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 their 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:
- A Secular shift to multi-core processors. This means that many servers will be able to handle multiple applications without necessarily needing virtualization software.
- Decreasing memory constraints. As memory becomes cheaper and more available, it may become less important to use VMW’s software to add efficiency.
- 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 and Citrix 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.
FD: Author does not have a position in VMW
Additional Reading:
Andrew Horowitz – Bearish on VMW
VMware, Inc. (VMW) – Behind the Scenes air sports
May 29th, 2008 at 4:51 pm
in these cases, you may be better of studying sales per share, and gross profit %, gross profit per share, because the company is not managing for GAAP earnings. That said the price to annualized sales ratio exceeding 10x might be bad news.
May 29th, 2008 at 6:40 pm
There may be other reasons why the market may not grow quickly, like budget constraints in the major world economies slip into recession, but not the one’s Credit Suisse gave.
Computers have been able to run multiple applications for years. The key benefit of virtualization is that it enables you to isolate applications running on the same machine. So if the application has a bug that brings the machine down, you only lose that VM that is running that app, not the whole machine.
Cheaper memory is probably why you will want to virtualize. Most apps
are not bound by the CPU, so this mean running 20 isolated apps on one machine makes a lot of sense, as you can save a lot of power and real-estate and man-power.
The ROI on virtualization is reduced power consumption, real-estate, man-power and physical hardware, not on bilking software vendors.