EMC-VMware Cloud Venture Could Reignite Growth

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Tech stocks have a cloudy outlook, caused by the migration of customers to cloud computing. And that has helped lower the value of many tech bellwethers well below those of other industry groups. Some have fallen to their lowest valuations since the financial crisis.

The issue for investors, of course, is whether those low valuations are a buying opportunity. Solid companies that have a compelling strategy for moving their business to a cloud model or creating massive new cloud-based businesses have the potential to rebound dramatically.

Computer storage giant EMC Corp. (EMC) and its 80% owned software subsidiary VMware (VMW) may be in a position to ride the cloud wave. Last month they unveiled a jointly owned subsidiary called Pivotal that will create new types of cloud-based software for big industrial companies. One of the biggest potential customers, General Electric Co. (GE), invested $105 million in Pivotal for a 10% stake and early access to the technology.

EMC and VMware have been rocky investments recently. The companies’ downbeat revenue and earnings outlooks have driven down their stock prices. Lower sales reflect a weaker than expected worldwide economy. But they also reflect the move of customers to the cloud, where storage prices are commoditized and capacity is purchased incrementally. Many cloud providers use open-source virtualization software rather than VMware’s pricier offerings.

The outlook has led to grim stock market performance. In the year-to-date, while the S&P 500 rose 11.5%, EMC is down 12% and VMware is down 25%, as seen in a stock chart.

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EMC Chart

But the recent declines have made both EMC and VMware better values than they have been in recent years, at least related to trailing earnings. To be sure, VMW’s 42 PE ratio is rich compared to many other enterprise software companies. And EMC’s 18 PE ratio is high compared to most hardware companies – in large part because about half its market value is accounted for by its stake in VMware.

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EMC PE Ratio TTM Chart

Bloomberg recently calculated that compared to the rest of the S&P 500, tech stocks have fallen to the lowest levels in at least seven years, trading at 13 times projected profit. That could spell opportunity for investors. Technology is always about rapid change, of course. And the change that is roiling the tech waters today is cloud computing. Consumers already do a lot of their computing in the cloud with Microsoft (MSFT) HotMail and Google (GOOG) Docs and DropBox and all the apps they use on their Apple (AAPL) iPhones and Samsung Galaxy phones.

Now enterprises are starting to adopt cloud computing, and that is posing a real challenge to IT vendors that specialize in selling to government agencies and big businesses. In the short term, that transition is problematic for EMC and VMware. Like other enterprise technology providers, they have high overhead related to their direct sales forces and other marketing expenses. Their success is linked to their ability to reach out to corporate CIOs and convince them to sign big contracts for hardware and software that they install in corporate data centers.

The cloud model lets CIO’s order storage and computing capacity directly from companies like Amazon (AMZN) and RackSpace, paying only for their actual usage. It turns IT from a capital expense to part of the cost of doing business, which many CFO’s appreciate.

So far, vendors like EMC and VMware have been fighting a holding action. They promote “private clouds, ” which are more efficiently run corporate data centers, and “hybrid clouds,” which combine private and public clouds. But most big companies are starting out some new IT work in cloud facilities. That poses a threat.

And it has contributed to a sharp slowdown in sales and earnings growth.

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EMC EPS Diluted Quarterly Chart

But Pivotal could open up a vast new market. EMC picked Paul Maritz, formerly VMware’s CEO, to head the new operation. It gathered almost 1,250 technologists and software developers from recent acquisitions to develop a new platform that will let companies continuously get data from devices like trucks, locomotives, airplanes and generators, in order to monitor them for repair or maximize their fuel efficiency. “We are going to be the leader in building a third generation platform” to handle all that data, Maritz said at press conference unveiling Pivotal.

Speaking on video, GE chairman Jeffrey Immelt, said the technology will use big data analytics to improve performance of operating machinery. “Very small changes in product performance can drive billions of dollars in customer productivity and profitability” he said.

Pivotal won’t start selling products until the fourth quarter. If the revenue opportunity justifies the $1 billion valuation the GE investment implies, it could make a significant contribution to the smaller VMware by the end of next year. More likely, if it shows its potential during the first half of next year, EMC is likely to sell part of Pivotal to the public, just as it did with VMware. If that is successful it would boost values of both companies.

Both companies are substantial firms with market leading positions, comfortable cash reserves and minimal debt.

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EMC Cash and Equivalents Chart

Neither one pays a dividend. EMC, however, announced a $1 billion stock buyback recently.

The cloud poses problems for the current business models of both EMC and VMware. But the two have a plan that could reap big gains from the same technological threat.

Bill Bulkeley, a contributing editor at YCharts, worked for the Wall Street Journal for more than 30 years, covering high tech since the birth of the PC. He also wrote about the Internet and the imaging industry. He has written for Technology Review, Knowledge@Wharton and CIO Magazine. He can be reached at editor@ycharts.com.


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