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Deeper look at VMWare's results spooks investors

Posted by: Aaron Pressman on September 18, 2007

When software hotshot and EMC (Symbol: EMC) spin-off VMWare (VMW) went public last month at $29, demand from investors was feverish and the shares shot up 76% on their first day of trading. Since then, they’ve gained even more, peaking at $82.75 in intraday trading last week. VMWare’s final IPO filing with the Securities and Exchange Commission included preliminary results for the second quarter that looked pretty impressive including a 125% leap in net income. Yesterday, the company followed up with a routine, audited second quarter filing that repeated the same happy results. And yet VMWare’s shares dropped over $4 during the day and stand at $73.19 today, down 12% from the high a week ago.

So here’s a mystery to ponder for the next hour as you await the Fed’s big announcement: if VMWare already announced its second quarter results, what in its 10-Q filing yesterday caused the sell-off? I don’t think you haver to look very far. Last month, VMware released its second quarter revenue, operating income and net income. There was no detail provided about expenses and cash flow. Yesterday’s filing included all the details and suddenly things look a little less great.

We already knew that the company’s revenue jumped 90%, operating income 81%, and net income 125%. Now we also see that operating cash flow increased only 43% to $85.6 million. And the rate of growth in some expense lines challenged the rates of growth of the previously revealed good stuff. Research and development expenses shot up 120% to $72 million, sales and marketing costs rose 83% to $99 million and general and administrative expenses climbed 124% to $31 million. At the bottom, the percentage of revenue eaten up by these operating expenses rose 1 percentage point to 68% from 67% a year earlier. Excluding stock-based compensation, an expense that tech companies like VMWare prefer to back out, expense growth looks even worse, increasing by more than 2.5 percentage points of revenue. This is a trend that was visible back in the original IPO filing, as I noted in April. With looming competition from Microsoft (MSFT), Citrix (CTXS) and other big fish, anybody think VMware’s expenses are going to start sinking anytime soon?

One other worrisome piece of the VMWare puzzle comes from the market’s valuation of EMC, which still owns 87% of VMware shares. That stake is worth over $20 billion today, or about half of the market’s valuation of EMC itself. Yet EMC shares have barely budged since VMWare went public, rising from $18.34 on August 14 to $18.90 today, or a 3% increase. How can a company’s biggest asset almost triple in value while the market yawns? The answer lies in the shortage of VMWare shares available to the market. Just like a zillion dot com bombs back in the day, there aren’t enough shares of VMWare’s total available to investors yet. The market isn’t saying that EMC, a long-established company, is undervalued. It’s saying that VMWare is overvalued. As more shares hit the market over the next year, that shortage will evaporate and so too will the VMWare’s p/e ratio of 231.

Reader Comments

mark weiss

September 19, 2007 2:46 PM

citrix and msft are well behind vmw per technology, some say 2 years behind. over those 2 years this gap may widen. given business practises etc of citrix and msft why think they'd give vmw any great competition. and given the brain power at vmw and the focus on that technology vmw will improve technically and in the market place.

nevertheless i can't buy a stock that has an eps so low and a multiple so high. plus they are not terribly transparent on the deals they make to buy other companies. plus the socalled 29.00 ipo price was not available to anyone but major wall st companies, institutions, underwriters and the like. retail wise i never saw it below 50.00. these characteristics harken back to the tech bubble dotcom years.

let's wait a while. maybe when emc goes up we can revisit vmw.


September 24, 2007 10:57 AM

The way I see it VM Ware needs to triple its earnings (via tripling its revenue) to put its PE in an area where I'm comfortable.

So the question is Will they triple sales and when?

The answer, Yes and I don't know (but the sooner the better) If you can come up with an estimate of when sales will triple from the 2Q levels I can give you a buy/sell/hold rating.

I am not surprised about the cash flow, and am ok with it as long as ample spending goes into the sales force/process, which it is.

They already have the superior product/service now they just need buyers. So in the near term scrutinize revenues, if they more than double in 3Q than look for a big jump in stock price. If it fails to double this quarter watch out below, and then buy it for the long haul.


September 24, 2007 11:06 AM

Don’t Confuse Growth With Sustainable Competitive Advantage
"The key to investing is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the durability of that advantage. The products or services that have wide, sustainable moats around them are the ones that deliver rewards to investors."

--Warren Buffett, Fortune magazine, 11/22/99


September 24, 2007 7:19 PM

I got in on VMW, 500 shares @ 68.90 and 500 more @71.30, but unfortunately I let jitters on the Fed meeting push me into setting a stop loss of 73.30. The stock barely reached that on the 18th and my shares were gone, I was not babysitting my shares, a lesson learned. Today it is up over $80 and I am pissed at myself. I plan to watch for a drop tomorrow and jump back in. I can't predict the future, but I am afraid to let this one go.


December 28, 2007 10:57 AM

VMWare is the leader with a sustainable earning potentioal. i would buy anytime.

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