On its face, VMWare (NYSE:VMW) looks too cheap. VMWare stock now has declined 30% so far this year. Most of the selling pressure has come in the last few weeks, as broad markets have accelerated to the downside.
At yesterday’s close of $97 — a 30-month low — VMW now trades at below 16x this year’s adjusted earnings per share guidance of 2020. That appears far too low a valuation for a company that remains a leader in “virtualization” of on-premise servers.
But looking closer, the case for VMWare stock does get a bit thinner. Yes, the multiple is low — but the same is true of earnings growth. There are underlying changes in customer behavior that present a risk.
Forced to choose, I’d argue VMW indeed is too cheap. I recommended the stock, if cautiously, in December. Until recently, I owned Dell Technologies (NYSE:DELL), VMWare’s majority owner. I’m far from a VMW bear.
The risks are real, however. And even at a cheaper price, after recent developments I’m not ready to start pounding the table for VMWare stock — yet.
The Earnings Multiple
Again, 16x this year’s earnings ‘feels’ too cheap. But looking at both 2019 results and 2020 guidance, that multiple appears far more reasonable.
At least from a profit standpoint, this no longer is a torrid grower. VMWare, in fact, isn’t much of a grower at all. Adjusted EPS rose 21% in fiscal 2019 (ending January). The figure grew just 4% in FY20, however. Guidance for fiscal 2021 given on the fourth-quarter earnings call is for adjusted EPS of $6.55 this year — up just 5% year-over-year.
There’s certainly a case that mid-single-digit profit growth can drove a modestly higher multiple. But at least looking at last year and this year, it’s tough to make the case that VMWare stock is dramatically undervalued. The fact is that FY20 performance was a bit soft. And fiscal 2021 guidance was quite soft relative to Wall Street expectations: consensus EPS estimates for this year were at $7.03 heading into the report.
VMW now is down well more than 22% since that release after the close on Feb. 27 — and the decline can’t be attributed to the market-wide sell-off alone. The fourth-quarter report was disappointing, both in terms of the actual numbers and guidance. Even in a more stable market, it’s likely VMW stock would have sold off, if possibly not to the extent that it has.
The Shift to Cloud
VMWare’s valuation needs to be considered in the context of the longer-term outlook as well. There are challenges ahead.
As Barron’s detailed in November, the rise of open-source Kubernetes software, originally developed by Alphabet (NASDAQ:GOOG,NASDAQ:GOOGL) is a threat to VMWare’s business. It allows companies to move from local servers to the cloud — bypassing VMWare’s vSphere in the process.
VMWare is trying to respond by bulking up its own cloud capabilities. The acquisition of Pivotal Software gives the company its own Kubernetes platform.
But these pivots are difficult, and expensive. Again, 16x for VMW stock might sound cheap. But IBM (NYSE:IBM), which acquired Red Hat to drive its own cloud transition, now trades at barely 9x the 2020 consensus EPS estimate. Oracle (NYSE:ORCL) is at 11.5x FY20 EPS.
If VMWare stumbles at all in its own shift, there’s not much reason it can’t see earnings multiples around those levels at some point. It’s true that IBM and ORCL had higher multiples just a month ago, and too have come down in the recent sell-off.
But even in what was still an optimistic bull market before late January, IBM and ORCL generally were valued at 12-15x earnings. If VMWare looks like another victim of the cloud, instead of a beneficiary, there’s not much reason it can’t see a similar multiple. And that suggests more downside even from $106.
The Case for VMWare Stock
The negativity here doesn’t mean that VMW stock is a sell, or a short, at the lows. Rather, the point is that there are real risks here — and at least some logic behind the sell-off. This is not a case where VMW’s only problem has been broad market weakness.
That said, there are reasons for optimism, too. VMWare, in my opinion, is not IBM or Oracle. The acquisitions of Pivotal and Carbon Black not only help the transition to the cloud — but they hurt near-term margins. The shift to subscription revenue — which is booked over time — versus perpetual licenses provides another near-term headwind.
The underlying profitability of the business is better than this year’s guidance suggests. Indeed, analysts see earnings snapping back next year to $7.61 per share — 16% above current FY21 guidance. (Worth noting: that guidance doesn’t appear to incorporate too much in terms of impact from the coronavirus, at least per VMWare commentary last month.)
If VMWare can get to that level, then VMWare stock may well be too cheap. The stock trades at less than 14x that estimate. That’s a multiple that prices in little, if any, growth from that point on — and I don’t believe VMWare’s days of profit growth are over for good.
Be Cautious With VMWare Stock
Still, from both a near-term and long-term perspective there is reason for caution. Near-term trading can get worse for VMW stock. Long-term, the company still has work to do.
And on both fronts, I’m not sure VMW is quite the most compelling play just yet. There are plenty of quality stocks out there with their own significant declines simply due to broad market trading.
VMWare’s disappointing earnings report means it’s not one of those stocks. It’s likely the stock has fallen too far — but that hardly means it shouldn’t have fallen at all.
Vince Martin has covered the financial industry for close to a decade for InvestorPlace.com and other outlets. He has no positions in any securities mentioned.