We See Value in VMware

VMware’s VMW strong fiscal 2020 second-quarter results included 12% year-over-year revenue growth and non-GAAP earnings per share of $1.60, both exceeding consensus expectations. A weaker outlook for license-based sales led to lower-than-expected third-quarter revenue guidance from management, but VMware kept its companywide revenue target for fiscal 2020 intact. We expect VMware’s massive footprint across the networking environment to benefit from the technologies it’s gaining, and we are maintaining our $194 fair value estimate. We believe this 4-star stock provides an opportunity for investors to benefit from the rapid adoption of cloud-based resources.

The narrow-moat company said it has reached definitive agreements to purchase Pivotal Software, a vendor offering a developer platform for container-based workloads, for a total enterprise value of $2.7 billion and Carbon Black, an endpoint security vendor, for an enterprise value worth $2.1 billion. The total cash outflow from the deals is $2.7 billion, supported by VMware’s cash balance and access to short-term borrowing. We believe these acquisitions support VMware’s intention to move from being an infrastructure player into a wider solutions provider for applications across various cloud and device ecosystems. While we are slightly apprehensive about the decision to acquire instead of remaining partners with companies that have underperformed recently, we envision VMware gaining from the enablement of secure application deployments across hybrid cloud ecosystems.

Licenses revenue and services revenue both grew 12% year over year. Compared with the prior year, NSX bookings increased 30%, vSAN bookings grew 45%, and end-user computing bookings increased 20%. While traditional solutions may be slowing, VMware continues to shine in more nascent efforts. Furthermore, we believe its unique ability to be a singular platform across Amazon Web Services, Microsoft Azure, and Google Cloud Platform gives VMware an enviable position for hybrid cloud solution providers.

Regarding its success with growing alongside the shift to public cloud, VMware Cloud on AWS is now in 16 regions, and we expect AWS to continue to provide VMware with solid growth in the public cloud as enterprises migrate workloads. VMware Cloud Foundation on Azure inked 20 customers within its first two months of availability, and in July, VMware announced its availability of VMware Cloud Foundation on Google Cloud Platform. In our view, VMware’s platform being available across the three major hyperscale cloud providers puts it in a position to take advantage of companies moving workloads from on-premises into various cloud ecosystems, no matter the cloud provider.

In the quarter, hybrid cloud subscriptions and software-as-a-service-based sales grew 40% year over year to 12.5% of total VMware revenue. This consumption model is creating a near-term headwind to overall revenue as customers pay less up front. With many customers preferring the SaaS-based consumption model, we believe the rise in these revenue streams will help create margin leverage over the longer term while providing customers with their desired consumption model. VMware said that remaining performance obligations at the end of the quarter were $8.05 billion, up 25% year over year.

VMware clearly announced its intention to enter the security arena. Management said about 33%-40% of VMware’s NSX revenue is associated with security use cases due to internal firewall protection, so we see the company declaring its entrance into the broader security market as in line with its existing strategy to expand from machine virtualization.

Carbon Black is an endpoint protection provider that has about 5,600 customers and migrated to be cloud-based from on-premises appliances. VMware plans to integrate Carbon Black’s offerings into its end-user computing, application, and then networking offerings to give endpoint management a more unified solution. While we have not seen endpoint security protection as a moatworthy business, we do like that Carbon Black is now cloud-based and that it’s focused on proactive protection instead of detection only. With VMware’s installed base and customer reach into the enterprise space, we do see VMware being able to accelerate Carbon Black-based revenue while enhancing VMware’s cloud-based offerings. While we aren’t greatly impressed by the acquisition, we do believe VMware may have swooped in at an opportune time, and this is a quick way to gain security customers as well as opening up Carbon Black’s customer base to much larger clients. Also, Dell Technologies’ large customer base and ownership of Secureworks gives a wider set of security offerings under the salesforces of Dell Technologies and VMware.

Pivotal Software has 350 customers, including a third of the Fortune 100. VMware has a history of working with Pivotal for application-based products and sharing revenue from sales related to products for the popular open-source container orchestration system Kubernetes. We see this purchase as a way for VMware to gain more control in its push into container-based technologies and public cloud application offerings. VMware’s offering for running and managing applications and infrastructure can now span into the developer and build realm with Pivotal’s technology. This acquisition follows on VMware’s efforts to embrace technologies, primarily containers, that were once thought as the downfalls of its virtual machine dominance. VMware has acquired Heptio, a Kubernetes software and services provider, and Bitnami, a company specializing in application delivery in Kubernetes environments, within the last year. We think these are wise moves, given that enterprises continue to favor deploying applications via container environments.

VMware expects Pivotal and Carbon Black to add over 2 percentage points of revenue growth and over $1 billion to its hybrid cloud subscription and SaaS revenue in the first year. In the second year after the acquisitions, VMware expects the two companies to increase total hybrid cloud subscription and SaaS revenue to over $3 billion. We currently model cloud subscriptions and SaaS at slightly more than a $1.2 billion annualized run rate. On a non-GAAP basis, VMware projects that the combination of Pivotal and Carbon Black will be operating income positive in year 1 and cash flow and EPS positive in year 2.

The Pivotal deal has an implied blended per share price of $11.71, which is calculated as $15 per Pivotal Class A share being paid for in cash and VMware exchanging 7.2 million VMware Class B shares to Dell Technologies at a 0.055 exchange rate for Pivotal Class B shares. The net payout by VMware is expected to be $800 million. After the exchange of shares, Dell Technologies will increase its VMware ownership stake by 0.34% to 81.1%. For Carbon Black, VMware agreed to offer $26 per share in cash for an expected payout of $1.9 billion. Both deals are expected to close in the second half of VMware’s fiscal 2020. After that, VMware’s historical financial statements will be updated to reflect the historical performance of Pivotal.

Besides these two headline-grabbing acquisitions announced Aug. 22, VMware has been on an acquisition spree in recent months. We generally view this positively as these companies are helping support VMware’s push into more diverse revenue streams like cloud application monitoring and optimization as well as security. In June, the company acquired Avi Networks, a provider of load balancing and web application firewall technologies, to gain expertise in application delivery in cloud ecosystems. In July, VMware announced its intention to acquire Uhana, a vendor that helps optimized carrier network operations and applications, which will be folded into VMware’s telco offerings. VMware will also acquire Bitfusion, which specializes in virtualizing hardware acceleration devices. So far in August, VMware has announced its intention to purchase Veriflow for network verification and troubleshooting capabilities in hybrid cloud ecosystems and Intrinsic, a serverless computing security company. Intrinsic will be part of VMware’s AppDefense platform as the company pushes its security solutions into the public cloud ecosystems.

For the third quarter, management expects license revenue to grow 7.5% year over year to $950 million and total revenue to expand 9.3% annually to $2.41 billion. It expects non-GAAP operating margin to be 30.3% with non-GAAP EPS of $1.42. We see these targets as achievable as the company continues to ramp up operating expenses to support continued growth in newer areas. We also believe that the fourth quarter will be very strong compared with the third quarter, given full fiscal 2020 guidance.