Good Things in Store at EMC
By Robert Hunter
October 20, 2000
HERE'S AN INVESTING idea, by way of a story.
You're name is Benjamin, and you're 22 years old. Your
parents have invited a few dozen family friends and
relatives — most of them twice your age — to the house to
celebrate your college graduation.
Your dad's gin and tonics are having the unfortunate
effect of loosening people up. You wish the guests would
remain as restrained as possible. You wish they had
remained at home.
You find yourself nearly paralyzed with revulsion and
terror. Suddenly, you break for the stairs to escape your
misery, praying that some wayward, half-in-the-bag guest
doesn't intercept you. Naturally, that's exactly what
happens. A 50-ish relic wobbles over, grabs your arm,
drags you poolside and utters the most incontrovertibly
brilliant advice anyone will ever give you: plastics.
That's right, I'm suggesting that you should invest in
plastics. Not the substance that your Rotato is made of,
but the reference. The cliché.
I hope you recognize the scene I've painted as being from
"The Graduate," the 1967 Oscar-winning classic. Soon
after that film was released, "plastics" and "Mrs. Robinson,
you're trying to seduce me" joined "I coulda been a
contenda" in the American vernacular — which now, of
course, also includes "You can't handle the truth" and
"[Our amps] go to 11." My point: People love movies.
It's difficult to invest in that simple concept. You could buy shares in a media conglomerate, but that
wouldn't quite do the trick, since movie studios generally don't add much, if anything, to corporate
bottom lines. More recently, people started looking at bandwidth and telecom stocks as roundabout
plays on the future of entertainment. But those and other tech sectors have been beset with problems
lately. Profit warnings and subpar earnings reports from Apple Computer (AAPL), Lucent (LU), AT&T
(T) and others have resulted in harsh sell-offs. I'm sure these stocks will turn around at some point, but
there isn't a compelling reason to buy them now, no matter how attractive their valuations seem to
be.
One corner of the tech sector is still booming, however: network storage, which includes the
refrigerator-sized bins that house bits of information and the software used to access those bits. This
may be the best play right now on humankind's love of film. Why? When the bandwidth revolution
takes hold three or four years down the road, all those movies-on-demand you download from your
cable provider will have to be kept somewhere. Enter network storage.
Of course, there's more to network-storage products than movie downloads. Like Black Sabbath
downloads, for instance. And less wholesome things like insurance-company data, government
records, entire university libraries — you get the point. Analysts say the network-storage market will do
$31 billion in sales this year, and grow by 40% for the next few.
"There's no business or economic trend that
is more constant than the growth of
information — not only its sheer volume but
its increasing importance to an
organization's success," says Mike Ruettgers,
chief executive of Hopkinton, Mass.-based
EMC (EMC). He should know. His company
controls 30% of the entire network-storage
market — three times more than any of its
rivals, which include IBM (IBM), Hitachi
(HIT), Sun Microsystems (SUNW) and
Compaq (CPQ).
On Wednesday, EMC lovingly unfurled an
earnings report that might as well have been
etched in gold. While IBM was busy stinking
up the market, EMC announced that it
increased its net income by 55% in the third
quarter, and had beat the Street's
earnings-per-share estimate of 19 cents by a
penny (up from 13 cents in 1999). EMC's
network-storage business grew by 47%
year-over-year, its biggest spurt in five years.
The company raked in $2.28 billion all told,
and will approach $9 billion for the year.
Despite the glowing report, however, shares
fell $5.31 to $89.63 on Wednesday. The
reason: While EMC's software sales
increased by 61% in the third quarter
year-over-year, they dropped 5% from the
second quarter. EMC explained that the
slump was a result of some component
shortages that won't be repeated. Most
analysts seemed happy with that answer.
"We think this is a nonissue," wrote Peter
Labe of New York-based Buckingham Research Group on Wednesday. "Investors should be prepared
for some fluctuation [from] quarter to quarter. Viewing this performance overall, it was a magnificent
quarter." EMC stock bounced back nicely on Thursday, popping $7.37 to close at $97.
EMC's success isn't a recent phenomenon — the company's been galloping along for years. Since
1992, when Ruettgers took over as CEO, its stock has increased 370-fold. These days, it trades at a
forward price-to-earnings ratio of around 118. That's nosebleed territory, I know. But EMC deserves its
lofty multiple.
Among network-storage products, EMC's are the gold standard (the company boasts a 99%
customer-retention rate). Its products are also the most expensive in the market, but customers aren't
fainting from sticker shock. Right now, EMC has greater than a 50% share in the mainframe storage
market, is tied for first with Sun Microsystems in the Unix-based market, and is No. 3 in the NT-based
market behind Compaq and Dell (DELL). EMC is also the biggest provider of network-storage
software.
The biggest growth areas in computer storage — but not yet the biggest revenue areas — are storage
area networks, or SAN, and network-attached storage, or NAS. In the SAN model, several giant disk
drives are linked together to form a network of storage drives. EMC dominates this market, with a 40%
share. According to IT consultancy Dataquest, the market is projected to grow to $11.4 billion in
2003 from $2.8 billion in 1999.
NASs, meanwhile, are stacks of disk drives with built-in servers attached to a computer network, and
are much less bulky and far cheaper than SANs. Right now, Sunnyvale, Calif.-based Network
Appliance (NTAP) controls this market. A one-terabyte NAS system from NetAp (capable of storing a
trillion bytes of information) costs around $235,000 — a pittance compared with the more than $1
million EMC would charge for a one-terabyte system from its flagship Symmetrix enterprise product
line. EMC is rushing to put out a product to compete with NetAp, an eight-year-old company that
could do $1 billion in revenue this year. (The overall market is expected to grow to $6 billion by
2003, according to Dataquest.)
Most analysts think EMC will be able to mount a credible challenge in NAS products, and bolster its
positions elsewhere, because of its hefty resources. In the third quarter, EMC's operating margin
totaled 25.3%, a 3.5% improvement from a year ago. Meanwhile, it increased its research and
development by $10.5 million from the second quarter, to $205 million — up 37% from 1999. The
fact that EMC has been able to increase R&D expenditures while simultaneously boosting operating
margins impresses analysts.
And, of all its
competition, EMC is
the only company that
offers a one-stop shop
of hardware, software,
service and support.
"In the storage space,
trust is key," says Doug
van Dorsten of Thomas
Weisel Partners.
"People have to have
their data safe and
secure, and EMC has
established itself as the
trusted name. That's
why it does well in the
face of competition
from IBM, Hitachi and
Compaq, which all have pretty good products. Hitachi, for example, has a really good box, but not
great software and weak service and sales. No one has a total solution that can match what EMC can
offer."
So let's add it all up: EMC's got a strong foothold in a rapidly growing market, it's got a great balance
sheet while spending heavily on R&D and its management has shown repeatedly that it can execute.
Should you invest now? It's difficult to view a company whose stock has already increased so
dramatically, and whose P/E is as high as it's ever been, as a good deal. It wouldn't appear that
there's much upside to be gotten. Moreover, at its current valuation, one earnings hiccup could send
the stock into a tailspin. Look what happened on Wednesday, when it posted stellar numbers overall
and still got smacked.
But we advocate the long view. Everyone agrees that the storage market is growing explosively —
and EMC's overall earnings growth, at least so far, hasn't been affected by external events like a
slowing economy or the weak euro, or even glitches like component shortages. That's impressive.
Labe says EMC is "a genuine growth stock, with prospects for growth in the area of 35% annually for
the next few years."
And EMC isn't exactly an IPO-fueled startup. It was formed in 1979 and, with a market cap of around
$195 billion, is the fourth-biggest high-tech company, after Cisco, Microsoft (MSFT) and Intel
(INTC). In the network-storage game, EMC is the purest play — and it deserves to be included with all
of the other bellwether Internet-infrastructure companies.
"People pay up for the names that continue to do well, the companies that execute every quarter
and have 34% sales growth instead of 3%," says van Dorsten. "In this market environment, where a
company misses a number and gets killed, the companies you want to own are those like EMC,
which consistently crank out good numbers."
So keep your eye on EMC, and think about buying some shares on the next big dip. Remember that
other great movie line: "Greed is good." |
