There are certain companies where the valuations and institutional investor love-fests seem to just drive some people to distraction. Salesforce.com (NYSE: CRM) is certainly one, and VMware (NYSE: VMW) is another. Whenever these companies report, bears bring out the long knives and do their level best to flense the company and the stock. While VMware's valuation is indeed rich by almost any measurement you name, the fact remains that VMware delivers oodles of growth and institutional tech investors lust for growth above all else.
Third Quarter Results – Is Good Good Enough?
VMware reported 32% year-on-year growth and 2% sequential growth – excellent results when compared with software giants like IBM (NYSE: IBM) and Oracle (Nasdaq: ORCL) and quite strong relative to smaller growth stories like Red Hat (NYSE: RHT). Of course, this being VMware there has to be a “but” to it.
Deferred revenue was up 48% and billings grew 47%, but some analysts and investors seem concerned about the 29% growth in license revenue and the sequential comparison there.
Profitability was solid again, though. GAAP gross margin improved more than a full point and operating income came close to doubling the year-ago level. That said, GAAP operating income did decline about 3% on a sequential basis, so this may once again feed the worries about whether or not the company can really leverage its sales and marketing efforts or whether it must constantly spend more and more here.
Does VMware Have A Moat Problem?
A few cracks do seem to be showing up in the VMware veneer. For starters, while Oracle and Red Hat management were pretty constructive on the IT market, VMW management was more cautious and pointed to expectations of decelerating revenue growth. In addition, there are growing worries about the efforts of companies like Microsoft (Nasdaq: MSFT), Red Hat, and Citrix (Nasdaq: CTXS) to commoditize the hypervisor component of virtualization. Going a step further, it looks as though the company tried a more aggressive pricing strategy when it rolled out vSphere 5, but had to back off quickly when customers complained.
What all of that suggests then is that while VMware may have a sizable lead on Microsoft and Citrix, it's not untouchable. If bulls want another thing to worry about, there is also the sluggish pace of server shipments at IBM, Hewlett Packard (NYSE: HPQ), and Dell (Nasdaq: DELL), though VMware has long since set its sights on decoupling its growth from servers.
Real Opportunities Still Out There
VMware is increasingly looking to develop tools to round out its offerings and it will be interesting to see to what extent the company finds itself competing with Microsoft, BMC (NYSE: BMC), Red Hat and the like. There's an argument out there that says tool-makers will have an easier time adding virtualization than virtualization companies will have adding tools.
At the same time, the company seems to be looking at a broader market opportunity for virtualization. The expectation has been out there for a while that VMware would/will challenge Citrix in desktop virtualization, but management seems to be taking a more comprehensive view and targeting not just desktops or laptops but all manner of devices – VMware View already runs on Apple's (Nasdaq: AAPL) iPad and the company has partnered with LG and Samsung to see that it can bring its software to their devices as well.
The Bottom Line
Even on a very aggressive cash flow projection, VMware is little more than slightly undervalued. To be cheap, VMware will have to find a way to wring more cash flow out of its revenue than even Microsoft or Oracle has ever managed and something on the order of what Check Point Software (Nasdaq: CHKP) achieves, all the while producing incredible top-line growth. The most likely outcome for this stock is that the valuation will (or has) overshoot its actual growth potential and then go flat – meaning that in the future the company will continue to deliver good results, but the stock won't respond much. Look around at the great tech names of yesteryear and you will see that effect.
In the meantime, VMware is a growth/momentum story with a lot of legs. Virtualization is here and there is money to be made in it. Given that the stock has arguably decoupled from its fundamentals, it is likely to be a volatile play and a plaything for momentum investors. Still, for investors who understand the growth tech stock game and have the stomach for it, there can be still be a play here.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.