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As VMware Grows Up, EMC's Value May Finally Shine Through

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The frustration of playing the EMC "stub" may be coming to an end.

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Over the last three years I could have repeatedly looked at EMC Corp.'s (NYSE:EMC) 78% stake in VMware (NYSE:VMW) and thought that isolating the value of EMC's business by going long EMC and shorting VMW was a no-brainer. After all, how could I go wrong shorting a crazy expensive stock when I could turn around and buy back 78% of it on the "cheap"? As Wall Street often has it, let me count the ways and the times I would have been wrong. Through 2010, as the poster child for "cloud infrastructure" spending, VMW's parabolic growth rate entitled it to an ever growing P/E multiple, and a Teflon stock price. But as inevitably happens to companies that grow revenues from $1.8 billion to $4.6 billion in four years, the "law of large numbers" eventually kicks in, and that's where VMW seems to be heading.

Let me make this clear: There's nothing wrong with VMW except its own unrepeatable success as a hyper-grower with a beloved momo stock. For the next several years VMW will probably continue to grow sales at a mid-teens clip and EPS at the same rate, and cash earnings will still come in at 2x its EPS. These results will not be enough to return VMW's P/E multiple to the 100, 80, or 60 of the halcyon days, so its stock price may well be resetting in a lower range. But what may not be ideal for VMW may well be just right for its proud parent, EMC.

Think of it this way: While VMW was growing Operating Income from $1,165 million to $1,490 million between 2011 and 2012 (a 20% increase) its stock was flying, and EMC was "pocketing" (the net income from VMW is not distributed to EMC) 78% of that or about $1,162 million. If VMW matches current 2013 estimates, its Operating Income will grow a "paltry" 13% to $1,715 million. That may crush VMW's multiple, but it will still earn EMC a cool $1,337 million, a 15% increase in what amounts to be an undistributed dividend EMC receives from its "kid" for just being its parent. Now, which stock would you rather own? VMW, whose heady growth days are probably behind it and still trades at 18x EV/FCF, or EMC, which trades at 9x EV/FCF while owning 78% of VMW and still grows its ex-VMW business 8-10% per year?

The rotation out of the former and into the latter, and the fact that peers such as IBM (NYSE:IBM) and Oracle (NASDAQ:ORCL) trade at EV/FCF multiples in the low teens, might just be enough to unlock the value of EMC's ownership in VMW and reasonably move its stock price up $6-8 based on two to three points expansion in the EV/FCF multiple.

Whether one chooses to play the EMC/VMW relative value story through a "stub" play, i.e. long EMC / short VMW (the neutral ratio is about .15 shares of VMW for every share of EMC), or by going straight long EMC is a matter of taste and risk. I'm inclined to use the former in addition to my existing long in EMC and I am watching the "stub's" chart for a reasonable entry point.



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Position in EMC
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