Spin-Off to Drive Growth in 2013

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

Last month VMware (NYSE: VMW) announced its plans to create a new virtual organization called 'Pivotal Initiative,' which would entirely focus on Big Data and Cloud Computing solutions. The new organization will combine various assets from the storage giant EMC Corporation (NYSE: EMC) along with the non-core assets from VMware. It will include Springsource, Gemstone, Cloud Foundry, Cetas Division from VMware and Greenplum and Pivotal Labs from EMC. This new organization will be formed by the second quarter of 2013 and will be headed by VMware's CEO Paul Martiz.

Potential Impacts

This spin-off will help VMware to completely focus on its core virtualization platform and management solutions in which it actually excels. I feel these markets still have meaningful growth opportunities, and eliminating the non-core segments will help VMware to optimize its operations in this segment. The spun-off units did not contribute any significant portion to the company's revenue and have been a drag on its margins. Therefore, the transition will help VMware to improve its profitability. VMware would spin out around 5% of its workforce (600 employees) into this new organization. I believe this could provide an incremental benefit of ~$50 million in its operating margins.

Speaking of EMC, the Pivotal Initiative will be a huge opportunity for the company to align its resources into a combined company to capitalize on the fast-moving and transformational period in Big Data markets. Over the years, EMC has successfully acquired certain businesses and technologies to profit from the rapidly growing Big Data and analytics and Cloud application services. I assume the financials of the new organization will be merged with EMC, and it is well positioned to benefit from this transformation in 2013.

Competitive Advantage

This move will give an upper hand to VMware to sustain its leading position in the virtualization market. 2012 saw some strong contenders, such as Microsoft (NASDAQ: MSFT), with its launch of Windows Server 2012 Hyper-V to expand its footprint in the virtualization space. This directly competes with the VMware virtualization solution vSphere, which is now clearly focusing its strategies of staying ahead of Microsoft's Hyper-V. Microsoft revamped its virtualization platform Hyper-V in 2012, as the earlier version lagged in terms of performance against VMware's technology. It made some updates for improving the scalability and performance, and now also supports interesting features such as live migration, disaster recovery, etc, which were missing or not fully supported in the previous version. Over a few parameters like maximum number of virtual CPUs in virtual machines or memory limits per virtual machine or the maximum size of virtual disks, Microsoft is able to exceed VMware. However, Microsoft still has a long way to go as vSphere dominates the virtualization market and generates around 90% of VMware's revenue.

Another positive factor for VMware which caught my attention is its ELA (Enterprise License Agreement) renewal portfolio. The ELA terms are generally for two or three years and the contract signings increased very nicely in 2010. Therefore, renewal deals will witness a significant upward trend in its 4Q 2012 and further in 2013. Looking at its ELA renewal portfolio, I expect a strong ~20% growth in its booking revenue for its 4Q results. In the same quarter, the company introduced a new program called Enterprise Purchasing Program (EPP), which is a token-based program. This allows greater flexibility to its customers in terms of deployment, procurement, and cost-savings. It offers higher incentives for larger and planned purchases as compared to its traditional program VPP which was for smaller purchases. This will further boost up the company's top-line growth via improved deferred license revenue and the bookings revenue in 4Q 2012, as well as 2013.

Summing up, I remain bullish on the overall VMware story. The strong opportunity around data center efficiency after the spin-off and a significantly larger renewal portfolio in 2013 are the positive tailwinds for its revenue acceleration. The company's operating margins have grown to around 80% in the last six years and it reported a margin of ~32.2% in 3Q 2012. As it is heading towards improved growth rates, I expect the margins to be somewhere around mid- 40s in the next two-three years. I believe it would be an attractive option for the investors at the current level looking at its growth rate and profitability.

ShwetaDubey 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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