Seeking Alpha
Recommended for you:
Long/short equity, deep value, value, special situations
Profile| Send Message|
( followers)  

We have been following EMC Corporation (NYSE:EMC) for the longest time since EMC is the largest and most well-known IT company in the Boston, MA area. EMC is located in the Boston suburb of Hopkinton, and one of our analysts worked next door to EMC's Westborough office. The operation within EMC that accounts for 57% of EMC's market capitalization is EMC's 80% stake in VMWare, Incorporated (NYSE:VMW). The reason why VMWare accounts for so much of EMC's market cap even though it accounts for only 20% of EMC's revenue is because VMWare is focused on the fast growing IT virtualization software and solutions segment and could be considered a "cloud-computing play." VMWare was founded in 1998 and is headquartered in Palo Alto, CA. It was acquired by EMC in 2004 for $625M and EMC floated 10% of VMWare's shares in an IPO in August 2007. VMW's shares went from $29 at its IPO to $125.25 in October 2007 before declining to $17.25 in November 2008. VMWare's shares have since recovered and reached a near-time high of $118.79 in April before easing back to $85 at the end of October. VMWare also recently hired Jonathan Chadwick away from Skype by way of McAfee and Cisco Systems (NASDAQ:CSCO) to serve as its first CFO.

Sources: VMWare's acquisition news release and VMWare's 2012 Proxy Statement

VMWare's Q3 2012 results were a bit of a mixed bag. On one hand, the company had posted 29% revenue growth in its Services revenue as well as a 33% increase in its gross margin dollars from services. On the other hand, License revenue only grew by 11% and its licenses gross margin % eased downward by nearly 2%. On one hand, the company's total revenue increased by 20% year-over-year. On the other hand, three of its expense categories grew at a faster rate than revenue, one grew at a similar rate to revenue and only one grew at a slower rate than revenue. However, we have taken note that the fact that company's expenses grew at a faster rate than its revenue was due to increased equity-based compensation expenses. Equity-based compensation expenses grew by nearly 50% year-over-year and if we take these expenses out of VMWare's total expenses, we see that VMWare's operating expenses increased at roughly the same rate as revenue.


Source: VMWare's Q3 2012 Report

In the Q3 2012 period, VMWare's revenue faced a 2% headwind from the strong U.S. dollar. The company had $4.4B in liquidity as of the end of the quarter and completed the $1.26B acquisition of Nicira. Nicira is similar to VMWare in that both companies operated in stealth mode for a while and Nicira is a networking start-up that has sought to do to networks what VMware has done to computers. VMWare is predicting Q4 revenue of $1.26B-$1.29B, which will result in annual revenue of $4.572B-$4.602B for 2012. This will represent growth of 18.9%-21.7% for Q4 2012 revenue versus Q4 2011 revenue and its 2012 annual projected revenue is expected to register 21.4%-22.2% growth versus FY 2011 levels.

EMC is not the only respected institution that owns a significant piece of VMWare. According to Morningstar Direct, Cisco Systems owns 6.5M shares of VMW, which represents a 1.5% stake in the company and is worth $552.6M. Artisan Partners has 2.4M shares, Marsico Capital Management has 3M shares and Criterion Capital Management has 1.28M.

In conclusion, because VMWare is off nearly 30% relative to its near-term highs and because the company's elevated expenses were due to equity-based compensation expenses, we believe that investors should take a second look at the company. Based on the softness in VMWare's stock price, we believe that might serve as a tailwind for VMWare's profits next year. While we would hesitate at entering into a long position ourselves and coming out and suggesting it to investors based on its PE of 37X its expected adjusted 2013 EPS, we believe that investors should approach the company carefully and wait for a perfect pitch before going long on VMWare or its peers.

Source: Morningstar Direct

Source: VMware: EMC's Engine Of Growth

Additional disclosure: This article was written by an analyst at Saibus Research. Saibus Research has not received compensation directly or indirectly for expressing the recommendation in this article. We have no business relationship with any company whose stock is mentioned in this article. Under no circumstances must this report be considered an offer to buy, sell, subscribe for or trade securities or other instruments.