A Creative Way to Own VMWare

Includes: DVMT, VMW
by: Zachary Scheidt

Due to a couple of requests by readers, I have spent some time this weekend looking at VMWare (NYSE:VMW). Some may recall a piece by Zachstocks on (EMC) back in September shortly after VMW was spun off from the parent company. VMW has now had time to work through some volatility and develop a trading pattern of its own. According to daily graphs, it has outperformed 95% of stocks listed on the US exchanges which speaks volumes about the amount of demand for the stock.

Fundamentally, VMW looks very sound. The company operates in the server virtualization space with a suite of products aimed at helping IT departments make more efficient use of their servers. The current industry practice is for companies to use a separate server for each application run by the company. This typically results in companies utilizing 10-15% of their server capacity but is seen as necessary in order to ensure a standard of quality for employees running these applications. VMW’s suite allows companies to run multiple applications on each server and has the desired effect of increasing capacity utilization to a level near 80%. Since servers are so costly to obtain and more so to maintain, a reduction in the number of servers greatly improves the economics of most any company’s IT department.

In essence, the purchase price of VMW’s licenses are dwarfed by the long-term cost savings a company will enjoy upon deploying the service. VMW licenses are attractive for growing companies because the license costs are fixed and perpetual. This means no additional costs once the system is installed but the savings are realized from month to month. This revenue model can be a bit disconcerting to VMW investors because it creates a less predictable cash flow stream, but as the industry expands and companies become more comfortable with the technology, revenue from new clients or expanding projects should provide strong long-term growth.

While claims of cost control are easier said than done, VMW appears to have passed the test of time and has landed an impressive stable of clients. William Blair research claims that each of the Fortune 100 companies use VMW products to some degree and the company has roughly 20,000 clients. This equates to a market share in the neighborhood of 80-85% but lest investors worry about market saturation, WMB points out that the overall target market is expanding and 48% revenue growth over the next 2 years is still expected.

Despite the incredible growth and strong margins, the stock is a bit difficult to justify because of its high multiple. No matter what metric is applied to the company, the results come back stating that the stock is trading at a premium to what is expected. This probably reflects investors confidence in VMW’s ability to grow, but it also poses a risk in that any mis-step or glitch in the next few quarters could trigger a sharp sell-off as optimistic investors become jaded. While I like the stock and feel it is trading in a healthy pattern, I am not willing to own it outright without some sort of hedge to protect against some losses.

There is a creative way to set up a “virtual position” in the shares by owning parent company EMC. At this point, EMC owns 85% of the economic value of VMW through a mix of class A and class B shares. The math works out to each share of EMC owning 0.155 shares of VMW. With VMW’s closing price of 80.55 from Friday, EMC’s ownership equates to $12.50 per EMC share in VMW ownership. This means that the rest of EMC is actually only being valued at $4.20 which may be an exceptional value. So it appears that the best way to own VMW may be to purchase EMC, which gives an investor a bit of diversification while still participating in successes from VMW. The trend is not attractive, so this would only be a good play for a long-term patient investor, but the risk still seems a bit more attractive than owning VMW outright.

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