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Robert Abbott
Robert Abbott
Articles (899)  | Author's Website |

What Could a VMware Spinoff Mean?

An Undervalued Predictable company that may go out on its own

There is a possibility that VMware Inc (NYSE:VMW) could be spun off later this year, likely by September. Currently, Dell Technologies Inc. (NYSE:DELL) owns 80.8% of VMware, so a spinoff would have several benefits for both companies, according to Dell CEO Michael Dell (Trades, Portfolio). In an interview with CRN, he said:

"Look, we believe that this spin-off that we're considering could benefit both the Dell Technologies and the VMware stockholders. It simplifies the capital structures, it enhances strategic flexibility and gives both companies more flexibility, while we continue with the mutually beneficial strategic and commercial partnership that we've had for many, many years that has worked extremely well and it continues to."

For Dell (both the man and the company), the deal would help reduce the heavy debt load of around $48 billion.

For VMware, it is likely to provide serious benefits, at least based on the experiences of many previous spinoffs. Once companies are spun off, they are able to set their own vision, mission and strategy without having to coordinate with the parent company. They also gain control of asset allocation (particularly when they reinvest their profits rather than send them to the parent), again without interference from the parent. Third, they can act more quickly because there is no need to await permission from above.

Essentially, a company in control of its own destiny is more likely to outperform than a company that is not.

At this point, a spinoff and how much VMware would benefit are still speculation. But for investors considering the company as a medium-to-long-term investment, the possibility must be considered.

Otherwise, this is a company worth considering on its current merits because it is on the GuruFocus Undervalued Predictable list. That means it is valued below its intrinsic worth according to a discounted cash flow analysis, and it has a record of consistently growing revenue and earnings.

What is VMware?

In an introduction to its business in its 10-K for 2019, the company observed: "Technologies emerge faster than organizations can absorb, creating increasingly complex environments. IT is working at an accelerated pace to harness new technologies, platforms and cloud models."

That's the problem and these are the solutions VMware offers: "We help customers manage their IT resources across private clouds and complex multi-cloud, multi-device environments by offering solutions across three categories: Software-Defined Data Center ("SDDC"), Hybrid and Multi-Cloud Computing and Digital Workspace—End-User Computing ("EUC")." Hybrid refers to situations in which a company has its own internal cloud and also uses cloud services provided by vendors such as Amazon Web Services and Microsoft Azure.

Overall, the business can be summarized with this slide, from the third-quarter 2020 earnings release:

VMware business

Along with the news that Dell is considering spinning off VMware came more recent news that the latter is looking for a new CEO. The current chief, Pat Gelsinger, is returning to Intel (NASDAQ:INTC) as its new CEO on Feb. 12. Presumably, the new occupant of VMware's corner office will be chosen with the potential spinoff in mind.

Competition

VMware reported in its 10-K for 2019: "We face intense competition across all markets for our products and services."

It has an interesting blend of competitors and partners and, in many cases, the competitors and partners are the same companies. The latter includes names such as Amazon.com (NASDAQ:AMZN), Microsoft (NASDAQ:MSFT), Alphabet's Google (NASDAQ:GOOG) and Oracle (NYSE:ORCL).

Competitive factors, it notes, include "the level of reliability, interoperability and new functionality of our product and service offerings; the ability of our product offerings to support multiple hardware platforms, operating systems, applications frameworks and public cloud platforms."

Part of its competitive strength and advantage come from its patents and trademarks. At the end of January 2020, it owned more than 3,300 patents in the U.S. as well as in other countries.

It reported that it invests "significantly" in research and development. To fund that R&D, it needs ample free cash flow. This chart shows its growth trajectory over the past 10 years:

VMware free cash flow chart

Fundamentals: Financial strength

Despite a four out of five-star predictability rating, VMware receives only a middling rank for financial strength:

VMware financial strength

As we see on the first five lines of the table, debt is an issue for VMware, with lots of orange and red suggesting it is lagging its competitors and peers, as well as its own history. Still, the interest coverage ratio is above 5; as GuruFocus explains:

"Ben Graham requires that a company has a minimum interest coverage of 5 with the companies he invested. If the interest coverage is less than 2, the company is burdened by debt. Any business slow or recession may drag the company into a situation where it cannot pay the interest on its debt."

It added that debt is an important factor in deriving the financial strength ranking.

Profitability

What VMware lacks in financial strength, it partially makes up with a strong profitability ranking:

VMware profitability

Note how its margins and return on equity sharply contrast. It beats the 10-year software industry medians, but underperforms its own 10-year medians. A strong ROE also suggests the company enjoys a moat or competitive advantage.

Turning to the three last lines on the table, the growth lines, we see respectable revenue and Ebitda growth, but its earnings per share without non-recurring items growth is exceptional.

Shareholder returns

VMware pays no dividend and its share buyback history has been weak, as shown in this 10-year chart of shares outstanding:

VMware shares outstanding chart

This is essentially a capital-gains-only stock.

Valuation

As an Undervalued Predictable stock, we would expect to see that it offers a margin of safety, a difference between the current price and its intrinsic value. However, the discounted cash flow calculator shows the opposite:

VMware discounted cash flow analysis

As I explained in a previous discussion about Nova Measuring Instruments (NASDAQ:NVMI), "An Undervalued Predictable Mid Cap," this contradiction is caused by different earnings growth rates over different periods. Over the past 10 years, the average earnings per share growth rate was 23.10% per year (likely accounting for the 20% growth rate in the DCF calculator). However, in the past three years, the rate accelerated to 73.80% per year. The algorithm behind the undervalued rating is somewhere between those two rates, meaning it uses a high enough rate to provide a margin of safety.

The GuruFocus Value chart finds VMware to be undervalued:

VMware GuruFocus Value chart

The price-earnings ratio shows the company's valuation to be near the software industry's median rating, while its current rating is slightly more attractive than its 10-year median.

The PEG ratio of 2.56% suggests overvaluation, but a closer look reveals that Ebitda has been contracting over the past decade (unlike earnings per share).

The case for undervaluation can also be seen in this 10-year price chart, where recent prices continue to lag:

VMware 10 year price chart

Overall, it seems that modest undervaluation is the best assessment at this time.

Gurus

A total of 11 gurus had positions in VMware at the end of the third quarter. The big buying action took place in the second quarter:

VMware guru buys and sells

Dodge & Cox added to its position in the third quarter, another 1.17%, to finish with 6,197,770 shares, good for a 1.48% stake in VMware and 0.81% of its total assets.

PRIMECAP Management (Trades, Portfolio) had the second-largest holding on Sept. 30 of 892,595 shares after a reduction of 5.49%.

Jim Simons (Trades, Portfolio)' Renaissance Technologies owned 468,556 shares after a significant reduction of 40.37%.

Conclusion

VMware is a strong player in the software industry, increasing its revenue and earnings per share. Its wealth of patents and trademarks gives it a competitive advantage in its business of managing cloud operations for IT departments. Given its potential growth and profitability, it should continue rewarding shareholders over the next five to 10 years.

If the spinoff does go ahead, as expected, there is a potential bonus for shareholders. The appointment of a new CEO along with more independence from Dell could signal even more ambitious growth in the next decade.

Although it is an Undervalued Predictable stock, it does not look like a fit for value investors, who might be uncomfortable with its debt load and valuation fogginess. Growth investors may wish to watch VMware for a return to higher share prices, while income investors will find nothing here to interest them.

Disclosure: I do not own shares in any of the companies named in this article and do expect to buy any in the next 72 hours.

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About the author:

Robert Abbott
Robert F. Abbott has been investing his family’s accounts since 1995 and in 2010 added options -- mainly covered calls and collars with long stocks.

He is a freelance writer, and his projects include a website that provides information for new and intermediate-level mutual fund investors (whatisamutualfund.com).

As a writer and publisher, Abbott also explores how the middle class has come to own big business through pension funds and mutual funds, what management guru Peter Drucker called the "unseen revolution."

Visit Robert Abbott's Website


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Comments

Thomas Macpherson
Thomas Macpherson premium member - 2 months ago

Thanks for the article Bob. I would only point out the ROE number is inflated by the $6.5B in debt the company took on this year. Investors may want scrub that out and then recalculate ROE against its 10 year average. Best. - Tom

Robert Abbott
Robert Abbott premium member - 2 months ago

Good catch, Tom! I appreciate your interest.

Robert Abbott
Robert Abbott premium member - 2 months ago

Following up on Tom Macpherson's comments, VMware's 10-year median return on equity is 14.74%. For more information, please visit the ROE page at https://www.gurufocus.com/term/ROE/NYSE:VMW/ROE-/VMware

Nicola Guida
Nicola Guida premium member - 2 months ago

Hi Robert, thanks for the interesting article.

Yes, debt has been an issue for VMWare but the situation looks much better today. If I look at the most recent quarter net debt, the company could actually repay it using 2 quarters of FCF. Not bad.

Best Regards, Nicola

Robert Abbott
Robert Abbott premium member - 2 months ago

As you say, "Not bad.". Thanks for noting that, Nicola!

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