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EMC Corp. reported second quarter earnings of 35 cents per share that beat the Zacks Consensus Estimate by a penny. Earnings (including stock-based compensation but excluding other non-recurring items) increased 9.3% year over year and 11.6% sequentially in the quarter.

Revenues

Revenues increased 5.7% year over year and 4.2% sequentially to $5.61 billion, slightly short of the Zacks Consensus Estimate of $5.63 billion. Product sales climbed 2.5% year over year and 4.7% sequentially to $3.26 billion. Services surged 10.5% from the year-ago quarter and 3.6% from the previous quarter to $2.36 billion.

Information Infrastructure segment revenues (76.7% of revenues) increased 3.5% year over year and 3.7% sequentially to $4.31 billion. The year-over-year growth was primarily driven by strong performance from RSA (up 3.6% year over year) and Information Storage (up 3.7% year over year), which fully offset a weak result from Information Intelligence (down 0.7% year over year).

On a sequential basis, Information Storage increased 4.3% while RSA and Information Intelligence declined 2.1% and 1.9%, respectively.

EMC’s majority owned VMware Inc. continued to impress with revenue growth of 13.8% on a year-over-year basis to reach $1.24 billion. Sequentially, VMware revenues increased 6.2% in the reported quarter.

During the quarter, EMC and VMware formed a new company called Pivotal (Apr 1, 2013), which combines Greenplum, Cloud Foundry, Spring, Cetas, Pivotal Labs, GemFire and other products from the VMware vFabrix Suite. General Electric also announced to make a strategic investment of approximately $105.0 million in Pivotal, representing a 10% equity stake.

Pivotal revenues jumped 11.1% year over year and 1.4% sequentially to $70.0 million in the quarter.

On a geographical basis, domestic revenues climbed 4.0% year over year to $3.0 billion and contributed 53.0% to revenues. Revenues from international operations increased 8.0% year over year to $2.7 billion and accounted for the remaining 47.0% of revenues.

Margins

Gross margin remained flat year over year due to lower product sales margin. However, on a sequential basis, gross margin expanded 130 bps due to favorable product mix.

Research & development expenses as percentage of revenues inched up 10 bps from the year-ago quarter but declined 10 bps sequentially. Selling, general & administrative expense as a percentage of revenues declined 50 bps from the year-ago quarter but remained on a sequential basis.

Operating margin expanded 40 bps on a year-over-year basis and 140 bps from the previous quarter to 20.3% due to higher revenue growth and gross margin base. Net income as a percentage of revenues was 13.7% compared with 13.4% in the year-ago quarter and 12.9% in the previous quarter.

Earnings (excluding stock-based compensation and other non-recurring items) increased 7.7% from the year-ago quarter and the previous quarter to 42 cents.

Balance Sheet & Cash Flow

As of Jun 30, 2013, cash and cash equivalents including short-term investments were $11.15 billion compared with $6.53 billion at the end of Mar 31, 2013. EMC generated $1.23 billion in cash flow from operations in the second quarter compared with $1.71 billion in the prior quarter. Free cash flow declined to $843.4 million in the reported quarter from $1.44 billion in the prior-year quarter.

Guidance

EMC forecasts revenues of $23.5 billion for 2013. Non-GAAP operating margin is expected to grow to 25.5% for 2013. Non-GAAP operating expense is expected to be $350.0 million for 2013. Non-GAAP net income is expected to be approximately $4.0 billion for the full year. EMC expects earnings of $1.85 per share for 2013.

Cash flow from operating activities is expected to be $6.8 billion, while free cash flow is expected to be $5.5 billion for 2013. EMC also expects to repurchase shares worth $3.5 billion in 2013 and in the first half of 2014.

Our Recommendation

We believe that EMC is well positioned to benefit from incremental data center hardware spending going forward. We believe that EMC’s vast product portfolio, which has products suitable for any kind of budget, will boost its market share going forward. Additionally, aggressive share repurchase will drive earnings going forward.

However, increasing competition from the likes of IBM Corp. and Hewlett Packard Co. and a sluggish IT spending outlook for the next two years will continue to keep margins under pressure in the near term.

Currently, EMC has a Zacks Rank #2 (Buy).

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