EMC (EMC) and VMware's (VMW) strategic forum gave analysts and investors a lot of information about the companies' technology and growth potential. The management teams also explained their plans for the spinoff of Pivotal, the joint Big Data initiative. In reaction, VMware's stock price jumped 8.1% to $81.37 per share and EMC was up 1.8%. However, VMware is still trading at the lower end of a multi-year trading range and is down 17% from the level before it announced Q4 2012 earnings. But, this was the first analyst day for VMware's new CEO and CFO and investors now have a better sense of their plans. In this article I will analyze VMware's multi-year trading range and discuss five big picture takeaways from the analyst day as well as the potential impact on the share price.
Background: VMware's Trading Range & Multiple Compression
VMware's share price rebounded from the 2008/2009 financial crisis low and returned to $80 per share in August 2010 but has traded in the ~$75-$115 range ever since. During this time VMware's trailing P/E multiple has contracted meaningfully and now stands at ~47x. (Its forward P/E multiple is 25.5x, but EPS estimates may change after analysts update their projections for the new information presented at the analyst day.) The multiple compression was driven, in part, by lower revenue and EPS growth rates.
Many technology companies experience the transition to a lower, mature growth rate and VMware should get credit as the stock traded above $75 per share throughout most of this transition and the market cap is now $35 billion.
The following charts display the share price history, P/E multiple compression and the revenue and EPS growth rates.
VMW data by YCharts
VMW PE Ratio TTM data by YCharts
VMW Revenue Quarterly YoY Growth data by YCharts
With this background, VMware hosted the analyst day to give more clarity about its future. The following are five big picture takeaways.
Restructuring Seems Done
VMware's management team has taken steps over the past few months to reset the business on a more growth oriented trajectory.
The first step was to hire a new CEO, Pat Gelsinger, and CFO, Jonathan Chadwick. After that, the new management team announced a reduction of headcount by approximately 900 employees, though this was more of a re-allocation of resources, since total company headcount is still expected to increase by 1,000 employees in 2013.
Furthermore, the spinoff of Pivotal was finally announced at the analyst meeting. Pivotal represents the highest growth markets for VMware/EMC and both will contribute several divisions to the new company. After the spinoff, VMware will be able to focus more on the growth opportunities in its core and newly announced markets.
Most of the disruption seems to be behind the company now.
VMware Still Has A Big Opportunity
There have been questions over the years about VMware's growth potential. Now that the company has transitioned to a more mature phase, the question is what growth rate will be a sustainable for the next few years. Also, many investors and analysts wonder if the company can continue to grow after it has already achieved high penetration in its core server virtualization market.
Management presented the case that it still has a big opportunity ahead and VMware is not only focused on server virtualization. It is going after the software-defined datacenter (SDDC), Hybrid Cloud and End-User Mobility (EUC) markets. In total, VMware estimates that it has a 2016 total addressable market opportunity of $50 billion (see slide below). Currently, VMware only has a $6 billion market opportunity, out of which it is projecting $5.16 billion of revenue in 2013 (pro forma for the Pivotal spinoff).
(Source: VMware 2013 analyst day presentation)
The challenge for VMware will be executing on the opportunities and grabbing as much of the $50 billion 2016 market as possible.
The challenge for investors is that it will take a few quarters/years until VMware shows meaningful results in these additional areas, so it is difficult to value the opportunities now.
VMware's management team provided updated guidance. Guidance is a big issue for VMware following the disappointing guidance on the Q4 earnings call that drove down the stock ~20%.
To summarize the outlook, in 2013 VMware will grow revenue 15.25% and achieve a Non-GAAP Operating Margin of 33.5% (both numbers are midpoints of the ranges and are pro-forma for the Pivotal spinoff).
However, management expects to accelerate its results following 2013. In 2014-2016, VMware expects to achieve revenue growth of 15-20% and increase operating margin by 50 bps per year.
The new guidance was not a game changer and seemed in-line with what management previously said. However, it is unclear how seriously investors should take this guidance. Management is new and has recently done a restructuring. Much of the future growth is coming from relatively new areas for the company. Management's visibility is probably limited and I would expect them to be very conservative in this situation.
In fact, after management presented the guidance it was asked if the 50 bps of margin expansion was too conservative since VMware's size should allow it to achieve a more aggressive margin target. Management is probably more optimistic than the guidance it presented.
It will be interesting to see how the analyst community adjusts their estimates for the new information. Currently, the average analyst estimates for revenue growth in 2013 and 2014 are 15.0% and 15.1%, respectively. EPS is expected to grow 11% in 2013 and 15.5% in 2014.
The Pivotal Initiative
The Pivotal Initiative is the new spinoff from EMC and VMware that will focus on "Next Generation Cloud & Big Data Apps." The two companies will contribute assets to the new entity and EMC will contribute cash. The new company, which will start operations on April 1, will be owned by EMC and VMware (69%/31%) and will generate ~$300 million of revenue in 2013.
Pivotal represents the fastest growing parts of EMC and VMware and the management teams decided that they can best maximize the value of these assets by creating a stand-alone company. The goal seems to do an IPO for Pivotal in a few years, like EMC IPO-ed VMware.
It is interesting to see how EMC/VMware deals with the problem of unlocking value of high-growth opportunities buried within a tech giant. EMC, like IBM (IBM) and other large tech companies, has a range of divisions with various growth rates. EMC's strategy is to spinoff each unit and create stand-alone companies. In a few years EMC, VMware and Pivotal may all be public companies with a web of cross ownership. It will be interesting to see how the market values this structure.
Aside from the structural issues, the Pivotal launch is interesting because it will bring more attention to EMC/VMware/Pivotal's initiatives in the Big Data space. Everybody is talking about Big Data (it was also the focus of IBM's last analyst day) and it seems like an exciting opportunity for EMC/VMware/Pivotal. EMC and VMware will likely not receive a valuation bump for Pivotal now, but could benefit from it over the next few years.
Sad State of IT Spending
EMC's management team presented the slide below with a long-term-outlook. The projection of $30 billion of revenue in 2016 assumes, in part, IT spending growth of 3%. Management was asked about this assumption and noted that the IT spending growth rate is down from previous forecasts and thereby reduced the revenue potential for the company. Management also noted that the forecast for IT spending may be conservative and there could be upside for the company if IT spending turns out to be stronger (please listen to the webcast for the exact Q&A about this).
(Source: EMC 2013 analyst day presentation)
This got me thinking. EMC (and, likely, VMware) are projecting IT spending growth of 3%, which seems in-line with global GDP growth, or maybe even a bit less. I recognize that a lot of macro issues are weighing down IT spending now, but is it realistic that IT spending would grow at a lower rate than global GDP? EMC's management said that they expect to grow revenue at ~3x the rate of IT spending, so if you believe that IT spending can grow more than 3% then there is likely upside in the EMC numbers (and maybe VMware's numbers as well).
VMware presented an impressive growth outlook at its analyst day. However, the initiatives with the most potential will take several quarters/years to play out. Still, investors will be tracking the progress of those initiatives for early indications of how much impact they will have. The main challenge for the company in the short term is execution.
Management's guidance is probably on the conservative side, but the limited visibility warrants a conservative approach.
VMware's stock price is trading at the low end of a multi-year range. Buyers have come in at this level several times since 2010 and the initial market reaction to the analyst day was very strong. The stock seems likely to continue to trade in the $75-$115 range for the foreseeable future if it continues to make progress on its growth roadmap. If the stock continues to trade in this range, it may be attractive around the current price of $80 per share.
There are many risks for VMware, including technology risks, inability to gain traction in new areas, increasing competition in its core server virtualization market and multiple contraction. Furthermore, a bad quarter or another reduction in guidance could be the catalyst for the stock to fall below its trading range.
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