Emerging Storage, VMware To Drive EMC’s Q3 Results As Core Product Sales Decline

Storage giant EMC (NYSE:EMC) is scheduled to announce its Q3 earnings on October 22. The company reported a 5% year-on-year increase in net revenues to $5.9 billion in the second quarter, with growth mainly coming from combined EMC services, which grew by almost 9% over the prior year quarter to $2.6 billion. Comparatively, consolidated product revenues stayed flat at about $3.3 billion during the quarter. Among the various divisions within the company, VMware, Pivotal and RSA Security have been the fastest-growing divisions over the last few quarters, while EMC’s core business has remained nearly stagnant. The second quarter this year was no different, with EMC’s core information storage business generating revenues of $4 billion during the quarter, which was nearly flat over the year ago period.

EMC’s consolidated gross margin was up by 100 basis points sequentially to 63.8% in Q2, mainly driven by an increasing proportion of revenues by sales of high-margin VMware licenses and services. However, margins for EMC’s core information storage division were compressed due to pricing pressure for high-end products from competing storage providers. ^[1] As a result, gross margin for the information storage division in Q2 was 150 basis points lower than the prior year quarter at 55.1%.

We have a $30 price estimate for EMC, which is about 10% higher than the current market price.

See our full analysis for EMC’s stock

Continued Stagnation In Core Business, Speculation Of Split

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 losing market share both sequentially to 30.1% in Q2 2014. This was over a percentage point lower than its market share in the second quarter of 2013. ^[2] EMC witnessed a second consecutive quarter of market share declines in the second quarter this year, the first time since 2008 that EMC lost market share on a y-o-y basis. Moreover, EMC’s sales of external storage systems in Q2 declined by over 5% while the industry-wide decline was only about 1%.

Weakness in its core business led to market speculation prior to second quarter earnings about EMC spinning off its VMware and Pivotal divisions. The company faced pressure from some of its large institutional investors to split up EMC into a core business and the faster-growing businesses. 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 in the last few weeks as EMC’s long-term CEO Joe Tucci is expected to retire early next year. ^[3] 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. ^[4] The company will provide more details about its future plans involving a possible split in its earnings call.

Fast-Growing Divisions To Maintain The Trend

While the core business remains stagnant, strong growth is expected from software and services-intensive businesses, namely VMware, Pivotal and RSA Security. VMware’s revenues are expected to grow by over 15% year-on-year, with its services division driving much of the growth (see: VMware Earnings Preview: Software-Defined Storage, Networking, Hybrid Clouds In Focus). VMware management expects robust growth in software-defined networking, hybrid cloud and end-user computing. Although VMware generates only a quarter of the company’s consolidated revenues, the highly-profitable business contributes about 38% to EMC’s net value, according to our estimates.

RSA Security, EMC’s information security division, grew by over 11% to almost $1 billion in 2013. That growth continued in the first half of 2014, but the growth rate slowed down to 6% y-o-y. The information security industry is growing, with customers allocating more of their security budgets to intelligence-driven analytics, where RSA Information Security excels. Additionally, as organizations increasingly adopt hybrid clouds, EMC’s information security division is likely to get a boost due to its added focus on security for hybrid cloud computing. We currently forecast RSA Security license sales to grow at over 6% annually in the coming years.

EMC expects its emerging storage product sales to drive 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 $300 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. ^[5] EMC and Pure Storage are the two largest players in the all-flash array market space with a higher-than-market growth rate in product sales. ^[6]

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1. EMC Q2 2014 Earnings Call Transcript, Seeking Alpha, July 2014 [↩]
2. Worldwide External Storage Market Q2 2014, IDC Press Release, September 2014 [↩]
3. Will EMC Federation survive a Tucci departure?, The Register, September 2014 [↩]
4. HP And EMC Call Off Merger Talks-Structural Issues Remain, Forbes, October 2014 [↩]
5. Why EMC sees gains from all-flash storage despite late entry, Market Realist, August 2014 [↩]
6. Pure Storage, EMC, And IBM Lead The All-Flash Array Pack, Enterprise Tech, September 2014 [↩]