The EMC stub, created by shorting EMC's ~80% ownership in VMware in the ratio of approximately 4 shares short of VMW for every 25 shares long of EMC, currently offers a compelling valuation on a dominant technology player that has been a fixture in "Big IT" for over 30 years.

The situation is at least partially explained by the dominance of long-only investment managers who don't think about EMC and VMW (with market capitalizations of roughly $40b and $30b, respectively) in terms of the stub valuation-if anything, these managers think of EMC as a cheap way to own VMW.

Background

EMC has been around since 1979, and is the dominant player in enterprise level storage solutions. Much of EMC's profits come from selling refrigerator-sized arrays of hard disks, like the one below.

One shouldn't draw comparisons to the huge mainframes of years past and assume that EMC makes lumbering dinosaurs that will be replaced with cheap clusters or commoditized by cheap Asian disk drive manufacturers and the storage industry's version of Moore's law. It turns out that the storage solutions that EMC makes are fundamentally different for several reasons, which make the space significantly more attractive over the longer term:

• Storage is really important to businesses. We are talking about the life-blood of a corporation here-anything from mission-critical transactional databases to email servers to corporate document storage and management. A storage system needs to be super reliable, fast, and scalable. The cost of a storage product then is not necessarily measured in terms of gigabytes per dollar, but in terms of the value of the underlying data being stored, and the potential cost to an organization from downtime or data loss. The expression "no one ever got fired for buying EMC" applies here: they are the undisputed masters of this space and have been on the forefront of innovation for decades.
• What matters isn't hardware per se (think disk drives or stacks of drive arrays), but storage solutions. In the modern corporate IT environment, storage is thought of more as service to be provisioned and dispatched throughout the organization. And it isn't a homogenous service, either: the right type of storage needs to be used for the right application. For example, heavy duty database stuff should be done on the very fastest (and most expensive) hardware, while archives of 10 year old emails can be done on a slower and cheaper part of the storage infrastructure. So what EMC does is create a solution for the customer, which is a whole ecosystem of hardware and software systems that assist in managing the various aspects of storage in the modern IT infrastructure.
• The amount of data being created today is mind boggling-so much so that it rivals the exponential growth in storage capacity. Not only is more and more business conducted online or through other electronic means, which creates a trail of data that must be constantly backed-up and stored redundantly, but there are increasing requirements to retain electronic records as a result of SOX and other regulations.  The basic officer worker at this point is well served in terms of the speed of his PC-there isn't much of a productivity boost to be had, for example, by doubling the speed of MS Word. Storage, on the other hand, is one of the few areas in technology where there is seemingly limitless demand, with even regular consumers using quantities of storage that would seem absurd even 10 years ago.
• The solutions which EMC sells are not just about storing data anymore-they cover the entire spectrum of content management, from security (see the 2006 purchase of encryption leader RSA) to virtualization (see VMware, which we will discuss in detail later) and  data efficiency products (see the recent acquisition of Data Doman, which makes data de-duplication systems to reduce wasted storage).
• EMC is part of the group of "Big IT" providers that are firmly entrenched in the IT departments of virtually all of the Fortune 500 companies. As such, EMC has the mind share of the large system integrators such as Accenture, IBM, EDS, Deloitte, etc. This is a large competitive advantage which creates a fairly solid barrier to entry for new participants in the market. The consultants at these firms are very familiar with the EMC technology and have been working hand-in-hand with the engineers at EMC for years to hone their deployment strategies. It's not hard to see why the risks associated with moving to another storage provider might easily outweigh the benefits to cost or performance (remember that the labor and expertise in setup is often the most expensive part of these systems).

VMware

EMC acquired VMware for $625mm in 2004. Needless to say, with a current market capitalization of close to $30 billion, EMC's remaining ~80% stake in VMW has been an incredibly good investment. So why is everyone so excited by VMW's prospects that it merits a forward p/e multiple of over 50x? It is hard to overstate the importance of virtualization in the coming cloud computing revolution. An excerpt from the entry for VMware from Wikipedia give a good idea of what the software does and the radical change it has brought about:

VMware software provides a completely virtualized set of hardware to the guest operating system. VMware software virtualizes the hardware for a video adapter, a network adapter, and hard disk adapters. The host provides pass-through drivers for guest USB, serial, and parallel devices. In this way, VMware virtual machines become highly portable between computers, because every host looks nearly identical to the guest.

In practice, a system administrator can pause operations on a virtual machine guest, move or copy that guest to another physical computer, and there resume execution exactly at the point of suspension. Alternately, for enterprise servers, a feature called VMotion allows the migration of operational guest virtual machines between similar but separate hardware hosts sharing the same storage. Each of these transitions is completely transparent to any users on the virtual machine at the time it is being migrated.

Virtual Machines (or VMs as they are known in the industry) allow companies to dramatically simplify the complexity of their IT infrastructure, reduce hardware and energy cost, and create lots of flexibility and scalability, all while reducing the risk of catastrophic system downtime as a result of transitioning to new hardware or systems. For example, a company might have a legacy system where they have a mail server, a print server, a file server, an application server, and a database server. Each of these servers might be a separate physical machine, with each one constantly  drawing electricity and requiring cooling and maintenance as security patches and other updates must be installed. The servers might be based on older, legacy systems that work reliably but are not really scalable and might not interface well with other parts of the IT architecture. Furthermore, from a utilization standpoint, the print server might only be using 10% of its capacity at any given moment (i.e., when it is actually processing a print job). The rest of the time, the server may sit idle, but it is still using up the same power load and requires the same fixed costs to maintain. In the old days, it would be a real pain to upgrade this infrastructure. It would probably be done on a piecemeal basis, one server at a time, at great expense. It would also create a real business risk of a critical piece of the IT stack going down, such as a crashed email server. To minimize these risks, companies might invest in redundant systems so there are fail-overs.

The situation today is much better. The company could install VMware software on each machine, and automatically clone the physical systems as a virtual image. This image would have each piece of hardware replaced with an idealized virtual hardware component, but all of this would be invisible and seamless to the user. Then the company could purchase one big modern server (say from Dell, HP, or IBM) and connect the server to an EMC storage system, and have each virtual server running inside of the big new server. So there would be one machine handling printing, email, database, etc., but it would still appear on the outside the same way as the legacy system. This minimizes tremendously the cost and risk of the transition (you would also still have your actual legacy hardware in case you needed to switch back-this process does not change the original servers in any way) and also allows for easy upgrades in the future. If you want to upgrade your computers in 4 years, you can buy the new server from IBM, the new storage from EMC, pause all of your virtual servers, copy them onto the new system, and un-pause them. It isn't hard to see how this sort of a change in IT is more or less earth-shattering.

So VMs are a big deal, and VMW has a very dominant position in the space, although Microsoft and Citrix are also involved. VMW has a real advantage over Microsoft however, in that Microsoft is perceived (probably correctly) as wanting everyone to be stuck in the Microsoft ecosystem of Windows, Office, Exchange, etc., whereas VMware has always supported various flavors of Unix and is viewed as platform agnostic. Now, the upside for VMW has clearly not gone unnoticed considering its 50x earnings multiple. Furthermore, I am advocating that this component of EMC's value be hedged out, so why even dwell so long on VMW? Well, aside from the dynamics of how EMC's stake is ever monetized or if any catalysts will cause the cross-ownership structure to unwind, VMware still has a meaningful impact on the EMC stub business.

That's because EMC has made great strides in terms of having the EMC storage products play nicely with the VMware eco-system. Customers know that if they plan on deploying VMware products in their infrastructure, that they will minimize headaches by sticking with EMC for all of their storage hardware needs. This means that even if you hedge out the sizzle by shorting VMW, the EMC stub still benefits from the VMW "halo" in terms of perceived compatibility and performance advantages over other storage companies such as NetApp.

The Stub Isn't Unliked, it is Just that Everyone Loves VMware

I mentioned above that the current valuation of the EMC stub business is a result of long only managers owning either VMW or EMC (or both) and not thinking about the situation in terms of the stub. The image below is a chart of the 2010 estimated p/e of the EMC stub, which depends on the relative prices of VMW and EMC and the revised consensus estimate of the earnings of VMW and EMC. The chart shows that the current 2010E stub multiple is on the order of 9 times earnings (excluding stock comp), which is significantly cheaper than in the recent past:

Why has the p/e of the stub come down so much? It could be a result of the VMW share price climbing faster than that of EMC, or it could come from increasing analyst earnings estimates for EMC relative to VMW. Or it could be a combination, which is in fact what happened. The chart below shows the share price development (indexed to 1.00 on 7/7/2009) of EMC, VMW, and the EMC stub.

It is clear from this chart that VMW has been on a tear, with EMC up but not nearly as much as VMW, with the result being that the stub is trading a bit below where it was about a year ago.

The chart below shows the 2010 consensus analyst estimates for adjusted earnings per share for VMW and EMC, also indexed to 7/7/2009, with the EMC stub EPS calculated from the EPS of EMC and VMW:

The chart demonstrates that, even while the stub stock price was flat over the past year, the earnings estimates for the stub business have increased at a faster pace even that the estimates for VMW. The result is the final chart below of the indexed p/e ratios:

Macro Risks and Competition

As mentioned earlier, EMC has won its seat at the table in the world of big company IT-they have great access to the top brass making decisions on how to spend vast IT budgets. The percentage of aggregate big company IT spending that goes to EMC has been fairly consistent, even as there has been volatility in aggregate IT spending levels. It is very hard to predict how much corporate IT spending there will be in the next few years-this depends on GDP, employment levels, etc. As we saw clearly at the end of 2008, almost nothing in a corporate budget is 100% non-discretionary, and IT budgets need to flex with business realities. So a stronger investment thesis might be more along the lines of "The EMC stub is cheap on an earnings multiple basis relative to a representative basket of other providers of enterprise IT products/services."

In order to quantify this, I looked at the last 10 years of results for an equal-weighted basket of large IT companies. In particular, I looked at EMC along with MSFT, ORCL, CSCO, HPQ, IBM, NTAP, DELL, SYMC, and CTXS. I took the trailing-12 month financials for these firms and looked at how EMC's share of the various metrics evolved over the last 10 years. The most relevant metric is probably revenue, which is a good measure of how much of the corporate IT spending pie EMC was able to capture in any 12 month period.

The waviness of the chart is a result of seasonality and the clustering of companies in different reporting periods. The chart shows that, at least for the past few years, EMC has held a fairly steady ~3.5% of the aggregate revenue of the group. The same can be said about EMC's share of the aggregate gross profit of the group:

It starts to get a little more interesting when we look instead at free cash flow (defined here as operating cash flow minus capital expenditures). Here we can see that EMC has done a good job in terms of cash generation, which is quite relevant given their historically acquisitive nature.

EMC has also done a fair amount of stock buybacks in the past, as shown in the chart below, which illustrates the number of outstanding shares of EMC over time. In its 2010 guidance the company says that it will buy back another $1b of stock in 2010.

Good capital allocation is especially important for a company that generates a lot of cash, and the EMC stub also has net cash on its balance sheet of about $1.5b, as well as a considerable amount of other investment securities. EMC is so large and so dominant in its core space that it is difficult for it to reinvest all the cash it generates organically into the business. As a result, EMC has been somewhat of a serial acquirer. Unlike many companies that do a lot of acquisitions, EMC seems to be pretty good at it. Aside from the grand-slam homerun that was VMware, EMC has made several strategic and complementary acquisitions in recent years. These acquisitions have not only allowed EMC to grow revenues, but they have given it a more well-rounded stable of products and services that allow for cross-selling opportunities. EMC can also leverage its strong brand and reputation to sell products that a smaller company might have trouble marketing to high level executive at a large company.

Valuation of the Stub

Relative to the other big corporate IT providers, the EMC stub is fairly cheap. The table below shows the forward p/e multiple for a handful of these other companies.

One issue with analyst estimates for technology companies is their seeming insistence that stock compensation is somehow not a "real" expense and so it can be added back. But if we apply this same methodology to the EMC stub we derive the following implied multiples:

EMC gives fairly good disclosure in terms of detailing the earnings of the stub business, which they refer to as the EMC Information Infrastructure segment (as opposed to the VMware segment). The historical non-GAAP financials for the stub business, along with adjustments, is presented below:

EMC also gives very specific guidance, and while VMW does not, it is covered by dozens of analysts and estimates are fairly clustered together. Thus by combining EMC's guidance with analyst estimates for VMW, we can piece together a fairly tight estimate range on the stub.

Based on this, I present below 3 scenarios for the stub's 2010 earnings:

The base scenario above is essentially in-line with company guidance. The bear scenario assumes that revenues and gross margins fall back to the same level as the 12-month period ending 6/30/2009, but also assumes that in that situation the company would dial back its R&D spend appropriately. Finally, the bull scenario assumes slightly higher revenues than the company guidance and incrementally better margins.

The fact that you would own the stub at roughly 14x adjusted earnings if the company performs the way it did during the height of the credit crisis in another economic downturn implies a significant margin of safety in the investment. In the meantime, you have a relatively high margin company with a solid competitive position that will continue to capture its share of IT spending in the economy, and which has demonstrated the ability to make accretive acquisitions and integrate them successfully with the rest of the business.