For investors bearish on VMware (NYSE:VMW), this was an interesting quarter. Plenty of other software companies (such as IBM (NYSE:IBM), Microsoft (Nasdaq:MSFT) and Oracle (Nasdaq:ORCL)) have talked about weak macro conditions, but VMware's stock was weak going into this report and the bookings number did look pretty soft. Although I happen to be more positive about the long-term fundamentals for VMware, the valuation still leaves plenty of risk for this once (and future?) growth darling.

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A Challenging Quarter, but not so Much in the Core Numbers
There has long been a fair bit of controversy with VMware. Will the company hold off companies such as Microsoft and Red Hat (NYSE:RHT) in servers? Can the company beat Citrix (Nasdaq:CTXS) in desktop and deliver on what has, thus far, looked more like theoretical potential? Unfortunately, this quarter doesn't really answer any of that (which is great for traders and analysts, but not for investors).

Revenue rose 20% as expected this quarter (up 22% in constant currency), with 11% (14%constant currency) growth in software licenses and 29% growth in the often-lucrative maintenance and service categories. Those were solid numbers in many respects; the license number actually represented sequential acceleration, while the maintenance revenue growth is good for future cash flow.

Profitability was also pretty good. Operating income rose by 25% by GAAP accounting and 28% by VMware's non-GAAP method (investors may want to note the magnitude of the difference between the two numbers). That 32% non-GAAP operating margin was a fair bit better than expected and due at least in part to a presumably temporary slowdown in hiring and marketing expenditures.

SEE: Analyzing Operating Margins

Bookings are Another Matter
If those revenue and margin numbers are the good news, then bookings have to be the bad news.

Books were up about 8% (10% in constant currency), well below the mid-teens growth expected by most analysts. Even worse, license bookings were barely up at all (though a little better in constant currency terms).

Now it's true that VMware faced a very difficult comp from last year, and those aforementioned large software rivals (IBM, et al) have all pointed to much tougher macro conditions in the third quarter and these first few weeks of the fourth quarter. That said, virtualization is supposed to be a growth market with plenty of room left. Suffice it to say, I expect bears will bring this point up again and again.

Is Growth Still Contingent on Desktop?
Nobody disputes that VMware has very strong share in server virtualization. What skeptics question, however, is whether they can maintain that against Microsoft, Citrix, Red Hat, Oracle, etc. for the long term, as well as whether the sluggish pace of server growth from the likes of IBM and Dell (Nasdaq:DELL) points to shrinking market opportunity.

With that in mind, it seems like a lot of debate revolves around VMware's opportunity in desktop. I am of the opinion, however, that "desktop" isn't just about virtualization. Virtualization may be the biggest single market opportunity tied to desktops, but what about app management/infrastructure, productivity and physical desktop management? Those should all be worthwhile markets (particularly for companies able to take a suite approach), and I like VMware's chances there relative to Citrix, though I wouldn't underestimate Microsoft.

Likewise, I wouldn't ignore VMware's opportunities in system management. It's a more crowded space, with companies such as IBM, CA (Nasdaq:CA) and BMC (Nasdaq:BMC) already there (and in some cases struggling to grow), but it could be a big opportunity for the right new mousetrap.

SEE: Great Company Or Growing Industry?

The Bottom Line
In declining about 10% over the past year, VMware is finally at a point where investors may actually be able to talk about expected growth rates and cash flow-based valuation instead of just "buy it and hope it grows ... a lot." Of course, it stands to reason that it would take pretty sizable macro and company-specific worries for that to happen.

I still believe that VMware can grow cash flow at a low double-digit rate, but I acknowledge that the company pretty much has to be successful in categories such as desktop, system management and software-defined networking for that to happen. That sort of growth points to a fair value in the mid-$90s to low-$100s, which doesn't seem like a particularly large margin of safety for a company with this sort of risk and volatility, but is more than most growth companies get. If you still believe that VMware is a growth company/stock, this might be the time to think again about these shares.

At the time of writing, Stephen D. Simpson owned shares of EMC, which owns a majority stake in VMware, since September 2012.

Tickers in this Article: VMW, MSFT, CTXS, CA

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