A Storage Giant with Room to Move


By Richard Stice CFA As spending on information-technology products and services continues to recover, we at Standard & Poor's believe the data-storage industry will benefit from the improving outlook. Our optimism stems from our view that the protection, replication, and security of data has become a higher priority for companies since the September, 2001, terrorist attacks. Moreover, we anticipate that requirements for storage capacity will be boosted by the growth of more advanced user applications, e-mail, and the Internet.

However, in the near term, we're concerned with ongoing pricing pressures and the fact that we're entering into a seasonally weaker demand period. Year-to-date through May 21, the Standard & Poor's Computer Storage & Peripherals Index declined 10.9%, vs. a 1.7% drop for the S&P 500-stock index.

One of our favorite stocks within the group is EMC (EMC

; rated: buy; recent price: $10.70). EMC has undergone a significant transformation in the last three years, in our opinion. As demand for its products cooled off during 2001, it began taking steps to improve its cost structure. Through a combination of headcount reductions and a renewed emphasis on manufacturing efficiencies, EMC was able to lower its quarterly revenue break-even level to below $1.31 billion (excluding acquisitions) by the end of 2003, a reduction of 26% from $1.78 billion in June, 2001. In addition, it revamped its sales force and became more competitive in the pricing of its products, in our opinion.

STRONG POSITION. We believe EMC has begun to reap the benefits of its strategy shift. It returned to profitability in 2003, with earnings per share of 22 cents, compared with a loss of 5 cents per share in 2002. In addition, gross margins have been steadily improving. In fact, in first-quarter 2004, this metric eclipsed the 50% barrier for the first time in three years.

Furthermore, we believe EMC's industry position within the data-storage sector is a major asset. According to researcher International Data Corp., during fourth-quarter 2003, EMC solidified its No. 2 position in the worldwide external disk-storage-systems category, garnering a market share of 20%. And its year-over-year sales growth rate of 20.5% easily surpassed the group's average of 8.4%.

EMC is also experiencing impressive growth in overseas markets, in our view. International revenues accounted for 43% of first-quarter 2004 revenues, up from 37% in the previous year. By region, excluding acquisitions and currency benefits, Europe, the Middle East, and Africa increased 24%, Asia/Pacific climbed 30%, and Latin America rose 22%.

BLACK INK. The company has expanded its product offerings in the past several quarters, largely as a result of acquisitions. It completed the purchase of two software companies during the fourth quarter of 2003: Legato Systems and Documentum. The combined costs for the two companies was $3 billion in stock, with EMC expecting Legato to be slightly accretive to 2004 results and the Documentum transaction adding to its earnings in 2005.

Software has become an integral part of EMC's product line, accounting for 26% of first-quarter 2004 revenues. We believe this strategy is prudent, since software margins are typically higher than those for hardware.

EMC's balance sheet is an additional positive factor, in our opinion. At the end of the first quarter of 2004, cash and investments totaled $6.7 billion (about $2.70 per share), and the long-term debt-to-capital ratio was 1%.

BETTER MARGINS. For 2004, we're forecasting revenue growth of 29%, to $8.04 billion, aided by our expectation of acquisition benefits, international expansion, and further market-share gains. We anticipate gross margins widening to 51% due to higher volumes, additional manufacturing improvements, and a more favorable product mix.

We project 2004 EPS of 33 cents, a 50% increase from 2003's 22 cents. Our S&P Core Earnings per share estimate for 2004 is 17 cents, vs. 2003's 4 cents, with the vast majority of the difference between our operating and S&P Core EPS numbers attributable to costs associated with stock-option expense.

The shares, which traded at $11.20 on May 26, are attractive from a valuation standpoint, in our opinion. Our 12-month target price of $17 combines three separate valuation metrics. The first is a historical price/sales measure, the second equates EMC's p-e-to-growth ratio with the S&P 500, and the third is an intrinsic-value calculation utilizing discounted-cash-flow analysis.

LOOKS GOOD. Our assumptions include a weighted average cost of capital of 13.3%, a peak growth rate of 24% in year five, and an expected terminal growth rate of 3%. Combining the three techniques equally results in our target price. Given our view of EMC's favorable industry position, expanded product offerings, and attractive valuation, we advise investors to purchase the shares.

Risks to our investment recommendation and 12-month target price include, in our view, weaker-than-expected enterprise-IT spending, a significant shift in business mix, abnormal pricing pressures, loss of market share, and instability in overseas markets.

Note: Richard Stice has no stock ownership or financial interest in any of the companies in his coverage area. He's a registered representative of Standard & Poor's Securities, Inc. (SPSI). Affiliates of SPSI received non-investment banking compensation from EMC during the past 12 months. Price charts and required disclosures for all STARS-ranked companies can be found at www.spsecurities.com Analyst Stice follows storage and peripherals stocks for Standard & Poor's Equity Research


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