VMware’s 2017 In Review

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VMware (NYSE:VMW) has had a positive year so far, with strong revenue growth across segments. This revenue growth was complemented by improvement in gross profit and operating profit margins. There have also been some key developments for VMware through the year. For example, the company signed an agreement with Amazon (NASDAQ:AMZN) to integrate its private cloud offerings with Amazon Web Services’ public cloud for an integrated hybrid cloud platform. This could fuel growth in its hybrid cloud offerings in the long run. Further, VMware announced its intent to acquire SD-WAN company VeloCloud and cloud SaaS management provider Wavefront this year.

VMware’s net revenue through the first three quarters of the year was up 11% to $5.6 billion, with a similar increase in non-GAAP gross margin. The resulting gross profit margin expanded 30 basis points to 87.3%, as shown below. A limited increase in operating costs (particularly SG&A expenses) led operating income to increase 14% to $1.8 billion with the operating margin (non-GAAP) expanding by almost a percentage point to 31.5%. Net income and earnings per share rose in the mid-to-high teens to $1.5 billion and $1.34, respectively, through the first three quarters of the year.

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It should be noted that all year-over-year comparisons made by the company in its press releases and in this note compare FY’18 (February 2017 to January 2018) with the corresponding previous fiscal year (January 2016 to December 2016), due to the company changing its fiscal calendar earlier this year. Beginning Q1 FY’19, the company intends to adhere to ASC 606 accounting standards, which would help reduce its high deferred revenue figures. Furthermore, VMware’s cloud revenues from AWS are also expected to be recognized on a net basis after the adoption of the new accounting practices.

Performance By Segment

VMware’s license revenues were up 12% y-o-y to $2.1 billion, while gross margins (non-GAAP) for the license business were up a 70 basis points to 98.4%. The company witnessed particularly strong demand for network virtualization platform NSX through the year, for which total license bookings for were up 100% on a y-o-y basis in the most recent quarter. In order to further assert dominance in the software-defined network (SDN) market, VMware acquired VeloCloud last month. Similarly, hyper-converged software suites including VSAN and VxRail also demonstrated strong growth through the year, with strong growth in Virtual SAN license bookings and a corresponding increase in the total paying customers.

Services revenues were also up 11% y-o-y to just under $3.5 billion, while the services gross margin (non-GAAP) improved by 10 basis points to 80.5%. Within the services segment, software maintenance revenues rose 9% to just over $3 billion, while professional services revenues were up 19% y-o-y to $474 million for the quarter. According to VMware’s management, hybrid cloud and Software-as-a-Service (SaaS) revenues have increased in double digits in recent quarters.

Sustained Growth Through End of the Year

After a successful year thus far, VMware’s management has given positive guidance for the full fiscal year, with net revenues expected to rise 11% to $7.9 billion. Similarly, improving gross margins and disciplined expense management through the year has helped improve the operating margin. This trend is also likely to sustain in the current quarter, due to which the non-GAAP operating profit margin is expected to be over a percentage point higher for the full year. Resulting non-GAAP diluted earnings per share could also be up in double digits for the fourth fiscal quarter and full year.

We maintain our $97 price estimate for VMware’s stock, which is around 20% lower than the current market price. VMware’s stock has risen by over 60% this year following successive quarters of robust growth and a strong future outlook. You can modify the interactive charts in this note to gauge how a change in individual drivers can have on our price estimate for VMware.

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