Tuesday, 29 December 2015

VMware's Year In Review Stock Continues To Be Undervalued By The Market Post EMC-Dell Deal

Virtualization giant VMware has witnessed massive growth in recent years, with its revenues growing from under $2 billion in 2009 to $6 billion in 2015. Over the last few years, VMware has expanded its offerings to include software-defined storage and network virtualization to add to its server virtualization capabilities. The company registered a 10% annual growth in revenues through the first three quarters of the year to nearly $4.8 billion (excluding the impact of $76 million paid for the GSA settlement).

Moreover, VMware is on course to meet its guided revenue range of about $6.6-$6.7 billion for the full year, which at the midpoint of the guided range implies a 10% annual growth. On a constant currency basis, the growth rate climbs to about 14%. Although near term growth in this segment could be hindered by a stronger dollar and tougher year-over-year comparisons this year, VMware is poised to capitalize on growth in this market.

VMware’s stock price fluctuated from $75 to $92 through the first three quarters of the year. Then in month following the announcement of the Dell-EMC deal, VMware’s stock price plummeted by about 25% to about $55. VMware’s shareholders remained skeptical after the deal was announced due to a number of reasons that included limited voting rights of VMware’s shareholders, the introduction of a tracking stock related to VMware and VMware’s involvement in the cloud joint venture with EMC.

Below we take a look at VMware’s year in review, factors driving the company’s future growth and why we remain bullish on VMware. We also take a look at some key challenges for VMware in the coming years that could potentially disrupt growth. Our $86 price estimate for VMware’s stock, implies a market cap of about $36.5 billion, which is significantly higher than the current market price.

The company launched the VMware NSX in late 2013, which merged its existing vCloud networking product line with the network virtualization platform of Nicira (which it acquired in 2012) into a single product family. Tthe number of paying customers for NSX rose to over 900 by the end of Q3, up from 400 at the end of Q4’14 and only about 150 at the end of June last year.

Additionally, VMware released the NSX 6.2 during the September quarter, which contributed significantly to the 100% annual rise in revenue generated through license bookings in Q3, as six out of VMware’s ten largest deals during the quarter included the NSX implementation.

The VMware NSX creates software-based network overlays on top of existing hardware, thereby decoupling networking-related intelligence from the hardware. This makes networks programmable and scalable, and gives enterprises the flexibility to implement technology changes through mere software upgrades.

Comparatively, Cisco’s approach to SDN is more hardware-centric, with the platform built on top of its Nexus switches which are controlled by application policy infrastructure controllers (APICs). As a result, the NSX platform is more appealing to enterprises since it allows them to put third-party software on cheap white-label networking hardware, making it potentially much less expensive to implement than installing Cisco’s hardware products that come with embedded software. The company expects the solid demand for NSX implementation to continue through Q4 and in the long term.

VMware has witnessed strong demand for its end-user computing and mobility solutions in the last few quarters since it acquired Airwatch for $1.5 billion in early 2014. The trend was highlighted by a 50-60% year-over-year increase in end-user computing license bookings through 2014 and in Q1 this year. Subsequently, VMware witnessed a 30% year-over-year increase in license bookings for AirWatch products in the June quarter, which further slowed to about 15% in Q3.

The growth rate has been lower in Q2 and Q3 mainly due to tougher year-over-year comparisons. Moreover, the total number of end-user computing customers for desktop, mobile, identity and content collaboration solutions combined stood at 60,000 at the end of Q3, up from about 15,000 AirWatch customers at the beginning of the year. In addition, VMware announced the acquisition of email-startup Boxer at the end of Q3 to boost its end-user computing and mobility management capabilities. The company has sustained growth in this domain and was recently recognized by IDC as a clear leader in enterprise mobility management domain.

Hybrid Cloud


VMware offers a common hybrid cloud platform that encompasses both on-premise private cloud deployment and deployment to the public cloud. The company rebranded its hybrid cloud service to vCloud Air at the end of Q2 last year, after which VMware has witnessed massive growth in the hybrid cloud business. The hybrid cloud business grew by around 90% year over year through 2014, making it one of the fastest growing segments within VMware.

Similarly, the company registered a 50% year-over-year increase in revenues generated by its hybrid cloud and software-as-a-service (SaaS) offering. According to the company’s estimates, hybrid cloud and SaaS combined contributed over 6% of VMware’s net revenues through the first three quarters of 2015, up from 5% in 2014 and under 3% of net revenues in 2013. In the most recent quarter, VMware announced general availability of new hybrid networking capabilities including VMware Hybrid Cloud manager and Advanced Networking Services.

After announcing its hybrid cloud service in the Asia-Pacific region last quarter, the company announced the addition of three new service locations in the U.S (in Texas, New Jersey and Virginia), so as to drive future growth. According to Research and Markets, the hybrid cloud market could grow at a CAGR of over 27% from $25 billion in 2014 to almost $85 billion through 2019.

VMware Steps Away From Virtustream, Voting Rights Remains A Concern

EMC initially had an 80% stake in VMware, with 97% of voting rights. With Dell’s proposed acquisition of EMC, the parent retains 97% voting rights but issues what effectively will be over 50% of VMware’s total shares as a “tracking stock” with no voting rights. Under the conditions of the deal, then, Dell will have a 28% stake in VMware with 97% voting rights, existing VMware shareholders will retain the 20% ownership with 3% voting rights, and over 50% ownership will lie with former EMC shareholders in the form of tracking stock and no voting rights. This represents significant dilution and is a key concern area for VMware’s shareholders.

After the Dell-EMC deal was announced, EMC released a statement announcing its intention to partner with VMware on a joint venture for a new hybrid cloud service business that uses capabilities of its recent acquisition Virtustream. Subsequently, some of VMware’s institutional shareholders demanded that VMware pull out of the joint venture mainly because Virtustream’s global expansion efforts in 2016 could drag down VMware’s earnings. In response, VMware’s management stated that the company would not go ahead with the joint venture, in an attempt to pacify shareholders.

Outlook For Future

VMware reported a strong set of results in Q1, Q2 and Q3 this year despite a slowdown in the software licenses business. Services revenues have driven much of the growth for VMware. With the key growth areas expected to continue to boost top line figures for VMware in the coming quarters, we believe that the company is poised to capitalize on the shifting market trends.

Parent company Dell (similar to EMC) is well represented in the enterprise market, while VMware has traditionally excelled in both the enterprise and the SMB market space. As a result, the presence of the parent provides access to a robust sales channel for VMware, while giving it enough freedom to operate as a separate entity. As a result, VMware’s dominance in the network, desktop and storage virtualization markets, coupled with the integrated hybrid cloud and end-user offerings, should help sustain growth in the coming years.

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