Beware Valuation Risks on VMware Stock

VMware is a low growth company, but VMW stock features a high growth valuation

In early May 2019, cloud computing and virtualization software giant VMware (NYSE:VMW) looked unstoppable. VMware was riding high on big-time partnerships with cloud platform giants Amazon (NASDAQ:AMZN) and Microsoft (NASDAQ:MSFT), the numbers looked great and VMW stock was soaring towards fresh all-time highs around $200.

Beware Valuation Risks on VMware Stock
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But, as seasoned investors know, when stocks look unstoppable — well, that’s when they are most likely to be stopped.

VMware stock has been no exception. In May 2019, VMW stock touched an all-time high of $206. Ever since, shares have shed more than 25%. The culprit behind the selloff? VMware has gone on an aggressive buying spree, and investors aren’t sure if all of these acquisitions will pay off in the long run. Organic revenue growth has also slowed over the past few months. Profit margins have started moving in the opposite direction.

Put all that together against a stretched valuation backdrop — VMW stock was trading at a multi-year high, 30-times forward earnings multiple in May — and it’s no wonder that the VMware stock price has come crashing down over the past few months.

What’s next? I’d say some choppy trading. Technically and optically, it looks like the worst of the selloff is over. But, fundamentally, near- to medium-term upside in shares is not compelling.

As such, I’m choosing to watch this one from the sidelines. Neither the bull nor the bear theses look all that good here.

Technicals and Optics Look Good

The technicals and optics for VMware stock look good, and both support the notion that the worst of this recent selloff is over.

From a technical perspective, you have a stock that was severely beaten up. But, shares have shown strength over the past few weeks. They are up nearly 20% from their late August lows, and the stock is getting awfully close to crossing above its 50-day moving average in a convincing manner. If the stock does retake this trend line, then the technicals will signal that a bottom in this selloff has been put in.

On the optics side, broader market sentiment has improved meaningfully over the past several years. With respect to VMW stock specifically, trade tensions have cooled and global economic activity has picked up. Both of these things have brought investors back into large-cap cloud stocks with global exposure, because there is a feeling out there that the global semiconductor market — which has been retreating for the entire year — is about to turn higher.

In the big picture, then, the technicals and optics here support the bull thesis for VMW stock.

Valuation Risks Remain for VMware Stock

The problem here is that the fundamentals do not support the bull thesis for VMW stock.

Here’s the VMware story in a nutshell. Several years back, the company pioneered x86 server virtualization. It was a huge hit. Companies started to realize that virtualization was a scalable way to perform IT workloads at significantly reduced costs. And when they started to employ server virtualization, they overwhelmingly did so with VMware. But, come 2016-17, the server virtualization market had pretty much dried up. That is, enterprise data-center virtualization levels were nearing 100%.

Growth at VMware dried up, too. Once a steady 15%-plus revenue growth company, VMware slipped to a 7% revenue growth rate in fiscal 2017. VMware responded by leveraging multiple acquisitions across many different verticals to transform into a multi-cloud infrastructure company focused on software-defined data centers, hyper-converged infrastructures and security.

Growth came back into the picture. Throughout fiscal 2019 and 2020, revenue growth rates have been north of 10%. But, here’s the catch — revenue growth is just 12%, and slowing, with analysts modeling for sub-12% revenue growth this year and sub-10% revenue growth next year.

Thus, while growth has come back into the picture, VMware is still just a roughly 10% revenue growth company. That’s not very big. Worse yet, gross margins are actually maxing out because the higher-margin licensing business is slowing while the lower-margin services business isn’t slowing. Operating expense rates aren’t dropping much because VMware is having to spend a bunch to sustain double-digit revenue growth in new competitive markets. Operating margins have actually retreated in FY20.

VMware is growing again, but not by that much. The stock trades at over 20-times forward earnings. That’s a big growth multiple. This is a low growth company. That’s not a great combination.

Bottom Line on VMW Stock

There may not be much pain ahead for VMW stock. But there won’t be much gain, either. This is a low growth company trading at a big growth valuation. That combination most normally results in choppy trade, meaning VMW stock going forward is in a “buy the dip, sell the rally” situation.

As of this writing, Luke Lango did not hold a position in any of the aforementioned securities. 

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