Storing Up the Gains

02/28/2008 12:00 am EST

Focus: STOCKS

Michael Murphy

Former Editor, New World Investor

Michael Murphy, editor of New World Radar Report, says EMC is a good way to play the explosion of electronic storage in all its forms—including its spinoff VMWare.

With the explosion in streaming video, government mandates to preserve more records and emails, and Google's efforts to put all of the world's knowledge online, the demand for online storage is stronger than ever. The leading storage company, EMC (NYSE: EMC), buys hard disk drives and builds large networked storage systems and software that they sell to companies and governments at good profit margins.

Virtualization is the key. This term refers to a group of physical devices, like hard disk drives or computers, that are treated as one device from the user's point of view. Today companies can buy lots of standard personal computers and "virtualize" them into a single computer resource that can run multiple operating systems and programs, accessing data wherever it is physically located. It's a money-saver for big and small companies and rapidly spreading as a way to improve performance while cutting costs.

The leading virtualization company, VMWare (NYSE: VMW), came public in August 2007 at $29 a share. It was a spin-off from EMC, and it was a hot stock, jumping 76% the first day. By the second day, it was up to $57.71, giving it a $22 billion market value. A few days later, VMW hit its all-time high of $125.25.

Since then, the stock [has] trended down, bringing it right [around the $60 area]. VMWare reported earnings well above the consensus forecast, but revenues were $5 million short. The Street removed $10 billion in VMW's market capitalization pretty much instantly.

So, does that make VMW cheap? No. The interesting investment here is not VMW but rather EMC. EMC still owns 85% of VMW's stock, and management has repeatedly said that they have no intention of selling any time soon.

EMC's share [of VMW] is worth around $19.6 billion. That's over $9 per EMC share. In addition, EMC has $1.20 a share in cash. So at Thursday's closing price of about $16, only about $6 of that is what Wall Street is paying for EMC's earnings. But based on EMC’s 2008 [earnings] guidance for 78 cents a share on a GAAP basis, that's a P/E ratio of 7.7X.

Yet this 29-year-old company is no slow-growing dinosaur. For the fourth quarter, EMC's revenues were up 19% to $3.83 billion and GAAP earnings were up 33%. It's a well-run company, they're growing fast, they throw off tons of cash, and they are buying back hundreds of millions of dollars worth of stock. The amazing thing is that EMC would be fairly priced even if they didn't own a single share of VMWare!That is a gift.

You could buy EMC under $16 for my $26 target by next April. But I want to see a potential double, and that means you should buy the EMC January 2010 (yes, two years out) LEAP call with a $15 strike price (WUEAC-X) up to $5.00 for an $11 target.  (They traded at $4.20 Wednesday—Editor.)

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