Back in mid-September, I wrote on InvestorPlace that caution was warranted on cloud computing and virtualization software giant VMware (NYSE:VMW) for one very simple reason: valuation. Specifically, I said that although the outlook of VMware in cloud virtualization was good, it wasn’t good enough to warrant the high valuation of VMW stock at the time.
Fast forward three months. VMW stock has since gone nowhere, while the S&P 500 has surged more than 4% to all-time highs. Other tech stocks have rallied even more, with the Nasdaq rising 6%. During this stretch, VMware actually reported pretty good Q3 numbers that topped analysts’ average estimates. In that report, management also delivered healthy Q4 guidance.
In other words, despite good news and strong market catalysts, VMware stock has flat-lined over the past three months. The reason for the weakness was the valuation of VMW stock. Ultimately, as I warned, worries about valuation have short-circuited the rally of VMW stock.
Unfortunately, these worries about valuation will continue to weigh on the shares. My numbers indicate that VMW stock isn’t worth much more than $150 today. That’s basically where the shares trade hands now. As a result, VMW stock seems destined for muted gains over the next few months.
VMware’s Outlook Is Good (But Not That Good)
Piper Jaffray recently initiated coverage of VMware stock with an “overweight” rating, saying that this company is a hybrid cloud monster. Indeed, VMware is powered by non-cyclical hybrid cloud adoption tailwinds. Yet its revenue growth rates are running around 10% and won’t go much higher anytime soon.
That’s the big problem for VMW stock. Its growth outlook at this point is good, but it’s not that good.
Several years back, VMware pioneered x86 server virtualization. It was a huge hit. The company’s revenues increased at a steady, 15%-plus annual clip as companies increasingly utilized server virtualization. But by 2016-2017, the server virtualization market had pretty much dried up. VMware’s growth rates dropped below 10%. Management responded by acquiring companies in multiple fields. In the wake of these deals, VMware was transformed into a multi-cloud infrastructure company that focused on software-defined data centers, hyper-converged infrastructure and security. The pivot worked, as the company’s revenue growth rates jumped back above 10%.
And that’s where VMware is today. After the company’s pivot towards multi-cloud infrastructure, VMware’s revenues look well-positioned to continue to power higher as more companies move to the cloud. But these hybrid cloud catalysts are as powerful as they are going to get, and VMware ‘s revenue growth is still just 12%-13%.
That’s not too impressive. It’s also not enough growth to increase the company’s profitability. That’s because VMware needs to keep spending on product development and marketing to sustain its growth. At the same time, its recent pivot towards cloud contracts has actually weakened its gross margins.
So VMware’s top line is rising just 10% and its margin drivers are muted. The company is generating decent growth, but its growth is nothing to write home about.
VMware Stock Is Fairly Valued Around $150
My calculations indicate that VMware stock is fairly valued around $150.
Global spending on the public cloud is expected to rise 17.5% this year, according to research firm Gartner. That growth rate is expected to drop below 15% over the next few years.
VMware’s revenue is currently increasing at an annual rate of about 13%. There isn’t much reason to believe that VMware’s share of the cloud market will increase over the next few years. Consequently, as the growth of the cloud market drops in coming years, so will VMware’s growth rates.
Realistically, VMware’s revenue should increase at a roughly 10% clip over the next five years. As the company generates more lower-margin services revenue, its gross margins won’t rise much.
Overall, VMWare’s profits won’t increase much. Roughly 10% revenue growth plus some margin pressures plus some buybacks of VMW stock will equal roughly 10% profit growth, as the company’s margin pressures and share buybacks roughly cancel each other out.
Under these assumptions, a realistic 2025 earnings per share target for VMW is $10.25. Based on a forward earnings multiple of 21, which is average for the information technology sector, and a 10% annual discount rate, that equates to a fiscal 2020 price target for VMW stock of just under $150.
The Bottom Line on VMW Stock
VMware has good — but not great — long-term growth prospects. The problem with VMW stock is that it was priced for great long-term growth. This disconnect has caused the shares to be weak over the past several months, despite the stock market’s strength.
Most, but not all, of the correction of VMware stock is over. VMW stock still remains somewhat richly valued relative to its long-term profit growth prospects. As long as that remains true, VMW stock will struggle.
As of this writing, Luke Lango did not hold a position in any of the aforementioned securities.
