Why Investors of This Stock Are Hating This Virtual Reality

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

That shares of VMware (NYSE: VMW) are trading down after a generally solid Q4 earnings report was not much of a surprise. Not to toot my own horn, but it was called here on the Fool well ahead of the announcement. In the article, which generated quite a bit of hate mail, I said the following:

  • 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 currently expensive. In its Q4 report on Monday, unless a higher rate of growth returns, investors should begin to question if what they’re paying for in VMware is real or just virtual.

Since the report, the stock is down over 20% as of this writing. Analysts were not thrilled with the company’s 2013 growth projections. For that matter, neither was VMware. However, the degree of punishment on the stock seems overdone. While VMware is not alone in its disappointment, the company now realizes it must work to re-establish investors’ trust. But will it be given the time?

Q4 results were good, but…

As we discussed prior to the report, VMware’s market position was never an issue – the valuation was. That shares were trading at a P/E 20 points above rival Citrix (NASDAQ: CTXS) and 3-times the earnings multiple of Microsoft meant that investors were paying for perfection. They didn’t get it – at least not to the extent it justifies the premium.

First and foremost, VMware posted a beat on both EPS and revenue – let’s just get that out of the way. Q4 adjusted net income arrived at $0.81 per share – growing 30% year-over-year and beating Street estimates by 4% (consensus $0.78). Revenue was solid – growing 22% year-over-year to $1.29 billion and 14% sequentially. Plus, revenue arrived $1 billion above analysts’ projections.

Revenue from licenses did well – growing 16% year-over year. While this was in-line with estimates, that business grew 3% slower than Red Hat and 1% slower than Citrix. On the other hand, VMware’s 27% surge in maintenance/service revenue outperformed Citrix’s 22%.

Then again, that license billings arrived at (only) 7% raised some red flags – marking the second consecutive quarter of single digit growth. So what was the problem? It talks about the strength of not only VMware’s business, the overall cloud/virtualization industry, which is the perfect transition into guidance - the reason the stock got hammered.

Outlook killed all hope

As is often the case with stocks priced for perfection, VMware’s current report (as good as it was) needed a strong outlook to punctuate the performance. Said more plainly, the Street was looking for a “beat-and-raise” – again, they didn’t get it. VMware completed only the beat part – guidance was down. VMware projected Q1 revenue to arrive in the range of $1.17 to $1.19 billion – 5% lower than consensus estimates of $1.25 billion.

It was at this point the stock immediately gapped down over $21 to as low as $76.33 – falling below its 50 and 200-day moving averages. The Street absolutely hated that management guided for only 13% growth versus consensus estimates of 20%. Worse, projected license revenue calls for merely single-digit growth versus estimates of 14%. Granted, these aren’t significant adjustments. Then again, investors aren’t paying for just average performance. When expectations come down, so does the valuation.

Is it an industry or competitive issue?

This is what investors are grappling with. In other words, aside from what appears to be broad erosion in the virtualization industry, VMware’s report heightened anxieties about the competition, which have chipped away at its lead. The good news though, is that gross margin arrived 60 basis points higher year-over-year and 1 point better than Street estimates.

Plus, operating income shot up 25% year-over-year and 16% sequentially. While all of this point to a well run organization, it was not enough to offset concerns about VMware’s guidance, which projected a negative image about the company’s underlying health. Then there’s also the dynamic with EMC, VMWare’s parent company. At one point investors saw this relationship as an advantage – not so much today as EMC is seen as draining VMware’s revenue growth.

Then there are fears about market saturation. However, I’m not ready to agree with this notion just yet – especially since the industry still seems capable of supporting other prominent players such as Red Hat and Citrix. However, this won’t be the case forever. And it’s certainly possible that VMware has begun to experience this reality. Unfortunately for investors, it’s real and not virtual.

Bottom line

The market is still filled with these examples of premium priced stocks that have met growth challenges. Nonetheless, at this point VMware has to work to prove it deserves to be an exception. We can get into debates as to why guidance has come down. It doesn’t change the fact that VMware’s valuation hadn’t made sense for quite some time.

For now, it's anyone's guess as to when enterprise spending is going to fully recover. The real question, though, is whether or not virtualization will remain a critical IT priority when it does. Assuming VMware’s management was accurate in their guidance, it seems they’ve answered this very important question. However, it was not in a manner that supports the long term outlook of the stock. 

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