VMware To Beat Guidance On Revenue, EPS Based On Preliminary Earnings Release

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VMware (NYSE:VMW) is scheduled to announce its third quarter earnings on Tuesday, October 20. [1]  Earlier this week, Dell announced that it would acquire VMware’s majority owner EMC in a $67 billion acquisition. Dell intends to keep VMware a publicly traded company, retaining an approximately 28% stake in VMware. VMware’s shareholders reacted negatively to the acquisition news, with its stock falling by about 12% to about $70 before open on Monday before recovering slightly to $72 by the end of the day. VMware’s stock price further fell to $69 through Thursday.

EMC had an 80% stake in VMware, with 97% of voting rights. With Dell acquiring EMC, it has effectively taken the 97% voting rights but floated over 50% of VMware’s stock as tracking stock with no voting rights. Under the conditions of the deal, Dell would have a 28% stake in VMware with 97% voting rights, while existing VMware shareholders retain the 20% ownership with 3% voting rights and over 50% ownership lies with former EMC shareholders in the form of tracking stock and no voting rights. [2]

Despite the dip in VMware’s market price, the company had some positive news for shareholders. VMware released its preliminary Q3 results following the news of the acquisition. The company expects Q3 revenues to be over $1.67 billion, which is a 10% year-over-year increase and is higher than the midpoint of the guidance given at the end of Q2. [3] In line with expectations, the services revenues could grow by 13-14% while licensed revenues could be up by about 7% on a y-o-y basis.

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We maintain our $86 price estimate for VMware’s stock, implying a market cap of just over $36 billion.

See our complete analysis for VMware here

Network Virtualization, End-User Computing To Sustain Growth

VMware has seen a strong customer response for the its software-defined networking (SDN) platform NSX, with the number of paying customers rising to over 700 by the end of Q2, up from only about 150 at the end of June last year. Five out of VMware’s ten largest deals in the most recent quarter included the NSX implementation. VMware’s software-centric approach to networking is a threat to Cisco’s (NASDAQ:CSCO) market share in the SDN market. According to the company’s estimates, the number of production customers that are currently using NSX is far greater than the number of customers using similar products of any competing provider. Many of VMware’s customers continue to upgrade their networking and security requirements owing to the hardware-bound limitations in their current architectures. On the other hand, non-IT small and medium enterprises are likely to migrate to a newer technology once it fully matures. Accordingly, VMware could witness an increasing mix of large-scale license agreements and implementations in the coming years.

VMware has witnessed strong demand for its end-user computing and mobility solutions in the last few quarters since it acquired Airwatch for $1.5 billion last year. The company has sustained growth in this domain and was recently recognized by IDC as a clear leader in enterprise mobility management domain. [4] Additionally, the company announced the acquisition of email-startup Boxer to boost its end-user computing and mobility management capabilities. [5]

VMware witnessed a 30% year-over-year increase in license bookings in the end-user computing domain in the June quarter. Within end-user computing, the desktop-as-a-service business grew by a healthy 15% on a y-o-y basis and the company gained share from competitors. [6] During the quarter, VMware announced upgrades for its desktop virtualization software suites VMware Fusion for Mac and VMware Workstation for Windows. The enhanced desktop hypervisors allow users to run Windows 10 sessions on their existing Mac or Windows computers systems.

Impact On Margins

The company’s software licenses gross margin (GAAP) expanded by almost 30 basis points over the prior year quarter to 92.8% in Q2. Similarly, the software licenses gross margin (GAAP) for the combined six month period was also about 30 basis points better than the previous year period at 92.1%. On the other hand, the company generated higher service revenues from hybrid cloud, network virtualization and end-user computing, due to which its cost of services rose by 19% y-o-y to $204 million for the quarter. As a result, the gross margin (GAAP) for the services division was about 90 basis points lower than the year ago period at 78.7%. With growth expected to continue in VMware’s services divisions, its services margins could compress in the coming quarters.

In terms of cash flows, the company reported a $75 million payment for the GSA settlement in Q2, due to which it lowered its expected cash flows from operations to $1.87 billion, from $1.95 billion previously. [7] Additionally, the company revised its capex guidance to under $350 million for the full year, down from about $400 million stated previously. [8]

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Notes:
  1. VMware to Announce Third Quarter 2015 Financial Results on Tuesday, October 20, VMware Press Release, October 2015 []
  2. Dell Will Issue a Lot of Not-Quite-Stock to Pay for EMC, Bloomberg View, October 2015 []
  3. VMware Reports Preliminary Q3 2015 Results, VMware Press Release, October 2015 []
  4. VMware Named A Leader in the IDC MarketScape for Client Computing Software, VMware Blog, June 2015 []
  5. VMware scoops up hot email startup Boxer, Giga OM, October 2015 []
  6. VMware Q2 2015 Earnings Call Transcript, Seeking Alpha, July 2015 []
  7. VMware will pay the government $75.5 million to settle an overcharging lawsuit, Business Insider, June 2015 []
  8. VMware Q2 2015 Earnings Call Transcript, Seeking Alpha, July 2015 []