Relative to its multi-year performance, VMware (NYSE:VMW) stock looks almost absurdly cheap. VMware has grown its earnings at a double-digit annual percentage rate for well over a decade, including a 21% gain last year and 18% the year before. Yet VMW stock trades at just 21 times next year’s average earnings per share estimate, and its free cash flow multiple is even lower.
Those multiples have compressed of late, due to trading that seems almost absurd. VMW stock is down 28% from its 52-week high. Heading into this week, VMW stock had fallen 15% in just the last 12 trading sessions. That recent weakness came despite the company’s third-quarter results, issued on Nov. 26, that beat analysts’ average estimates and led at least two analysts to raise their price targets on VMW stock.
But there is some logic to both the post-earnings decline of VMW and the low multiples of VMW stock. There are real risks to the core of VMware’s business, driven largely by the ever-changing tech landscape. And there’s at least a chance that VMware’s earnings will never rise meaningfully again.
I still believe VMW stock easily is worth buying despite those risks. In fact, I own shares of Dell Technologies (NASDAQ:DELL), much of whose value comes through its 81% stake in VMware. (I have hedged part of DELL’s exposure to VMW via options.) But investors should remember that the risks facing VMW stock are real — and that VMware has a tricky path ahead.
Pressure From the Cloud
VMware’s core offering is its vSphere platform, which drives the so-called “virtualization” of on-premise servers. That platform essentially allows data-center hardware to run multiple operating systems and to be shared by multiple end users. Virtualization significantly lowers maintenance costs and better utilizes hardware.
Both attributes are enormously attractive to companies, as shown by VMware’s impressive growth. If the company’ meets analysts’ average FY20 top-line estimate, its revenue will have almost exactly quintupled over a decade. That’s a compounded annual growth rate (CAGR) of over 17%.
But it’s important to note that VMW specializes in on-premise servers. Companies are steadily moving to cloud applications, and that provides a potentially significant headwind to VMW’s revenue.
The Rise of Kubernetes
As Barron’s detailed last month, the rise of open-source Kubernetes software, originally developed by Alphabet (NASDAQ:GOOG,NASDAQ:GOOGL) unit Google, has created a real threat to VMW stock. Many companies are moving from local servers, which require VMW’s vSphere, to cloud offerings which don’t.
Barron’s cited a study by Morgan Stanley which named VMware as “one of the vendors most likely to lose market share as companies migrate workloads to the cloud over the next three years.” According to Barron’s, there are estimates that vSphere drives “roughly half” of VMW’s total revenue; Deutsche Bank reportedly put the figure at 60%-70%.
VMWare itself wrote in a recent SEC filing that vSphere sales “have remained strong”, but no longer are the majority of its licensing revenue. Licensing revenue, however, only accounts for a little over 40% of the company’s total sales, and vSphere may constitute a greater share of its services revenue. In addition, VMware noted that vSphere revenue has declined relative to that of its other products.
In other words, vSphere sales are growing at a slower pace than VMware as a whole. And if those sales are 50% or more of its total revenue, then the risk facing VMW stock is obvious. If vSphere revenue flattens or even turns negative, VMware is going to have a difficult time posting any top-line growth. And with VMW trading at 21 times forward earnings, there’s still some growth priced into VMware stock.
The Pivot and VMware Stock
VMware is aware of the shift to the cloud — and it’s reacting accordingly. As InvestorPlace columnist Dana Blankenhorn detailed last month, it’s using acquisitions to improve its cloud capabilities. Its purchase of Carbon Black added a security layer to VMWare’s cloud capabilities. VMW’s acquisition of Pivotal Software (NYSE:PVTL) was announced the same day and will give VMWare a true Kubernetes platform going forward.
The need to pivot to the cloud from legacy on-premise offerings obviously isn’t unique to VMware. Microsoft (NASDAQ:MSFT) has done it masterfully, though even that giant did let Amazon.com (NASDAQ:AMZN) take the lead in the cloud with its Amazon Web Services. But IBM (NYSE:IBM) has struggled with the cloud transition. For Oracle (NYSE:ORCL), the jury is still out.
Those disparate experiences highlight the risks and potential rewards of VMware stock at the moment. VMW is trying to shift to the cloud world, but those shifts aren’t necessarily simple. And its competition will be intense.
IBM’s acquisition of Red Hat could upend a key partnership for VMware, as VMW itself noted in its SEC filing. That combined entity now is a significant competitor for VMW. Nutanix (NASDAQ:NTNX) is a major competitor of VMW, and the long decline in its share price before a recent rally highlights the risk facing VMW’s sector.
Microsoft and Oracle offer free on-premise virtualization software with their servers. Virtualization is a crowded industry right now, and while VMware’s revenue may not suddenly start to decline, the impact of lower growth and higher costs on its margins has become worrisome. That issue has led to the recent pullback of VMW stock.
On their face, VMware’s Q3 earnings look impressive. Both revenue and earnings were nicely ahead of analysts’ average expectations. VMW stock actually initially climbed in the wake of the report.
But since then, VMware stock has declined steadily. On this site, Josh Enomoto highlighted one potential reason for the weakness: VMW’s results got some help from the Carbon Black acquisition, which doesn’t appear to have been included in analysts’ estimates. So its results may not have been quite as good as they appeared.
There’s another factor at play, however. On the Q3 conference call, VMware gave directional guidance for fiscal 2021. The company expects its revenue to grow in the “low double digits”, as CFO Zane Rowe phrased it. But higher spending is expected to reduce its operating margins by up to two percentage points. As a result, EPS estimates for FY21 have come down about 4% since the report, with the average dropping to $7.01 from $7.29. That represents 6.5% year-over-year growth.
The risk facing VMW stock isn’t necessarily that VMware’s virtualization business will collapse. A more realistic concern is that VMW is going to have to spend more to keep pace with its competitors, pressuring its earnings growth going forward. Relative to VMW’s past growth, a forward price-earnings multiple of 21 looks cheap. But if its growth slows to 7% or less for good, the current valuation of VMW stock isn’t necessarily that attractive.
The Case for VMW Stock
Even considering those risks, however, I still see value in VMW stock below $150. For one, VMware’s cash flow is enormous. VMware should generate well over $3 billion this year. Based on its current market cap of $50 billion, that would put its price-free cash flow multiple in the high-teen-percentage level.
That valuation prices in little growth for VMW. Essentially, it prices in the status quo. If VMware muddles through the transition and drives modest free cash flow growth going forward, VMW stock will likely hold up.
If it successfully pivots to the cloud, however, VMW stock could rise meaningfully, as Microsoft stock has in the wake of MSFT’s successful cloud pivot.
VMW’s strong free cash flow adds to the options of VMWare’s majority owner, Dell. Dell, in turn, is controlled by its founder, Michael Dell, and private equity firm Silver Lake. Starting in 2022, those owners can either buy out VMW’s minority shareholders or spin VMW off to DELL’s shareholders. Dell and Silver Lake can choose the most beneficial path for their shareholders.
That is why I own DELL rather than VMW, and I still believe DELL is the more profitable way to get exposure to VMW stock. Still, VMW on its own is an attractive pick at these levels, particularly if Dell winds up buying the rest of VMW stock at a premium. And some investors may not want exposure to Dell’s personal computer and storage businesses, which have posted mixed results in recent years.
The selloff of VMW stock does make some sense, considering the dynamics of its industry. But given VMW’s free cash flow and the likelihood of a value-creating event down the line, that selloff still has gone too far.
As of this writing, Vince Martin is long shares of Dell Technologies and has a small bearish options position in VMW as a hedge. He has no positions in any other securities mentioned.