Valuations in the software sector, particularly among those companies having anything to do with "cloud," are pretty bonkers right now. That leaves stocks like VMware (NYSE:VMW) and Citrix Systems (Nasdaq:CTXS) as what passes for "value." Value doesn't come without a catch, however, and in the case of Citrix, that catch is the sharp and ongoing debate about whether desktop virtualization can really catch on beyond the early adopters who are already on board.
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How Much of the Second Quarter was Macro?
We'll all know before too much longer how Citrix's third quarter went, but the second was not flawless. Revenue was up about 16%, which is not bad in an absolute sense, but it doesn't generate as much enthusiasm with the growth/momentum crowd. In particular, desktop license growth of 7% was a real concern - not only was that the lowest level in several months, but the comps are becoming more difficult in the second half.
There could certainly be some macro factors at work here. Companies ranging from IBM (NYSE:IBM) to Oracle (Nasdaq:ORCL) and beyond have all talked about a tougher enterprise market, particularly in Europe. But the real question, apart from the real ultimate market size/opportunity for desktop virtualization, is where virtual desktop infrastructure (VDI) sits on the enterprise IT priority list. If it is close to the bottom, as the bears argue, then license growth could weaken even further this year.
Citrix Offers Some Meaningful Advantages, and the Market Could Grow from Here
A case may be made that the argument over desktop virtualization is more about timing than ultimate size. For instance, improving server and storage technology (and improving price/performance) has lowered the cost of VDI and made it a more viable option for more companies. Here too, Citrix has an advantage - the capital expenditure needed to support VMware's desktop virtualization can be twice that of Citrix.
Mobile could also change the addressable market. Given the demands for security, compliance and whatnot across the enterprise, the spread of high-function mobile devices should also extend the market opportunity for Citrix's XenDesktop in mobile.
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Will They All Stay Friends?
Citrix has benefited from its relationships with Microsoft (Nasdaq:MSFT) and Cisco (Nasdaq:CSCO), but it's worth asking whether those relationships are built to last. Microsoft has its own ambitions in enterprise software and cloud apps, and that could ultimately strain the relationship. Likewise for Citrix and Cisco, when it comes to servers, ADCs and WAN optimization.
More Buying on the Way
Like so many tech companies, Citrix has been an active acquirer. Those deals, however, haven't necessarily translated into impressive growth (at least not yet). With both VMware and Oracle making deals in the software defined networking space (SDN), it's worth asking whether Citrix is going to need to do its own deal to keep pace.
At this point, I'd say probably not - Citrix likely could have bid on Nicira (the SDN company acquired by VMware) if it thought it needed to be in that space. Nevertheless, if VMware and/or Oracle seem to be getting a real leg up, it doesn't seem unreasonable to think that this concern/rumor could pop up again for Citrix.
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The Bottom Line
With some analysts thinking that the desktop virtualization market is less than 15% penetrated, and with other growth opportunities in data centers and cloud networking, Citrix could be only scratching the surface of its real potential. While it very well may be cheap relative to a broader peer group that includes names like NetSuite (NYSE:N) or Salesforce.com (NYSE:CRM), it's not especially cheap in absolute terms.
Even if Citrix grows its free cash flow by 14% a year over the next decade, it's maybe 10% undervalued today. Admittedly Citrix could grow faster than that if the desktop virtualization market is as large as the bulls believe. At the same time, investors buying today have to realize that the potential for buying Citrix "on the cheap" does also carry the risk that the next couple of quarters bring disappointing desktop license growth and a great deal of crowing (even if premature) from the bears.
At the time of writing, Stephen Simpson did not own shares in any of the companies mentioned in this article.