|Shares Out. (in M):||2,025||P/E||10.5x||10.0x|
|Market Cap (in $M):||20,850||P/FCF||6.0x||5.0x|
|Net Debt (in $M):||-11,860||EBIT||3,215||3,500|
This recommendation, and associated quoted price in the header, refers to an investment in “EMC Stub,” that is, a synthetic investment created by going long 1 share of EMC and short 0.164 shares of VMW (VMWare, Inc., EMC’s publicly-traded carve-out). EMC Corporation (the consolidated entity, not the stub) owns 80% of VMW (with the balance as public float), which yields the 0.164 ratio.
EMC Stub (the “Company”) presents an investor with an interesting value proposition. For a net price of a little over $10/shr (or roughly $5/shr net of cash), an investor is buying exposure to a set of businesses that are generating roughly $1.00/shr in run-rate operating earnings. Thus, an investor is paying somewhere between 5x and 10x earnings, depending on how much credit you wish to give for the Company’s cash (5x gives full-credit for cash, 10x gives no credit for cash). These multiples would typically imply a business in either secular decline or potential financial distress, neither of which is the case for EMC Stub. The business is, admittedly, a relatively slow grower with the top line expanding at a mid-single-digit rate and some recent margin compression. However, the Company’s strategic position is relatively sound and there are strong secular tailwinds for the Company’s business. The quality of the underlying business is evidenced by consistent delivery of both operating margins and ROICs in the high teens. Like many mature technology companies, EMC Stub has adjusted its capital return policy in recent years towards a combination of both reasonably aggressive share repurchases and dividends (initiated in 2013).
EMC Stub’s valuation can be contrasted with its closest public competitors, NetApp, Inc. (ticker NTAP). On an apples-to-apples basis (i.e. fully penalizing P&L for share-based compensation, which is material for both EMC and NTAP), NTAP trades at a range of 11-16x EPS. The 11x multiple gives full credit for cash, the 16x multiple gives no credit for cash.
EMC Stub’s primary business is the provision of hardware, software, and services associated with enterprise-level storage systems. It also owns i) RSA, a provider of systems security products (including the popular SecurID tokens), which it purchased in 2006, and ii) roughly 60% of Pivotal Software, a provider of data infrastructure software. EMC Corporation carved out VMW, the leader in server virtualization software, in 2007 seeking to highlight VMW’s higher growth rate (relative to EMC Stub) and garner an associated better overall valuation.
Enterprise-level data storage has some decent secular tailwinds, in particular, the continued explosion of all things digital (video, audio, data…) in combination with ongoing movement of both consumer and business storage to the cloud. The latter trend, specifically, favors enterprise-level storage companies at the expense of PC-based storage offerings from the likes of STX and WDC. There are, of course, threats to EMC Stub from a variety of competitors and upstarts. However, my layman’s assesment of these is that none, at least in the near-medium term, are paradigm changers (for some background, see the recent Mar 6 WSJ article under the EMC ticker). Some comfort in EMC Stub’s competitive position can be gained from the fact that it has been consistently gaining market share in enterprise-level storage from its competitors. In addition, the deferred revenue balance (for EMC Stub) was running at nearly 20% growth year-to-year in the most recent quarter, which is not only robust on an absolute basis, but represents the second sequential quarter of acceleration after bottoming out at 14% in the Jun 2013 quarter.
The primary negative to an investment in EMC Stub (IMO) is the lack of a discernible catalyst. If management were to announce today a plan to spin EMC Corporation’s remaining interest in VMW to shareholders, I would expect a minimum increase in stub valuation of 50%. This would imply a base valuation of roughly 10x operating earnings (with full credit given for cash), a valuation reasonably in-line with other slow-growing, large cap tech companies. The issue is that management has consistently rebuffed suggestions to initiate such a spin and, in fact, routinely claims that that sales synergies between EMC and VMW would make such a separation inadvisable. Personally, I think this assertion is questionable. CIOs routinely indicate a willingness to buy best-of-breed solutions, and the results of the large tech conglomerates (HPQ, IBM, CSCO) that have pursued the single-point-of-sale approach have been mixed at best. My opinion, though, is clearly irrelevant. Recent EMC management actions have further strengthened the corporate ties between EMC and VMW (thereby lowering the likelihood of a spin), as evidenced by the joint venture structure of the Pivotal Software subsidiary (in which both entites have a financial interest). From a trading perspective, EMC Stub pricing over the last two years has ranged from $8-$14/shr (see chart below). The trading lows typically occur around earnings announcements, when disparate results (vs. both trends and expectations) between EMC and VMW drive temporary dislocations/inefficiences in the stub valuation.
For those interested in looking at EMC Stub’s historical results, below are the results since 2007 with the component pieces that feed the EMC Stub results (i.e. EMC Consolidated less VMW):
Notwitshtanding the lack of a discernible catalyst, in today’s environment (with what I view as a paucity of attractive investments), I’m happy to hold ownership in an entity with high teens operating margins, high teens ROIC, a reasonably strong competitive position, and deferred revenue balances growing at 20% Y2Y, at an attractive absolute multiple of 5-10x operating EPS and a 40-50% discount to its closest publicly-traded competitor.
Final note #1: A primary consideration for some investors looking at creating this stub might be the capital required to establish the trade. Although the EMC Stub trades at just over $10/shr, creating that $10 of net exposure requires an outlay of roughly $27 on the long side (cost for EMC Corporation share) and $17 on the short side (cost of 0.164 VMW shares). Thus, even if you think the stub has 50% potential upside, the actual theoretical return on capital invested is quite low. Personally, given what I view as a lack of interesting opportunities, I am sitting on lot of cash. Thus, return on capital deployed is not relevant for me today; what drives my decision is the amount of portfolio return (i.e. basis points) I believe that I can generate for each unit of net exposure of a given investment. However, if your portfolio is capital constrained, this trade is clearly not for you.
Final note #2: Please note that a (different) write-up on EMC Stub was recently posted on another investment website. I’m not associated with the other write-up, and don’t know the author. I was part way through this write-up when the other one was posted.