, the option burn-rate over the past three years is 2% or less, within one standard deviation of the industry mean.
However, we view unfavorably the combined positions held by the chairman and chief executive officer. Also, shareholders do not have cumulative voting rights, and the board can increase or decrease its size and amend bylaws without shareholder approval.
Risks to our recommendation and target price include technological obsolescence, and dependence on suppliers and distributors accounting for an inordinately large proportion of revenues. Serving an international marketplace, the company is also subject to international risk.