This Stock's Value Is 'Virtual' But 'Really' Expensive

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The market is filled with examples of stocks that trade at high premiums. Ask any investor and they will gladly tell you with great conviction why such a high valuation is deserved. But if you press the issue and inquire about growth rates, uncertainty takes over. To that end, VMware (NYSE: VMW) serves as a perfect for example.

While there’s no question that VMware is the undisputed market leader in virtualization software, I worry that its rate of growth will soon become an obstacle to the premium it commands. Said more plainly, the stock is expensive. In its Q4 report on Monday, unless higher rate of growth returns, investors should begin to question if what they’re paying for in VMware is real or just virtual.

Q3 Proved Challenging As Competition Caught Up

While I’ve always liked VMware, I’ve also wondered how much revenue deterioration investors will tolerate. Nonetheless, the P/E keeps rising. Granted, the core operational numbers have been steady as evident by how its kept rivals such as Microsoft (NASDAQ: MSFT) and Red Hat (NYSE: RHT) at bay.

However, as VMware showed in Q3, in areas such as desktop and delivery, Citrix (NASDAQ: CTXS) is proving to be a worthwhile threat. VMware reported net income of $156.8 million, or 36 cents per share on revenues of $1.13 billion. On an adjusted basis, the company earned $303.4 million, or 70 cents per share when excluding stock-based compensation and other items.

VMware did what it had to do to meet revenue targets while also beating EPS estimates of 63 cents. While the rate of growth was solid at 20%, it is not significantly outperforming Microsoft, which trades at  one quarter of VMware’s P/E. Likewise, Citrix, which trades at a P/E that is 18 points lower, outgrew VMware by 1% in revenue.

Let’s not forget Red Hat, which posted an 18% year-over-year increase in revenues, which is only 2% lower than VMware. In other words, though the virtualization business may have some challenges in the broader context, competition is beginning to chip away at VMware’s once-wide lead.

Then again, VMware understands the gap is narrowing. That the company recently spent 30% more in R&D speaks to its level of commitment and it will spare no expense to protect its market lead. In many respects, this has worked since of its 20% growth, almost 30% was due to increase services demand. Nonetheless, there are constant questions about the industry’s future and investors should get more clarity when VMware announces its results.

Expectations for the Quarter

The Street will be looking for earnings of 54 cents per share – representing a year-over-year growth of roughly 4%. This is a 2 cent increase over the past three months from estimates of 52 cents. It seems analyst have taken a slightly bullish stance on earnings despite the drop in profits in Q3. For the full fiscal year, analysts are expecting earnings of $2.01 per share.

In terms of revenue, analysts are looking for another quarter of 20% growth – albeit flat sequentially. Sales are expected to arrive at $1.28 billion for the quarter and $4.59 billion for the full fiscal year. Seeing as VMware has produced double-digit revenue growth over the past four quarters, these should be fairly easy targets to meet.

For that matter, the company has averaged almost 24% revenue increases during that span. As is often the case with high-growth companies, profitability remains the issue as net income has decreased over the past two quarters, including -11.7% in Q3.

Then again, this was due to VMware’s increase in spending. With rivals clawing at its heels, VMware was fighting for the business that still remains in an environment that has raised doubt about the long-term future of the desktop virtualization industry.

Is Virtualization Here to Stay?

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. For instance, even though VMware posted an 11% jump in license revenue, the growth rate was slower than expected.

However, there are signs that this has become an industry concern, because although Citrix reported 21% revenue growth in its recent quarter, Citrix only generated 7% growth in desktop licenses – its lowest level in quite some time.

What’s more, with licenses being the industry’s primary growth metric, investors are eager to learn if this was an aberration or a sign of an eroding virtualization business. On the other hand, it may be a case where one rival is dominating the market seeing as Red Hat posted 19% growth in subscription revenue. Does that mean customers have now favored Red Hat? It certainly seems that way.

The good news for VMware is that aside from having a solid solution it is majority owned by EMC, so it will continue to enjoy a great deal of support. Likewise, Citrix will continue to benefit from its relationship with Microsoft that has existed for almost two decades. But it’s worth asking if Microsoft’s own cloud/virtualization ambitions might interfere with their relationship.

Bottom Line

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. And even if virtualization evolves to mobile devices such as tablets and smartphones, investors should not assume that these rivals are simply going to roll over and concede the market for VMware.

For now, VMware’s strong fundamentals and market position will help carry it through the sector’s transition. Too, the company’s strong cash position and solid balance sheet makes VMware one of the toughest names to bet against. But at current levels, the stock does not work – not at this valuation. 

Richard Saintvilus has no position in any stocks mentioned. The Motley Fool recommends VMware. The Motley Fool owns shares of 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.

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