Since my last report, shares of VMware (NYSE:VMW) found support at about the $77 per share level. Following some volatility post third-quarter earnings, the company found plenty of bids. Heading into fourth quarter earnings, there could be some volatility, but I will almost certainly be bullish on the company following the release of fourth quarter earnings.
The organization is attempting to become a cloud management provider, which is a transformation from offering primarily server virtualization solutions. At the same time, the server virtualization market is expected to grow 18% annually, near term. This is as medium-sized enterprises are still in the early stages of deploying a server virtualization offering.
Simply said, the evidence suggests that the industry dynamics remain favorable for this high-flying growth stock. Given the growth rate and valuation relative to the market, 45 times earnings and 6 times book is not excessive.
- VMware hired two Citrix execs to help bolster its desktop virtualization offering.
- Server virtualization is expected to grow 18% annually, which suggests that the market is unsaturated.
- VMware appointed Ben Fathi as Chief Technology Officer; Fathi has been with the company since 2012.
- VMware announced the general availability of its latest VMware Cloud Management Solutions.
- VMware announced a partnership with Palo Alto Networks, which is backed by a new jointly developed solution.
VMware, Inc., is a provider of virtual infrastructure software solutions from desktop to the data center. It works with more than 1,300 technology partners, including server, microprocessor, storage, networking, and software vendors.
VMware is a growth stock as annual revenues cross the $5B mark. The company exhibits the typical profitability profile of both a growth stock and a software developer. In this case, VMware is generating GAAP net income. The question remains, how long will management continue to reinvest revenues into operations?
What EPS would VMware have to generate create wealth for investors over the next 12 months? I estimate that VMware would have to generate at least $1.22 of earnings per share over the next twelve months to preserve shareholders' wealth. Over the previous twelve months VMware generated GAAP basic EPS of $2.07.
At the end of the September quarter, the cash ratio was 2.03 with a current ratio of 2.41; VMware is liquid. The net cash balance was $5.39 billion. The financial leverage ratio was 1.75. The trailing twelve months EBITDA-to-interest expense was 346. I think there is excess liquidity and VMware should return more capital to shareholders; I would like the company to initiate a dividend.
VMware generates plenty of free cash flow; the trailing twelve months free cash flow was $2.01 billion. Free cash flow grew 50% y/y during the quarter ending in September. That follows 32% FCF growth y/y in the quarter ending in June. The pace of FCF growth is unsustainable; I think a pace in the high teens is more sustainable over the next five years.
In a study of 321 IT professionals, 43% said that their organization already deploys server virtualization. A smaller percentage, 15%, said their organization plans to deploy server virtualization in the next 12 months. Also, 21% of respondents said that their organization is studying server virtualization deployment. Overall, there is a significant number of companies who could potentially deploy server virtualization in the future. Citrix (NASDAQ:CTXS), Microsoft (NASDAQ:MSFT), VMware and Red Hat (NYSE:RHT) will be amongst the companies battling to win share of IT expenditure.
The x86 server virtualization space is competitive. Red Hat Enterprise Virtualization, Microsoft Hyper-V and Citrix Xen Hypervisor are server virtualization offerings that compete with VMware vSphere. Microsoft and VMware are the market leaders with Microsoft gaining ground on VMware. There are open source alternatives to the aforementioned branded solutions.
- The share price is likely to remain volatile and investors could lose a portion or all of their investment.
- Investors should judge the suitability of an investment in VMware in light of their own unique circumstances.
- A decline the global economic growth rate and/or a decline in the pace of economic growth in the United States could adversely impact the results of operations and the share price.
- Cyclicality in IT expenditure may affect the performance.
- The technology industry is characterized by rapid technological change, which could materially adversely impact the results of operations.
- Competition in product development and pricing could adversely impact performance.
- Incorrect forecasts of customer demand could adversely impact the results of operations.
- Higher interest rates may reduce demand for VMware's offerings and negatively impact the results of operations and the share price.
This section does not discuss all risks related to an investment in VMware.
VMware traded up to $95 per share after finding support at roughly the $77 per share level. The company remains in a bull market and the next test could be the $100 per share level. From a short-term technical perspective, investors would accumulate on minor corrections.
How much of the variation of the share price of VMware is explained by the variation of the S&P 500? Since the beginning of 2009, 42.6% of the variation of the share price of VMware is explained by the variation of the S&P 500. Since the beginning of 2011, 16.1% of the variation of the share price of VMware is attributable to the variation of the market. But since 2013, 55% of the variation of VMware is attributable to variation of the market. During some periods the share price of VMware and the broader market disconnect, but at other times, expected market returns are a good measure of expected VMware returns.
Does an investment in VMware provide diversification benefits? Since the beginning of 2009, the correlation between VMware and the S&P 500 is 0.65, which is statistically significant at the 95% confidence level. Since the beginning of 2011, the correlation is -0.40, which is statistically significant. And since 2013, the correlation is 0.74, which is statistically significant. So, there are diversification benefits from investing in VMware.
I utilize 3-month, 6-month, and 12-month price forecasts. The 3-month price target is $105.95. The 6-month price target is $108.91. And the 12-month price target is $114.83. That would be 13.6%, 16.8%, and 23.1%, respectively, above the current share price.
As a growth company, VMware is going to be more expensive than the market. The company trades at 45.7 times earning and 6.1 times book while the market trades at 18.6 times earnings and 2.6 times book. In the context of high teens industry growth relative to a global economic growth rate of roughly 5%, paying slightly more than twice the value of the market is not exorbitant.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.