A Closer Look At VMware’s R&D Budget

VMware (NYSE:VMW) has been one of the fastest-growing software companies this decade, with the company commanding a sizable share of the virtualization market. The virtualization software market began expanding massively in late 2000s, with initial server virtualization capabilities leading the way for companies to subsequently develop software-defined storage and network virtualization (or software-defined networking) products and services. As a leading virtualization provider, the company has benefited significantly from its strong presence in a fast-growing market space.

Research and development efforts are generally the lifeline of software and technology companies. Tech companies often spend a significant percentage of their revenues on R&D to stay relevant in a quickly evolving landscape. As VMware continues to mature, it is imperative for the company to manage its operating expenses to diminish the impact of revenue growth slowdowns (due to large base factor) on net cash profits. To quantify the company’s operational efficiency, the revenue generated per dollar spent on R&D expenses can be regarded as a key indicator for operational efficiency.

Measuring R&D Efficiency For VMware

VMware’s revenues have grown from $4.6 billion in 2012 to $7.1 billion in 2016 – a compound annual growth rate of over 11%. Similarly, VMware’s gross profits have also increased at a CAGR of over 11% from 2012 through 2016. In the same period, the company’s total research and development expenditures have increased at a CAGR of over 13% from around $700 million in 2012 to over $1.1 billion in 2016. It should be noted that we adjust cost of revenues and operating expenses for depreciation, amortization, share-based compensation and other non-GAAP reconciliation measures, which explains any discrepancies between the numbers shown here and the reported figures.

As shown in the table above, VMware has generated roughly $6-7 per dollar spent on R&D expenses in the last five years. This ratio improved slightly from $6.70 in 2012 to $6.80 in 2013 before consistently declining to around $6.30 by the end of 2016. Similarly, VMware’s adjusted gross profit per dollar of R&D expenses stood at $5.90 in 2012, which improved slightly to $6 in 2013 before falling to $5.50 in 2016. A key trend to note here is that despite consistent revenue increases on a year-over-year basis, the revenue or gross profit generated per unit R&D expenditure has declined at a gradual pace over the years.

While VMware has continued to develop and launch disruptive technologies in fast-growth markets such as network virtualization (NSX), virtual storage and end-user computing and mobility solutions (AirWatch), cloud computing and SaaS initiatives, it has been expensive for the company. Moreover, these technologies require significant reinvestment throughout the course of the product life in order to maintain its competitive edge in the market.

However, this process often entails greater risk than incremental benefits by reinvestment, given that the company faces tough competition in the virtualization market. With businesses increasingly using public cloud and SaaS-based offerings, they are shifting existing workloads to the cloud, thereby slowing the demand for on-premise IT resources. As a result, VMware could face tough competition from infrastructure-as-a-service offerings from large public cloud providers such as Amazon’s (NASDAQ:AMZN) AWS and Microsoft’s (NASDAQ:MSFT) Azure. In addition, VMware also competes with networking giant Cisco (NASDAQ:CSCO) in the SDN market. While this is likely to slow down the growth rate of revenues in the coming years, it is also likely to lead to higher R&D investment in order to sustain its market presence.

Going forward, we forecast VMware’s net revenue and gross profit to increase at mid single digits over the long run due to increasing competition and tougher year-over-year comparisons. We forecast VMware’s adjusted R&D expenses in absolute terms to increase from around $1.1 billion in 2016 to nearly $1.6 billion by 2021 – a CAGR of over 7%. As a result, the revenue generated per dollar spent on R&D is likely to decline slightly in the coming years, according to our estimates.

You can modify the interactive charts in this note to observe the impact a change in VMware’s Gross Margin, and R&D expenses as a percentage of gross profit, can have on our price estimate for the company’s stock. We have a $90 price estimate for VMware’s stock, which is slightly lower than the current market price.

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