'Virtual Value' Isn't Good Enough for This Stock

NEW YORK (TheStreet) -- Investors often show little patience for sell-side analysts raising concerns about stocks that trade on unrealistic expectations. They are always considered the enemy.

However, many are feeling vindicated Friday following VMware's ( VMW) fourth-quarter report.

Although the virtualization giant beat on both the top and bottom line, the Street was not happy about the company's outlook, which raised concerns about its underlying condition.

That shares are currently trading at $76.80 (as of this writing) means the stock is down 22% from a high of $99.10 reached just ahead of the report. But was it justified? Although valuation had been a popular cited bear argument, VMware has proven that it can meet growth expectations. This quarter was no different, at least not entirely.

For the period ending in December, VMware earned 81 cents per share on revenue of $1.29 billion, beating EPS estimates of 78 cents and edging out the consensus revenue projection by $1 billion.

As VMware has often shown, growth has never been a problem as evident by the 22% climb. Likewise, net income advanced 3% to $205.8 million, or 47 cents per share.

VMware also showed it was doing well with recurring revenue as licenses grew 16% year-over-year. Even though this was 3% slower than Red Hat ( RHT), it arrived in line with estimates. On the other hand, maintenance/service revenue surged 27% - outperforming Citrix's ( CTXS) 22%. Clearly, VMware is holding its own from a competitive standpoint.

Profitability was also impressive. Not only did gross margins advance 60 basis points year over year, but it beat Street estimates by one point. What's more, operating income grew 25% year over year and 16% from the previous quarter.

So with a report like this one would expect the stock to trend upward. The Street saw things differently -- with a little help from management.

End of the Run?

This is what investors are wondering today after management issued guidance that arrived below consensus. The company projected first-quarter revenue in the range of $1.17 to $1.19 billion, which was 5% lower than what analysts were modeling at $1.25 billion. On these numbers, the stock got hammered -- falling below its 50- and 200-day moving averages.

In other words, management is calling for growth of 13%, or 7% lower than what would have pleased investors. What's more, analysts absolutely hated that VMware guided license revenue for growth in only single digits versus growth estimates of 14%. Granted, these adjustments weren't entirely drastic. Then again, the premiums investors have been paying were not for average performance either.

It also didn't escape analysts that license billings posted only 7% growth, the second consecutive quarter of single-digit movement. This means that demand is beginning to slow. Although there had been concerns about the overall health of the virtualization industry, it is clear these worries are valid.

VMware must convince investors it can restore its growth momentum. In the meantime, management has begun to focus on extensive cost-saving efforts, which include the elimination of 900 jobs. It's unfortunate that it has come to this. But despite strong profit margins, growth seems to be what investors want. Will this be enough?

VMware understands the challenge it is up against. The company realizes it has seen a decline in license revenue over the past several quarters. By and large, this has contributed to the central question of whether the company can continue to grow into its valuations. As evident by the 20% decline in the stock, investors are no longer willing to risk it.

The good news, though, is VMware is still the market leader in virtualization. This should afford the company some time to turn things around.

But the gap is beginning to narrow. Aside from Red Hat and Citrix, there's also Microsoft ( MSFT), which has its own ambitions in this arena with SMS -- growing that business 5% to $5.19 billion. Although Microsoft is not a threat today, it should not be taken lightly.

Bottom Line

VMware has to prove that this bump in the road is temporary and not a sign of poor fundamentals. Although it has the support of EMC ( EMC), which owns 80% of the company, EMC has been considered a drain on VMware's growth.

So from that standpoint, there may be some other challenges ahead. In the meantime, growth has to come back to the 20%+ level before this stock is going to work again.

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

This article was written 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.

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