VMware (NYSE:VMW) announced its Q2 2014 earnings on July 22, reporting a year-over-year (y-o-y) increase in product license revenues (+16%) and services revenues (+18%). VMware’s net revenues of $1.46 billion for the quarter were slightly higher than its guidance and the company seems to be on course to meet its full year revenues expectation of $6 billion. The company expects its Q3 net revenues to be 17% higher than the prior year quarter at $1.47 billion, while license revenues are expected to be around $640 million, 13% higher than the year-ago period.
The company’s software licenses gross margin has consistently improved over the last few years, from 87.7% in 2009 to over 90% in 2013. The trend continued in 2014, when the gross margin for software licenses grew to over 91% in Q1 and further improved to 92.5% in the June quarter – almost 3 percentage points higher than Q2 2013. VMware expects its margins in the September quarter to remain similar to Q2 levels.
VMware management mentioned that the company remains “laser focused” on three main areas of growth – software-defined data centers (SDDC), the vCloud Hybrid suite and end-user computing. Software-defined networking and software-defined storage both form an integral part of the SDDC vision articulated by VMware. The company saw a positive customer response for both VMware NSX, the network virtualization platform, and the newly launched Virtual SAN (vSAN) software-defined storage platform during the quarter. We have a $100 price estimate for VMware’s stock, which is slightly higher than the current market price.
Network Virtualization, Hybrid Cloud Service And AirWatch Deliver Strong Results
VMware introduced NSX, its own software-defined networking (SDN) platform in late 2013, to establish itself in the fast growing segment. The company reportedly made significant progress in the previous quarter by signing deals with major clients that included a number of large enterprises in the finance, banking and telecommunications sectors. The company continued to add more customers in Q2, with more than 150 paying customers for NSX by the end of the quarter. Gaining a large number of customers in a short time has seemingly put VMware in a strong position relative Cisco (NASDAQ:CSCO), a main competitor in the SDN market (see VMware And Cisco To Fight It Out In The SDN Arena). VMware generated over $100 million in revenues from NSX sales. The company believes that SDN could be a “decade-plus opportunity” for VMware – not just in terms of network virtualization, but also in terms of network security.
VMware also announced its seventh production data center, due to which it expects the company-operated cloud to be available in over 75% of the world’s cloud market by the end of the year. The company already has over 4,000 service provider partners for VMware cloud, which should help the company reach out to its solid customer base (about half a million in numbers) for hybrid cloud adoption. VMware’s hybrid cloud business, which includes vCloud Service Provider Program and vCloud Hybrid Service, grew by nearly 80%, while cloud management license bookings grew by more than 30% y-o-y in during the quarter. Although this is still a nascent market, the company expects a large chunk of 500,000 customers to start adopting enterprise class hybrid cloud service. Management will add more color on expectations for the hybrid cloud service at its annual industry conference VMworld in August.
VMware-acquired mobility management business AirWatch also witnessed strong growth in the first half of 2014, with its total customers rising from 10,000 at the end of last year to about 13,000 at present. VMware’s end-user computing license bookings, including those of AirWatch, grew by over 50% year-over-year during the quarter. Moreover, the company has made AirWatch’s enterprise mobile management platform available on the VMware price list starting from Q3. VMware has a global network of about 75,000 partners that will be able to purchase AirWatch products. The company announced a deal with Box recently, to enhance secure enterprise collaboration across mobile devices for enterprise mobile management. Although this deal did not have any impact on Q2 results, it should help the company further expand its reach in the mobility management arena.
The June quarter was VMware’s highest ever quarter in renewal rate for support services, with the average term for support staying well above 24 months. Due to the long-term renewal period, the company’s total unearned revenue was $4.39 billion at the end of the quarter, 22% higher than the prior year quarter, out of which $1.68 billion were long-term unearned revenues. VMware’s enterprise license agreements (ELAs) as a percentage of license bookings had declined to about 25% in Q1 from over 40% in Q4 2013. The company had a considerably high renewal rate for ELAs in terms of number of deals renewed during the quarter. This figure jumped back to 37% of total Q2 bookings, which was the second-highest quarter contribution ever. VMware was able to close eight deals greater than $10 million in Q2, close to an all-time high for deals of this size in a quarter.
Positive Outlook For 2014
In line with our expectations, VMware’s services division witnessed a solid 18% y-o-y increase in Q2, generating $843 million in revenues. However, the gross margin of the services division fell by 3 percentage points over the year-ago quarter to 80%. The decline in margins can be attributed to an increasing proportion of service-based revenues in new and emerging technologies. We expect these margins to improve in the long run, as hybrid cloud and end-user computing services gain more popularity. VMware’s services division is likely to continue to reap benefits from its hybrid cloud offering as the vCloud Hybrid service gains popularity among buyers. The company has now expanded to Asia, with Japan being the third country after the U.S. and the U.K. where VMware will deploy its hybrid solution. The company also signed a deal with China Telecom (NYSE:CHA) to build a hybrid cloud service that will be ready to launch next year.
The company’s net income was about 25% lower than Q2 2013 at $200 million, which it attributed to higher operating expenses (sales, marketing and administrative) due to the AirWatch acquisition in February. The company intends to continue to invest in newer technologies and next generation products to gain long-term benefits. Despite higher investment, VMware expects non-GAAP operating margins to be 31% for the full year – about 150 basis points higher than Q2 levels. Growing competition from competing virtualization and cloud providers Amazon (NASDAQ:AMZN), Cisco, Microsoft (NASDAQ:MSFT) and Citrix (NASDAQ:CTXS) remain key concerns for the company in the coming quarters.
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