Sunday, May 8, 2011

VMware: The Sweet Smell of Success

They say that 75% of the earth is covered by water and the remaining 25% is covered by VMware (VMW). That's how much of a strangle-hold they've got on the server virtualization industry. About a year ago they commanded an 80% market share according to ReadWriteWeb which is sponsored by Intel (INTC) and VMware. In addition, the company has a 95% penetration rate among Fortune 1000 companies as reported by Standard & Poor's. Now that's what I call coming from a position of strength.

Besides a quality product, much of this dominance can be attributed to their hardware partners Hewlett-Packard (HPQ), Dell (DELL) and IBM (IBM) who are all pre-installing VMware's vSphere product on most of their new servers, to paraphrase a 4/19/11 article in Investor's Business Daily.

If you aren't familiar with what virtualization server software does, it is basically the straw that stirs the drink in cloud computing. To quote the earlier S&P report, "Virtualization software allows multiple virtual machines with different operating systems and application software to run on a single physical machine.". Think Apple (AAPL), Microsoft (MSFT) and Google's (GOOG) Android all in one package. It enables data centers to reduce hardware expenditures, energy consumption and employees which in turn increases savings.

Although market research firm IDC estimates corporate cloud computing is expected to grow at a blistering pace of more than 25% a year to $55.5 billion by 2014, VMware has recently come under attack because of the competition. Oracle (ORCL), Microsoft, Citrix Systems (CTXS) and Red Hat (RHT) have all fired shots across the bow of the VMware juggernaut putting some pressure on the stock in January, February and March. That was then, this is now.

In late April they reported industrial strength 1st quarter earnings. It was a piece of art and VMware hit all the right notes. Earnings grew 50% beating analyst targets. This is not an illusion. Even the company was surprised. In the conference call transcript, CFO Mark Peek reported that: "The financial and business results from our first quarter of 2011 exceeded our expectations.". Besides earnings, sales were up 33% from the year before and the stock responded, gaining over 10% the next day, rising from $86 to $98. The equity remained elevated for a week, but has since come down some to $93 as the overall market has corrected.

It's no secret that we are in the beginning of the post-PC era with the proliferation of mobile computing devices like smartphones, laptops and tablets. Virtualization software plays an enormous part in the infrastructure of the cloud which is an integral part of the post-PC architecture. The question remains, how much do you want to pay for a stock like VMware? The 37 analysts that cover the stock are pretty much divided on what you should do: nineteen have a hold, one is an underperform while two say to sell. The remaining sixteen have either a buy or strong buy rating.

If we examine the consensus measurables as reported by Yahoo Finance, we can see that the trailing twelve month P/E Ratio is a whopping 99. I don't make this stuff up, but it's not where the earnings have been, but where they are going that counts. Profits for 2011 are slated to be $1.97/share and for 2012, $2.33/share. At the current price of $93, we get a 2011 P/E Ratio of 47 and a 2012 P/E Ratio of 40.

Those aren't astronomical figures when you consider earnings were up 50% last quarter, but like I just said, it's not where they've been, but where they're going. If you look at the estimated earnings growth rate from 2011 to 2012, it's only 15%, which gives it at PEG Ratio (price/earnings/growth) of roughly 2.7 for next year. That's on the high side. Sure, analysts could be low-balling projections, but it makes me wonder how much of a window of opportunity is open for VMware in the next two years in regards to share price.

This is not a boring and predictable stock. Although VMware has reported show stopping numbers, the security has had anything but a straight ride from a 52 week trough to top - $54 to $98. In fact, from last August to the present, the share price has hit $75 three separate times and the upper 90's twice. That's a lot of wiggle room. To stoke the debate, I contend that the stock may languish for a year or go lower as the market takes a rest from the two plus year historical rally. With a Beta of 1.48 and a prominent position in the inflated cloud computing sector, VMware could very well trade much lower in the Summer months.