2008 has been a brutal year for shareholders of VMware, Inc. (VMW).  The stock has declined from a high above $120 to a recent low at $17.25.  ZachStocks has been cautious on the name for some time now and unfortunately even at this lower price, the invesement picture is not much better.  The stock still trades at a multiple of roughly 25 times earnings and those expected earnings are becoming less and less clear.

Morgan Stanly issued a very interesting “sell” recommendation on the stock in November.  Now, I don’t always put too much credence in recommendations from brokerages, but since sell ratings are so rare, I thought it worth a look.  Upon further review, there were some very interesting red flags raised that indicate caution is still important with this name.

For starters, Morgan believes that VMW will have a difficult time meeting fourth quarter revenue numbers.  As early as November the “channel checks” that analysts do suggested weakness in the sector.  The company has been pushing their Enterprise License Agreements (ELA) which requires a much bigger decision from customers.  While these agreements are more profitable (because they usually cover a broad range of services), the lead time for making such a decision is becoming longer.  This is a direct reflection of the state of the economy and companies’ reluctance to commit much capital if avoidable.

Management appears to be speaking out of both sides of the mouth as mixed messages were given in the most recent earnings release.  The first qualitative statement expressed confidence as customers were said to have a need to do “more with less” implying that even with global recession, customers were being driven to VMW’s products as a cost saving measure.  However, further down in the report when it came time to give guidance, the release said “Current uncertainty in global economic conditions makes it particularly difficult to predict product demand.”  So it sounds like there may be more weakness than we have been led to believe.

Getting back to the Morgan Stanley report, the analyst expects headcount to weigh on profitability in the first half of 2009.  At the end of 2008, headcount will be 31% higher than the previous year and operating expenses will have grown a potential 43%.  For a company that is having trouble estimating demand for their products, these rising expenses are alarming.

Finally, there have been some questions raised as to the company’s treatment of R&D Expenses.  It appears that software development expenses have been capitalized which is a bit of an aggressive accounting tactic.  Essentially, the company is deciding to spread the expense of developing the software out over the course of the useful life of the product.  The more conservative alternative would be to take the expenses as they occur but that would make earnings look much lighter.  So at this point, earnings are being propped up by this accounting technicality.  As a comparison, the Morgan Stanley report states that competitors have typically used a more conservative approach.

So there are enough points of concern and the stock is still expensive enough to warrant caution.  For aggressive traders, I think the recent lift in the stock gives an opportunity to short and I certainly wouldn’t own any un-hedged shares at this point.  There are plenty of growth names out there to invest in that don’t have the potential baggage carried by VMW.

FD: Author does not have a position in VMW
VMW Notes

Additional Reading:
Another Sell Rating – on EMC
Intel Dumping Shares of VMW