Hybrid Cloud, Network Virtualization, End-User Computing Drive VMware’s Q3 Results

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VMware (NYSE:VMW) announced its third quarter earnings on Tuesday, October 21. The company reported an 18% increase in net revenues over the prior year quarter to almost $1.52 billion – close to the upper end of the guidance given at the end of Q2. Services revenues were up by 21% y-o-y to $876 million while software license sales rose by 14% to $639 million. VMware has maintained its full year net revenues guidance at just over $6 billion, which is 15-16% higher than 2013 revenues. [1]

In line with our expectations, software licenses gross margin (GAAP) expanded by almost 2 percentage points to 92.8%. On the other hand, as the company generated higher service revenues from hybrid clouds, network virtualization and end-user computing, its cost of services rose by nearly 50% y-o-y to $196 million. As a result, the gross margin (GAAP) for the services division was about 4 percentage points lower than the year ago period at 77.6%. Moreover, VMware’s operating expenses, including research and development, sales, marketing and other administrative expenses, were 25% higher than the year-ago quarter at over $1 billion in Q3. Consequently, the company’s reported net income was 20% lower than previous year levels at $244 million. However, VMware’s non-GAAP adjusted net income was about 4% higher than Q3 2013 at $377 million – in line with the company’s expectations. VMware expects its non-GAAP operating margin to be 31% for the full year – about 150 basis points higher than the operating margin in Q2. The company expects that the integration of technology from the AirWatch acquisition and related cost synergies could help improve profitability through the rest of the year.

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vCloud Air, NSX and AirWatch Drive Revenue Growth

VMware’s management mentioned that the company has been focusing on fast-growing segments including network virtualiztion, or software-defined networking (SDN), hybrid cloud services and end-user computing. The company continued to witness strong demand for these products and services, leading to a 100% y-o-y rise in their consolidated revenues.

  • Hybrid Cloud

VMware’s hybrid cloud business, which was recently rebranded vCloud Air, grew by nearly 80% y-o-y in the second quarter. The trend continued in Q3 as the company kept up an 80% growth rate. As a result, hybrid cloud and software-as-a-service offerings combined currently form only 5% of VMware’s net revenues, up from under 3% in the year ago period. Although this is a small portion of VMware’s net revenues, it is one of the fastest growing sub-segments within the company, due to which its contribution could rise significantly in the coming quarters.

  • Network Virtualization

Over the last few quarters, the company has seen a positive customer response for NSX, the network virtualization platform launched by VMware in late 2013. VMware reportedly made significant progress in Q3 this year through strategic partnerships and reseller agreements with peer technology and networking companies such as F5 Networks (NASDAQ:FFIV), Hewlett-Packard (NYSE:HPQ) and Dell (NASDAQ:DELL). VMware now has over 250 paying customers for NSX, up from 150 at the end of the second quarter. Management articulated that VMware’s infrastructure-as-a-service (IaaS) offerings would be built on open source platform OpenStack and would be made available integrated with NSX offerings going forward.

  • AirWatch and End-User Computing

VMware announced the acquisition of mobile device management (MDM) provider AirWatch, for $1.54 billion back in January this year in an attempt to add enterprise-mobile management and security to its offerings in the end-user computing space. The company has since witnessed a strong demand for mobility solutions, as evidenced by 50-60% y-o-y growth in end-user computing license bookings in the both Q2 and Q3. Management mentioned that the company is increasingly leveraging end-user computing solutions and offering integrated products to large enterprise customers. Within the end-user computing space, VMware’s software license bookings for desktops grew by double digits.

Geographic Expansion

VMware is focused on expanding its international presence, with the recent announcement that it will be opening a new vCloud data center in the U.K, as well as the closing of deals with Japanese telecom provider SoftBank and China Telecom (NYSE:CHA) to start deploying hybrid clouds globally. VMware’s share of revenues from international markets rose from 51.5% in 2011 and 2012 to 52.3% in 2013. Although this mix further increased to 52.7% in the first half of 2014, the company witnessed softness in certain international markets. Sales in Russia declined by over 50% y-o-y owing to the tense geopolitical situation in the region. Moreover, macroeconomic conditions in Germany and Japan kept sales low in these countries as well. Despite a setback in these major markets, the company witnessed a higher-than-industry average growth rate in China and the rest of Asia-Pacific. Additionally, the company had robust sales in southern Europe despite tough macroeconomic conditions.

VMware expects the company-operated cloud to be available in over 75% of the world’s cloud market by the end of 2014. As a result, it has announced its on-demand hybrid cloud service early access program in Japan and Germany in addition to opening up a hybrid cloud location in New Jersey to serve the U.S. government.

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Notes:
  1. VMware Q3 2014 Earnings Call Transcript, Seeking Alpha, July 2014 []