Buy This, Not That
Chad is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
This one really comes down to simple math, the company VMware (NYSE: VMW) is an exciting and growing company that improves businesses efficiency and flexibility as well as enabling substantial cost savings. I know that investors want to buy the fast growing company, but this seems like a prime case where buying the parent company makes a lot more sense. The parent in this case is EMC (NYSE: EMC), which not only bundles the VMware software with their storage units, but also owns 79.3% of the company. If you're wondering what you get by investing in VMware, let's take a look at the company's most recent earnings report.
How Good is VMware?
VMWare reported revenues up 21.91% and adjusted EPS increased 15.79%. While some seasonality and hiring moves slowed down the company's overall results, you can see the impressive growth beyond the headline numbers if you look at the company's two divisions. The Licensing division which accounts for 46.06% of revenues grew revenue by 11.28%. Though this doesn't sound that great, this is becoming a smaller part of the business and has a huge gross margin. Licensing carries an 89.07% gross margin and has dropped from 50.45% to 46.06% of total revenue since last year. The really exciting revenue growth comes from the company's services division, which is becoming a bigger part of the company's revenues and income. Revenue in this division jumped 32.73%, and is now nearly 54% of revenue versus less than 50% last year. Though the margin in services is lower than licensing, a nearly 80% gross margin is still very impressive. In fact, the company's overall gross margin compares favorably to several of their competitors. For example, competitors like Microsoft (NASDAQ: MSFT) and Google (NASDAQ: GOOG) carry gross margins of 80% and 68% respectively. One direct competitor that beats VMware in this area is Citrix Systems (NASDAQ: CTXS), which in the last quarter reported a gross margin of over 90%. You can see that all of these companies benefit from offering cloud-based solutions that help their customers save money and become more efficient.
Who Offers The Best Growth?
Looking at companies that offer the same type solutions that VMware and EMC bundle together, the combined entity has a faster expected earnings growth rate than any of their competition. Citrix would appear to be a good compromise for investors, as the company is expected to grow earnings at about 17.5% over the next few years. However, Citrix can't offer the same bundled solutions that VMware and EMC can offer. When it comes to Microsoft, while the company is pushing to move its Office software to the cloud there is likely to be some cannibalization of traditional software sales in this action. In addition, the company still is heavily reliant on its Windows operating system sales, and has shown no willingness to move this software outside of company servers and individual's hard drives. Where Google is concerned, they do offer several cloud-based applications and solutions, but the company simply has no competitive answer to EMCs top-of-the-line storage systems. VMware is expected to grow earnings at over 23%, and EMC is expected to grow earnings by nearly 15%. This combination easily trumps each of their competitors.
To understand the reason that it seems EMC offers a better value than buying VMware directly, you only need to look at each company's market capitalization. At the current time, VMware has about a $40 billion market cap versus roughly $53 billion at EMC. Given that EMC owns 79.3% of VMware, this means just this stake alone is worth almost $32 billion. This means investors are actually buying EMC for a net of about $21 billion. Just for point of comparison, at the current time Dell Inc. carries a current market cap of roughly $20 billion. Dell is making a push to move into connected servers and storage solutions as a way to try and improve their growth rate in the future. However, considering the huge struggles that Dell faces, and the clear leadership that EMC exhibits, it doesn't seem to make sense that EMC and Dell would be valued similarly. This is particularly true when you realize that Dell is expected to grow earnings at just over 5% versus analysts expect nearly 15% growth at EMC. As if triple the growth rate wasn't a good enough reason for EMC to sport a much higher valuation, consider that the company also has nearly three times the gross margin compared to Dell. I think you can see that EMC seems to represent an attractive way to buy the growth expected from VMware at a cheaper price. With VMware selling for about 35 times forward earnings estimates, and EMC selling for less than 15 times earnings estimates the choice is clear. Investors should consider buying EMC instead of VMware.
MHenage has no positions in the stocks mentioned above. The Motley Fool owns shares of EMC, Google, Microsoft, and VMware. Motley Fool newsletter services recommend Google 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.If you have questions about this post or the Fool’s blog network, click here for information.