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Technology Stocks : EMC How high can it go? -- Ignore unavailable to you. Want to Upgrade?

To: Raymond Clutts who wrote (7914)	10/22/1999 11:18:00 AM
From: JustMy2Cents	Read Replies (2) \| Respond to of 17183

Investment Highlights: o Investors reacted negatively to EMC's lack of disclosure regarding Data General. Still, results were on track and the outlook positive. We have modestly increased estimates and reiterate our Buy; our price objective of $90 is 62X our 2000 estimate for a PEG of 2.0. o Storage demand, boosted by the Internet, should buoy the stock. We believe the real issue will be how long EMC can maintain its price premium. Fundamental Highlights: o Earnings of $0.29 per share beat our $0.27 estimate because of a higher gross margin. Revenue was a touch light due to softness at McData. o Guidance was upbeat. Y2K is not expected to pose a problem, and EMC expects to grow the top line about 35% next year ex-Data General. o Financial details regarding the DG integration were not available, but the company maintains it should be accretive in 2000. We expect that 35% EMC classic growth and about 20% DG growth should result in roughly a 30% combined revenue increase. Third Quarter Highlights Revenue was a bit light due to a shortfall at McData. The top line increased 33% to $1.3 billion. International was strong, with Europe up 25% and Asia/Pacific jumping 45%; EMC has moved top sales execs to the regions. Hardware rose 28% to more than $1 billion for the first time. Software was quite robust in rising by 75% to $207 million or 15.5% of revenue, breaking the 14% level of the past three quarters. More than 70% of systems now go out with software packages. The McData subsidary was disappointing at $24 million versus our $44 million expectation. Sales of ESCON directors to IBM were soft and are expected to remain so (Connectrix sales are recognized by EMC in enterprise hardware). Some 1,900 subsystems were shipped, down year over year but the configurations are getting larger. The total includes 250 small systems, 950 medium systems, and 700 large ones, showing a continued mix shift to the high end. Over 80% were new generation systems introduced early in the year. Connectrix switch sales were $45 million. SANs are coming, but our surveys suggest mainstream implementation is two years away. Indirect sales were less than 10% of revenue with HP gone. A high gross margin caused an earnings upside surprise. We figured our margin estimate could be low given the historic pattern of 3Q margin above 2Q. The reported gross margin of 57.5% was two points higher than we looked for driven by software sales, more direct business, and larger capacities. Expenses again grew faster than revenue. Management is happy to hire sales people if it results in higher gross margins. Receivable days ticked up. DSOs increased from 80 in 2Q to 87, not a trend we like to see. Often that means deferred payment terms were required to get business done. EMC explained it as higher direct and international sales. We're inclined to give the company the benefit of the doubt because similar issues in the past have been quickly resolved. Inventory turns of 4.2 should rise to 4.5 at year end.Outlook: How Does DG Fit In? Y2K is not an issue. The guidance for "classic" EMC was quite positive. Y2K should not slow down sales in 4Q or 1Q, which has been management's view all along. Our surveys have supported that view. No doubt some companies are putting off purchase, but EMC says it hears the opposite more often, that customers are done and ready to buy again. Internet applications now constitute over 10% of demand. There are the dot-com companies, where EMC has 80% of the top names. Perhaps more important will be the Fortune 1000 as they move on-line, what IBM calls below the e-line companies. CEO Mike Reuttgers said his five strategic initiatives include (1) dot-coming all businesses; (2) fibre channel network storage, already 40% of system shipments; (3) software; (4) international; and (5) attacking the $10 billion middle market opportunity with DG. MC classic should grow about 35% next year, but DG should slow the total to perhaps 30%. The preliminary guidance for next year is that EMC can grow revenue in the mid-30s, certainly as good as investors could hope for. Given EMC's penchant for beating numbers, the rate of increase might be even higher. Unfortunately, management could not address the effect of adding Data General. The acquisition is expected to be accretive next year (and not dilutive in 4Q was the suggestion to us). But EMC hasn't had time to nail down the top-line impact, which distressed investors. We expect the company to give some guidance in November. We like the deal strategically because it's in the core business (except for AViiON servers, which EMC plans to make profitable with Bob Dutkowsky running it). The companies are close geographically, too. And it appears EMC needs a midrange solution for NT consolidation. The cultures are quite different, though. And EMC will create a tiered sales force with CLARiiON specialists augmenting Symmetrix sales folks. EMC assures us it knows how to execute this model but selling multiple product lines could prove tricky. We are modestly increasing estimates. First let's consider EMC classic. Revenue in 4Q should rise by 33-34% with a flat-to-down gross margin sequentially, resulting in about $0.33 per share. The top line could increase by 35% next year, the gross margin should rise again thanks to software, and expenses may grow in-line with revenue for earnings of $1.45 per share. Adding DG, whose September quarter results we don't know, should be neutral to slightly dilutive to earnings as it could be for the first half of 2000. We've taken a shot at modeling the combined entity. The figures EMC has released show the combination growing 25% in the first half (EMC alone 36%), a gross margin of almost 50% (EMC over 54%), and an operating margin of 20% (EMC 26%). Yet overall first half earnings were only $0.02 less than EMC alone, suggesting accretion might not be a stretch. We figure DG can grow close to 20% next year with CLARiiON up big and AViiON down. Combine that with EMC classic's 35% increase and total EMC grows by about 30%. We don't have details, but the EPS impact should be neutral to positive, so we're going with $1.45 per share. What about competition? Although DG has investors spooked, our view is that the real threat is increasing competition pressuring EMC's price premium of 50- 125%. We're reassured that pricing is not an issue today. The company continues to diss the competition (customers giving back HP/Hitachi storage, IBM's Shark not ready for the big leagues). We're comfortable that price pressure won't be an issue near-term, but users in our Corporate Buyers' Survey believe EMC won't be able to maintain its premium indefinitely.