EMC Squared
The Bull Argument
By
Mike Trigg (TMF Tonto)
Let me begin by congratulating David on his performance last week in the Fool's Duel cage. In case you missed the debate over biotech firm Biogen <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: BGEN)") else Response.Write("(Nasdaq: BGEN)") end if %>, our Voting Fools overwhelmingly declared him the victor. But, unlike last week's assignment, this week David isn't afforded the opportunity to take shots at a company with an unimpressive product pipeline and disappointing financial results. In fact, finding a weakness in storage superpower EMC <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: EMC)") else Response.Write("(NYSE: EMC)") end if %> is as difficult as standing in a six-ton chamber of ice for 62 hours, which magician David Blaine recently accomplished.
EMC is the undisputed storage champion of the world. There's no question about that, but plenty of debate regarding its future exists, particularly considering the success of upstart Network Appliance <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: NTAP)") else Response.Write("(Nasdaq: NTAP)") end if %> in the network attached storage (NAS) market. That's something I'm sure David won't let us forget. Nevertheless, EMC's growth prospects can be summed up in five areas: international sales, storage networking, mid-market storage, e-business initiatives among the Global 2000, and software.
In EMC's third-quarter conference call, CEO Mike Ruettgers updated its success in each area. Storage revenues year-over-year grew 130% in Asia/Pacific, 62% in Latin America, and 39% in EMEA (Europe, Middle East, and Africa). Storage networking growth was equally impressive, with storage area network (SAN) and NAS revenues increasing 380% to $480 million and 189% to $133 million, respectively.
In the mid-market, sales of its midrange system, CLARiiON, increased 40% to $165 million. Finally, Ruettgers cited statistics from Dataquest, showing strong demand among the Global 2000 for EMC's products. According to the market research firm, information technology (IT) spending will increase next year 5.9% for PCs, 6.2% for servers, but a whopping 22% for storage infrastructure.
Those reasons alone provide sufficient cause to be bullish on the future of EMC. However, I've "stored" the best for last: software growth. Its commitment to software has come to life through both organic growth and acquisition. The company continues to devote nearly 80% of its total research and development budget to building software -- some $164 million in the most recent quarter.
On the deal side, the company has made several software-related acquisitions in recent history including Conley Corp. for an undisclosed amount in 1998, Softworks for $192 million in December 1999, Terascape Software for $50 million in January, and most recently CrosStor Software for $300 million. The CrosStor purchase had added significance because much of the company's software is used in NAS devices, which is a market that EMC is aggressively attacking.
Nevertheless, EMC is still thought of as a "box maker," but software growth is key to its success. As the demand for networking storage products grows, EMC has the ability to bundle its traditional storage products with a set of software attachments. That's a huge competitive advantage. In the Fool's third-quarter EMC research report, Foolish Research Analyst John Del Vecchio discussed this very notion. "As the adoption of SANs and NAS continues to accelerate, software attachments should rise as well, creating software growth above 50%," he wrote. "Software will increase the pace of adoption through improved functionality, performance, and cost savings."
With competitive pressures in the storage market heating up and the price of storage hardware dropping, companies unable to improve their financial status won't be around long. Nearly 15% of total revenue was attributed to software in the recent quarter, which improved its financial position. Software is an attractive space (our own Zeke Ashton showed why) because it's a high-margin business. The initial costs for creating software can be high, but additional expenses for licensing and renewal are near nothing. Thus, there are extremely high gross margins, which provides more incremental revenue contributing to bottom-line profits. In the third quarter, EMC's gross margin expanded to 57.7% from 51.9% in the year-ago period.
Rule Maker Co-Manager Matt Richey also pointed out earlier this year that software has improved EMC's operating leverage, a model taken straight from the Microsoft <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: MSFT)") else Response.Write("(Nasdaq: MSFT)") end if %> play book. In short, EMC's traditional storage boxes have large variable costs that sway with the number of units sold. That makes profit increase proportional to revenue increase. On the other hand, its growing portfolio of software products have large up-front fixed costs, which propels profit growth to exceed revenue growth. Matt also pointed out that EMC's 26% increase in revenue over the past 12 months has corresponded with an 83% increase in free cash flow.
The company's software performance so far is noteworthy, posting well over 50% year-over-year growth, quarter after quarter. In fact, year-to-date it has already reached nearly $1 billion in software sales and it leads the storage management software market with 30% market share, while Veritas Software <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: VRTS)") else Response.Write("(Nasdaq: VRTS)") end if %> is close behind at 26%. With more than $2.7 billion in cash, sufficient capital exists to make additional software-related acquisitions.
Overall, the future looks good for EMC because storage remains the top priority of IT infrastructure spending. Storage spending is predicted to grow 22% annually over the next five years to nearly $80 billion. Still, it's likely David will spend a great deal of his initial argument telling us that EMC is poorly positioned in the storage market and late to the NAS game.
If that's the case, I'll be more than ready. True, its NAS efforts vindicate Network Appliance's approach to storage, but "mind share still equals market share" and EMC is still the most trusted name in storage. Plus, who's to say that the NAS market isn't big enough for both companies? I'll talk more about that in the rebuttal. (The Motley Fool examines the network storage market in Industry Focus 2001.)
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