EMC = Exceptionally Managed Company
The High Tech Arena 3/7/99
By Joe Arena
Editor
In the arcane realm of high tech investing, many investors (including the great Warren Buffet) shy away from companies they cannot understand or are unfamiliar with. Such is the case with EMC, although considering its lofty valuation on a p/e basis, it can hardly be considered one of Wall Street's best kept secrets anymore. Borrowing a page from the book of Peter Lynch (i.e., if you can't explain to a 10 year old child in 30 seconds why you own a stock, you should not own it) That being said, consider the following explanation concerning EMC relative to the compelling investment premise that it represents.
"Anytime you use the Internet to work, play, communicate, or buy something, you create information that must be kept somewhere. EMC is the leading maker of products that store this information so that it can be used to help make people more productive. With the Internet adding seven new users every second, there will be a huge need to store a lot more information, and EMC is in the best position to make money from this trend."
Drilling down into the business of EMC reveals even more cogent reasons why this stock should be a long term core holding for every high tech investor. First and foremost, the data storage business has grown at a 90% annual rate over the last four years, and according to IDC, will double annually for at least the next 3-5 years. From a revenue standpoint, EMC has a goal of $10 billion in 2001, up from $4 billion in 1998.
This projection may prove to be somewhat conservative, as EMC should have a market opportunity of $35 billion during this time frame. This opportunity breaks out in terms of
$13.5 billion for mainframe/Unix storage, $8.5 billion for server consolidation, $4.5 billion for PC consolidation, and $8.5 billion for storage software. In addition, the market for tape replacement, professional services, and ESN (Enterprise Storage Networks) will equate to another $6 billion in market opportunity in 2001, for a total of $41 billion. Assume EMC will secure a 35% share of this opportunity (EMC currently has 35% with IBM being second with 22% that is declining, no other competitor has over a 10% share) and the company would have sales over $14 billion in 2001.
One of the most salient factors in making the bullish case for EMC has to do with a very favorable shift in product mix. Specifically, a transition toward larger capacity systems is not only resulting in greater revenue, but has been the key to expanding gross margins. For example, the 3700/5700 disk storage system, which currently supports up to 128 drives, grew from 23% of unit sales in to 35% of sales during 1998.
EMC's smaller capacity disk storage product, the 3330/5330, which supports up to 32 drives, has declined from 20% of unit sales to 14% of unit sales in 1998. During the last eight quarters, this salutary change in mix has resulted in revenue per unit increasing from $322,000 to $424,000. Moreover, the addition of licensed software in the product mix has also played a significant role in EMC's torrid growth. During the last two years, software revenue per storage system has grown from $16,000 to $76,000.
Another crucial element driving EMC's growth is their proprietary storage management software, which is also what differentiates them from the competition. (e.g., IBM, sunw, cpq, dell) EMC has become the fastest growing major software company, with 1998 revenues totaling $445 million, representing a compound annual growth rate of 161%.
One of the key trends that EMC is exploiting in terms of their software business is that of the changing role of information technology in the corporate space. For example, the bar is being raised relative to how IT managers are evaluated. No longer are they just expected to deliver cost savings via personnel cutbacks or consolidation of floor space. They now must bring a whole new array of skill sets to the party in terms of utilizing information techonology to bring products to market quicker, enhance customer service, and improve information availability. The point here is that EMC is rapidly developing a relationship with its customers that is based on providing solutions via storage management which add to the top line as well as the bottom line.
One of the major competitive advantages that EMC has realized is the ability to provide storage products that work for mainframes, Unix machines, and Windows NT Servers. The strengths of its competitors, conversely, are confined to one specific segment. For example, IBM and Hitachi are strong in the mainframe and Unix segment, but are weak relative to NT servers. Compaq and Dell are strong in the NT segment, but are not viable competitors in the mainframe segment. Sun Microsystems is very strong in the Unix segment, but not a major competitor in the high end or low end of the market.
Enterprise storage is a vital market segment which EMC is focusing on, and have stated their goal to garner a 50% share of this business. With the rapidly increasing importance of e-commerce to every company, success hinges on the ability to efficiently and effectively locate information about customers, competitors, suppliers, and internal operations, regardless of where that information is located. In many cases, this data resides in distributed storage systems geographically dispersed and disparate servers, where instant accessibility to all users is a virtual impossibility. EMC's product offering to provide a solution in this area is called ESN, or Enterprise Storage Networks.
It is also noteworthy that EMC had the foresight to recognize the growth potential of Windows NT, and incorporate its storage solutions to capitalize on this trend. More importantly, EMC believes that Windows NT/2000 will grow faster than any other operating system (yes, that includes Linux) and may very well replace Unix systems in three or four years. The significance of this is the growth of Windows NT/2000, which is creating storage management nightmares for corporate IT personnel. (MSFT is currently selling 100,000 NT servers per month) EMC estimates that by 2002, 44% of all servers will be running Windows NT/2000. Also, based on EMC estimates, storage management comprises 55% of the cost of such decentralized environments. However, by implementing an EMC solution, the cost is reduced to only 15%. Ultimately, the greater share of market that Windows NT/2000 achieves, the greater the competitive advantage realized by EMC.
The greatest risk to owning EMC from an investor standpoint has to do with its high valuation. However, we believe that in this slow growth, deflationary environment, a company which could very easily more than triple its top line in 3 years deserves a premium multiple, especially given our belief that the yield on the long bond could return to levels below 5% by the end of the year. Furthermore, we feel compelled to reiterate one of our key investment tenets, "you are buying a business, not a stock." Thus, you want to own the greatest businesses you can find if you have a long term time horizon and are prepared to dollar cost average when building your position in the stock. We would rather pay reasonable prices for superior companies than bargain prices for decent companies. And given EMC's projected earnings growth of 35% during the next 3-5 years, a case can be argued that the current stock price is not excessive, especially in a liquidity driven market. The point here is that EMC is well on its way to becoming the Microsoft of data storage, and the best is yet to come. And if you had worried about the high valuation of Microsoft in 1986, you would never have owned the stock.
TRADING UPDATE: We have taken another trading position on the MSFT Jan 01 150 calls, purchased last week at 39 7/8. We anticipate the stock running up to test the old high of 175, as investors anticipate the split and there is a paucity of negative news due to the trial recess. We would be sellers of this trading position within several days after the split, however. We continue to hold short positions in CSCO puts, specifically the March 90, 95, 105, and July 105. The cash we took in shorting these puts was put to work establishing the MSFT long leaps calls position. We are also considering initiating a position in the EMC Jan 01 80 calls on margin in our trading account, anticipating a breakout to new highs as a result of the upcoming split. We will also begin shorting EMC Jan 01 85 puts, using the cash from this trade to begin building a long term position in the stock.
DISCLAIMER: The information herein has been obtained from sources which are
believed to be reliable, but there are no guarantees as to its
accuracy or completeness. Neither the information nor any opinion
expressed constitutes a solicitation for the purchase or sale of any
security.
THE HIGH TECH ARENA
Joe Arena
Editor
JRArena@aol.com |
