Why Citrix Remains Too Expensive

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

I’ve never been a big fan of stocks that carry enormous expectations - they make me nervous.  Although in the tech sector high valuations are par for the course, there comes a point when “potential” has to manifest itself in execution. This is where I’ve arrived with virtualization giant Citrix (NASDAQ: CTXS). Although the company is doing well now, investors are beginning to worry on the long term viability of the virtualization business.

Too, it seems that competition from the likes of VMware (NYSE: VMW) and Red Hat (NYSE: RHT) have introduced concerns about Citrix’s enterprise leverage and the company’s ability to maintain its margins. And unfortunately, Citrix’s second quarter earnings did little to avert these fears.

Still Very Much To Prove

Overall, Citrix’s earnings weren’t that bad relative to expectations. Nonetheless, 16% revenue growth for a stock that trades at a price-to-earnings ratio of close to 40 was unimpressive. The company generated revenues of $615 million compared to the $531 million it logged a year ago.

For the quarter, net income arrived at $92 million or 49 cents per share, which includes approximately $22 million related to the closing of audits with the IRS of previous tax years. Excluding this cost, Citrix exceeded its EPS of 43 cents posted last year.

On the other hand, that the company generated 7% growth in desktop licenses was a huge concern. This was Citrix’s lowest level for quite some time. With licenses being Citrix’s lifeblood, investors are eager to learn if this was an aberration or a sign of an eroding virtualization business.

Is Virtualization Here to Stay?

The company did reward investors with almost $400 million worth of stock buybacks. This is on top of the approximately $87 million that remained from a previous authorization from the first quarter. Guidance was also disappointing. However, the macro climate hasn't been all that welcoming either for rival companies.

For now, it's anyone's guess as to when enterprise spending is going to recover. The real issue is whether or not virtualization will remain a critical IT priority when it does. But Citrix investors are beginning to get mixed signals. For instance, although rival Red Hat's 19% growth in subscription revenue may be viewed as an encouraging sign for the broader market, then again, it highlights a fundamental issue with Citrix’s market position.

What’s more, Red Hat logged an 18% year-over-year increase in overall revenues, which is still 2% higher than Citrix. In other words, though the virtualization business may have some challenges in the broader context, there are names that are struggling more than others. Unfortunately, Citrix might have just made that list.

The good news for Citrix is that it has some very important friends in high places such as Microsoft (NASDAQ: MSFT). These two have been tremendous enterprise partners for almost two decades. But it’s worth asking if Microsoft’s own cloud/virtualization ambitions might interfere with their relationship.

However, if there is any company that Citrix needs to fear it's VMware, the current market leader. And with a recent quarter which produced 20% revenue growth, it does not seem that VMware plans to relinquish that title any time soon. Remarkably, of that 20% growth, almost 30% of it was due to increase services demand.

That the company also spent 30% more in R&D suggests that VMware means business and will spare no expense to protect its market lead. As the future of IT takes shape it will be interesting to see not only what becomes of virtualization, but how the sector evolves in terms of valuation.

Bottom Line

Citrix operates a sound business in an industry that seems to be in transition. The good news is that the company has an excellent management team and a solid enterprise presence that should allow it enough time to figure out what its next strategy should be. In the meantime, the stock remains expensive - although the Street thinks differently.

Granted, 16% revenue growth in this market should be good enough. But not for the premiums that investors are paying today for the stock. As it stands, I don’t believe Citrix’s business fundamentals and the future of the sector support its current valuation.

rsaintvilus has no positions in the stocks mentioned above. The Motley Fool owns shares of Microsoft and VMware. Motley Fool newsletter services recommend 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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