Hybrid Clouds, End-User Computing, SDN To Boost VMware’s Q1 Earnings

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Virtualization and cloud computing provider VMware (NYSE:VMW) is scheduled to announce its first quarter earnings on Tuesday, April 21st. VMware has been one of the fastest growing companies in its domain, with a 16% year over year growth in net revenues to $6 billion in 2014. The company reported a 14% increase in product license revenues over the prior year period to $2.6 billion. On the other hand, services revenues were up by 17% year over year  to over $3.4 billion. [1] Management attributed much of the growth to fast-growing market segments such as hybrid cloud services, end-user computing and network virtualization, now often called software-defined networking (SDN).

Management expects 2015 revenues to be 10-12% higher than 2014 at about $6.7 billion. VMware’s services revenue stream is likely to continue to witness a higher growth rate (of about 14%) than revenues generated through license bookings (+8%). The company has given revenue guidance for Q1’15 at about $1.5 billion or about 11% higher than the year-ago period. License booking revenues are expected to rise by 5%-6% on a year-over-year basis, while services revenues could rise by about 13%. [2]

VMware’s licenses gross margin (GAAP) expanded by almost 2 percentage points to 92.6% through 2014. On the other hand, VMware’s cost of services rose by nearly 40% year over year  to $725 million for the full year 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 2014 was over 3 percentage points lower than the previous year at 78.9%. Moreover, VMware’s full year cash operating expenses, including research and development, sales, marketing and other administrative expenses, were 23% higher than the previous year at nearly $4.1 billion. Consequently, the company’s reported net income was 13% lower than previous year levels at $886 million. However, VMware’s non-GAAP adjusted net income was about 6% higher than prior year levels at $1.5 billion.

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See our complete analysis for VMware here

Fast-Growing Product Lines

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’s software-centric approach to networking threatens to cannibalize Cisco’s (NASDAQ:CSCO) market share in the SDN market. What makes VMware’s SDN 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 made significant progress in Q3 this year through strategic partnerships and reseller agreements with technology and networking companies such as F5 Networks (NASDAQ:FFIV), Hewlett-Packard (NYSE:HPQ) and Dell (NASDAQ:DELL).

VMware reported over 400 paying customers for NSX by the end of December, up from 150 at the end of June last year. 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.

VMware’s hybrid cloud business grew by over 100% year over year in the March quarter last year, after which the company introduced its cloud-based disaster recovery services. The growth continued through Q2 and Q3, with this business growing by 80% year over year  in both quarters. The company rebranded its hybrid cloud business to vCloud Air after Q2. The December quarter continued to be a strong period of growth for vCloud Air with a 100% annual increase in revenues. As a result, hybrid cloud and software-as-a-service offerings combined formed about 5% of VMware’s net revenues through 2014, up from under 3% of net revenues in the 2013. Although hybrid cloud is one of the fastest growing sub-segments within the company, management expects a stronger dollar and tougher year-over-year comparisons to limit growth in this segment in the coming quarters.

The third key area of growth for VMware was end-user computing and mobile device management, which was boosted by the $1.5 billion Airwatch acquisition in January last year. The company has since witnessed strong demand for mobility solutions, as evidenced by 50-60% year-over-year growth in end-user computing license bookings through Q2, Q3 and Q4. At the end of Q4, the total number of AirWatch customers stood at over 15,000, while net revenues generated through license bookings crossed the $200 million mark in the December quarter. Owing to a significantly large customer base VMware is the clear leader in the enterprise mobile management market domain, with nearly twice the customers of its closest competitor. [2]

We have a $90 price estimate for VMware’s stock, which is slightly higher than the current market price.

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Notes:
  1. VMware 10-K, SEC, February 2014 []
  2. VMware Q4 2014 Earnings Call Transcript, Seeking Alpha, January 2015 [] []