Virtually Unstoppable: How to Play the Secular Growth in Server Virtualization

Includes: CTXS, LOGM, VMW
by: Simon Monger

Server virtualization companies like VMware, Inc. (NYSE:VMW) and Citrix Systems, Inc. (NASDAQ:CTXS), which provide solutions to lower IT costs and streamline business processes, have seen their share prices rise more than 50% over the past 52-weeks as companies seek out solutions to increase efficiency. But, is it too late for new investors to take a position, and should existing shareholders take any profit?

The growth in the server virtualization space is primarily driven by a secular move away from physical servers and massive IT overhead and into more efficient options. While smaller enterprises can move their businesses onto cloud-hosted solutions, larger companies often desire a more centralized on-site approach and opt for server virtualization as another way to reduce overhead and streamline.

Strong Earnings Growth Continues

During the first quarter, VMware reported earnings of 48 cents per share, compared to 42 cent estimates, on revenues of $844 million, compared to an $815.35 million consensus. Meanwhile, analysts expect similar growth from competitor Citrix Systems, with Caris expecting margins to increase and Wedge Partners calling for "very strong" first quarter results.

Looking ahead to FY2011, VMware indicated that it expects revenues to reach between $3.55 and $3.65 billion, which exceeds the analyst consensus estimate of $3.52 billion. Meanwhile, the firm also expects its adjusted operating margins to expand slightly year-over-year, indicating that the growth is coming from customer demand and not pricing adjustments or other factors negative to the bottom line.

Analysts Remain Bullish on the Sector

Many analysts also remain very bullish on the server virtualization sector, revising their ratings higher and higher each quarter. For example, Susquehanna raised its price target on VMware to $120 per share, a premium of about 25%, citing accelerating international growth, improved traction with service providers, and better than expected growth from the hardware OEM channel.

Analysts have also came out bullish on competitor Citrix Systems. Morgan Keegan initiated the company with an Outperform rating and $80 per share price target in late-March, while Wedge Partners and Caris have indicated that they expect the firm to report very strong first quarter results. If this is true, it is likely that more upgrades and raised targets could come afterwards.

Finally, analysts are also bullish on other names in related industries, such as LogMeIn (NASDAQ:LOGM).

New Investors: Too Late to Get Involved?

While VMware and Citrix Systems are past their explosive growth phase, the fact that they continue to report growth without sacrificing margins indicates they may be a good way to integrate a high-growth portion of the IT sector into a long-term stock portfolio. Between server virtualization and cloud hosting services, investors would be wise to capitalize on these two secular trends in the industry.

However, the sector's high price-earnings ratios may warrant a correction if growth does begin to slow. As a result, new investors may want to look at a more moderately bullish position, such as a LEAPS bull spread options play. Using this strategy, investors can purchase a LEAPS call at-the-money and sell a LEAPS call out-of-the-money at a target price and benefit from the difference while only risking the premium.

Existing Investors: Time to Take Some Profit?

Existing investors in the server virtualization space may be sitting on some profits and thinking of taking some of their position off of the table. While this may be a good idea to diversify a larger portfolio, these companies have yet to show any signs of slowing growth, so selling right now may be inopportune. Instead, these investors may want to consider an options strategy.

By selling covered call options at their target prices, investors can make money (premiums) by simply giving others the right to buy their stock at a target price that may or may not be met. This way, investors are able to offset some potential declines with the premiums, while maintaining their upside to a certain price. Those worried about a decline could purchase a "free" put option using that premium, too.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.