EMC And VMWare Will Overcome European Worries

We would like to highlight two such companies, for whom Europe is an possibility to grow, not a risk. EMC and VMware are lynchpins in the research world. EMC is the worlds largest data storage company and VMware is the leader in virtualization research. EMC is the majority owner of VMware, owning 80% of the company, an in the extreme shrewd purchase on its part. Two things have caused us to examine VMware and re-examine EMC, which we reccommended on September 16. First, VMware has shown remarkable resilience year to date. How can this be? VMware trades at a P/E of over 65. Shouldn't such stock be the first to be crushed in weak markets, just as the one we are currently in? VMware has held up remarkably so then, and has in fact outperformed its parent and the S&P 500, both of which have a much lower valuation. We think this sets shares of VMware up for a large rise. The shares have stayed in a range, rarely venturing above $100. Even more, EMC has been aggressively buying shares below $100. No one, aside from VMware itself, knows VMware's business better than EMC, and if it thinks that VMware shares are a buy below $100, we think so too. But, as much as we would like to, we cannot simply recommend VMware on large insider buying. We must as well look at the company's fundamentals, and what we have found furthermore reinforces our opinion that VMware is a buy at these levels.

On October 17, VMware reported its third quarter results. The company posted GAAP EPS of 41 cents/share on earnings of $942 million, which grew 32% from last year. CFO Mark Peek noted that:

Volatility in Europe does not appear to be showing up in either VMware's top or bottom lines. On the conference call, management noted that growth in Europe was strong, led by increasing demand for virtualization products from Germany. How can this be? Isn't Europe supposed to be falling apart? Simply put, when you offer clients a product that saves them money, as VMware does, and it leverages a secular trend, demand will grow regardless of economic conditions. We take issue with the assumption that the European debt crisis will take down all companies. It is true that some will suffer as a result of slowing demand in Europe, however VMware is not one of them. International earnings grew by 37% on a constant currency basis in the third quarter.

VMware, to be fair, has guided conservatively for this quarter, citing the usual "uncertainty." All in all, management stated on the conference call that they have not seen meaningful cancellations from their clients. Nor have public sector clients changed purchasing patterns in fear of austerity or budget cuts. VMware not only has strong operational results, however strong financial metrics as so then. Free cash flow grew 72% in the most recent quarter to $1.8 billion, and has been growing an average of 38.3% a year over the past 5 years. Just in case, VMware has $3.5 billion in net cash on the balance sheet. VMware is a company that seems to grow no matter what is occuring in the global economy. The company's products are changing the world of research and sit at the nexus between cloud computing and cost reduction. This secular trend has allowed VMware to deliver outstanding results for its clients and shareholders. We think that this trend is not going away anytime before long, and analysts agree with us. The Reuters average price target stands at $107.02, 10.98% above current prices. We think the average is too low. VMware has guided too conservatively for the fourth quarter and 2012, in our opinion, and the then quarter's results should provide a catalysts for analysts to raise their price targets.

VMware's innovation allows its clients to do business more efficiently, and VMware's stock should allow investors to cash in as so then. Nevertheless what if VMware is simply too expensive for some investors? During we think that VMware's multiple is fair given its growth, some investors simply refuse to buy expensive stocks, no matter how rapidly the underlying company is growing. We think in other words a flawed strategy, for high P/E ratios do not make a stock a poor investment on their own. Yet for those investors who prefer stocks with lower multiples, EMC is the obvious alternative to VMware. EMC is the world's largest data storage company, and the parent of VMware, owning 80% of the company. EMC trades at a far lower P/E of 23, and like VMware, it has a number of catalysts going for it. On September 16, we suggested EMC, arguing the stock was too cheap relative to its growth potential. Since at that time, EMC stock has risen by 3.79%, lagging both the S&P 500, and its VMware subsidiary. We think this underperformance was, ironically, caused by EMC itself. Competition between EMC and NetApp, its main competitor in the data storage and management sector is fierce. And the competition is taking its toll. NetApp's most recent quarter missed expectations, and as a result, the stock plunged, taking EMC along with it. We think this is an unwarranted drop. EMC is far better positioned than NetApp, able to both outspend and out-innovate NetApp. On November 16, NetApp posted its second quarter results. And even though non-GAAP EPS reached a record of 63 cents per share, NetApp noted weakness in several of its largest accounts, and forecast third quarter revenues below consensus estimates.

On its conference call, NetApp commented that "macroeconomic uncertainty" has made it impossible to accurately forecast fourth quarter revenues at this time. On October 18, EMC posted its third quarter results, and the company as well had a record quarter, in terms of revenue and income. Revenue grew 18% to $4.98 billion, and EPS grew to 27 cents per share. The company as well posted record gross margins. Spontaneously conference call, EMC stated that its European division grew by 12%. EMC did admit to some softness in southern Europe, however core European demand remains strong. EMC, in our mind, has credible management, and we trust that they are fully aware of what is going on in Europe. Investors bearish on EMC will see these two reports as evidence that both EMC and NetApp are suffering. Given that NetApp reported its results nearly a full month afterwards EMC, bears may contend that the weakness NetApp spoke of will be revealed in EMC's straightway earnings release; we do not think so.

Third party data from Gartner, a leading market innovation firm, shows that EMC extended its dominance of the data storage market in the third quarter. EMC grew its market share by 3.6% to 32.1%, during NetApp lost 0.7% of market share, now claiming 10.7% of the market. EMC's VNX line, targeted at small to medium sized businesses, is seen as one of the reasons for EMC's success. We think that the selloff in EMC shares prompted by NetApp's weak results is unwarranted, given that one of the primary causes of weakness at NetApp is strength at EMC. EMC is able to both outspend and out-innovate NetApp. Free cash flow stood at $3.8 billion over the last 12 months, and the company has $6 billion in net cash on the balance sheet, allowing it to not only invest more in R&D, nevertheless to outbid NetApp should both companies wish to acquire the same company. The fact of the matter is NetApp has no one to blame for its weakness yet itself. EMC has proven that it operates on a different level. The company is able to ride the wave of VMware's growth as so then, putting in a class all by itself. EMC sits on the horns of a dilemma of cloud computing, social networking and digitization. This places EMC in a unequalled posiiton to serve its clients and investors, and analysts agree. The Reuters average price target stands at $29.92, representing upside of over 27% from current levels. EMC is anyway you look at it extending its lead over its competitors, and adding to or initiating positions in EMC stock will allow investors to beat the market.