VMware: Strong Fundamentals and Vision
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Since shipping its first product in 1999, VMware (NYSE: VMW) has clearly established itself as the leader in x86 server virtualization software and has posted impressive top-line growth over the past few years due to its differentiated core platform (vSphere). Although the licensing growth stabilization in Q2 poses a concern, we still remain positive on the fundamentals surrounding the VMware story, and believe that competition remains a few versions away from presenting serious threats on the server virtualization front. With the positive dynamics in work for VMware with the server refresh cycle and VMware’s entry into the multibillion SDN market, we believe that VMware is a buy.
Software Defined Networking (SDN) - Nicira Acquisition:
The big news from the 2Q12 earnings call was the acquisition of SDN provider Nicira for $1.05 billion in cash plus $210 million of assumed equity options - the largest transaction till date for VMware. This acquisition accelerates VMware’s move into the markets beyond the standard hypervisor, as Nicira provides network virtualization. Nicira works towards cost savings around network ports in a similar nature to what VMware accomplished with its ESX platform. Nicira currently boasts of several large Cloud and datacenter customers including AT&T (NYSE: T), Rackspace, eBay (NASDAQ: EBAY) and Nippon Telegraph (NYSE: NTT). While the total price of $1.26 billion for a company with negligible revenues seems inflated, we believe that this deal immediately establishes VMware as the leader in the SDN space, enabling it to tap into the $37 billion data networking market, which is currently dominated by Cisco (NASDAQ: CSCO). This acquisition signifies VMware’s futuristic vision compared to some of its competitors who are still trying to come to market with a competitive hypervisor. It also greatly accelerates VMware’s vision for the software-defined datacenter, which leverages pooled computer, storage and network resources to build dynamic virtual datacenters. We believe that this is clearly a strategic acquisition that could turn into a multi-billion opportunity over the next few years.
Product Catalysts in 2H12:
With about 90% of revenue coming from vSphere and vSphere products, we believe that expanding the company’s product footprint would be beneficial to VMware. VMware is expected to refresh vSphere in the 2H12. The vSphere refresh should help VMware to remain the leader in core virtualization, even when Microsoft (NASDAQ: MSFT) is expected to launch Hyper-V 3 platform in 2H12. We also expect VMware to post a strong December quarter due to the momentum provided from exciting new product announcements at VMworld 2012. We believe that with the new refreshes and new product launches, the company can expand its margins while leveraging the cross-selling opportunities.
Licensing Growth Concern Overemphasized:
Although investors seem to be worried about VMware’s license growth with the penetration rates of server virtualization increasing and the server shipments decreasing amidst the tough macro conditions, we believe that VMware can still benefit from:
(1) International expansion (international growth was relatively robust at 22% YoY in Q2).
(2) Broadening its product footprint in the field with SDN.
(3) Strong ELA renewals and additional license sales with the new upgrades.
(4) Positive catalyst in the form of virtualization of Tier 1 & Tier 2 apps and increased traction in desktop virtualization
While VMware is going through changes and license growth has softened in Q2, we believe that it has a much larger medium-to-long term opportunity. The company has considerable upside opportunities from the migration of tier-1 applications to virtual infrastructures, a meaningful inflection in virtual desktop computing, and the building of Cloud infrastructure. As the recent Nicira acquisition establishes VMware as the leader in the multibillion SDN space, we rate it as a buy.
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The article was co authored by Rahul Agarwal and Ashish Sharma. Both have no positions in the stocks mentioned above. The Motley Fool owns shares of Microsoft. Motley Fool newsletter services recommend eBay 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.
