EMC Corporation (NYSE:EMC) reported a mixed set of results in its Q1 earnings on April 23. The company reported a decline in its core information storage revenues, partially offset by a growth in other businesses such as VMware (NYSE:VMW) and Pivotal. The information storage business witnessed stagnating sales in the first three quarters of 2013, which slightly recovered in Q4 2013 due to EMC’s emerging storage product sales. But the slump continued in Q1, with information infrastructure product sales (storage, RSA security and content management software combined) declining by almost 7% year-over-year to $2.4 billion. EMC’s overall revenues were nearly flat over the prior year quarter at $5.4 billion with maximum improvement coming from VMware services (+17%) and Pivotal (+40%). 
EMC’s storage gross margins were nearly 13 basis points lower than the prior year quarter at 61.1%, which the company attributed to the increasing contribution of relatively low margin services to overall revenues. Looking ahead, the company expects margins to remain around Q1 levels in the coming quarters. We have a $29 price estimate for EMC, which is more than 10% higher than the current market price.
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VMware To Drive EMC’s Future Performance
According to our estimates, EMC derives about 40% of its value from VMware. VMware’s contribution to EMC’s net revenues has consistently gone up from about 15% in 2009 to 22% in 2013. It’s revenue contribution further increased to 25% of EMC’s net revenues in the quarter. Moreover, VMware’s cost of revenues is relatively low since it is predominantly a software company. It is interesting to note that VMware’s gross margins are over 30 percentage points higher than the rest of EMC’s consolidated margins, which means that a higher proportion of VMware’s sales translates to enhanced profitability for the EMC.
VMware’s revenues grew by 16% y-o-y during the quarter, with both products and services individually growing by 15% and 17% respectively. However, a relatively higher growth in services implied a slight decline in VMware’s gross margins, from 89.3% in Q1 2013 to 87.6% in 2014. Going forward, we expect strong growth in VMware’s product sales and services to continue owing to the growing adoption of cloud-based storage, network virtualization and hybrid cloud services. We expect VMware’s revenue contribution to EMC to continue increasing to about 30% of EMC’s net revenues by the end of our forecast period.
Storage Hardware Slumps, Emerging Storage Continues Growth
EMC’s Emerging Storage sub segment continued its impressive run and grew by 81% year-over-year (y-o-y) in Q1 2014, with a strong customer response for XtremIO, VMAX, Isilon and Atmos. But revenues generated by the emerging storage sub-segment constitutes only about 10% of the EMC’s Information Storage revenues. Comparatively, EMC’s revenues generated by information storage declined during the quarter. Going forward, we expect emerging storage to continue to grow strongly this year, as the company expects a significant demand for its XtremIO all-flash storage arrays, Islion network-attached storage platform and Atmos object-based cloud storage platform. However, the company would need a strong performance from both VMware and emerging storage products to meet its full year revenue guidance of about $18 billion from information infrastructure segment. Given the declining storage products revenues, it seems like a difficult task for the storage company.
Pivotal Impresses, Reporting Metrics Changed
EMC’s Pivotal venture is the fastest growing independent division within the company, with a 40% y-o-y growth in Q1 2014. Pivotal’s platform consists of new generation data fabrics, application fabrics and a cloud-independent Platform-as-a-Service to support cloud computing and Big Data applications, which have started gaining traction among customers. Going forward, EMC has transferred data computing appliance and Pivotal’s implementation to its information infrastructure business. Pivotal’s operations are now concentrated on Big Data analytics and strategic services. In the coming quarters, a similar growth can be expected from the Pivotal venture as customers are spending more on intelligence-driven analytics and Big Data applications. Management mentioned that some of Pivotal’s growth may not be immediately realized into numbers since Pivotal is building out a subscription based revenue stream, which is likely to be beneficial in the long run. Given that Pivotal constitutes only about 1-2% to the company’s value, VMware’s performance is likely to be the primary driver of the company’s overall earnings, at least in the next couple of years.Notes: