EMC Corporation (EMC) Q4: Revenue defies expectations

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Raymond James U.S. Research analysts Brian G. Alexander, Jeffrey Koche and Justin Patterson rate EMC Corporation (NYSE:EMC) as a Strong Buy as the company reports strong fourth quarter results and 2014 guidance seems more aligned with investor expectations.

EMC’s 2014 guidance

We maintain our Strong Buy rating on EMC Corporation (NYSE:EMC) as 2014 guidance seems more aligned with investor expectations and may even be conservative; Information Storage (IS) grew revenue 4.5% y/y in 2013, with 4% y/y product growth in spite of anemic market growth. While investors will have to adjust to the “new seasonality” from EMC carrying more backlog in the first three quarters of the year, annual revenue growth of 5.5% (2-3% ex VMW) in 2014 and flat core operating margins (excluding VMW) seem reasonable. Looking at it differently, if we adjust 1Q guidance to a normalized backlog, IS would be up 3% y/y instead of down 4% y/y.

We sense investors will still question EMC Corporation (NYSE:EMC)’s ability to stabilize gross margins given intensified pricing pressure, and management’s explanation of bookings margins holding flat y/y may not be too comforting. That said, the $1.95 EPS guidance should prove to be a sufficient reset to estimates (ex $0.05 dilution from AirWatch) for investors looking to become more constructive. While secular concerns linger, our view is that cyclical strength will emerge through 2014 as IT spending improves and pent-up demand is unleashed. FCF is expected to remain strong and EMC modestly increased its 2014 share repurchase expectation. Valuation is compelling, particularly excluding VMW, at 3.0x EBITDA and compared to “secularly challenged” IT companies. Pivotal momentum is a wild card given a business model shift, but we do not think this is priced into shares. Based on a sum-of-the-parts analysis, we derive a fair value range of $29 to $35, with our base case scenario maintaining our current PT of $31.

The good: Revenue defies expectations

EMC Corporation (NYSE:EMC) revenue/EPS of $6.68 billion (+11% y/y)/$0.60 was above expectations, overcoming fears that above seasonal q/q growth was unachievable. Strength was broad as revenue accelerated in High-End (VMAX), Unified/Backup (VNX, Data Domain), and Emerging Storage (XtremIO, Atmos, Isilon).

The bad: Product margins weaken, guidance optics

Info Storage product margins fell 200 bp y/y to 57.2%, implying a contribution margin of 64%. This is below the 76-77% contribution margins in 4Q11 and 4Q12, and the lowest level since 4Q10. 1Q14 guidance for revenue/EPS of $5.39 billion/$0.35 was weaker than expected but reflects our view that EMC Corporation (NYSE:EMC) is adjusting its sales model to current end market dynamics. 2014 revenue/EPS guidance of $24.5 billion/$1.95 was in-line with our view, but surprisingly excluded VMware, Inc. (NYSE:VMW)’s AirWatch acquisition. This adds $75 million to revenue but impacts EPS by -$0.05. Thus, EPS should be $1.90 when accounting for AirWatch, notably lower than guidance.

EMC’s free cash flow

EMC Corporation (NYSE:EMC) sees free cash flow (FCF) >$5.5 billion for 2014 and plans to spend $2 billion on share repurchases. While this provides some stability to shares, we believe a VMware spin-out would ultimately unlock more value.

Estimates and valuation for EMC

2014E revenue/EPS go to $24.2 billion/$1.89 from $24.5 billion/$2.00 previously. We introduce 2015E revenue/EPS of $26.0 billion/$2.15. Our $31 price target is based on an EV/EBITDA multiple of 8x, slightly above the three-year average of 7x, but justified due to our sum-the-parts analysis.

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