Immediately after Hewlett-Packard (HPQ) announced it would split into two companies, investors turned their attention to EMC (EMC). Investors have long dreamed of EMC divesting itself of its super-majority voting stake in VMware (VMW). Some investors even believe that EMC's enterprise business is under attack and that the company should divest VMware and sell itself to Hewlett-Packard. Others think VMware is holding the whole company back. Should EMC divest itself of VMware? Sell itself to Hewlett-Packard?
VMware was founded in Palo Alto, Calif. in 1998 and was acquired by EMC in 2004 for $625 million. The company operated as a subsidy of EMC until August 2007, when EMC sold 15% of the company on the New York Stock Exchange. EMC owns about 79.6% of VMW's Class A common shares and 100% of its Class B shares.
Many activist investors think "core" EMC is undervalued. According to them, EMC sells for just 3x earnings before interest, taxes depreciation and amortization (EBITDA) and just 8x fiscal year 2015 earnings. Competitors, such as NetApp (NTAP) sell for around 6x EBITDA and 13x earnings. By dumping VMware, these investors think EMC could be worth more than $35 a share. These investors also believe VMware's growth rate is slowing and it would be wise for EMC to dump the company while it can.
While it sounds like a great theory, VMW grew revenue 13% in 2013 and is on track to grow 16% this year and another 15% next year. In fact, VMW has grown sales 22% in the last three years and increased its net income by 37%. The company has also managed to grow without giving up gross margin and it finished 2013 with gross margins of 86%.
But I would argue that VMware has been a positive to EMC. As the leader in virtualization, VMware has given EMC a powerful partner in the server virtualization business. EMC's annual storage revenue grew 50% from 2007 to 2013. Over the same period, VMware doubled EMC's operating cash flow to nearly $7 billion.
Investors believe EMC is a mature enterprise company and it's vulnerable to attack from companies that provide less expensive cloud storage solutions. While growth at EMC has certainly slowed down (5%-6%), I think EMC will continue to be a leader in storage. First, much of the data that is stored in EMC hardware is mission critical. Conservative IT managers are not likely to move that data into the cloud anytime soon. (Do you want your bank to move your account to the cloud?)
Second, EMC is making the leap toward storage virtualization and solid-state drives, which should keep it ahead of smaller rivals. EMC and VMware created a company called Pivotal, which has developed a next generation platform designed to tackle cloud computing and big data. Pivotal is growing like crazy. The company did $270 million in revenue in fiscal 2012 and is estimated to reach $340 million by 2016. While Pivotal accounts for only 1% of EMC revenues, it shows that management isn't just sitting around letting major trends take off with out it.
VMware's Virtual SAN (vSAN) product, which was launched in early March, already has over 300 customers. These virtual storage area networks, or vSANs, are software defined virtual storage environments. The software combines all of your hard drives and solid-state storage devices into a giant storage pool. IT managers can provision computer and storage resources on the fly as demands on the network change. vSANs allow IT managers to add storage by simply adding hard drives to the network. The software recognizes these devices instantly and adds them to the storage pool. Instead of buying another $100,000 dedicated storage device, IT managers can purchase $20,000 worth of raw drives and add them to the pool.
With an installed base of more than 50 million virtual machines worldwide, virtual SANs have the potential to become a $7 billion to $10 billion market. Considering the potential for opportunities generated by Pivitol and vSANs, I think EMC would be crazy to divest itself of VMware. EMC has too many opportunities to reignite its growth with VMware as a partner.