After its successful spin-off from Dell Technologies (DELL, Financial) last year, VMware Inc. (VMW, Financial) generated high-single-digit revenue growth in its 2022 fiscal year. However, the company’s stock price has been down since January 2022 given the interest rate hike, inflation and geopolitical tensions impacting the technology sector's share prices.
VMware may not be a classic high-growth tech play, but its valuation is surprisingly low after the recent correction despite the company's focus on hybrid clouds, which is expected to be the major growth driver of revenues and cash flows. Here's why I think the stock has become critically undervalued.
Recent financial performance
VMware reported a top-line of $3.53 billion for the most recent quarter ending in January 2022, which implies 7.19% growth as compared to the $3.29 billion revenue reported in the corresponding quarter of the previous fiscal year. The company beat the analyst consensus estimate of $3.52 billion.
The quarterly revenues translated into a gross margin of 82.81% and an operating margin of 22.63% which was lower than in the same quarter of last year.
VMware reported net income of $586 million and adjusted earnings per share (EPS) of $2.02, which outperformed the average Wall Street expectation for adjusted EPS of $1.98.
In terms of cash flows, VMware reported $1.14 billion in the form of operating cash flows and spent $117.00 million in investing activities during the previous quarter. It produced lower cash flows as compared to the same period in the previous year, which could be a point of concern.
Hybrid cloud upside
With organizations prioritizing cloud computing infrastructure over on-premises computing infrastructure, the company’s strong cloud provider partnerships, including hyperscalers, will help them navigate the changing market landscape. VMware’s growth should ideally be driven by its ability to connect computing infrastructures, networking locations and burgeoning security and developer offerings, bolstered by its strong end-user compute portfolio.
Many large enterprises are preferring the use of hybrid cloud solutions similar to VMware’s offerings. Although public clouds can rapidly expand network capacity, enterprises must deal with integration issues between on-premises, private and public clouds. VMware's Cloud Provider Program offers thousands of cloud partners collaborating with VMware software and hyper-scale cloud provider partnerships. This allows the company to remain embedded in networks while also bridging private and public clouds.
The company's integration with cloud vendors and cadence of product releases outside of Dell's umbrella have ended an uncertain future. Their strong franchises in end-user compute, security, virtualized networking and storage cannot be overlooked, and growth ventures like VMware's integration of Kubernetes-based container management within vSphere continue to be developed.
VMware's continued growth will also likely be fueled by software cohesion across on-premises and cloud environments, as well as new networking products.
Key developments
VMware has a large installation base in mission-critical enterprise data center servers as the dominant player in server virtualization. VMware's core server virtualization business helped it carve out a competitive advantage in its domain. Given its strong brand, VMware's product offerings should be on customers' shortlist of potential vendors during network upgrades because it is well entrenched in one of the most mission-critical pieces of IT operations.
The company recently introduced VMware Cloud Universal, a program that provides customers like Western Union (WU, Financial) with flexibility in utilizing VMware hybrid cloud offerings as they progress on their cloud journeys. With VMware Cloud Universal, its customers are able to deploy applications on their choice of three VMware technology-based infrastructure stacks, i.e., VMware Cloud Foundation, VMware Cloud on Amazon (AMZN, Financial) Web Services, or VMware Cloud on Dell EMC.
It is worth highlighting that the company’s Tanzu platform saw substantial customer momentum across key verticals, including financial services. VMware also secured a key win with Telecom Italia (MIL:TIT, Financial) in order to help them deliver a better digital experience and modernize their operating infrastructure.
Digital transformation and other new ventures
VMware has been a major beneficiary of the digital transformation trend across the globe that is pushing enterprises to adopt the cloud over on-premise applications. VMware’s solutions act like a bridge that allow companies to deploy their workload, data and applications to public cloud venues such as Amazon Web Services, Microsoft (MSFT, Financial) Azure and Alphabet's (GOOG, Financial)(GOOGL, Financial) Google Cloud.
It smoothens the process of migrating to a cloud-based framework, which is an increasingly popular trend driven even faster by the Coronavirus prompting companies to go as light as possible in terms of their on-premise presence.
Apart from this, the company has diversified its revenue streams with solutions for cybersecurity, application modernization and unified digital workspaces. Their virtualization ecosystem has expanded beyond server computing into areas such as storage and networking. These newer VMware ventures are important because these offerings have high customer switching costs. VMware's software installed throughout enterprise server racks creates a barrier to switching vendors. The company established a large virtual machine and hypervisor market, then profited from its first-mover advantage.
Final thoughts
VMware’s stock has corrected significantly in January 2022 and has been moving sideways for the past few weeks. Its valuation appears to be cheap, not only as per the GF Value Indicator but also as per its forward price-earnings ratio of 16.56 and its enterprise-value-to-free-cash-flow multiple of 14.66, both of which are well below the software industry averages.
The company is aggressively pushing its Tanzu application platform and getting more customers to collaborate with VMware in order to build a consumer-centric technology foundation using the same. This could be a major growth driver in the coming years.
Given VMware's mission-critical portfolio and robust customer relationships, the company does merit a better valuation, in my opinion. Their recent performance has demonstrated continued progress toward the strategy of becoming a multi-cloud subscription and software-as-a-service company.
