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Will Hybrid Cloud Catalysts Push VMware Stock Higher in 2020?

Hybrid cloud tailwinds are already full priced into VMW stock

Cloud computing and virtualization giant VMware (NYSE:VMW) has had a rough run the past few months. While the broader market has surged to all-time highs, rising roughly 10% over the past six months, VMW stock has shed more than 10% over that same stretch, as the company’s revenue growth trajectory has flattened out amid dwindling cloud market tailwinds.

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Source: Sundry Photography / Shutterstock.com

Many investors and analysts believe the recent underperformance in VMware stock presents a good opportunity. Piper Jaffray is pounding on the table, recommending that investors buy the dip in VMW stock. So are KeyBanc, Citi and Oppenheimer, as well InvestorPlace’s Dana Blankenhorn and Tom Taulli.

The thesis across all these “buy the dip” arguments is pretty simple: hybrid cloud, or a mix of private and public cloud services, is the future of cloud computing.

Corporations will increasingly adopt and deploy hybrid cloud infrastructures over the next few years. As they do, they will spend more on VMware’s suite of offerings, since the company is leveraging its own platforms as well as multiple acquisitions to become a hybrid cloud giant. Consequently, over the next few years, VMware’s growth trajectory will meaningfully improve, and VMW stock will shoot higher.

Will this actually happen?

Most of it, yes. But, I’d argue that bulls are overstating the potential of hybrid cloud tailwinds to push VMW stock higher, and understating the reality that VMW stock is already fully valued.

Consequently, while shares can and will march higher in 2020, the magnitude of such gains will be greatly limited.

VMware Has a Promising Future in Hybrid Cloud

There is no denying that VMware has a promising future as a major player in the soon-to-be-very-big hybrid cloud market.

Long story short, hybrid cloud is the future of cloud. Companies don’t want all of their data and processes uploaded to public cloud services hosted by Amazon (NASDAQ:AMZN) and Microsoft (NASDAQ:MSFT). There are certain workloads they’d like to run on-premises, primarily for security purposes. But there are also certain workloads that they would like to run on those public cloud services, mostly for cost and convenience purposes.

Consequently, the future of cloud environments is a mix of private and public cloud services.

To be sure, most companies have already made this migration. About 84% of corporations employ a multi-cloud strategy, while 69% use hybrid cloud computing. Still, those numbers will inch close to 100% at scale, so there’s plenty of room left for growth here. Also, of those companies that employ multi-cloud strategies, the vast majority are shifting workloads from public to private clouds, creating more demand for hybrid cloud infrastructures.

Who supplies those infrastructures? VMware. Through both organic platform development and various acquisitions, the former virtualization giant has turned into what Piper Jaffray calls a “hybrid cloud monster” that is optimally positioned to turn hybrid cloud deployment tailwinds into sustained revenue growth over the next several years.

Upside Potential in VMware Stock Is Limited

When you take a look at the numbers, it becomes clear that upside potential in VMware stock is limited by valuation friction.

According to Gartner, cloud spending trends will slow over the next few years. Global cloud spend rose 16% in 2019; it’s expected to rise 17% in 2020, 16% in 2021 and 15% in 2022. Thus, while the enterprise cloud migration trend will persist over the next few years, growth rates will come down post-2020.

VMware’s market positioning will grow more favorable as hybrid cloud moves front-and-center of the market. This favorable positioning, coupled with hybrid cloud becoming a bigger revenue contributor at VMW (it only accounts for 13% of revenue today), will propel VMware’s revenue growth rates higher over the next few years.

But not that much higher. Remember, the pace of cloud spend growth will slow post-2020. And the cloud services landscape is very competitive. The hybrid vertical in that market will only grow more competitive as the market attracts more customers and money.

Consequently, VMware reasonably projects as a 10%-15% revenue grower over the next few years, versus today’s ~11% growth rates. Assuming margins mildly improve with scale, then my modeling pegs VMW’s 2025 earnings per share at $11 at best. Based on the information technology sector-average 21-times forward earnings multiple and a 10% annual discount rate, that implies a 2020 price target for VMW stock of $160 — not much higher than today’s $150 price tag.

Bottom Line on VMW Stock

The bulls are right: VMware is transforming into a hybrid cloud monster. But they’re overstating the potential of this transformation. What it will do is sustain VMware’s double-digit revenue growth rate in an already-slowing cloud market. But VMW stock is already priced for this reality. Consequently, further upside potential through hybrid cloud tailwinds seems limited.

As of this writing, Luke Lango was long MSFT.


Article printed from InvestorPlace Media, https://investorplace.com/2020/01/will-hybrid-cloud-catalysts-push-vmware-stock-higher-in-2020/.

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