VMware’s Top Line Growth To Be Helped By Improving Margins

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VMware (NYSE:VMW) is scheduled to announce its Q3 fiscal 2018 earnings on Thursday, November 30. The virtualization and cloud computing provider has demonstrating strength in its business this year, with fast-growing segments such as network virtualization, hybrid cloud, hyper converged software and vSAN driving growth. VMware’s license business and services business have both grown at a steady pace this year – a trend consistent with recent years.

We have a $91 price estimate for VMware’s stock, which is around 20% lower than the current market price. VMware’s stock price has increased by 40% in the second half half of the year following a strong set of recent results and solid guidance for future quarters.

See Full Analysis For VMware Here

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Guidance For Q3’18 & FY 2018

After a successful first half, VMware’s management has given positive guidance for the third quarter and full fiscal year. Third quarter revenues are expected to be around 12% higher at just under $2 billion, with full year revenues expected to rise 10% to $7.8 billion. Similarly, its operating profit margin is expected to continue to improve through the year due to disciplined expense management.

Resulting non-GAAP diluted earnings per share are also expected to be up to by double digits for the quarter and full year according to the consensus estimates. Please note that all year-over-year comparisons made by the company in its press release, and in this note we compare Q3 FY’18 (August to October 2017) with Q2 of last year (which was July to September 2016). Similarly, all full year comparisons involve FY’18 (February 2017 to January 2018) and the previous fiscal year (January to December 2016) due to the company updating its fiscal calendar earlier this year.

Fast-Growing Areas Key For Strong Results

VMware’s net revenues have continued to grow at a rapid pace in recent quarters, driven by strength in fast-growing areas such as network virtualization (NSX), hybrid cloud, hyper converged software and end-user computing (AirWatch). Hybrid cloud and SaaS revenues have risen annually by 25-30% in recent quarters, corresponding to the increase in total vCloud Air hybrid cloud license bookings. Similarly, the total number of paying customers for network virtualization platform NSX are up to over 2,600, from around 1,400 last year. Correspondingly, the total bookings for NSX have grown at high double digits in recent quarters. According to VMware’s management, most of the large-scale implementations for VMware (greater than $10 million) now include NSX as a part of the deal. In the most recent quarter, all big deals over $10 million included NSX. Furthermore, hyper-converged software suites including VSAN and VxRail have also demonstrated strong growth, a trend likely to continue in the near term.

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In recent years, VMware has gradually transformed from primarily a software license vendor to a services-based model. Over the last five years, the contribution of software licenses revenues to net revenues has fallen from around 50% in 2010 to 40% last year. In addition, economies of scale led to an improvement in gross margins (non-GAAP) for both the licenses and services businesses last year.

In addition to an improvement in gross margins, VMware’s operating income has also grown at a similar pace. While R&D expenses remain fairly high, the company has taken measures to reduce SG&A expenses in order to improve its operational efficiency. This could help the company to meet its targeted operating profit margin range of almost 33% through the end of the year (read: A Closer Look At VMware’s R&D Budget).

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