Over the past several years, EMC (NYSE:EMC) has done an excellent job reinvesting earnings to keep pace with the constantly evolving IT landscape. Publicly traded EMC subsidiary, VMware, is a good example. With a commanding lead in compute virtualization, we saw VMware's profits plowed back into R&D and acquisitions, leading to compelling product offerings for storage virtualization and network virtualization, both necessary elements for converting on-premises IT investments into so called "software defined" data centers. As for EMC's traditional, "core" storage business, again management has done a very good job sustaining profit share in an IT environment characterized by stagnating budgets and lengthening decision cycles. Over the past few product cycles, we've seen plenty of product cannibalization of EMC's existing product portfolio, which we think is a quite positive, albeit rare, trait for such a large, established IT shop - launching highly successful product lines (from a revenue standpoint) including: all-flash arrays; vendor agnostic cloud-based storage; and hyper-converged architectures and solutions, to name a few.
However, management has noted that these products have meaningfully lower return profiles compared to previous cycles. We surmise that this shrinking profitability pie is related to the proliferation of pure cloud-based solutions, often used as a substitute to traditional on-prem solutions. While this is not a new trend, however, we are of the strong opinion the market significantly overestimates the available profits for these cloud-based players and we question the long-term viability of them as substitutes, especially should a more difficult funding environment emerge. That said, we have no edge in predicting the timing of such a macro-oriented event, and in the mean-time, EMC's highly profitable business must continue to compete with "not -for-profit" substitutes. Combined with several new investment opportunities that emerged during the quarter, and enforcing our self-imposed cap of 22 stocks, we decided to sell EMC from portfolios to fund more attractive ideas. Continue Reading »