VMWare Q3 Earnings: Signs of Weakness

VMWare (VMW) reported Q3:08 revs and EPS of $473M (up 32% y/y) and 24c, compared to our estimates of $453M and 21c and consensus estimates of $463M and 20c (see conference call transcript). License revenues were $285M, compared to our estimate of $280M (up 13% y/y and down 1% q/q), but they drew down another $3-4M from deferred license revs on the balance sheet. Service and Maintenance revs were $187M, up 9% q/q and 70% y/y, compared to our estimate of $173M.

It’s important to point out that license revenue grew only 15% y/y while maintenance revs continued to grow rapidly at 70% y/y. As a reminder, software companies charge their customer a maintenance fees to receive updates and support and are typically priced as a percent of the undiscounted license fee. It appears that VMW is discounting product licenses, but is not discounting maintenance fees, which are 18% of the license fee and is charged annually. Discounting license fees is typical when competition increases (BEA Systems (BEAS) did that too). This is a sign of weakness and implies that maintenance revenue growth will slow significantly on a y/y basis in 09E in our view.

We remain Neutral on VMW based on increased competition coupled with a slower IT spending environment, which is resulting in a significant slowdown in license revenue and total revenue growth for VMW. We think VMW is discounting license fees to keep maintenance revs growing rapidly, which we view as a sign of weakness. We think VMW should be able to grow total revenue 17% y/y in 09E, which is a big slowdown from 08E revenue growth of 42%. This has put significant pressure on the P/E multiple which is very unlikely to reverse going forward, because VMW’s market share gains have peaked.

To account for the slight bump up in maintenance revs for 09E and the lower tax rate, we are raising our price target a bit from $21.00 to $22.50, which equates to 20x our C09E EPS of $1.12.

Disclosure: none