VMware’s Year In Review: Hybrid Clouds, Software-Defined Networking, End-User Computing In Focus

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Virtualization and cloud computing provider VMware (NYSE:VMW) has been one of the fastest growing companies in its domain, with a 16% year-over-year growth in net revenues to $4.3 billion through the first three quarters of this year. The company reported a 14% increase in product licenses revenues over the prior year period to $1.8 billion. On the other hand, services revenues were up by 18% y-o-y to over $2.5 billion. [1] VMware’s management attributed much of the growth to fast-growing market segments such as hybrid cloud services, network virtualization – or software-defined networking (SDN) – and end-user computing.

VMware’s software licenses gross margin (GAAP) expanded by over 2 percentage points to 92.1% in through the first three quarters. On the other hand, VMware’s cost of services rose by nearly 40% y-o-y to $519 million as the company generated higher service revenues from hybrid cloud services and end-user computing. As a result, the gross margin (GAAP) for the services division in the first three quarters was about 3 percentage points lower than the year ago period at 79.4%. Moreover, VMware’s operating expenses, including research and development, sales, marketing and other administrative expenses, were 25% higher than the year-ago quarter at nearly $3 billion in the period from January through September. Consequently, the company’s reported net income was 18% lower than previous year levels at $560 million. However, VMware’s non-GAAP adjusted net income was about 5% higher than prior year levels at $1.1 billion. VMware expects that the integration of technology from the AirWatch acquisition and related cost synergies could further enhance profitability in the coming quarters.

Below we take a look at key areas of growth for the company, and the company’s efforts to expand internationally this year. We have a $95 price estimate for VMware’s stock, which is over 10% higher than the current market price. VMware’s stock traded at a year-high of $111 in early April and fell to as low as $76 in mid-December.

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See our complete analysis for VMware here

Software-Defined Networking

Over the last few quarters, the company has seen a strong customer response for VMware NSX, its network virtualization platform launched by  the company in late 2013. VMware management stated that the company does not intend to harm its partnership with networking giant Cisco (NASDAQ:CSCO) by launching competing SDN products. [2] However, a software-centric approach to networking threatens to cannibalize Cisco’s market share. The VMware NSX creates software-based network overlays on top of existing hardware, thereby decoupling networking-related intelligence from the hardware. This makes networks programmable and scalable, and gives enterprises the flexibility to implement technology changes through mere software upgrades. What makes SDN even more appealing to enterprises is that it allows them to put third-party software on cheap white-label networking hardware, making it potentially much cheaper to implement than installing Cisco’s hardware products that come with embedded software. Moreover, the NSX can be integrated with vSphere, VMware’s existing server virtualization platform.

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). At the end of Q3, VMware reported 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. Going forward, VMware’s NSX suite seems like an attractive option for new customers, especially small and medium enterprises (SMEs), as it cuts huge capital expenses required for hardware and equipment, while the company expects strong revenue growth in the coming quarters.

Hybrid Cloud

VMware’s hybrid cloud business grew by over 100% y-o-y in the first quarter, after which the company introduced its cloud-based disaster recovery services. The trend continued in Q2, with its business growing by nearly 80% y-o-y in the quarter. After Q2, the company rebranded its hybrid cloud business to vCloud Air. Subsequently, the company kept up the 80% growth rate through the third quarter. According to a Gartner report, VMware is one of the only five major cloud computing providers in its 2015 forecast for enterprise-class hybrid cloud computing. [3] 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. VMware management believes that the the company’s rapidly growing hybrid service offerings and a vast partner network could help raise the contribution of hybrid cloud revenues to the company’s top line in the coming quarters.

AirWatch And End-User Computing

VMware announced the acquisition of mobile device management (MDM) provider AirWatch for $1.54 billion back in January 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% annual growth in end-user computing license bookings in 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. Management believes that with the AirWatch business under its belt, it now has the leading market share in enterprise mobile management and security domains. Furthermore, the company released the VMware Workspace Suite, which offers an integrated portal to access Desktop-as-a-Service (DaaS) platform VMware Horizon, content management solutions and AirWatch.

Geographic Expansion

VMware focused on expanding its international presence during the year, with recent announcements 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 10-Q3, SEC, November 2014 []
  2. VMware CEO: NSX Isn’t Going To Hurt Cisco Partnership, And It Could Help, CRN, August 2013 []
  3. VMware Q3 2014 Earnings Call Transcript, Seeking Alpha, October 2014 []