This earnings cycle has been relatively better than feared for most tech stocks so far, but VMware Inc. (NYSE:VMW) is going to go down as a glaring exception. While fourth quarter results were generally solid relative to expectations, the Street absolutely hated what management had to say about lower overall growth in 2013 and sales growth more heavily weighted to the second half. The stock's nearly 20% drop as of this writing seems overdone, but VMware is going to have to rebuild its credibility before valuation matters again.
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Fourth Quarter Results Were Mostly OK
VMware reported 22% revenue growth over last year and 14% over the prior quarter, good for a small beat relative to Wall Street estimates. License revenue was basically on track with a 16% growth, while maintenance/service revenue rose 27%. Although that all looks good, as did the 15% bookings growth, the 7% growth in license billings was not only disappointing, but also the second straight sub-10% quarter.
Margins and profits came in pretty solid. Gross margin (non-GAAP) rose 60 basis points (BPS) from last year, and beat the average estimate by a full point, while the GAAP number was up about a full point. Operating income (again, non-GAAP) grew 25% from last year and 16% from the prior quarter, and VMware delivered nearly a full point of year-on-year operating margin improvement (and 80 BPS better than expected). On a GAAP basis, the year-on-year growth was 18%.
There is one part of the financials that I don't like. The company reported a big (and unusual) increase in accounts receivable. This can be a sign that the company garnered a significant portion of its business late in the quarter and/or had to really press for that business - not exactly a solid marker of good underlying conditions.
Guidance Leads to a Plunge
Investors and analysts weren't going to be ecstatic about the single-digit license billings growth, nor the big jump in accounts receivable, but that's not why the stock is getting hammered. Management's updated guidance calls for less growth in 2013 - 15% versus a prior expectation of 18% - and more of that growth to come in the back half of the year. The company's guidance also pointed to sub-10% license growth against an expectation of around 14% growth.
These aren't huge revisions, but VMware is supposed to be a growth company and growth companies don't do this. It's true the company has difficult comps in the first quarter and the new pivotal joint venture with parent company EMC Corporation (NYSE:EMC) could be siphoning off revenue growth, but it's not a pretty situation - particularly with fears already running rampant that the company has saturated its core market and/or that it's being undermined in its follow-up products.
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Where's the Growth Going to Come from?
The biggest fear is that with about 70% of the addressable server market already virtualized, there's not much further for VMware to go with its core products. What's worse, Microsoft (Nasdaq:MSFT) has been gaining real traction with its free Hyper-V alternative, and other rivals like Red Hat Inc. (NYSE:RHT) and Citrix Systems Inc. (Nasdaq:CTXS) likewise seems to be siphoning off business.
It can be argued whether or not VMware was going to get much of the business that the free offerings of Microsoft and the others are capturing - it could well be the case that these are smaller businesses that weren't going to easily afford VMware software anyway. The potentially bigger risk is to vCloud and other management tools and applications that VMware hopes to sell. Simply virtualizing a server is only part of a rather involved process and VMware has been looking to products like vCloud (and its three times higher ASP) as a means of growing the business. Unfortunately, clients aren't thrilled with the idea of being fully locked in to VMware, and rival offerings like OpenStack are gaining traction.
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Software-Defined Network - Next Big Thing, or Unicorn Ranch?
There's nothing so overly wrong with VMware that a few strong quarters won't fix. Even so, it would help the stock if the opportunity around software-defined networking (SDN) became more evident. At this point, the idea is that SDN can essentially move the emphasis in networking from hardware to software, and companies like VMware and Cisco Systems Inc. (Nasdaq:CSCO) have invested considerable sums. While the potential of SDN is measured in the billions of dollars, it's at least a little like a unicorn right now - everybody agrees as to what it is and what it can do, but that doesn't mean it's actually real.
The Bottom Line
For brave investors put off by VMware's sometimes steep valuation, now could be an opportunity to buy shares. I do believe that the business is facing some near-term challenges, but I also have confidence that the new product/license opportunities are real, that the addressable markets are still very large and that the guidance revision is motivated at least in part by a new management team that wants to clear the decks and start on good beat-and-raise footing. At a minimum, we'll know in a couple of quarters.
If VMware can still grow its free cash flow at a long-term rate of 10%, these shares are too cheap and value-oriented investors should dig deeper. Clearly there are risks here today, but growing tech stocks almost never get cheap without some major worry fueling the process.
At the time of writing, Stephen D. Simpson owned shares of EMC since 2012.
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