VMware's Success Is its Own Worst Enemy

NEW YORK ( TheStreet) -- As much as Wall Street seems to love virtualization giant VMware ( VMW), the stock remains priced for perfection, a point of contention for many investors. The question has always been can the company grow into its valuation and maintain the sort of momentum needed to justify its price-to-earnings ratio of 50.

With each passing quarter, VMware has replied, "yes, we can." This has been despite stiff competition from rivals such as Microsoft ( MSFT) and Citrix ( CTXC).

However, during its most recent quarter, its numbers suggest that things were less clear than the usual slam dunks.

A Virtually Good Quarter, but...

For the period ending in September, VMware reported net income of $156.8 million, or 36 cents per share on revenue of $1.13 billion. On an adjusted basis, the company earned $303.4 million, or 70 cents per share when excluding stock-based compensation as well as other items. The company met revenue targets while beating EPS estimates as analysts were expecting adjusted earnings of 63 cents per share.

As expected, the company produced revenue growth of 20% -- helped by a 29% surge of services revenue, which registered at $642.6 million. Revenue from licenses climbed 11% to $491.1 million. While the pace was relatively slower, it was still impressive.

Likewise, the company did well in terms of profitability -- reporting 25% increase in operating income. But on the other hand, VMware reported an increase of 24% in operating expenses, which came in at $943 million.

The company reported an increase of 24% in sales and marketing while its R&D expenses grew by 30%. It seems these rising expenses contributed to the company's 11% year-over-year decline in net income. But should this be cause for concern? Likewise, although the company is still growing at an impressive rate, there continues to be evidence that the competition is gaining some ground -- as minute as it may be.

Where's the Growth Coming From?

I think VMware understands the challenge it is up against and realizes it has seen a stable decline in license revenue over the past several quarters. By and large, this has contributed to the central question -- can the company continue to grow into its valuations? I think this is what growth investors are looking to answer.

As a result, the company has since turned its attention to growing sales to fight off the likes of IBM ( IBM), Hewlett-Packard ( HPQ) and Red Hat ( RHT). The company is willing to do this now even at the expense of near-term profits.

But will the strategy pay off? The company is willing to spend to grow, but it also needs to answer from where the growth is going to come.

VMware is the undisputed market leader in virtualization -- this much is a given. But how about the other markets in which it competes, which include desktop virtualization, servers as well as system administration tools. Investors are left to speculate how well the company can grow market share in these areas -- particularly as rivals are projecting tougher quarters ahead.

Investors should also not assume these rivals are simply going to roll over and concede the market for VMware.

Bottom Line

The company's strong cash position and solid balance sheet coupled with an excellent management team makes VMware one of the toughest names to bet against. Its biggest challenge continues to be too-high expectations. The only question is to what extent its growth will justify the stock price. At some point valuation will start to matter.

From that standpoint, I wonder how much revenue deterioration investors will tolerate before its P/E drops a bit from nose-bleed levels. Even more concerning is that its success and dominance has placed a target on its back from rivals who want nothing more than to put it out of business.

I like the company, but I want to see a reversal of the growth trend before the stock would make sense right here.

At the time of publication, the author held no position in any of the stocks mentioned.

This article is commentary by an independent contributor, separate from TheStreet's regular news coverage.
Richard Saintvilus is a private investor with an information technology and engineering background and has been investing and trading for over 15 years. He employs conservative strategies in assessing equities and appraising value while minimizing downside risk. His decisions are based in part on management, growth prospects, return on equity and price-to-earnings as well as macroeconomic factors. He is an investor who seeks opportunities whether on the long or short side and believes in changing positions as information changes.