Data General Acquisition Cools EMC's Red-Hot Growth
Software vendor must resolve problems to jusify stock's premium.
EMC (EMC) reported a solid March quarter as the result of a red-hot core business, but the company must address serious problems with recently acquired Data General to justify its premium stock price.
EMC, an enterprise-storage hardware and software vendor, reported March-quarter earnings per share of $0.30, just topping the Wall Street consensus estimate of $0.29. This small, positive earnings surprise is the result of a combination of impressive margin improvements and lukewarm top-line growth.
Total revenue growth came in at a relatively tepid figure, 23%. That might be impressive for a company the size of EMC, but it's not for a stock trading at 85 times the consensus estimate for 2000. EMC's base revenue growth (excluding Data General) of 38% was much more robust. Revenue for Clariion, Data General's midrange storage business, declined almost 8%, however. Data General's server business, which EMC is de-emphasizing, dropped more than 30%. The decline in the server business was expected, because the company seems to be biding its time until it can sell off that business. The drop in Clariion revenue, however, is a big problem.
EMC's solid cost controls have gained the company some breathing room to resolve the problem of Clariion's declining revenue. Gross margins expanded an impressive 8% year over year. Operating margins, although still impressive, expanded a more modest 2%. While research and development expenditures held steady as a percentage of revenue, EMC has been aggressively plowing more money into sales and marketing efforts. It seems unlikely that this rate of margin expansion is sustainable, and it cannot make up for sluggish top-line growth forever.
EMC is the dominant enterprise-storage vendor, but investors expect the company to leverage that market dominance into accelerating top-line growth. EMC's core high-end storage business is already running full-bore, so the key to its top-line growth probably will be Clariion. Data indicate that the market for Clariion's midrange storage is as large as the market for high-end storage, so the opportunity is there.
EMC's competition has been unable to lay a glove on its enterprise-storage dominance. IBM's (IBM) Shark, while promising, has run into roadblocks and isn't a direct threat to EMC yet. Sun Microsystems (SUN) could encroach on EMC but has yet to lay out any specific plans. Hewlett-Packard (HP) is in a so-called rebuilding year and unlikely to pose any threat to EMC in the near term.
EMC's projected decline in software-revenue growth, from an impressive rate of 75% to something more like 50%, could simply be the effect of the law of large numbers--big companies' high growth rates must eventually decline. However, it could be a sign that pure-play storage vendors such as Veritas (VRTS) are finally making a serious play for some of EMC's business.
Investors are already paying a substantial premium for EMC shares because of the company's perceived market dominance. Simply put, EMC owns high-end storage. If the company cannot make good with its Data General acquisition and begin building a similar franchise in the midrange storage market, investors may begin questioning whether the company deserves its premium price.
Joseph Beaulieu does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.