How Has VMware Performed This Year?

by Trefis Team
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Virtualization and cloud computing provider VMware (NYSE:VMW) had an uncertain start to the year, with the pending Dell-EMC deal awaiting confirmation from shareholders in early 2016. At the time, EMC management proposed a joint venture between EMC-owned cloud service platform Virtustream and VMware. VMware management backed out of the cloud venture, as VMware shareholders remained uneasy with speculation about the company’s future. [1] In that period, VMware’s stock price plummeted from around $80 at the end of Q3 last year to $44 by the end of January.

Over the course of this year, VMware has demonstrated strength in its business, with its revenues and profits seemingly unaffected by the acquisition of the parent company. Subsequently, its stock price increased through the year to around $80 currently. We maintain our $76 price estimate for VMware’s stock, which is slightly lower than the current market price. Below we take a look at how VMware performed through the year.

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Core Business Sustains Growth

The strong growth in virtualization software sales has led market leader VMware to report strong growth in revenues over the years. VMware’s net revenues surged from around $2 billion in 2009 to $6.6 billion in 2015 – a compound annual growth rate of almost 22%. Although the growth rate has slowed down in recent years, the company has reported an 8% annual growth in revenues this year. While software licenses revenues have only grown at around 1% this year, services revenues have grown at 9% y-o-y to $3.2 billion as shown below.

vmw_yir3

In terms of key growth areas for the company, VMware’s network virtualization platform NSX had around 900 paying customers at the end of Q3 last year. This has jumped to around 1900 paying customers by the end of the September quarter this year. The company announced the acquisition of cyber security and software-defined data center operations company Arkin Net during Q2 to help customers adopt its NSX platform faster. [2]

In addition, the number of Virtual SAN customers increased to 5500, up from under 3000 customers at the beginning of the year as shown below. VMware also reported that combined revenues of hybrid cloud and SaaS offerings were up by over 30% on a y-o-y basis to almost $400 million this year. This growth was driven by a 35% annual increase in vCloud Air Network bookings through the quarter. [3]

vmw_yir1

VMware’s business has gradually transformed from primarily a software licenses vendor (over half of net revenues from license agreements in 2009) to a services-based model with software licenses revenues falling to around 40% of net revenues in 2015. Since services typically have lower gross margins than the licensing business, VMware’s gross profit margins have compressed almost 88% in 2011 to under 87% in 2015. However, VMware reported an increase in Non-GAAP gross margins for both licenses and services division this year. The adjusted gross margin of the licenses division improved by 80 basis points to 97.7% while gross margin of the services division was around 30 basis points higher than the comparable prior year period to 80.4%. As a result, the company-wide gross profit margin was up by 50 basis points to 87%.

vmw_yir2

On the other hand, higher operating expenses led non-GAAP operating income to grow at around 6%, as compared to the 8% revenue growth. VMware’s management mentioned that the company aims to improve its operational efficiency by reducing operating expenses and headcount. The company intends to reinvest its resources into fast-growing areas such as the network virtualization platform NSX, hyper-converged infrastructure solutions (vSAN), virtual storage and end-user computing and mobility solutions (AirWatch). [4]

Going forward, the growth rate for revenues and gross profit is expected to slow down to mid single digits in the long run. Moreover, the increase in VMware’s operating expense could also slow down further as the company matures. With increasing employee headcount and higher R&D expenses, it is imperative for management to focus on improving profitability of the services division. You can modify the interactive charts in this note to observe the impact a change in individual drivers can have on our price estimate for VMware.

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Notes:
  1. Another hiccup for Dell-EMC deal: VMware backs out of cloud venture, Market Watch, December 2015 []
  2. VMware Announces Intent to Acquire Arkin Net to Help Customers Accelerate Adoption of VMware NSX and Software-Defined Data Centers, VMware Press Release, June 2016 []
  3. VMware Q3 2016 Earnings Call Transcript, Seeking Alpha, October 2016 []
  4. VMware Q4 2015 Earnings Call Transcript, Seeking Alpha, January 2016 []
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