Putting the conclusion first:
VMware (NYSE:VMW) recently reported results of its fiscal Q1. The results were decent and not more than that but the shares soared almost 15%. Much of the share price increase has to do with the announcement that the company will resume share buybacks once the merger between VMware's parent, EMC and Dell is completed sometime in either Q2 or Q3. The transaction is quite complex in terms of its structure and the potential for VMW shareholders. With a new tracking stock to be available, there is going to be lots more stock for sale, I imagine.
But I am going to try to look beyond all of those factors and simply focus on the potential that VMW enjoys in becoming a leader in providing software infrastructure in the hybrid cloud space. I am also going to speculate a bit about the potential revenue synergies of the impending transaction as they may impact VMW. The net of it all is that with decent execution and focus, VMW can return to moderate growth and improvements in operating margins as well. In addition, the cachet of being a leading provider in the cloud area, will almost certainly lead to higher valuations as investors search for cloud stories that are not valued in nosebleed territory. I think with the merger impending; it is more prudent to attempt to scale into the shares rather than trying to establish an entire position immediately. If, as is possible, the shares encounter significant headwinds when the merger is complete, I would be far more aggressive in stepping up purchases.
Forecasting execution regarding something with little history is perhaps a bold exercise. Most of us are far more comfortable forecasting established trends. It is far simpler and history provides a framework for drawing a conclusion. But this company has had several lives already and I think it is not unreasonable to believe that it will be able to pull off the strategy as I describe below.
Fond Memories and Uncertain Tomorrows
VMW, it seems, has been reinventing itself for at least the past 5 years now. And re-inventing seems to be much harder to pull off than pioneering. Just to put things in some historical perspective, VMW hit its peak in terms of share price way back in October 2007 at $125/share. Just more than a year later, during the market crash of the Great Recession, the shares lost 85% of their value. They subsequently recovered to the $90 range in which they traded for more than 4 years until the middle of 2015. From that point, the shares lost more than half of their value until bottoming earlier this year at $43. Much of the share price decline was probably the result of two interrelated factors. In mid-October last year, Dell announced that it was buying EMC (EMC) for $67 billion. As part of the deal structure, EMC is to issue 223 million tracking stock shares in VMW to current EMC shareholders. That is a lot of additional shares for the market to absorb, even if they are to be "tracking" shares. But of equal significance, at least to this writer, is that the transaction almost certainly means that the VMW shares not already owned by EMC will not be bought by either the new parent or by anyone else. Over the last several years, some of the value in VMW shares had been based on speculation that EMC would reacquire the public shares that it had sold or that EMC would sell VMW to a strategic buyer such as Cisco (NASDAQ:CSCO). Since the announcement of the Dell/EMC transaction that is no longer in the cards; Dell considers the VMW asset to be the crown jewel of the transaction.
After the shares made their bottom in early February in the midst of the early year market turmoil, the shares have recovered by about 29% including a decent move in the wake of what was considered a decent earnings report. Some observers were encouraged by the company's announcement of a buyback once the Dell-EMC merger is complete sometime in the next 60-120 days. Personally, I doubt that buying back $1.2 billion of shares during the course of 2016 will be a meaningful share price catalyst. The company has an enterprise value of around $19 billion. At current share prices of $55/share, $1.2 billion is just over 2 million shares, barely more than the average of a single day's trading.
Just for the record, VMW reported earnings non-GAAP of $0.98 for the quarter up 5% from the prior year. Revenues also grew 5%. While license revenues were down 1%, license bookings actually increased 2%. In addition, the company is attempting to raise its profile in the hybrid cloud domain and increased S and M spend by 4%.
Operating cash flow grew slightly, but essentially all of the increase flowed from an increase in stock-based comp, which increased from 8% of revenues in 2015's Q1 to 10% of revenues in the latest reported quarter. Free cash flow showed an increase from $577 million to $679 million mainly due to a steep decline in capex. The free cash flow yield of 4.3% is probably in line in the IT world as a whole, although it is surely not at value levels. On the other hand, the company's free cash flow margin, which reached 43% last quarter, is in the upper quintile of that metric for software companies. Despite press reports to the contrary, I think the quarter might best be characterized as "better than feared." Guidance was increased a bit - revenue growth expectations are now 4%-7% compared to a prior consensus growth of 3%. The EPS guidance at the midpoint went from a prior consensus of $0.94 to guidance of $0.955.
All of that being said, however, the guidance increase is totally a function of the share buyback later this year. Company management took great pains during the course of the conference call to say it was reiterating its operating performance forecast it had made back in January.
Trying to make some sense out of a relatively complex transaction:
But of course, by far, the largest consideration for potential investors at this point really isn't the share price history or even, to an extent, the forward prospects of VMW's business but exactly how the company will fare in the soon to be consummated acquisition of VMware's control shareholder, EMC by Dell. As many readers realize, EMC owns 81% of VMW and that ownership will pass to Dell when the merger is complete. However, current EMC shareholders are going to receive 223 million VMW tracking stock shares, or 0.11 tracking shares for each share of EMC stock that they currently own. The tracking shares will represent 53% of the economic interest in VMW although the shares will be without any voting rights.
The lack of voting rights hardly matters. The current VMware shareholders only have a 3% voting interest in the current company even though they have 19% of the outstanding shares. Needless to say, regardless of the specifics, issuing 223 million tracking shares of VMW is inevitably going to lead to some kind of short-term pressure on the valuation of the company. It has already led to 20 million shares being held short, most likely as an arbitrage against the tracking shares that are going to be issued to current EMC holders.
I am not too sure what more can be said, specifically about the likely short-term impact of the transaction on current VMW shareholders. But I do think it is a reasonable time to consider the likely track for VMW once it is owned by the new Dell/EMC combination. There are clearly some significant opportunities and a few risks for VMW as the new company attempts to develop revenue synergies out of what will effectively be a subsidiary.
Trying to make sense out of a moving 3D chess board:
Many readers probably know of VMW as a company who pioneered server virtualization and became a tech industry shooting star. For those unfamiliar with the technology concept, server virtualization masks physical server resources including the identity of physical servers and processors from many contending users. The administrator uses software to divide a single physical server into multiple isolated virtual environments. It substantially enhances utilization levels for servers so that users need far fewer of them than would otherwise be the case. It is hard to imagine how modern data centers, which contain as many as 1 million servers, could possibly operate with the efficiency that they do, without virtualization.
The desktop virtualization business was fun when it was growing at rates of 50% or more as was the case 10 years ago. But desktop virtualization by its nature is a very finite market and VMW's success spawned lots of competitors. Over the years, VMW brought its virtualization technology to many other corners of the IT stack. It would be far too tiresome to go through all of its initiatives. I will just touch a few highlights. The company is a leader in virtual storage. As an adjunct, if you will, it is a leader in hyper-converged infrastructure. The company has a solution it calls the Software-Defined Data Center which essentially is the software necessary to provide fully virtualized infrastructure including compute, network and storage. VMW has many, many different product suites that encompass its solutions and conference calls are punctuated by reference to many of these different products. A description of VMW's product set is far more than readers need to or would want to know in order to reach an investment decision.
What investors need to know is that this company, if it is going to be successful, has to become known as the leading vendor of software infrastructure for the private cloud and especially the hybrid cloud. If the initiative works, VMW can, over time, become a story of moderate growth.
The strategy can be articulated quite simply. The company needs to extend its market position in helping users in the private, public and hybrid clouds. The private cloud is said by the company to be the cornerstone of VMW business currently. But the company's strategy, that I think can be successful involves the company stepping up to create and further develop solutions to manage all kinds of cloud. It needs to accelerate the development of hybrid cloud models using VCloud Air. And it needs to develop a significant capability in implementing, managing and securing endpoints in the public cloud space, acting as a partner of AWS (NASDAQ:AMZN) and Microsoft (NASDAQ:MSFT) Azure. It is going to be far more difficult to execute against that strategy than it was in articulating it.
The other significant issue is what, if anything, the complex set of transactions outlined above, is going to mean to the operating performance of this company. The new Dell will control VMW. And the new Dell has to sell lots and lots of hardware in a very unforgiving market space. VMW for several years has been managed by EMC as a federated company. VMW has made investments in joint ventures with its parent and outside investors in several technology ventures such as Pivotal. Again, I don't intend to discuss those joint ventures in the interests of focus. But one of the keys to VMware's future is going to be if the new combination results in revenue synergies. Essentially, if Dell wants to sell its own servers and EMC storage as the building blocks of a what is called a hybrid cloud solution, will it be able to incorporate VMware solutions and drive synergistic revenue growth. I really think that almost everything regarding this company is noise although I am sure that some readers will doubtless have different views.
Are there any proof points or signposts along the way?
Honestly, if the numbers were that simple, this would be easy. One thing to note. While management is forecasting just single-digit growth in revenues, it is forecasting as much as 10% growth in total bookings. And like most managements, it has emphasized 2nd half strength, although, in fact Q1 bookings grew 10% despite no growth in the computing segment which encompasses the desktop segment. This is a year of transition for the company and I have my doubts that overall the company is going to print any significant upsides along the way. But there are some signs of success in the company's transition strategy.
Management spoke in its prepared remarks during the conference call about strength with the "new products in the portfolio, use cases and updates across our software-defined data center and mobility portfolios." We do know that hybrid cloud and SaaS rose to 7% of total revenues, although without any historical context. And we know that the important products in the group rose more than 20% year on year. We also know that the company's legacy flagship product, vSphere has dropped to less than 35% of bookings compared to greater than 50% 2 years ago. That is an encouraging sign. Many transitions that I have seen founder because the legacy product that is going down is just too large a fraction of the total for the new product to overcome. So, strange as it may seem, the decline in vSphere bookings as a proportion of the total is a good thing if you want to handicap the probability of success.
One of the key product offerings for the cloud at VMW is what is called NSX. NSX is not a car although you will see many cars if you bring up NSX on the web. NSX is part of VMW software-defined data center concept which offers cloud computing on VMWare's virtualization technology. NSX is perhaps furthest along of VMW's cloud solutions and has 1400 users and grew by 100% last quarter. 350 NSX sites are finally in production. Rather than recapitulating specifications that are readily available on the web, I will simply say that NSX is more than buzzword compliant and it has some advanced technologies that are more or less unique these days. If VMW's strategy is going to work, then NSX has to work. Last quarter, 8 of VMW's 10 largest deals included an NSX component. So far, it appears as though NSX it is working for VMW.
On the qualitative side of the equation, probably the most significant announcement was IBM's adoption of VCloud Air as part of its own hybrid cloud strategy. Partnerships in the software industry are creatures of the devil in terms of projections. They often break one's heart. But IBM, relative to VMW is a very big target for VCloud Air. Overall, VCloud Air's partnership business grew 25% in Q1.
I will just add some qualitative comments here. I think that many readers are aware that sexy and growthy as the public cloud is and will be, not every user is going to move all workloads to the public cloud immediately. Having a strategy and solution sets to manage use cases involving private, hybrid and public cloud makes an awful lot of sense for this company. Managing workloads on AWS and on Azure will be a significant proof point. I wrote an article regarding the prospects for RAX now that it is focusing on services and the management of public cloud infrastructure for clients. This is another company that is going down a similar path, but frankly with a higher software content and with a strategy that can address almost any user plans be they private, public or hybrid. The cloud opportunity is going to be overarching and will have lots of decent pockets. As an investor, I can't buy shares in AWS or in Azure. Even if I could, with growth rates of 70% and rising margins at scale, the valuations of such animals would be astronomic.
The only really pure cloud plays are the SaaS vendors and of course, they have different issues for investors. So a vendor that has the capability to benefit from the transition to cloud in a meaningful way with a company that has solutions for all of the ways that customers are implementing cloud seems to me to be optimal.
As mentioned above, the other crucial variable in evaluating the outlook for VMW is the potential revenue synergies that it can achieve. Of course, the transaction isn't complete and so there are few mileposts that one might see. Management spoke in qualitative terms about the opportunity with Dell. It mentioned something called VxRail which is an appliance to create hyper-converged infrastructure and software-defined networking based on VMware software and EMC hardware. Dell is already selling the VxRail on its website store where it will get far broader distribution than if were just sold by EMC. Just as an aside, the opportunity for next generation hyper-converged systems is in the billions of dollars to the extent that Dell can participate in that growth, selling VMW's product could have a visible impact on numbers and expectations.
On the call, management said that this kind of collaboration is part of the opportunity they see once the merger is complete. VMW CEO Pat Gelsinger said that VMW was spending a significant amount of time, "really grinding through the details of that. And we see some of those are starting to materialize…" It goes without saying that there is simply no way to even attempt to quantify the magnitude of revenue synergy opportunities.
How do you value a cloud transition story?
At the moment, VMW has an enterprise value of $18.6 billion with projected sales this year of $6.9 billion. That is an EV/S of 2.7X. That is surely a modest valuation metric to the extent that this company can transition to a growth status. The P/E based on current consensus estimates is 14.4 and as I wrote earlier the free cash flow yield is a bit over 4%. The real issue, at least in looking solely at the published estimates, is that analysts do not believe the transition story. There are 38 analysts covering this name and they are forecasting all of 4% growth in 2017. EPS growth forecasts are even more muted with a current year consensus of $4.05 followed by a forecast of $4.15 for 2017. Much of that conservatism is doubtless a product of past VMW transformations that never really happened. As recently as 2 years ago, VMW was trying to live on its first product which by that time was coming up on its 15th birthday. So analysts need to be convinced that this time is different.
Needless to say, with those kinds of forecasts, analyst ratings on this name are very muted. There have been no fewer than 9 downgrades and 1 upgrade in the past 6 months. Part of the reason for the strong performance of the shares is that most analysts were quite surprised, as much by management's tone on its call, as by actual Q1 performance. If the company really can achieve 10% bookings growth this year, in what is obviously a transition period, then expectations have to improve considerably. I do not expect that this company can ever again be a momentum growth story. If it only had to sell software used on the cloud, maybe it could get to that status again. But while having 35% of business coming from the company's initial product is good in the sense that is less than 50%, it is still 35% of revenues that will certainly not grow and will most likely decline gradually over time.
But I think that it is quite reasonable to think that over a 2-3 year span these shares can double with a growth rate in double digits and with rising margins. I think the balance of risks and rewards favors investors at this point.
A few closing themes!
VMW is a company in yet another transition. Will this time be different? My forecast is that it will. While the impact of issuing 223 million tracking shares to current EMC holders is not really clear in terms of the share price, there are other benefits from the merger.
Most important to me in my analysis of the company is its multi-pronged strategy to use its software to build cloud infrastructure from private to hybrid to public. There are some signs that the transition is starting to happen, but it has a long, long way to go. There have been some proof points in terms of revenue growth both for specific solutions and for the company's overall suite of cloud solutions. The company is forecasting bookings growth substantially above revenue growth. The total opportunity for what VMW is trying to do is clearly vast - users are going to need lots of help in their transitions and the way to do that is not by attempting to find web trained professionals of whom there are few but by outsourcing as much pain as possible to knowledgeable vendors.
VMW and the new Dell organization have some significant product and sales opportunities. If Dell wants to build a credible cloud presence, starting from as far back as it is, it is going to have to use VMW software to differentiate its offering. The VxRail, which Dell is already selling, is an example of the type of product collaboration that will happen. How Dell might market other, VMW technology that is just software is not known at this time.
There are almost no value stories in the cloud world at this point. This is probably as close as it will get if investors are looking for a cloud value story. And I think it is worth a look.
Disclosure: I/we 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.