1 Great Reason This Company Stays on Top

Chad is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

It never ceases to amaze me how cheap certain stocks have become relative to what they used to trade at. I remember a time when EMC (NYSE: EMC) was a darling of Wall Street and traded for a very high multiple. The stock seemed to go straight up until the dot-com bubble burst, and it was one of the highest return stocks in the market. However, times have changed and investors question how fast this huge company can continue to grow. Given the recent earnings report, it looks like the skepticism from investors is correct, but there are underlying numbers that suggest the company is doing better than people think. In addition, there is one number in particular that is all-important for technology companies to stay on top of their game.

At this point, it's not really a question of who is going to take the lead in cloud storage and server sales, it's more of a question of what will be left of some formerly high-performing companies. Many people are aware of the tremendous decline in both Hewlett-Packard (NYSE: HPQ) and Dell (NASDAQ: DELL). While both companies are currently talking a good game about trying to move towards storage and server sales, and increasing their services offerings, there's really no question both companies are in shambles. If you want proof, consider that both shares trade for low single-digit P/E ratios, Hewlett-Packard is expected to see no EPS growth in the next few years, and Dell is only expected to grow earnings at just over 5%. On a relative basis these two companies make EMC look like a huge growth story with analysts expecting earnings growth of better than 14% going forward. Another competitor, NetApp (NASDAQ: NTAP), also looks like a potentially good alternative as investors and analysts alike seem to undervalue this company's tremendous balance sheet strength. That being said, whether investors choose EMC or NetApp, the race for cloud storage dominance seems to have already been decided. I know some investors might not have been impressed with EMC's current quarter results, but looking beyond the headline revenue and EPS numbers shows a company that is doing very well.

In the last three months, EMC reported revenue up 6%, and non-GAAP EPS of 8%. Digging into the results, we see that product sales increased an anemic 0.33%, but service sales were up over 15%. The company saw single-digit growth in virtually each of its storage platforms. The most impressive results came from the company's high-end server and storage platforms, which grew by 5%. If you don't believe EMC outperformed its competition, take a look at how each of the company's competitors did in the last three months:

<table> <tbody> <tr> <td> <p><strong>Name</strong></p> </td> <td> <p><strong>Revenue</strong></p> </td> <td> <p><strong>Non-GAAP EPS</strong></p> </td> </tr> <tr> <td> <p>Dell</p> </td> <td> <p><span><span><a href="http://idc.api.edgar-online.com/efx_dll/edgarpro.dll?FetchFilingConvPDF1?SessionID=fCmIFoe97jD94fS&ID=8921198">Down 11%</a></span></span></p> </td> <td> <p>Down 28%</p> </td> </tr> <tr> <td> <p>Hewlett-Packard</p> </td> <td> <p><span><span><a href="http://idc.api.edgar-online.com/efx_dll/edgarpro.dll?FetchFilingConvPDF1?SessionID=qqmIF31u-3fjefS&ID=8927575">Down 7%</a></span></span></p> </td> <td> <p>Down 1%</p> </td> </tr> <tr> <td> <p>NetApp</p> </td> <td> <p><span><span><a href="http://idc.api.edgar-online.com/efx_dll/edgarpro.dll?FetchFilingConvPDF1SessionID=WvmIF3NKvHFJ1fS&ID=8917229">Up 2.26%</a></span></span></p> </td> <td> <p>Down 19.05% </p> </td> </tr> </tbody> </table>

As you can see, EMC posted better numbers in both categories by a landslide relative to their competition. In addition, if storage and networking is going to be Dell or Hewlett-Packard's future, that future doesn't appear to be occurring right now. Hewlett-Packard saw a decline of 9% in sales of servers, storage, and networking revenue. Dell saw its enterprise and services sales increased by just 3% by comparison. Though some investors have worried that these two companies could pose real threats to EMC, it appears that customers are making the choice to go with EMC regardless of what either Dell or Hewlett-Packard might say. From what I can see, there are at least two reasons that EMC is able to stay on top of its industry.

The first reason EMC performs as well as it does has a lot to do with the company's pricing power, which is proven by their higher gross margin. If you look at EMC and NetApp relative to Hewlett-Packard or Dell, you can see the tremendous difference that the focus of the first two on servers and high-end storage solutions has on their margins. In the last three months, EMC's gross margin topped 64%, and NetApp reported a gross margin of almost 59%. By comparison, Hewlett-Packard's gross margin was just over 23%, and Dell reported a gross margin of 21.67%. While it's true that Hewlett-Packard and Dell both operate large PC divisions that carry much smaller margins, there is another reason that EMC has separated itself from its competition, and that is their spending on research and development.

Technology companies simply don't have the luxury of not spending a significant amount of money coming up with new products and services. If you look at the percentage of R&D spending versus sales at each of the companies I've mentioned, you can see a tremendous difference between the haves and have-nots. EMC leads the way, spending better than 21% of its sales on R&D. NetApp comes in a close second spending over 15% of its sales on R&D. The two struggling companies of Hewlett-Packard and Dell spend just 3% and 1.8% of their sales on R&D respectively. What this tells investors is that in theory EMC is able to stay ahead of the curve because they are willing to spend money to develop new technologies. Until either Hewlett-Packard or Dell can ramp up their R&D spending, neither company should represent a serious threat to EMC. Given this information, the question of which company is the best investment is easy to answer.

While both Dell and Hewlett-Packard pay dividends above 3.5%, neither company is expected to show significant growth in the next several years. Given that neither company spends very much on R&D, these numbers are not likely to change. NetApp is an interesting possibility primarily because of the company's huge cash and investments. The company shows over $4.3 billion in net cash and investments, which represents over 39% of their current market cap. Though NetApp trails EMC in both market share and R&D spending, this huge cash and investment amount could represent an uncovered value in the stock. On the other hand, EMC has a large cash balance to the tune of over $10 million, and the company's ownership of VMWare represents a huge hidden asset as well. Given that EMC sells for a P/E ratio of under 13, is leading the way in its industry, and is expected to grow at better than 14%, this one seems like a no brainer.

MHenage has no positions in the stocks mentioned above. The Motley Fool owns shares of EMC. Motley Fool newsletter services recommend Dell. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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