During the quarter, we increased our weighting in EMC Corp. (EMC) after the stock had been flat over the trailing 12 months, compared to the over 20% run up in the S&P 500 Index. Combined with EMC's double digit free cash flow generation, the stock has gotten cheaper, in our view, through benign neglect. Much of the neglect stems from perceived threats to EMC's role in enterprise data centers. However, as a developer of IT infrastructure, it is normative for EMC to face competition from disruptive new technologies and workflows, especially at the enterprise scale. For example, just a few years ago, EMC's most relevant competitors seemed to be Hewlett Packard, Dell, IBM and NetApp, whereas today, Amazon and a host (no pun intended) of other players in the acronym heavy cloud services industry are more apt at competing with EMC for a dollar of profitability. However, across our multi year holding period, one of the most powerful competitive advantages at EMC has been its robust distribution network. While not nearly as exciting as the technology that gets distributed, EMC's distribution advantage p resents formidable barriers to entry for bot h legacy and new competitors. T he Company can rapidly scale emerging technologies across an unparalleled, information infrastructure focused direct sales force and customer base that is over half a million and g rowing. Of course, most of EMC's competitors know this, but cultivating several hundred thousand points of sale is "easier said, than done." For instance, in 2009, EMC purchased a competitor Data Domain and its roughly $300 million in annual revenues. Not quite four years later, EMC's Data Domain unit is generating revenues at an over $1.5 billion annual run rate (over 400% growth). In a similar vein, during 2010 EMC purchased Isilon Systems, a competitor in scale out storage with roughly $200 million in annual revenues. Less than three years later, this EMC unit is generating revenue at an over $1 billion annual run rate ( again, over 400% growth). It is not clear if these companies would have been able to grow this quickly as standalone competitors that did not have access to EMC's distribution network. What is clear is that significant value was generated for EMC clients and shareholders, thanks to this distinct advantage.
As for VMware (EMC holds a significant ownership share in VMW), after several years of enabling, at least, primitive versions of private clouds for more than 500,000 customers worldwide (including 100% of the Fortune 100), investors are concerned that the proliferation of open source substitutes and public cloud alternatives wil l significantly erode the Company's future earnings power. VMware trades at a historic ally low valuation (a low teen enterprise value to free cash flow multiple, which is half to one third of its recent range), but we think its longer term growth and prof itability prospects are not as dire as the market is implying. While the natural progression for smaller and mid sized business ("SMB") IT departments seems to be the utilization of lower cost, subscription based public cloud services, this will not likely be a winner take all market, especially since EMC has aggressively established itself in the "channel" which is the network of thousands of value added resellers and consultants to SMB IT departments. Further, VMware has a several year head start in cultivating a developer ecosystem, with several thousand applications, many of them mission critical, explicitly supported. In the interim, VMware's product scope is rapidly expanding, thanks to robust reinvestment, where their expertise in abstraction technology puts them at the "tip of the arrow" as data centers become more dependent on the software layer. Further, the value proposition of the public cloud is less robust for larger enterprises, especially those that have long established investments in on site infrastructure, so we believe the barriers to entry into this market segment by VMware rivals and substitutes will be much higher, relative to SMB. In the future, we expect EMC (and VMware) to maintain its competitive positioning in the perpetually changing technology infrastructure industry by continuing to dedicate significant resources towards expanding their product scope – both through acquisition and organically and then maximizing those investments by leveraging their expansive distribution capabilities. So while we recognize the highly competitive nature of enterprise IT innovation, we believe that there is substantial future growth and value still to be recognized in our EMC investment. Continue Reading »