VMware Still Has Significant Upside Potential

| About: VMware, Inc. (VMW)
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Summary

VMware shares have outperformed the market by a wide margin over the last five years.

The company's shares have, however, lagged the market this year as investors become skeptical about the company's future growth prospects.

VMware has been launching new products which, coupled with the company's healthy share buyback program and a possible spinoff from parent company EMC, can support a significantly higher share price.

VMware (NYSE: VMW) has been a stellar performer over the last five years. Its shares have easily outclassed those of its parent company, EMC (NYSE: EMC). Whereas EMC's shares have been in lockstep with the S&P 500 over the last 5 years gaining about 97% vs. 95% gains for the S&P 500, VMware shares have tucked on gains in excess of 220% over a similar timespan.

Year-to-date, however, VMware shares seem to have lost their Midas touch, barely managing to gain 10%, while the S&P 500 managed to crank out 11.86%. It would appear that VMware is running out of growth drivers and investors are a bit pessimistic about its future prospects. But, I don't believe that VMware is anywhere near running out of gas. Here are some bullish drivers for VMware.

New Product Launches

Any ardent follower of VMware will tell you that it's been a long time since the king of virtualization software launched as many new products and services on tap as it has done this time. For instance:

  • VMware started selling its own software-defined storage, vSAN, in the first-quarter of 2014, and has already managed to garner more than 300 customers. VMware has traditionally relied on storage solutions by EMC. EMC has ViPR, which seems to be a mirror image of vSAN since both provide hyper-converged storage. ViPR appears to be a better fit for customers who prefer external storage, a market that has continued to decline in the high single digits every quarter. Meanwhile, vSAN is a real monster - the product can support 32 nodes each with 100 virtual machines, giving it a capacity of 4.4 Petabytes of storage and 2M IOPS (100% read). That's more than enough for all but the largest enterprises. VMware's hyper-converged solution represents the direction that the hyper-converged market is likely to move in the future. VMware-centric IT shops looking for hyper-converged storage are very likely to quickly adopt it. That's good news for VMware since the company is still the undisputed leader in the server virtualization space with 64.1% market share, close to five times that of its closest rival Microsoft's (NASDAQ: MSFT) Hyper-V with 13.2%, despite having conceded some market share over the last three years. VMware can now do much of its own heavy lifting without having to depend on EMC.
  • VMware announced a joint venture with Softbank, a leading Japanese telecom in July. This was VMware's first vCloud hybrid cloud solution in Asia and will be available to Far East customers as well during the current quarter.

Creating Shareholder Value: Potential Spinoff

VMware has been joined at the hip with EMC since 2004 when the storage giant bought it out for $625 million. Activist investor Elliott Management has been agitating for a break-off. EMC partly spun-off VMware and still retains a huge 80% stake in the company. Elliott has been arguing that this is the reason why EMC shares have been badly lagging those of its more vibrant brethren. EMC is a stodgy value stock while VMware is a rapidly growing and innovative company. But that's just part of the story. EMC has been badly lagging VMware on many key growth metrics for the last five years including revenue (69.12% growth for EMC vs. 189.5% growth for VMware); FCF (92.26% growth for EMC vs. 186.6% growth for VMware).

Many studies have shown that corporate spinoffs more often than not create significant shareholder value. Spinning off VMware, however unlikely it appears to be, would create significant value for both companies. Corporate spinoffs are known to be one of the most effective ways to create shareholder value. A good case in point is the spinoff of TripAdvisor (TRIP) by Expedia (NYSE: EXPE) in 2011. Shares of both companies have outperformed the market by a wide margin. The same case applies to Fortune Brand Home & Security (NYSE: FBHS) which was spun off Beam (NYSE: BEAM) in 2011. Shares of both companies have also beaten the market by a healthy margin.

Not all spinoffs are so gilt-edged of course, and there have been a few failures, notably the spinoff of ADT (NYSE: ADT) from Tyco International (NYSE: TYC) in 2012. ADT shares have underperformed both the S&P 500 and those of its parent company by quite a margin.

Several analysts have suggested that EMC would likely receive a 30% premium on VMware shares in the event of a spinoff on top of the $34 billion it would receive for its stake in the company. The estimate seems to be in the ballparks. That's a great return on a $625 million investment held for just a decade.

Meanwhile, VMware shares would rise by at least the premium margin if EMC confirms that it's indeed looking for a buyer, going by recent spinoffs. But the real gains would be made in the next 2-3 years.

Share Buybacks

Not all activist investors who agitate for a corporate breakup succeed in their mission. But they at least do succeed in other ways, albeit indirectly. Carl Icahn famously failed in his attempts to breakup eBay (NASDAQ: EBAY) and PayPal. eBay, however, massively increased its share buybacks from about $200 million in 2013 to $1.8 billion in the current fiscal year.

The same thing is happening at VMware. VMware has for the last four quarters been using share buybacks a lot to prop up its share price. VMware buybacks have generally spiked when its share price dragged and ebbed when it raced higher. The company seems to have jacked its buybacks considerably in the current year. VMware authorized $700 million in share buybacks to be executed over the next 18 months. Mind you this is to be spent on top of what the company had left over from the previous $250 million authorization. VMware followed that up with another $1 billion buyback authorization to be complete by 2016. By the time the company exhausts this order, its share count will be down by more than 2%. Share buybacks are considered to be truly effective when a company buys back 5% or more of its shares over a given period so VMware will still be short of this target. But at least it's moving in the right direction.

Of course this could also be a case of VMware using its cash assets badly by throwing good money to support a falling stock. The buybacks will use up almost 50% of its cash hoard. In its defense, the company's management does not have a history of profligacy so it probably believes that it will get a good return on its investment, in the form of significantly higher share prices.

In another article, we will look at what would happen if EMC takes a 180-degree turnaround from what most people expect and fully reunites with, instead of spins-off, VMware.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.