Behind the Scenes at VMware

Reading through earnings releases from VMware, Inc. (VMW), it is easy to get excited about virtualization software and how the phenomenon is revolutionizing the way businesses manage their information systems.  On top of the glitzy technological issues, it also doesn’t hurt to have sales growing astronomically, and a stock price that is more than double the IPO price from last summer. 

Currently, there is very little direct competition to VMware’s products and the fact that both small and large companies can take advantage of the technology makes for a very broad potential customer base.  It’s no wonder analysts tend to love the stock, and projections keep getting revised higher.

In April the company announced earnings with revenues for the first quarter coming in at $438 million representing a 69% increase over last year.  The revenue was made up of both software licenses ($294 million) as well as subscription and professional service revenue which was $144 million.  Over time, the strategy is to grow the number of installed licenses so that the service revenue becomes a virtual annuity as the company maintains the installed base.

In addition to the $438 million in revenue, the company announced an increase of $88 million in its deferred revenue which is essentially revenue the company has received for service not yet performed.  The total is now $641 million which should help to stabilize future revenue as the company can draw on this balance during future periods.  In fact, a Credit Suisse analyst had an interesting theory stating that this quarter was helped significantly by the company drawing on this deferred revenue base instead of new business actually driving the strong revenue number.

As VMware grows and develops a broader client base, it has pulled in more international business.  In particular, management noted strength in Australia, Brazil, China and Russia.  For the quarter, nearly half of the revenue came in from overseas.  This has opened up currency issues as the company noted margin weakness due in part to the falling dollar.  Management noted that it would be very difficult and complicated to hedge foreign currency exposure.  As such, it seems investors will have to simply accept the fact that the unpredictable currency fluctuations will be part of the earnings picture in the future.

While most of the material I came across lauded the technology advances made by VMware, a few analysts began to poke holes in the investment thesis.  Credit Suisse has three main issues that could lead to a lower addressable market and theoretically a lower growth rate.  These issues are:

1. A secular shift to multi-core processors.  This means that many servers will be able to handle multiple applications without necessarily needing virtualization software.
2. Decreasing memory constraints.  As memory becomes cheaper and more available, it may become less important to use VMW’s software to add efficiency.
3. Potential change to “per server” licenses.  Changes in overall licensing processes may reduce the benefits of a virtual approach to server management.

In addition to a potentially shrinking market opportunity, Lehman noted the entrance of competitors into a market that VMW has held a virtual monopoly over up to this point.  As both Microsoft (MSFT) and Citrix (CTXS) launch competing products this year, it will likely cut into the established position VMW has cultivated.  While management talked a big game about not needing to reduce prices, this is simply part of the positioning game as it would be unwise to signal to clients that a potential price decrease is in the wind.  But once new entrants hit the market, there is a high probability that prices will decrease as the three companies compete for customers.

Finally, the stock price is more than 40 times estimates for 2009.  This is a high multiple even for the technology industry, especially considering that the consensus earnings numbers are likely to be a bit aggressive.  The stock has bounced from its low and has likely set up a good short entry below $70.00.  The overall market will have a good bit of influence on the short-term direction as the name is a fairly popular technology investment.  However over the long-term it seems the potential is good for the stock to trade lower and fall more in-line with earnings levels.

VMW notes

FD: Author does not have a position in VMW.

Comments

[dpinvest:]

Author cites stats for bullish case. But no stats for short sale case. Citing competition from MSFT & Citrix from as yet unreleased products is pure speculation - and as we all know, MSFT has stumbled mightily trying to compete with GOOG & others. Plus VMW has a 7-year head start & is being used by ALL of the top S&P 100 companies, which all in process of expending their use of VMW products. Author says 40x 2009 earnings is "too high, even for tech" - well, it's not too high when your earnings growth rate is higher than your PE, thus a PEG of below 1. In fact, the best techs often trade at PEGs above 1 because people love good companies who are more likely to sustain earnings growth. Add to this most important fact that companies today , as always are looking to save time & bmoney, every VMW purchase reduces corporate costs & use of their valuable time.

2008 May 29 09:34 AM

[ChannelVirt...:]

Altough CTX and MSFT are not evaluated in this article, I believe that the comments bij 'dpinvest' are a lit over the top. Both competitors have indeed newer products in which VMware might have a headstart, yet both also have products in which VMware is only stepping into and in which VMware does not have a headstart (I refer to Thinapp, ...). Furthermore referencing that all of the Top S&P100 companies run on VMware is also 'bullish', the complete S&P100 comapnies also run on MSFT and on CTX.

There will be probably a price decrease of the products which will result in lower margin and lower profitability. The market will stabilize in the following years with the 3 major players remaining.

2008 May 29 04:34 PM

[Paul Milligan:]

As a technologist rather than an investment analyst it is important to note that VMware is considered a mature proven product whereas Xen is proven but immature and Hyper-V is a new entrant. Corporate IT users don't like products less than 2-3 years old (particularly from MSFT -there's an unwritten rule -wait for SP1 (typically release +2-3 years)).

Xen is not just backed by CTX but also SUNW, NOVL, RHT and ORCL and is thus will gain traction in each of these customer sectors. However the fragmentation implicit in this will impact the emergence of a single strong competitor for VMW.

VMW also has a wider range of products but seems to lack a strategy to monetise its SME product VMware Server.

2008 May 30 06:08 AM