EMC - A Bellwether Bargain

There's been quite a bit of concern amongst tech analysts that a slowdown in business IT spending is imminent, specifically amongst the precious financial services firms who are seeing their profits deteriorate as a result of the sub-prime/credit mess. As was seen during the dot-com fallout, bad front office performance directly correlates to a drastic reduction in IT investment, so it isn't all that bold to predict the same will occur as a result of the whole sub-prime fiasco. EMC, along with Cisco, HP, and IBM, are the typical tech heavyweights whose performance are largely tied to business IT spending and have recently seen their share prices fall over the past couple months. As EMC sits with 86% ownership of VMWare (VMW) equity in their back pocket, the value proposition is increasingly compelling following the pullback to around $16 per share. This article will address mainly macro-level issues that impact EMC/VMWare and will not focus on a detailed technical analysis of their respective balance sheets or short term performance.

As a brief background, EMC is the market leader of external controller based storage (SAN/NAS) and provides a range of enterprise products and services to improve the way corporations can secure, access, and manage their data (Documentum for content management/RSA for security). While perhaps difficult to grasp for the layman, EMC's infrastructure solutions store and manage the critical data for many large corporations and government agencies around the world. Recent spin off/IPO superstar, VMWare, is in the exciting and emerging field of virtualization, which in simple terms, is software architecture that reduce hardware spend by creating multiple logical instances on a single physical device. This allows companies to get control of their out-of-control data centers, reduce power/space consumption, and lower the entire physical footprint of their IT infrastructure by maximizing the value of underutilized hardware resources. There is a reason why VMWare carries such a lofty valuation, and it's because their solutions address a growing pain point for most enterprise environments and they actually reduce costs!

VMWare has seen it's shares vault to $125 per share before returning to a more realistic $73 as the valuation models began to reflect increased competition and future pricing pressures. At $73, VMWare still sports a mouth-opening market cap of around $28bn. With 86% of VMW, EMC owns just under $24bn worth of VMWare equity. A pretty good investment for EMC, to say the least, considering they spent $635mm for VMW just a few years back.

So let's explore why I am bullish on EMC as everyone begins to predict a decline in spending. First, let's outline why VMWare is such a coveted asset:

1. VMWare is 'best of breed' in a game changing technology. Virtualization is changing the manner in which IT executives are strategizing and VMWare stands to benefit from what will be a multi-year explosion in virtualization investment. If indeed business IT spending is reduced, VMW should still expect to grow rapidly as they compel executive (IT and even non-IT) management with a demonstrable ROI that most other standard IT investments cannot.

2. Bears of VMWare point to increased competition and inevitably lower pricing with the 800lb gorilla, Microsoft (MSFT), sporting their own hypervisor platform. While I expect Microsoft to chop away at market share due to tight integration with Server '08 and beyond, it would be foolish to discount VMWare's sizeable lead and unparalleled credibility in this space. Microsoft has never provided a compelling virtualization product before (never really needed one as an OS monopoly other than a sloppy Virtual PC) and has left a lot of IT decision makers with a perception that they are reactively, and reluctantly, entering the virtualization space. Microsoft will have a close to impossible time pulling large customers who have signed multi-year ELAs (enterprise licensing agreement) with VMWare, and quite ironically, will struggle from the same competitive barriers that made Microsoft the behemoth that it is in the OS space.

A hot topic these days is virtualization security, and VMWare will benefit from the perception that Microsoft can't even secure it's own software along with a mental barrier about using Microsoft software to manage non-Microsoft operating systems whom they aim to destroy. VMWare offers a range of solutions, services, and partners around virtualization management (monitoring/security/patching/maintenance/etc), and the scope will extend beyond Microsoft's reach as the antitrust courts ever watching eye ensures nothing too sneaky. It should be expected that pricing will fall as VMWare transforms to a management services company and hypervisor products see price wars that will inevitably make them low cost/free. However, if VMWare can fend off Microsoft somewhat successfully, it is not outlandish to anticipate VMWare will eventually (5-7 yrs) become more profitable than EMC's entire core business.

3. IT systems engineers like VMWare solutions. They are getting trained and certified in mass as part of an industry wide expansion of their professional skillset. No new entrant has penetrated enterprise IT departments over the past 5 years as quickly and as successfully as VMWare has. Their VMWorld customer/partner conference breaks attendance records every year and the penetration of their software over the last 5 years has been nothing short of amazing. Dell, HP, IBM, and any other x86 based manufacturer with a large enterprise sales force has been desperately partnering with VMWare to get their fair share of the lucrative services market around integrating VMW virtualization products with their physical products. The market outlook for virtualization is full steam ahead and VMWare is sitting on top, swallowing niche competitors and preparing to defend their position.

4. Virtualizing the data center and virtual appliances are where all the hype is right now, but at some point over the next decade (and many billions of $$$ later) they will be widely adopted and reach a certain level of maturity. The next explosive market in virtualization is at the desktop level where just north of 1% of enterprise desktops are virtualized. IT research firm Gartner predicts that by the end of 2010, all new PC deployments will be virtualized. That's a whole lot of market to compete for. While Microsoft is well positioned to get a good portion of this market by building virtualization into future operating systems, they struck out with Vista in this area (amongst many others).

Providing just a product is no longer the answer for Microsoft as VMWare is lining up vendor partners who provide end to end solutions that address systems management, support, audit/compliance, and ofcourse the needs of the end user. One such partner, Panologic, leverages VMWare infrastructure solutions to simplify the desktop environment and reduce costs. While Panologic might not turn out successful as a result of being too early to the game, the concept will eventually be a success and VMWare stands to benefit from even minor market share gains. I encourage you to visit Panologic's website to get a glimpse at the next wave of desktop technology, VMWare style.

Despite Microsoft's clear advantage as an enterprise desktop monopoly, innovation is somewhat limited due to their legacy dependence on x86 hardware manufacturers. VMWare benefits by developing a brand that represents a shifting dynamic in IT strategy to previously unthinkable solutions to the growing hardware management problems. Microsoft created the problem, and has missed the mark for years in identifying the solution. VMWare is forcing their hand, and Microsoft will once again resort to reactive tactics that have cost it loyalty and brand perception value.

Now let me get into why I like EMC:

As mentioned earlier, EMC's core business provides infrastructure products and services that stores critical enterprise data. They are, however, not alone in this space as Network Appliance, IBM, HP, Hitachi, and Sun all compete in the saturated NAS/SAN market. With new technologies emerging every time you turn the corner, EMC is always seen as facing the risk of losing market share to the 'next big thing'. Here is why EMC's market share is difficult to penetrate and it's core business is strong:

1. Their established customers (usually the biggest of the large enterprises) are buying complex engines (i.e. Centera) with technically complex back end storage arrays (i.e. ClaRiiON/Symmetrix). This technology requires a lot of investment, not only to buy the gear and supporting management tools, but also to train inhouse IT engineers on how to implement and support it. This skillset and investment alone create high barriers for entry and have led to EMC retaining critical customers for long periods of time (with no loss in sight).

2. Given that NAS/SAN solutions store the most critical enterprise data, migrations away from EMC's proprietary solutions would create significant operational/business risk and, dare I say it, a potential to lose critical data. In the new world of Sarbanes-Oxley and strong regulatory oversight, there are very few large enterprises that would accept this risk. While competitive offerings may leave EMC temporarily at a disadvantage, they have proven that customer patience will be rewarded. Next gen NAS topics like thin provisioning might not have EMC out in front, but they will be there over time with industrial strength solutions.

3. EMC's active acquisition strategy clearly paid off with VMWare, but a number of niche acquisitions have not culminated into corresponding product offerings to customers. I expect this to change in the coming years as EMC is more mature in their organizational structure and has learned what works with their culture and what doesn't. Spinning off VMWare was a sign of maturity for EMC management as they understood it was better off independent compared to being tied down to the rest of EMC's product portfolio.

4. Lastly, and most importantly, when IT spending practically came to a grinding halt in 2001-2002, the following were factors in play that are not present today:

• 1998-2000 - The markets bubbled beyond comprehension and Y2k preparation resulted in extreme and unsustainable IT spending as businesses/governments spent freely in preparation of a doomsday scenario. This 'over spending' inflated the underlying growth of the tech sector, therefore leaving it vulnerable for a correction
  
• 9/11/2001 - Terrorism occurred and created an almost unprecedented level of fear in the markets. New regulatory requirements were instituted and the disaster recovery model was born, both requiring IT infrastructure gear like EMC's for compliance.
  
• 2001-2002 - The dot-com bubble burst and created a situation of uncertainty with regards to tech growth. Valuations became difficult and the entire tech sector went down, and in retrospect, much harder than necessary.

While EMC may struggle to make the numbers that analysts forecasted for '08, I don't expect the impact to be nearly as bad as their share price indicates. EMC now has a market cap less than $34bn and an '08 PE of 19.3. With VMW ownership factored in, EMC's core business is valued at less than $10bn and a '08 PE of less than 6. At this valuation, the market is assuming that not only will IT spending shrink, but that VMW is worth about half it's
current market cap. I don't agree.

The current credit crisis and pending recession are reason for concern, and I discussed the events above to highlight that a return to 2001-2002 is very unlikely to happen. The market is valuing EMC at a level that assumes many negative events that have yet to unfold, and with an emerging growth currency in VMW equity, it seems too conservatively priced and trades at a 25% discount.

Enterprise IT spend might not meet the expected growth in the coming year and VMWare shares may continue to fall into more achievable valuations, but if you can weather some short-term term volatility, EMC is quickly becoming a bellwether bargain.