VMware Too Pricey? Buy Its Parent, EMC

A slew of analysts say the growing value of VMware alone gives EMC upside despite concerns that have bogged down EMC shares

Investors who missed the surge in VMware's stock price can still get a slice of this year's hottest initial public offering on the cheap. Some Wall Street analysts recommend buying shares in VMware's majority owner—and stock market laggard—EMC.

Shares of VMware (VMW) have been on a tear. The company's "virtual machine" software lets customers consolidate the work of several computer servers onto one to save capital expenses and lower data-center power bills. The shares closed $4.52 higher, at $83.83, for a 5.7% gain on Sept. 24, lifted in recent days by bullish calls by analysts. The stock has soared 189% from an opening price of $29 in what has been the tech industry's most successful IPO since Google (GOOG) first sold shares in 2004.

But EMC hasn't been basking in the VMware glow. While it owns an 86% stake in VMware, EMC's stock has been bogged down by concerns over growth in its core data-storage business. That could be set to change. On Sept. 24 analysts at Bear Stearns (BSC) and Citigroup (C) upgraded EMC—and its shares rallied. EMC climbed $1.48, or 7.8%, to $20.51, just shy of its 52-week high.

The analysts said EMC's share price, little changed the past two years, undervalues the effects of controlling VMware, which pioneered a fast-growing market (BusinessWeek, 9/10/07) and could fuel demand for its products. Given the dearth of VMware shares and its lofty price, buying EMC could be a cheaper way to get in on the action. With a market value of $32.1 billion, VMware stands at three-quarters the value of EMC.

A Valuation Disconnect

Bear Stearns analyst Andrew Neff said EMC's stake in VMware could be worth $34.6 billion by the end of 2008 and cited an "apparent disconnect in EMC's valuation relative to VMware." Every $1 of appreciation in VMware's stock will add 14¢ to EMC's, Neff said in his report, and he recommended that investors buy EMC shares to tap the unrealized value. "EMC has been highly effective at finding the 'next big thing' in [information technology] spending," he wrote, adding that EMC's stock price could reach $25 to $28 in 2008.

Citigroup analyst Paul Mansky upgraded EMC to a buy from a hold and raised his price target to $23 from $16, citing a "clear valuation disconnect" between EMC's share price and the value of its VMware stake. The rush by IT departments to put virtual servers into their data centers could also goose demand for EMC's storage products, he said. And if VMware shares reach Citigroup's $100 target price, that valuation alone would lift EMC shares to $24, Mansky said.

Realizing more value from VMware is key to investors in EMC, which has spent more than $7 billion on acquisitions since 2003, though has slowed its buying pace this year. Management has said the company has no large purchases in the offing, though EMC reportedly has acquired software startup Mozy, whose product lets PC and Apple (AAPL) Macintosh users back up their files over the Internet (BusinessWeek, 6/25/07), for a reported $76 million, according to the Web site TechCrunch.

The gains in EMC's stock price came as other Wall Street analysts issued rosy outlooks for VMware, helping the company bounce back from a temporary dip in recent days. VMware stock slipped following a Sept. 17 filing with the Securities & Exchange Commission that revealed rising costs. It had previously issued a report showing profit more than doubled, to $34.2 million, on an almost 90% gain in sales, to $296.8 million. But the SEC filing showed operating cash flow increased by only 43%, to $85.6 million (BusinessWeek, 9/18/07), while research and development and general and administrative expenses each more than doubled.

Roller-Coaster Shares

A week later, VMware's stock had recouped its losses and then some. Citigroup's Brent Thill initiated coverage of VMware on Sept. 24 with a buy rating and a price target of $100, which he called "very conservative." Thill said in a report that 2007 and 2008 profit-margin declines will likely be "short lived" and that forecast margins will rise from the mid-20% range to about 30% after that. "Virtualization, enabled by VMware, is driving a complete infrastructure refresh cycle through the tech industry in an effort to improve computing resources, save energy, secure systems, and cut capital expenditures," Thill wrote. In issuing the call, he cited VMware's 85% share and technical lead in the market for running virtual machines on low-cost servers that use chips from Intel (INTC) and Advanced Micro Devices (AMD).

UBS (UBS) analyst Heather Bellini kicked off her VMware coverage on Sept. 24 with a $92 target price and a buy rating. Bellini's report called VMware "the dominant player in a strong…growth market." She added that the company is poised to sell its products to small and midsize businesses, in addition to the large companies currently in its crosshairs.

Credit Suisse (CS) analyst Jason Maynard was slightly less sanguine, launching coverage with a neutral rating and a price target of $85. He said in a report that the market has already priced much of VMware's future value into the stock. Indeed, VMware will face challenges in coming periods as Microsoft (MSFT) prepares to release its own virtual-machine software for Windows servers in 2008. Maynard compared VMware's growth to "the early days of Microsoft and Oracle" (ORCL) and predicted that the company could sustain 35% growth in revenue and cash flow over the next few years.

Still, that leaves VMware in some pretty formidable company. It's now the world's fourth-biggest software maker by market capitalization, after Microsoft, Oracle, and SAP (SAP). VMware booked nearly $704 million in 2006 sales and is on track for $1.2 billion in 2007. And as long as the EMC spin-off keeps climbing, two sets of shareholders stand to benefit.

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