Why Would Anyone Buy VMware?

What we do not understand we fear. This phenomenon applies to stocks with many "investors". People who will spend two hours deciding which shower curtain is the best value for money will buy a hot stock at the drop of the hat.

Last week, a friend of mine asked me whether he should buy VMware (VMW). My answer was an obvious no. He bought VMWare at 84 anyway. Here are his reasons:

1. All his friends bought this stock at 56 and he doesn't want to be left behind. Talk about peer pressure.

2. When told that VMware is overvalued, he parroted out "People said the same thing about Google (GOOG)." (He gave me a similar bizarre logic when I tried to stop him from participating in a ponzi scheme).

With investors like this in abundance, it's no wonder VMware, a company that could raise its earning to $100M after 10 years of operation, is currently valued at $31B. I will now tell you the reasons why VMW is overvalued.

1. Current earnings are 100M a year. The earnings rose about 125%, so we may assume that VMW will raise its earnings 100% for next 5 years and then 50% for another 5 years before being a victim of technology disruption. To make the calculation simpler and to show the ridiculousness of the valuation of VMW, even if we discard the discount factor, the sum of all the earnings based on the growth rate mentioned above comes out to be about $31B. That is equal to the current market valuation of the company. If we take the discount factor into account the value will come out to less than $25B. Considering this, do you think there is any chance of this stock increasing further? Sure, public enthusiasm may raise it in short term, but like Ben Graham said - "The stock market is a voting machine in short term and a weighing machine in long term". This stock is bound to come down.

2. People are buying VMW like there is no competition. Microsoft (MSFT) has a very strong product in the same technology area and if the virtualization sector really has as much meat as we are made to believe, then do you think Microsoft will not use its billions and its dominance in the OS market to destroy the competition? Google may have caught Microsoft napping but VMW does not even have that luxury. This argument takes care of "people said the same thing about Google" logic.

The main idea is that what we don't understand, we fear and this fear is the biggest enemy of an investor. This fear stops us from doing thorough analyses of the securities we buy. The moral of the story is - If you love your money, don't buy the stocks of a company whose business you don't understand. Find out what the company does, what the market is for its product, how the management is, how its books are (no one would have believed that corporate accounting would be the most most inventive industry in 21st century) and whether the market valuation right.

Disclosure: none

Comments

[Jane Sandow]

You talk about understanding VMW, but you don't seem to understand it very well.

> Microsoft has a very strong product in the same technology area

Microsoft has aged hosted products (Microsoft Virtual PC and Microsoft Virtual Server) that they inherited from their Connectix acquisition after they failed to acquire VMware. These products lag many years behind VMware's, because Microsoft hasn't updated them. They even pulled the plug on Virtual PC for Mac the same day VMware announced they were working on VMware Fusion for Mac.

Microsoft has a new hypervisor product (code named Viridian). It will ship in late '08 if everything goes well, and will be less capable than what VMware VI3 did several years ago. Like most Microsoft vaporware, you can expect the first few iterations of that software to be utter garbage.

Not to mention that Microsoft is currently extremely busy trying to deliver what they, as usual, over-promised, and which is much more critical to their revenue stream: Microsoft Vista.

VMW caught MSFT sleeping just like GOOG did. MSFT is falling apart. Am I predicting MSFT's death? No. Like IBM, MSFT will stay a force to reckon with, but it will lose its monopoly status.

[PrashanthCherukuri]

Totally agree. I think Seekingalpha should take a serious look at who's contributing to the website. This is a very narrow-minded, baseless and hollow critique.
Please do us a favor: visit Yahoo Finance , and in VMW's page, read Profile. See what the company does, what their qtrly growth is, and then you'll see you should delete your article.

[nhsrikanth1]

The author is ignorant of the extent of VMWare's leadership in the technology and the fact that the technology just hit critical mass. The growth rates could be higher than what the author considered as ridiculously high in his example.

Next, 85% of the stock is in the vaults of EMC, Cisco and Intel and they don't have any intention of selling out in the near term. The current float is extremely low and the shorts who felt it was overvalued at 60 would have a painful story to narrate.

Google WAS overvalued at $80 based on its then revenue and business. However, it used its IPO money and stock valuation prudently to acquire assets and advance position to achieve market dominance. What is to say VMW (with a strong backing of EMC) can't achieve the same.

EMC is grossly undervalued, least of which is to do with the value of VMW. EMC is the market leader in Network storage and with the market leading VMWare in its pocket, it is bound to increase its dominance. Its main competitors like Network Appliance do not have such synergy though it has similar PE.

Other competitors like Sun, Hitachi, IBM and HP as not core players in the Network space.

All of the above is my personal opionion. Do your own DD.

[xYike]

"Microsoft (MSFT) has a very strong product in the same technology area ... "

Wow, talk about not knowing what YOU are talking about!!! Microsoft has a very strong product in the same technology area? What is that exactly? I'm a MS fan but you are completely wrong here.

[SalilDeshpande]

"Microsoft (MSFT) has a very strong product in the same technology area ... "

Wow, talk about not knowing what YOU are talking about!!! Microsoft has a very strong product in the same technology area? What is that exactly? I'm a MS fan but you are completely wrong here.

[PrashanthCherukuri]

Totally agree. I think Seekingalpha should take a serious look at who's contributing to the website. This is a very narrow-minded, baseless and hollow critique.
Please do us a favor: visit Yahoo Finance , and in VMW's page, read Profile. See what the company does, what their qtrly growth is, and then you'll see you should delete your article.

[Brian29]

There is no way you can justify a 48 billion market cap for a company that should do around 1.2 billion in sales this year and maybe 2 billion in 2008. These same bogus valuations helped the nasdaq decline 80%. Good luck.

[HindsightRAM]

I saw this old article and looked back a little at what happened. Sure VMW climbed in value and then it dropped. But then again look at similar Tech markets, they all kinda tanked lately.

I blame the financial analysts, for the state of the IT markets. You know what a run on a bank is? Well most financial analysts are telling people to stay away from IT stocks. They say little chance of recovery in that area for at least 18 months. It may be true, but even if it isn't just saying this often enough to enough people, makes it happen.

I've started to hear more and more people talking about the problems that MSFT is having. If enough people continue to voice this, it will have the same effect. If this happens, the most attractive tech stocks, will most likely be VMW, GOOG and NOVL (If they could merge I would be happy, but not likely to happen). If you ask me why, I would answer they are the big players offering alternatives that will still integrate very well with Windows products.

I am by no means a Microsoft fan but I am impressed with how they can get out of major disasters with not loss of consumer confidence. Hotmail got hacked... no biggie. Someone broke in to the MSFT Exhange server and emailed everyone all MSFT usernames and passwords... no biggie. Vista... do I have to say anything else?

I am not sure I understand financial markets. It would strike me that a company making software, must be the toughest to assess. What are R&D costs,? How much are they selling their products? How many do they have to sell to break even, how many are they likely to sell? Oh yeah and is support free and what is it costing the company? Long story short it is a tough market to invest in. But if you know the technology and have a big mouth to make people believe in products you believe in, you should invest in those products... (for the long haul)

My BIG (mouth) dream... Have GOOG approach Sony and Nintendo, to make bootable SD device for their game consoles, that will run a GOOG thin client, to a Linux or JAVA based portable computer on the GOOG net running OpenOffice, FireFox and Thunderbird, etc. GOOG better do this before MSFT does this with the XBOX (For security reasons I am assuming MSFT may not want to go down that road). It would be a interesting way for Nintendo and Sony to say to MSFT, you came fishing in our backyard, we are going fishing in yours. It would really help the Linux cause too, maybe NOVL should get involved in brokering that deal. VMW could work on the thin client aspect... They should all merge...