Value Investors Club / EMC Corp. (EMC)

Description

SUMMARY

EMC completed a carve-out IPO for VMW on August 14^th at $29 while retaining a current 85.9% stake in the company. Since the IPO, VMW’s shares have rocketed to an intraday price of $79, or 172%, while EMC’s share price during the same period has barely budged. We believe this dislocation creates a compelling value in the EMC stub.

We believe that the core business of EMC is significantly undervalued in light of the following: 1) its current holdings in the VMW carve-out; 2) an overcapitalized balance sheet; and 3) above average prospects for the core business. By shorting out the company’s ownership stake in VMW, one can create EMC at a valuation of 9 times consensus 2008 earnings estimates with a corresponding free cash flow yield of 12.1%.

This short write-up will first “create” the stub by backing out the value of the VMW holding and excess capital and then discuss a reasonable valuation scenario for the core business. In the end I think you’ll find the EMC stub to be one of the cheapest technology companies around.

CREATING THE EMC STUB

At an intraday price of $79.00 with approximately 380 million shares outstanding, VMW is sporting a market capitalization of $30 billion. After the carve-out IPO, EMC retained an ownership position of 85.9% of the common which is currently valued at $25.8 billion. With approximately 2.12 billion shares outstanding, EMC’s ownership in VMW represents $12.15 per EMC share.

At the end of the second quarter this year, EMC had a cash balance of approximately $5.9 billion. In addition, the company received around $1 billion in cash proceeds from the VMW IPO. The resulting current cash position should be around $6.9 billion. The company has around $3.45 billion in debt for a net cash position of $3.45 billion or $1.62 per share. If we keep $1 billion on the books for working capital, etc., net cash comes to $1.15 per share.

At a current intraday price of $18.95, the stub value after backing out the VMW holding ($12.15) and excess capital ($1.15) comes to around $5.65 per share with a market value of $12 billion. The current market capitalization of EMC is about $40 billion with VMW representing approximately 64% of the overall equity capitalization. So to create a complete stub you would need to short $0.64 of VMW for each dollar long in EMC.

EMC CORE BUSINESS VALUE

Since EMC consolidates VMW earnings; we must recreate the EMC income statement by backing out earnings from VMW. To do this, I will simply use the most recent EMC consolidated earnings estimates provided by Goldman Sachs and back out 100% of the VMW earnings as estimated by ThinkEquity Partners. Backing out 100% of VMW earnings rather than EMC’s 85.9% interest should provide a reasonable cushion.

Core Earnings Per Share

2007 2008 2009

EMC Consolidated Net Income (Goldman)   $1,442.0        $1,723.9        $2,133.9
VMW Net Income (ThinkEquity)              $242.1          $397.3          $571.2
Core EMC Net Income                     $1,199.9        $1,326.6        $1,562.7
Core EMC EPS                               $0.57           $0.63           $0.73
Core EMC P/E                                9.9x            8.9x            7.7x

Core Free Cash Flow

2007              2008              2009

Core EMC Net Income                   $1,199.9        $1,326.6        $1,462.7
ADD: D&A                                 $860.1          $892.5          $930.5
ADD: Other OCF                            $100.7          $146.6          $147.7
MINUS: CAPEX                             ($873.9)        ($914.3)      ($1,084.1)
Free Cash Flow                          $1,286.8        $1,451.4         $1507.8
FCF Yield                                  10.7%           12.1%           12.6%

Another way to look at the company is from an EV/EBITDA basis. Estimated 2007 operating income for the core EMC business is expected to $1.56 billion and D&A is expected to be $860 million with resulting EBITDA at $2.42 billion. The enterprise value of the core business is approximately $11 billion after backing out the VMW holdings and total net cash balances. That puts the EV/EBITDA ratio at a mere 4.52 times. Even the most ardent critic must agree that this is a very low multiple for a solid, growing business. Here’s how the closest comparables come out:

Comparable Companies

2008 P/E               TTM EV/EBITDA

IBM                                  14.8x                     10.6x
HPQ                                  15.5x                     11.9x
HIT                                  57.5x                      6.7x
NTAP                                 22.7x                     21.1x

EMC                                   8.9x                      4.3x

BUSINESS TRENDS

Along with a rather compelling valuation, we believe the core business has above average prospects. I suspect most everyone knows about EMC, so for the sake of brevity I will address several points that indicate that the core business is just fine. If you want more detail, there are about 20 analysts covering the name.

1.       Revenues in the core storage segment are growing in the low double digits;

2.       All major geographies are growing over 15%;

3.       About 40% of business is international and should be helped by the weak dollar;

4.       Software and services are above 50% of the revenue mix and growing;

5.       Gross margins are expanding;

6.       Operating margins are expanding;

7.       EMC is taking share in the midrange market;

8.       EMC is taking share in Asia;

9.       The company is rolling out a significant number of new products in fourth quarter;

10.   Management is consistently buying back a material amounts of stock;

FAIR VALUE

We believe EMC deserves a premium to both IBM and HPQ as it’s grow prospects and position in the storage market are considerably stronger. But if we simply put a 15x on the $0.63 core 2008 estimates, we’d have a reasonable $9.45 value for the stub. That’s about 67% above the current value.

Catalyst

1. Continued share repurchases;
2. Continued business momentum;
3. An eventual spin-off or liquidation of VMW;
4. Market recognizes the embedded value of VMW.

show sort by

			2007	2008
Price:	19.00	EPS
Shares Out. (in M):	0	P/E
Market Cap (in $M):	40,000	P/FCF
Net Debt (in $M):	0	EBIT	0	0
TEV (in $M):	0	TEV/EBIT