EMC Earnings Preview: Emerging Storage To Revive Stagnating Core Information Storage Business

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Storage giant EMC (NYSE:EMC) is scheduled to announce its Q4 earnings on Thursday, January 29 (delayed one day due to inclement weather). The company reported a 9% year-on-year increase in net revenues to $6 billion in the third quarter. EMC witnessed revenue growth in both combined services, which grew by almost 11% y-o-y to $2.6 billion, and consolidated product revenues, which rose by over 7% y-o-y to $3.4 billion for the quarter. All of EMC’s divisions – including VMware (NYSE:VMW), Pivotal, RSA Security, content management (or Information Intelligence Group) and core information storage – grew on an annual basis. However, EMC’s core information storage division observed a rise in storage product revenues in the third quarter after two consecutive quarters of declines. Management expects Q4 and full year revenues to grow by nearly 6% y-o-y to $7.1 billion and $24.5 billion, respectively.

EMC’s consolidated gross margin (GAAP) stood at 62.8% in Q1 2014, which sequentially rose to 63.8% in Q2, mainly driven by an increasing proportion of revenues from sales of high-margin VMware licenses and services. However, margins declined in Q3 to 62% (10 basis points lower than the prior year period), mainly as VMware’s gross margin declined by 2 percentage points y-o-y during the quarter to 86.5%. [1] Additionally, margins for EMC’s core information storage division were compressed due to pricing pressure for high-end products from competing storage providers. [2] As a result, the gross margin for the information storage division through the first three quarters of 2014 was almost a percentage point lower than the year-ago period at 54.7%. We have a $31 price estimate for EMC, which is slightly higher than the current market price.

See our full analysis for EMC’s stock

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Information Storage Picks Up In Q3

According to IDC reports, worldwide spending on information storage was low in the first half of the year, while demand picked up slightly in Q3. [3] EMC has been a clear leader in the external storage systems market for the last few years, with its share growing from under 23% in 2009 to over 31% at the end of 2013. However, EMC lost market share in the external storage systems market in the first two quarters of 2014. This was the first time since 2008 that EMC lost market share on a y-o-y basis. EMC’s market share in external storage systems declined from 30.2% in Q1 2013 to 29.1% in the first quarter of 2014. This trend continued in Q2, with the company’s share at 30.1% in Q2 staying a percentage point lower than its market share in the prior year period. [4] Moreover, EMC’s sales of external storage systems in Q2 declined by over 5% while the industry-wide decline was only about 1%. However, product sales picked up in the third quarter, with storage product revenues rising both sequentially (+2%) and annually (+7%) to $2.6 billion in Q3. [5] EMC’s share in the storage systems market through the first three quarters of 2014 was 30.2% – about 50 basis points lower than the comparable year ago period.

Weakness in its core business led to market speculation prior to Q2 earnings about EMC spinning off its VMware and Pivotal divisions. The company faced pressure from Elliot Management, one of its large institutional investors, to split up EMC into a core business and a  faster-growing businesses (specifically VMware). However, EMC’s management refuted the speculation and stood by its “federation” business model, wherein some of the acquired companies operate as separate entities while they still collaborate on products for large clients. These speculations resurfaced before Q3 earnings as EMC’s long-term CEO Joe Tucci was initially expected to retire in early 2015. [6] There were also rumors of EMC merging with Hewlett-Packard (NASDAQ:HPQ) as a result of the latter deciding to split its fast-growing and stagnating businesses. However, these merger talks have been dismissed by both companies, citing structural differences between the two companies. [7]

More recently, Tucci addressed these speculations at the Wells Fargo investment conference in November. [8] According to him, EMC needs to remain a big company to compete with other big players, rather than splitting into smaller entities. The company as a whole caters to most IT setups that use older technology, while VMware and Pivotal serve the newer businesses on what is referred to as the the third-generation IT platform. Furthermore, the consolidated company has grown at a faster pace than its peers. Tucci mentioned that it may not immediately reflect on the share price or earnings per share since the company has made significant investments in acquiring smaller companies to fuel long-term growth. These smaller companies include XtremIO, Nicira, AirWatch, ScaleIO, DSSD and more recently buying out Cisco’s (NASDAQ:CSCO) stake in joint venture VCE.

VMware, Emerging Storage To Sustain Growth

While the core business remains stagnant, strong growth is expected from software and services-intensive businesses, namely VMware, Pivotal, RSA Security and EMC’s emerging storage. VMware’s revenues are expected to grow by over 13% year-on-year in Q4, with its services division driving much of the growth (see: VMware Q4 Earnings Preview: Hybrid Clouds, Network Virtualization Key). VMware’s full year revenues could be 15-16% higher than 2013 at about $6 billion. VMware’s management expects robust growth in software-defined networking, hybrid cloud and end-user computing. Although VMware generates only a quarter of EMC’s consolidated revenues, the highly profitable business contributes about 48% to EMC’s net value, according to our estimates.

EMC expects its emerging storage product sales to drive core product revenues in the coming quarters due to the increase in demand for new products such as XtremIO, Isilon and Atmos. The all-flash array XtremIO has been a key driver for EMC’s product sales since the beginning of the year, generating $500 million in revenues on a run-rate basis in the most recent quarter. IDC expects the all-flash array market to grow at a CAGR of over 50% through 2015 to become a $1.2 billion market. [9] Total sales of emerging storage solutions including XtremIO, Isilon and Atmos grew 47% year-on-year, with the contribution of emerging storage rising to over 60% of all high-end solutions provided by the company. The revenue contribution of emerging storage in Q3 rose to $2.3 billion on an annualized revenue run-rate basis.

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Notes:
  1. EMC Q3 2014 Earnings Call Transcript, Seeking Alpha, October 2014 []
  2. EMC Q2 2014 Earnings Call Transcript, Seeking Alpha, July 2014 []
  3. Worldwide Quarterly Disk Storage Systems Tracker Q1 2014, IDC Press Release, June 2014 []
  4. Worldwide External Storage Market Q2 2014, IDC Press Release, September 2014 []
  5. Worldwide Quarterly Disk Storage Systems Tracker Q3 2014, IDC Press Release, December 2014 []
  6. Will EMC Federation survive a Tucci departure?, The Register, September 2014 []
  7. HP And EMC Call Off Merger Talks-Structural Issues Remain, Forbes, October 2014 []
  8. EMC CEO Joe Tucci tries to win hearts and minds from VC backers, The Register, November 2014 []
  9. Why EMC sees gains from all-flash storage despite late entry, Market Realist, August 2014 []