VMware (NYSE:VMW) reported the results of its Q2 operations on July 18, 2016. I recently wrote an article regarding VMW's outlook within the context of the just approved deal through which Dell is acquiring EMC (EMC). Most of that article was centered on the alternatives facing investors in terms of acquiring EMC with the expectation of receiving .11 shares of a VMW tracking stock. It presents a very low cost way of acquiring VMW shares at the expense of tying up some capital at zero return for the next couple of months until the merger is finalized.
I commented at that point that I did not see that there were any huge benefits for VMW in the new structure. So far, as this writer is concerned, anything that the Dell relationship adds to the picture will be lagniappe. In this last conference call, CEO Pat Gelsinger said that the Dell relationship is seeing some traction and that there were a number of high profile wins in which Dell had resold VMW solutions. It is a nice straw, but straw is all it is, as the overall numbers for the quarter were just a modest beat. The case to own VMW shares ought to have very little to do with the potential benefits that the company might reap from the Dell relationship in the wake of the merger.
This article will focus on the company's operating results and the upside surprise the company printed. The shares appreciated by 9% yesterday. There is more than a bit of healthy skepticism regarding the shares. No analyst raised their rating and the average rating below the midpoint of buy/hold is quite modest and less than the average, although many raised their price target modestly. There have been no upgrades since last October and that one was a real outlier in a sea of downgrades.
The shares have appreciated 19% since the trough they reached in the wake of the company's disappointing Q3 earnings release last October. Over the same span, the IGV software index has appreciated by almost 9%. Over the past week, VMW shares have appreciated almost 14% compared to no change for the IGV index.
One obvious question has to be whether appreciation the last two days has taken away much of the potential positive alpha. The other questions regard the handicapping of future prospects based on the company's multiple pivots.
The shares remain cheap. They were up 9% Wednesday and that brought EV/S to 3.2X. The P/E on the consensus estimates for 2016 of the 32 analysts who publish is 15.9X and it has a 15X P/E on next year's consensus estimates. Operating cash flow jumped by 82% year on year last quarter and a significant amount of the improvement was driven by the change in deferred revenues (unearned revenues), which more than doubled year on year. The growth in stock-based comp was not inconsequential (23.5% year on year). Stock-based comp represents 26% of operating cash flow and represented 30% of reported non-GAAP EPS. CapEx is relatively minor for VMW and actually declined year on year and is projected to decline for the full year. The growth in free cash flow reached 120% compared to the comparable quarter of 2015.
The real issue remains the question of growth. The consensus forecast for top line growth is 5% this year and a bit less in 2017. Analysts are more than a bit skeptical that the company will grow more than marginally, and currently, the consensus price target of 23 reporting analysts is $70. Management actually raised guidance in conjunction with this earnings release and regardless of any Brexit impact.
Analysts simply are dubious with regards to management's forecast. Is that quite reasonable? The shares dropped sharply at the time earnings were released last October. It is hard to say the drop was based on operating performance. Most of the drop appeared to be tied to confusion regarding the structure of the Dell/EMC/VMW organization. The earnings and guidance for that Q3 were at least in line, if not a small beat. In the following two weeks, however, the shares lost 37% of their value. The December release may have been a bit more ambiguous in that forward guidance was less than the consensus at the time and the market was cratering. In any event, the shares lost 10% of their value in a few days before making a low for the year.
The company hasn't achieved a full-fledged "blow-out" quarter in some while, but I think that analyst expectations have generally been fulfilled and that the share price valuation has suffered more than might be warranted by the company's operating performance. VMW is a company in transition from selling desk top virtualization to a company selling far broader virtualization solutions with an emphasis on its private/hybrid cloud strategy. As detailed below, that strategy certainly has the potential to return VMW to rapid growth and indications as to its ultimate success are positive. The path to the Elysian Fields is rarely as straightforward as many observers and investors want to believe.
Revenue growth in the quarter was consistent with the growth reported in the past several quarters. Overall, revenue growth in the quarter was 6%. Service growth was 9.3% for the period. (I've have excluded the cost of the GSA settlement from my calculations as it was a one-time event.) Given the strong growth of deferred revenues, the metric that most people call bookings grew by 10% in constant currency and excluding the GSA settlement. The sequential growth in license was 12.5% essentially equivalent to the sequential growth in reported license revenue in the prior year.
The company increased its GAAP operating margins significantly. Overall, GAAP margins reached 19% compared to 13.5% in the 2015 period. The improvement was broad based. In particular, the sales and marketing expense ratio fell from 37% to 34% while the G&A expense ratio fell from 12% to 10%.
VM and its cash flow - what to do with all of that stream of cash
The investment case for this company is all about future growth. Margins can improve, there is still plenty of operating leverage available. And the company has a huge level of cash resources available should it wish to make acquisitions… or heaven forefend, it could even pay a dividend. Free cash flow for the first 6 months of this year has reached more than $1.2 billion, so the company's cash return program is such that cash is likely to continue to build up from levels that are already far beyond conceivable needs. The company's cash balance of $8.6 billion is more than half of assets, and the only significant use of cash would be the growth in receivable balances, should the company's revenues start to grow significantly. An additional 30% of assets are goodwill and intangibles.
VMW has not made any substantial acquisitions in the last couple of years which is unusual for a software company of its size. Its last significant acquisition was at the start of 2014 when it acquired a company called AirWatch for $1.54 billion. AirWatch was one of the numberless mobile device management companies that flourished in the early part of this decade and was ultimately consolidated. It seems to have been reasonably successful in its current incarnation as the foundation technology for VCloud Air Network.
AirWatch itself has divested a component of its offering that has been referred to as Wandering Wi-Fi, but it has been growing overall at double-digit rates. It has been less successful in terms of its English diction creations… hybridity is not an English word nor should it ever be, but I suppose one of the penalties of covering the tech sector is dealing with marketing messages that are based on jargon. Most recently, VMW bought a company called Arkin Net that had been founded a few years ago by a former VMW veteran, Shiv Agarwal.
Arkin Net is designed to fit in with VMW's NSX solutions that were part of its Nicara acquisition. NSX is one of the key foundations of VMW's growth strategy as part of a concept known as software defined data centers (SDDCs) that allow users to reconfigure their network and reroute traffic on the fly in order to optimize the productivity of their server base. NSX is a virtualization engine that allow users to get more applications onto fewer servers and manage the traffic versus software and not manually.
My guess is that after the merger between Dell and EMC is completed and after the potential retirement of CEO Pat Gelsinger takes place - if indeed the rumors of his departure prove to be accurate - VMW will do something to modify its capital structure or to acquire operating assets. Accelerated share repurchase is conceivable, cash dividends are also possible although I wonder how that would work out for holders of the new Class V tracking shares, but it seems most likely that VMW will be able to acquire companies that fill in specific product holes in the company's strategy.
VMW growth strategy - what it is and how it is faring
It is somewhat hard to think of VMW as an "old" software company, but it really is. It was founded in 1998, and it was acquired by EMC in 2004. EMC sold off 15% of the firm in a public offering in 2007 and it exists in that condition currently. Although there is to be some restructuring of the ownership positions within the new Dell/Denali, it means very little to current VMW holders, and has been well detailed by both this writer and elsewhere. Dell/Denali will control VMware in the future as EMC controlled it in the past. There will be both public holders of VMW, and a class of VMW tracking shares that reflect the economic performance of VMW and nothing else.
VMW was founded to sell desktop virtualization software, which was a hot product area at that time. These products are now in their sunset years, and in a somewhat controversial move, the company dismissed several hundred developers who had been creating new desktop releases on a regular basis.
VMW still gets 30% of its business from standalone vSphere. The first part of the company's growth strategy has been to substantially reduce its dependence of vSphere as well as the host of solutions it describes as "compute" technology, and concentrate its resources on the balance of its products. But one of the larger risks for growth in this company is the rapidity with which its vSphere revenues decline. Forecasts are hard enough when they simply concern the future; they are harder still when they concern the time it takes for a declining technology to reach asymptotes.
VMW has developed a suite of virtualization solutions for the enterprise as well as a strategy for the hybrid cloud. These strategies have seen rapid growth, albeit from low revenue bases.
VMW has a competitive solution in what is called the hyper-converged storage (HCS) space which is one of the faster growing, if not the fastest growing trends in the technology space. VMW basically goes to market with a physical device manufactured by a division of EMC called VCE or the Virtual Computing Environment Co. VMW is seeing 200%/yr. growth in revenues from this space which is not all that surprising given that over time, hyper-converged will replace the storage architecture that has come before.
While revenues in the "converged" storage market are growing at around 8%/year according to the latest data from IDC, hyper-converged and software defined storage ((SDS)) technology is rapidly replacing disc-based legacy products. HCS are cheaper, they have better performance, and they are more reliable. It is not any wonder that the storage world is being turned upside down by the technology and at some high level, it is part of the strategic vision and perhaps the central justification of the Dell/EMC transaction.
Gartner says the market for HCS grew by 79% last year to $2 billion. Gartner being Gartner, it says that one segment of the HCS market will reach $5 billion in revenue by 2019, and that will be 24% of the total. So, basically the HCS market is to grow by 10X in 4 years as it starts to sweep away everything in its path. The major independent competitor in the HCIU market is a private company named Nutanix which may go public at some point this year if the IPO market conditions are favorable. But at this point, the joint venture of EMC and VMware called VCE has taken over the leadership role in the race and with 200% growth, it is going to be hard to catch. Nutanix now has $400 million in revenue run rate suggesting that the revenue run rate for EMC/VMW/Dell in the space is probably at or above $500 million. On the call, CEO Gelsinger reported that Virtual SAN deployments increased from 3500 customers to 5000 in just the last quarter.
NSX is another of the company's new flagship offerings and probably will emerge as the company's largest growth driver and perhaps as the company's largest revenue generator in absolute terms over a period of time. NSX is an offering that essentially moves networking to software. Without going through the technology - which I would be unable to do at any significant level of detail in any event - the concepts are based on something called Micro-segmentation that allows you to move workloads seamlessly from one virtual machine to another in literally minutes and it cuts the time users need to provision their networks from weeks to seconds. The market size for what is described as Software Defined Networking is estimated to be worth over $12 billion by 2020 which gives the VMW product family lots of runway to grow. IDC is projecting the CAGR of the space to be more than 50% over the next several years. The major competitor in the space is Cisco's (NASDAQ:CSCO) ACI architecture, and of course there are more than a few other vendors including Juniper, (NYSE:JNPR) Hewlett Packard (NYSE:HPE) and other legacy networking vendors competing in the space.
VMW's NSX continues to achieve triple-digit growth and now has 1700 customers. There has been a tendency for users to buy both hyper-converged storage along with a software defined network as part of a complete package of solutions and this, in time, will be a significant market opportunity for VMW.
I do not propose to try to elaborate on the competitive positioning of all of the vendors trying to sell into either the two large hot markets in which VMW is a leader or to comment in any detail on the company's other growth markets. And I am not going to try to elaborate on all of the high growth markets in which VMW is established or is building capabilities. VMW has a leading position in cloud management and in data center automation. The cloud management offering is based on something called the Photon platform and the VMware vSphere integrated containers. VMW has partnerships with IBM (NYSE:IBM) as well as other vendors to offer something with the simply dreadful name of the vCloud Air Network that facilitate the use of VM technology to take workloads into private, public and hybrid clouds.
I think that the investor takeaway from this discussion is that VMW has market leading positions in what are arguably some of the hottest spaces in IT at this time.
Just to reemphasize - and with malice aforethought as the expression goes - there is probably nothing hotter in the IT firmament in the middle of 2016 than what can only be described as tsunami of adoption of hyper-converged infrastructure for storage. And other than some of the unfortunate names such as VxRail, Virtual SAN and vCenter Server, VMW and its partners are clearly the leading vendors in the space.
Analysts have complained for some time that VMW provides only the most minimal and marginally useful quantification as to the revenue impact of its new technologies. And outsiders do not really know with precision the revenue splits between Dell, EMC and VMW in selling the parts and pieces that make up an HCIU from those companies. CFO Zane Rowe, appointed earlier this year, discussed some primitive metrics on the contribution of these products, but the company has a long way to go before it is providing complete disclosure.
The issue of growth for VMW is not that of TAM and so far as it goes, it doesn't seem to be a function of execution at this point, it is really the timing of the transition from legacy stand-alone virtualization software which VMW calls compute licenses to some of the newer offerings. Compute software solutions are now less than half of the company's total bookings and declined less than expected last quarter in the low-single digits. It ought to be apparent that VMW shares are not priced for any, but the most modest growth - perhaps because there hasn't been but the most modest growth for a couple of years. But unlike some other transitional companies, the math regarding this transition is potentially far more favorable and could lead to far greater growth and earnings than seems to be baked into investor expectations at this point.
I think that the VMW growth strategy is faring about as well as anyone might expect at this point, and it is probably one of the more under-appreciated opportunities in the IT world.
Taking a bit more of a look at valuation, both absolute and relative!
I do not think there is some magic formula regarding valuation. Yes, Graham and Dodd is required reading, and I suppose over a long enough time period, the axioms in that treatise will win out. But quantification like all Gods has both its good days and its bad days. When I try to address valuation, I know I have to start by thinking about style as much as about numbers. Investors, even institutional investors have visceral likes and dislikes when it comes to stocks and the degree to which anthropomorphism can be taken never ceases to amaze this writer. Investors, at some level either believe the consensus or they find it absurdly misbegotten. Investors may or may not believe management guidance mainly based on past records. There are often elements of ennui that make up valuation for companies in the tech space.
A few years ago, when Apple first debuted Siri in the fall of 2011, many investors were enthused about Nuance (NASDAQ:NUAN) because it was the Nuance natural language software that powered the breakthrough part of the Siri application. Of course, the fact that Nuance was getting paid a fixed price on a consulting contract to implement Siri and would not get any ratable payments based on the acceptance of that iPhone version mattered little. Siri was in style, Nuance was in style, and the shares at that point were valued at levels they have yet to approach again.
Virtualization has gone through similar phases. Virtualization is so widely accepted these days that it is hard to remember just how impressive investors considered the potential of the technology to be when VMW initially went public almost a decade ago. But just because desktop virtualization is no longer enjoying growth doesn't mean that virtualization as a concept hasn't loads of growth opportunities.
To a greater or lesser extent, it is my view that VMW shares are suffering from ennui as investors and analysts wait for the good parts of the outlook to finally overtake the declining parts of this company's business. That is both the opportunity and the potential value trap.
As mentioned earlier, on most relative scales, VMW shares are in the category of some growth at a reasonable price. EV/S of 3X or so on 2016 estimates. P/E of 16X current year estimates. This company does forecast free cash flow, removing a difficult task from analysts who often have little to work with in projecting that metric. The operating cash flow being forecast by the company is $2.3 billion and the free cash flow forecast is $2.15 billion. That is a free cash flow yield of 9.6%. 9.6% is one of the higher free cash flow yields that investors might find in the IT space and suggest that this company has an extraordinary range of opportunities to reward investors, either directly through accelerated capital return or through the acquisition of strategic partners who might enhance the growth rate significantly. A free cash flow yield of that magnitude coupled with moderate growth would be enough to support a strong purchase recommendation that would be far different than the manifest skepticism embodied in the consensus recommendation and consensus price target.
The share price valuation is reasonable on current numbers. It becomes a table pounding buy if the growth perspectives that already exist start to overwhelm the declining numbers from the company's legacy business. That seems likely given the company's market position in the rapid-growth areas and the fact that the slow growth revenue piece of this company has slipped to less than half. There ought to be a clear inflection quarter when all the stars align and growth sharply accelerated. But I would be loath to attempt to make that a specific forecast in my investment outlook for these shares.
Buy the shares now for their value and their modest growth and hope to be surprised by a nice dollop of lagniappe when the high growth areas start to move the bookings and license growth needles.
- VMW reported its operating results for Q2 after the market closed on Monday, July 18th. Results were a modest beat on both revenues and EPS and bookings growth accelerated as well.
- The company is in the midst of a product transition. Its new offerings have market leading positions in some exceptionally high-growth market segments.
- The company is, along with its partners, EMC and Dell, the market leader in the hyper-converged storage space, perhaps the hottest area of all in the enterprise information technology space.
- The company is a market leader in software define networking where it competes against many legacy vendors including Cisco.
- The company has a well developed cloud strategy to facilitate user migration to private and hybrid clouds.
- The company has a very healthy balance sheet and has huge cash generating capacity with a very high free cash flow yield.
- The company is not well loved by analysts who are skeptical that VMW will ever achieve the potential inherent in its new offerings.
- The company will have two classes of shares outstanding in the wake of the impending merger between EMC and Dell. It is possible that investors have held back on commitments to VMW shares until the merger is consummated and issues of governance become more clear.
VMW shares represent a reasonable investment at current share prices. When and if the decline in its older technology moderates - as was the case last quarter - and when the new contribution from the new products of the company have a more visible impact on reported financial metrics, the shares have strong upside.
Disclosure: I am/we are long VMW.
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.