Is EMC Stock Suitable for Your IRA or Roth IRA? (EMC)

Is EMC Stock Suitable for Your IRA or Roth IRA? (EMC)

EMC Corporation (NYSE: EMC) is a mature, dividend-paying company that is in the midst of an acquisition attempt by privately held Dell, Inc. The stock's price is being determined by the likelihood of the announced acquisition continuing as planned, as well as expectations of future performance of VMware, of which EMC is an 80% shareholder. Special tax treatment afforded by both traditional and Roth IRAs can help investors benefit from potential appreciation in EMC shares, which is a stable-enough company to warrant a long-term position regardless of the acquisition. If investors are comfortable with EMC's valuation and the risk related to the acquisition outcome, then either a traditional or Roth IRA is suitable depending on how investors intend to reinvest gains from shares. If the acquisition falls apart, a traditional IRA is more appropriate.

Outlook

EMC's revenue growth rate is influenced by economic cycles, as memory hardware installations or upgrades are capital investments. For a company to engage in capital investment activities, it must have a sufficiently strong growth outlook and access to capital at a low-enough cost to justify investment. EMC also holds 80% ownership of VMware, which provides cloud and virtualization services and software. Industry analysts at firms such as IDC expect continued growth in global storage hardware markets, with increasing cloud IT infrastructure needs driving demand and spurring annual compound annual growth rate (CAGR) above 15%. Despite this relatively high growth rate, a highly competitive environment and drags on some legacy business cause analysts to expect growth rates of the major industry participants to lag that of the industry as a whole.

In October 2015, privately held Dell announced a deal in which it would acquire EMC for a total consideration of $33.15 per share, paying shareholders $24.05 per share of EMC stock and $9.10 of a tracking stock representing Dell's share of VMware. Though the offer has been tentatively made and accepted, it is not certain it will go through. There are several issues raised by shareholders, one of which is VMware's ownership of Virtustream, which is expected to lose money in the coming years. Though EMC shareholders will be compensated in cash for the EMC portion of their shares, part of their buyout compensation is tracking shares of VMware, which continues to be a publicly traded company. Therefore, EMC shareholders are not completely done with this story in the event the deal is finalized.

Financial Analysis

EMC achieved rapid revenue growth in the years following the financial crisis, but the pace of sales expansion has slowed each year since 2010. In the quarter ending in September 2015, revenue only grew 1% above the prior year. Currency headwinds played a significant role in this modest growth figure, with an appreciating dollar negatively impacting foreign sales reported on a dollar basis. Slowing revenue and currency headwinds have taken a disproportionate toll on profits, which have declined over the past two years despite top-line growth.

As of December 2015, gross margin in the most recent quarter was 60.9%, declining from 62.1% in the prior year. This figure compares favorably to results posted prior to 2012, and other large-cap storage device firms such as Seagate Technology and Western Digital Corporation report much lower margins ranging from 26 to 41%, though this is largely attributable to sales mix, with proportionately less of EMC's consolidated revenue being generated by hardware and devices. EMC's 13.4% operating margin over the 12 months ending in September 2015 marked the third straight year of decline since peaking above 18% in 2012, though this figure is the best among peers that have operating margins ranging from 10 to 13%. Net profit margin falls within the peer group range.As of September 2015, EMC carried $7.4 billion of gross debt and held a $200 million gross cash position. With a total liabilities-to-equity ratio of 1.07 and a long-term debt-to-total-capital ratio of 0.20, EMC's leverage ratios are comparable to peers and do not indicate financial risk. A current ratio of 1.12 and a quick ratio of 0.88 do not indicate any liquidity concerns, and many investors would consider these levels minimal. For retirement investors, EMC's financial health appears sufficient to take long-term positions.

Valuation

Even if a company appears financially stable and has a strong qualitative narrative, an investment can only be justified if the expected returns are high enough relative to the price paid for an asset. Valuation ratios are an important tool for understanding the worthiness of stock pricing. At the December 2015 share price of $25.56, EMC's 12.8 forward price-to-earnings (P/E) ratio is substantially higher than Seagate's or Western Digital's, which are both close to 8.3. This can be partially explained by a higher growth outlook. EMC's five-year price/earnings to growth (PEG) ratio, which adjusts forward P/E for consensus analyst growth forecasts, is a reasonable 1.22. Seagate's PEG is 1.15 and Western Digital's is 1.10. With a price-to-book (P/B) value ratio of 2.4, EMC is comparable to peers, whose P/B ratios range from 1.5 to 5.6. EMC's dividend yield is 1.82%, which is low compared to peer group members Seagate and Western Digital, which pay 7% and 3.2%, respectively. Based on these common valuation metrics, investors have no obvious reason to anticipate price appreciation. Rather, EMC shares are priced at a premium relative to comparable stocks.

Due to the announced deal with Dell, valuation for EMC shares is driven by different considerations than other companies. The December 2015 share price of $25.56 represents the assumed likelihood that the Dell deal will be completed for the given price of $33.15. This is further complicated by the tracking shares of VMware which will continue to fluctuate in value after the deal is completed. This story requires complicated analysis for most IRA holders, but optimistic investors will consider the opportunity provided by the steep discount at which shares are priced relative to the takeover offer.

Suitability for IRA

Traditional IRAs are great for mature companies that pay dividends. Traditional IRAs allow retirement investors to reduce taxable income by the amount of a qualifying IRA contribution, and then defer tax on dividend income throughout the life of the account. This special tax treatment allows investors to maximize the return on invested and reinvested income. Withdrawals are then taxed as regular income during retirement, which carries some negative impact if the account contains very high growth stocks that would only be taxed as capital gains upon realization. Roth IRAs provide no special treatment for contributions, instead allowing holders to draw untaxed gains from qualifying withdrawals, making this vehicle ideal for growth companies.

EMC is in an uncommon situation in which a deal has been announced but is highly uncertain. On fundamentals alone, there is little reason to anticipate substantial price appreciation, highlighted by the market's stubbornness in the face of a buyout offer. Though the 1.8% dividend yield is fairly modest, EMC more closely resembles a company that is suitable for a traditional IRA. However, the bull case for EMC investors lies with the opportunity for appreciation if the Dell deal goes through as announced.

Roth IRAs are usually more appropriate for stocks with high upside opportunity, but this opportunity is somewhat different from that of a standard growth story. The horizon for the acquisition-based appreciation is short, with a binary outcome that will lead to sharp appreciation or depreciation, likely within a year of any share purchase for an IRA holder. At that point, the cash paid in the acquisition would have to be reinvested. The downside of the traditional IRA, in the case of appreciation, is investors do not get the benefit of the capital gains rate. However that rate does not apply to any gains realized within a year. The suitability for one type of IRA or the other depends entirely on how investors intend to reinvest gains from the short-term appreciation of EMC's stock.