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.

SEE: A Primer On Investing In The Tech Industry

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.

SEE: Technology Sector Funds

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.

SEE: Clean Or Green Technology Investing

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.

Related Articles
  1. Investing Basics

    Learn How to Trade Semiconductor Stocks in 4 Steps

    The enormously diverse semiconductor industry requires market players looking for exposure have specialized knowledge.
  2. Mutual Funds & ETFs

    What Exactly Are Arbitrage Mutual Funds?

    Learn about arbitrage funds and how this type of investment generates profits by taking advantage of price differentials between the cash and futures markets.
  3. Investing News

    Ferrari’s IPO: Ready to Roll or Poor Timing?

    Will Ferrari's shares move fast off the line only to sputter later?
  4. Investing News

    Why the Philippines Is the #1 Source for Tech Startups & Talent

    In the last few years, the Philippines has been working diligently to re-invent itself, and that work has paid off. The Southeast Asian nation is rapidly gaining notoriety as a leading source ...
  5. Investing News

    Austin Set to Rival Silicon Valley

    Over the years, Austin, Texas has lovingly embraced its quirky reputation with the slogan “Keep Austin Weird.” Today, the capital city is attracting several tech startups and investors, making ...
  6. Stock Analysis

    5 Cheap Dividend Stocks for a Bear Market

    Here are five stocks that pay safe dividends and should be at least somewhat resilient to a bear market.
  7. Stock Analysis

    The Biggest Risks of Investing in Amazon Stock

    Find out which risks are most important to Amazon's shareholders. Learn which operational risks impact share prices and which financial risks affect investors.
  8. Investing

    How to Win More by Losing Less in Today’s Markets

    The further you fall, the harder it is to climb back up. It’s a universal truth that is painfully apparent in the investing world.
  9. Fundamental Analysis

    Use Options Data To Predict Stock Market Direction

    Options market trading data can provide important insights about the direction of stocks and the overall market. Here’s how to track it.
  10. Stock Analysis

    2 Oil Stocks to Buy Right Now (PSX,TSO)

    Can these two oil stocks buck the trend?
  1. How do dividends affect retained earnings?

    When a company issues a cash dividend to its shareholders, the retained earnings listed on the balance sheet are reduced ... Read Full Answer >>
  2. What is the difference between called-up share capital and paid-up share capital?

    The difference between called-up share capital and paid-up share capital is investors have already paid in full for paid-up ... Read Full Answer >>
  3. Why would a corporation issue convertible bonds?

    A convertible bond represents a hybrid security that has bond and equity features; this type of bond allows the conversion ... Read Full Answer >>
  4. How does additional paid in capital affect retained earnings?

    Both additional paid-in capital and retained earnings are entries under the shareholders' equity section of a company's balance ... Read Full Answer >>
  5. What types of capital are not considered share capital?

    The money a business uses to fund operations or growth is called capital, and there are a number of capital sources available. ... Read Full Answer >>
  6. What is the difference between issued share capital and subscribed share capital?

    The difference between subscribed share capital and issued share capital is the former relates to the amount of stock for ... Read Full Answer >>

You May Also Like

Trading Center
You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!