When Will VMware Turn Into EMC?

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After years of strong growth, one has to wonder when VMware (NYSE: VMW) will turn into a slow growing, low multiple stock like parent EMC (NYSE: EMC). The company is already approaching the valuation of EMC, though revenue remains a fraction of the bigger corporation. Such equations should make investors wonder if the market hasn’t lost touch with proper equity valuation.

The company is the leading provider of virtualization solutions from the desktop to the data center and to the cloud. It was founded in 1998 so it is has moved far from the young technology startup back as the Internet bubble hit.

Pricey valuation

Trading at roughly 29x forward earnings, VMware remains one of the most expensive large cap stocks in the investment universe. The company now has a market cap near $40B, yet it still trades like a high flying growth stock. Not that EMC is only worth around $52B.

Analysts do forecast 18% revenue growth in 2013, but the earnings are only targeted at 15% higher. It wouldn’t be surprising to see the company actually hit 20% earnings growth next year. Unfortunately for investors, that growth rate and the high margins will be impossible to keep as the company approaches nearly $5.5B in revenue for 2013.

EMC on the other hand is only expected to grow 9% in 2012, but analysts forecast a similar 15% growth in earnings. The stock though only trades slightly north of 12x earnings. At a similar multiple, VMWare's stock would fall by 50%.

Big data and cloud plans

A potential positive for the stock could be the plans for EMC and VMware to combine the big data and cloud groups into one organization. The new group will focus on transforming the infrastructure of applications for the cloud, mobile, and big data.

The new initiative will include EMC’s Greenplum and Pivotal Labs groups and VMware’s vFabric, Cloud Foundry, and Cetas groups. Combined, over 1,400 employees will be focused on this new organization. More importantly, the former VMware CEO, Paul Maritz, will run the new group.

Red Hat On The Attack

In a recent Business Insider interview, Red Hat's (NYSE: RHT) CEO pointed towards VMware as a prime target for server virtualization in the public cloud. The company recently bought enterprise cloud management startup ManageIQ. One of the major plans for the company is to run it on top of VMware to add visibility and planning that VMware doesn’t offer.

While possibly a small example of the issues facing the company, it could ultimately lead to margin compression as Red Hat provides the market a cheaper solution.

Stock price

Even with strong earnings growth in 2012, the stock has flat lined in the $80 to $110 range for the last two years. Investors who want to own this stock can look at buying it at the bottom of the range at $80, but it won’t be surprising to see it end 2013 within the same range. The current $92 price tag can’t be justified and $80 would be hard to swallow as well.


VMware remains a leader in the technology sector and specifically the explosion in data center growth with its virtualization products. Unfortunately the stock offers limited growth for investors at the current price.

If anything tells the story the best, it would have to be the recent announcement of a $250M expansion to the stock buyback program. A company with net cash of roughly $4B and strong cash flows should be able to initiate a program of larger scale. The fact the company is only willing to tiptoe into repurchasing shares suggests management realizes the valuation is stretched. The growth that justifies the current market multiples can’t go on forever. Just ask EMC about that outcome.

Mark Holder and Stone Fox Capital Advisors, LLC have no positions in the stocks mentioned above. The Motley Fool owns shares of EMC and VMware. Motley Fool newsletter services recommend 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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