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VMware Inc. (VMW) reported a stellar third quarter 2011, as earnings per share (EPS) escalated 68.0% year over year and surpassed the Zacks Consensus Estimate by 9 cents. The better-than-expected results were driven by solid revenue growth, based on strong global demand for VMware products.

EPS (including stock-based compensation) was 42 cents in the reported quarter compared with 25 cents in the year-ago quarter. Excluding one-time items and stock-based compensation, EPS was 53 cents, up 35.9% from 39 cents reported in the year-ago quarter.

Operational Performance

Gross profit (including stock-based compensation) was $817.7 million, up from $622.4 million in the previous-year quarter. Gross margin was 86.8% versus 87.1% recorded in the prior-year quarter. The year-over-year decline in gross margin was due to higher proportion of service revenue in the mix.

Operating income (including stock-based compensation) in the reported quarter jumped 49.9% year over year to $193.6 million. Operating margin was 20.5% in the quarter, compared with 18.1% in the year-ago quarter. The upside was primarily driven by strong revenue growth and strict cost control measures.

Net income (including stock-based compensation) was $180.0 million, up from $110.4 million in the third quarter of 2010. Net margin was 19.1%, up from 15.5% in previous-year quarter.

Revenue

Revenues increased 31.9% year over year to $941.8 million, marginally beating the high end of management’s guided range of $915.0 million to $940.0 million. The upside was primarily driven by strong Enterprise License Agreement (ELA) growth, strong demand in the U.S. and across Asia-Pacific markets, and seasonal strength with the U.S. Federal Government.

License revenue was up 29.3% year over year to $443.6 million, and was primarily attributable to strong global demand for vSphere and VMware’s management tool solutions. ELA were 22% of total third quarter bookings and included two transactions worth $10 million or more. The company experienced stronger demand for end-user computing and management products with the renewals of ELAs.

Services revenue jumped 34.3% year over year to $498.2 million. Software maintenance and support revenue was $426.8 million, up 35.9% year over year.

VMware stated that with every new license being purchased, customers continued to buy more than 24 months of support and maintenance, a reflection of their strong commitment to VMware, as a core element of their data center architecture and hybrid cloud strategy. Professional services revenue was $71.5 million, up 25.7% from the year-ago quarter.

US revenues (47.0% of the total revenue) increased 22.0% year over year to reach $443.0 million. Similarly, international revenues (52.0% of the total revenue) witnessed a year-over-year growth of 42.0% to gross $499.0 million.

Balance Sheet and Cash Flow

VMware exited the quarter with cash and cash equivalents (including short-term investments) of $3.98 billion, compared with $3.70 billion in the previous quarter.

Cash from operations was $524.0 million versus $539.0 million in the prior quarter. Free cash flow was $494.0 million in the quarter, an increase of 108.0% prior-year quarter.

During the quarter, the company used $365 million in aggregate for M&A, capital spending and share repurchase program and was benefited from a tax refund of $100 million from EMC Corp. (EMC).

Guidance

Management provided robust guidance for the fourth quarter. VMware expects total revenue to range from $1.03 billion to $1.06 billion, reflecting an increase of 23.0% to 27.0% from the fourth quarter of 2010. The Zacks Consensus Estimate anticipates revenues of $1.03 billion, inline with the lower end of management guidance.

For the fourth quarter, operating margin is expected to increase sequentially and to range between 30.5% and 31.5%. The GAAP operating margin for the fourth quarter is expected to be approximately 10 to 13 percentage points lower than the non-GAAP operating margin.

Management believes weak technology spending and troubled macro-economic environment to make 2012 a challenging year for the company. Management expects first quarter 2012 revenues to decline sequentially to the range of $1.0 billion to $1.03 billion (increase of 18% to 22% from the first quarter 2011) from the fourth quarter 2011.

The first quarter operating margin is anticipated to be below 30% and the GAAP margin approximately 9 to 14 percentage points lower than the non-GAAP operating margin.

Our Take

VMware has reported strong quarterly results on the back of higher license revenues and a healthy mix of renewals and new customer gains. International revenue, particularly from the Asia-Pacific was strong.

We expect VMware to benefit from increasing adoption of virtualization and cloud computing technologies. Enterprises that are shifting to the cloud need proper infrastructure, which VMware provides through its four key products: vSphere that helps in coordinating and automating computer storage and networking; vShields for virtualized Edge functions and security; vCloud Director to enable cloud functionality; and vCenter Operations Suite for management.

During the third quarter, the company announced theist new cloud infrastructure suite and the general availability of VMware vSphere. Additionally, VMware announced VMware Micro Cloud Foundry, an open Platform as a Service (PaaS) solution. These new products are expected to boost VMware’s top-line growth going forward.

However, a sluggish North American and European market coupled with weak IT spending environment will be an overhang on the stock over the next 12 to 18 months, in our view. Moreover, increasing competition from Microsoft Corp. (MSFT) and Citrix Systems Inc. (CTXS) will hurt profitability going forward.

We have a Neutral recommendation on VMware over the long term (for the next 6 to 12 months). Currently, VMware has a Zacks #3 Rank, which implies a Hold rating on a short-term basis.

Source: VMware: Earnings Preview