In the past week, VMware‘s (NYSE:VMW) stock has plunged more than 15% to reach near its 52-week low of $67 (before recovering more than 7% to cross $71 on Thursday). The stock opened this year at around $92 and hit a high of $100 before slumping to below $70 levels. The new wave of selling came after a number of downgrades by various investment banks. In addition, during its capital allocation conference call, VMware’s parent company EMC presented lower operating cash flows ($1.87 billion)  from VMware in 2013 than what it generated in 2012 ($1.9 billion). 
While VMware provided guidance for double digit revenue growth in its Q1 earnings conference call, the new data could be a sign of a further slowdown in growth and/or pressure on operating margins. The business environment has weakened in the U.S. in the last couple of months due to budget sequestration even as persistent weakness in the European markets has been weighing on the growth. Further, Dell recently announced that it would cease its VMware-powered public cloud service. Growing competition for its core server virtualization offerings is also presenting challenges for the company.
While we expect the stock to remain under pressure in the near term due to weak IT spending, we believe it is undervalued at its current levels and is worth $101 based on its leadership position in the core virtualization business, mobile desktop virtualization and software defined data center opportunities and recently undertaken Pivotal initiative.
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- What’s VMware’s Fundamental Value Based On Expected 2016 Results?
VMware Still A Preferred Player In A Fast Growing Market
Gartner’s Magic Quadrant report states that virtualization workloads will grow five-fold by 2015, and this is a very large growth opportunity for VMware.  Though competition from Microsoft, Citrix, Oracle and more recently Openstack has taken some market share away from VMware, we think that these concerns are overdone. According to a recent survey, open source cloud initiatives like Openstack have not received traction as strong as expected.  VMware continues to remain the preferred private cloud supplier with Microsoft coming in at second place.  VMware still holds about 60-70% of the market with medium-sized companies as well as high market share among large companies, albeit just a little lower.
EMC is the majority stake holder of VMware and is also the global leader in the enterprise storage system and the storage software markets. We believe enterprises moving to the cloud present a huge growth opportunity for storage and virtualization. EMC’s customers buying storage can also benefit from virtual desktops and resource pooling, and this presents a cross selling opportunity for EMC to generate leads for VMware products. Further, VMware is also known for its creative pricing and licensing strategies to get better deals.
Software Defined Datacenters, Mobile Virtualization Key To Future Growth
With increasing mobile computing and the bring your own device (BYOD) movement, data traffic has increased substantially. This has been putting significant pressure on traditional data centers due to the inefficient capacity use of switches (which connect storage hardware with the network through cables). ((Oracle Acquires Xsigo: Will It Deliver ‘Pleasant Surprises’?, Forbes, July 30 2012)) Further, many of these companies offer converged infrastructure, and their switches are mostly not cross-compatible with products from other vendors. This forces enterprises to stick to their original vendors and buy expensive switches, which translates to higher costs. However, with cost-cutting taking priority for many enterprises, software defined networking (SDN) is gaining traction.
VMware acquired companies such as Nicira and DynamicOps in the second half of 2012 to gain entry in the SDN space. These companies use software to abstract hardware resources and pool it into aggregate capacity, which can be used efficiently as needed. During Q1 earnings, VMware announced its intention to create a new product line called VMware NSX. The platform will merge VMware’s vCloud networking product line with Nicira’s network virtualization platform into a single product family. With new innovative products like NSX, we can expect continued growth in VMware’s revenue going forward.
The mobile desktop virtualization opportunity is also a much bigger opportunity than desktops as it covers smartphones and tablets, which are growing at a much faster rate than PCs. As the workforce becomes more mobile and demands CRM and data services on the move, the mobile desktop virtualization market is expected to see rapid growth. VMware has partnered with Nimble to deploy virtual mobile desktops that will enable employees to access company data securely through virtual snapshots, irrespective of the device used, and we expect this to pay off going forward.
Big Data Analytics, Pivotal Initiative Provide New Growth Opportunities
VMware is making efforts to tap the Big Data analytics space with the acquisition of Cetas. Big data analytics is currently used for processing massive amounts of data and costs dearly in deployment and maintenance. The Cetas software, however, is designed to run on virtual resources like Amazon Web Services and VMware’s vSphere, making it easier to scale and cheaper to use. This acquisition makes sense for VMware as its applications are deployed on the vSphere, its established product, and provides an opportunity to cross sell. This cost efficiency and the analytics-as-a-service model will help VMware meet the unmet demand from small and medium enterprises in the analytics space.
Pivotal, a joint venture of EMC and VMware (a subsidiary of EMC), started its operations on April 1, 2013. Through Pivotal, EMC and VMware are aiming to focus on Big Data and Cloud application platforms. IDC cloud research shows that revenue from IT cloud services is expected to reach $72.9 billion in 2015 at a compounded annual growth rate (CAGR) of 27%.  This is over four times the growth expected from the worldwide IT market and presents a huge growth opportunity. The formation of Pivotal will enable EMC and VMware to focus on their core competencies while pursuing the growing cloud services market.
Pivotal is expected to garner almost $300 million in revenues in 2013 and up to $1 billion by 2017.  Pivotal also recently received $105 million investment by GE for a 10% stake, which implies the venture is already being valued at over $1 billion. Notes:
- EMC Capital Allocation Conference Call, EMC, May 30 2013 [↩]
- VMware’s CEO Discusses Q1 2013 Results – Earnings Call Transcript, Seeking Alpha, Jan 28 2013 [↩]
- Gartner x86 Virtualization Infrastructure Report, Gartner, June 2012 [↩]
- Open Source Cloud Is Failing To Gain Traction: Survey, Channel Biz, May 09 2013 [↩]
- ref:5 [↩]
- IDC Cloud Research, IDC [↩]
- EMC, VMware To Launch Pivotal Initiative As Separate $300M Firm, CRN, March 13 2013 [↩]
- GE invests $105M in Pivotal to build the Industrial Internet, Venture Beat, April 24 2013 [↩]