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Tickers in this Article: EMC, MSFT, SUNW, DELL, HPQ, IBM
It's no surprise that EMC Corp. (NYSE:EMC) wants to do a spinoff of its enterprise software subsidiary, VMware.

These days, sales of VMware's server "virtualization" software are on a tear - revenue could hit $1.2 billion this year. As a result, the deal could unlock plenty of value in EMC stock, which has been trading down for some time. Analysts predict the company could be worth $10 billion.

Why Buy?
Lots of academic studies show that spinoffs, statistically speaking, have a better chance of outperforming the market than the average stock. The big reason, spinoffs frequently receive less publicity or hype than regular IPOs, which can lead to undervaluation.

But, buyer beware. While the timing's probably good for EMC shareholders, it may not be great for buyers hoping to jump into the spinoff's IPO. For starters, the outlook for VMware's software is a tad murky.

David and Goliath
Virtualization software allows customers to dramatically reduce the number of servers they require to run network operations, creating huge cost savings. And the potential market for the software is big - only about 5% of servers employed use it.

Certainly, the technology looks exciting right now, and it will no doubt eat into server sales at hardware makers such as HP (NYSE:HPQ), Dell (Nasdaq:DELL), Sun Microsystems (Nasdaq:SUNW) and IBM (NYSE:IBM).

But red-hot virtualization is attracting a lot of big competitors. VMware may be on a collision course with Microsoft (Nasdaq: MSFT), who also has its sights set on the virtualization. The industry Goliath is reportedly taking aggressive steps to limit VMware's ability to maneuver in the server software space. VMware's value could easily slump depending on what Microsoft does down the road.

Growth And Valuation
Then consider VMware's blistering rate of expenditure growth. In 2006, VMware had $704 million of revenue, $121 million of operating income and net income of $87 million. So, revenue was up 82%, operating income 29% and net income 30%. Looking at costs, several line items grew even faster than the rapid rise in revenue, including R&D (up 104%), sales and marketing (up 90%), general and administration (up 127%) and costs of servicing revenue (up 158%).

If that kind of expenditure growth-rate continues, the 26-times forward-earnings multiple that forms VMware's hefty valuation may well be a blip. (To learn more, see our Introduction To The P/E Ratio.)

More worrisome is that none of the money raised from the spinoff will be re-invested in VMware. All of the proceeds will go straight back to EMC as part of an $800 million dividend payment. EMC could be extracting too much from the deal, and leaving VMware short on the cash needed to sustain growth.


Parting Thoughts
Remember, investors gain from spinoffs when the subsidiary gets plenty of autonomy early on. But after the deal, EMC will own all of VMware's 300 million Class B shares giving it 99% of the voting power. This means that, until those shares are redistributed, EMC will exert clout beyond its financial stake. This begs the question, if EMC won't let go of the reins, then why bother having VMware go public?

Think twice before buying into VMware. It's more than just timing. It's about taking time to carefully examine what EMC is selling.

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