A Few Reasons Why This Company Is Worth Watching

Alexander is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

These days, it seems companies, or the C-suite are becoming increasingly flexible to the demands made from buy-outs. After all, VMware (NYSE: VMW) doesn’t mind buying out a technology company that literally has a tradition of drinking beer on Friday. In an environment where large technology companies are willing to buy any and all start-ups that provide a promising product, or a unique technology idea, this doesn't come as a surprise. According to Bloomberg:

VMware Chief Executive Officer Pat Gelsinger is not interested in taking away startups’ Friday beer parties. Preserving small companies’ cultures is a key to successful acquisitions, the former EMC executive said today on a panel at the Economist magazine’s Ideas Economy conference in Berkeley, California.

While the Friday beer parties seem like a bit of a stretch, for my imagination, the advantages of buying out small tech start-ups and keeping the cultures intact are numerous.

  • Buying out smaller technology companies generates new ideas. For example, the employees of the start-up or the company itself may have unique intellectual property, skills, talents, or abilities that could contribute to the parent company.
  • An acquisition will reduce the cash balance on the balance sheet without increasing the expense item on an income statement. This helps to keep EPS figures inflated even as the company continues to acquire new employees, research, and intellectual property. This helps to control research and development costs.
  • In certain instances, a buy-out might be worth a substantial amount of money in the future. Examples of this include Yahoo!’s stake in Alibaba, Google’s (NASDAQ: GOOG) success with YouTube, and Microsoft’s (NASDAQ: MSFT) success with Skype.

Success in innovation can come from strategic acquisitions. Generally, technology companies tend to strategically integrate other companies, which helps reduce the research and development costs. For example, Microsoft purchased a company called Fast Search and Transfer in 2008, for $1.2 billion. This Norwegian company provided intellectual property that helped to make Microsoft's Bing search engine more effective at indexing searchable content.

Google exemplifies technology integration through its buyout of DoubleClick. The buyout was valued at $3.1 billion and was executed in 2007. DoubleClick's products provided unique information to advertisers that allowed them to measure the return that could be generated on marketing dollars.

The integration of DoubleClick's software into Google Ad Sense allowed advertisers to understand the amount of revenue that was being generated from Google's advertising program. Following the integration of Double Click, Google was able to grow earnings 36.60% year-over-year in 2007, followed by a 54.25% increase in 2009. Providing transparency through a data-tracking platform boosted profits for Google's shareholders.

Generally speaking, a good alternative to keeping shareholders' money at work with the intent of generating future profits are buy-outs. That being the case, VMware is investing aggressively into its future based on the R&D expense figure below.

<img alt="" src="http://g.fool.com/editorial/images/32617/4-14-13-vmw-expense_large.png" />

The increase in R&D related expenses are generating diminishing returns. Revenue growth over the past five years has declined. The declining revenue growth does not necessarily indicate that VMware is a lousy investment opportunity, but what it does indicate is that management must become more efficient with the use of its cash.

<img alt="" src="http://g.fool.com/editorial/images/32617/4-14-13-vmw-annual-growth_large.png" />

The declining revenue growth is clearly indicated in the analyst estimates for growth. Analysts, on a consensus basis, anticipate the company to grow earnings at 21.10% on average for the next five years. VMware has been able to sustain 30.79% annual growth over the past five years. It should be able to sustain growth at a rate of 20% based on the historical data and its current business strategy.

VMware provides cloud-based solutions, which is a growth market. The cloud is projected to be a $210 billion industry by 2016, according to AT&T. Investors are willing to pay a higher multiple on VMware because it provides a large product portfolio for virtualized software solutions in the business space along with practical applications for consumers. Investors are willing to pay 44 times earnings because of the high rates of growth projected for “big data” systems that integrate information through the internet to all electronic devices.

I believe VMware is a reasonable investment opportunity despite the high earnings multiple, weird acquisition strategy, and declining revenue growth. The growth in the business makes up for the high valuation.

Alexander Cho has no position in any stocks mentioned. The Motley Fool recommends Google and VMware. The Motley Fool owns shares of Google, Microsoft, and VMware. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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