VMware Must Conquer the OpenStack Battleground if It Wants to Grow

NEW YORK (TheStreet) -- Virtualization and cloud giant VMware (VMW) is not in a good place.

The company, which reports second-quarter earnings Tuesday, is up 4.5% for the year to date and trades around $94. But this is a "nervous" 4.5%. There has been no real conviction to the stock's direction. Since the stock reached its 52-week high of $112.82 on April 2, VMware has lost more than 15% of its value.

Although VMware is the undisputed market leader in virtualization software and cloud-based infrastructure, the company is now facing credible threats from Citrix (CTXS) and Red Hat (RHT), among others.

Investors want to know to what extent VMware can grow in the new battleground that is OpenStack  while also advancing its server and system administration business. This is the only way from VMware to grow into its valuation and justify that it deserves investors' confidence to bless it with a P/E that doubles the industry average.

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The stock, which trades at a P/E of close to 40, is not cheap. Aside from almost doubling the industry average P/E of 22, VMware shares don't offer better value from, say, Microsoft (MSFT), which competes in the same markets. Not only does Microsoft pay a dividend, Microsoft comes with significantly less risk.

It's true VMware is growing faster than Microsoft and, for that matter IBM (IBM). However, investors must consider the expected earnings from VMware's growth may never materialize, because VMware's market is rapidly changing.

What we've come to know as "the Cloud" is shifting in a new direction. OpenStack is the new battleground and it's not going away. Several companies have already proclaimed themselves experts. This is even though they have yet produced the numbers to prove it.

Jim Whitehurst, Red Hat's CEO, told me recently that "no one knows OpenStack better than us." Red Hat has a long history with open source and 90% of Fortune 500 companies are already using Red Hat's software.

Whitehurst explained that some "make the mistake of confusing OpenStack's relationship to the cloud and server virtualization." This, to me, was a not-so-subtle jab at VMware.

In other words, having a cluster of virtualized servers does not qualify as a legitimate cloud platform. This is what VMware is struggling to overcome. Virtualization is VMware's bread and butter.

Management seems to understand what it is up against and doesn't appear worried about its prospects. The company's new VMware NSX platform, which it launched last October, is aimed at conquering Cisco's (CSCO) enterprise lead in cloud-based infrastructure. In response, Cisco declared VMware its "public enemy number one."

Both companies that were once partners are now rivals in software-define networking (SDN). Cisco, which specializes in routers and switches to make intelligent data-delivery decisions, is moving away from a hardware-based solution and making investments (whether via R&D or acquisitions) towards software.

VMware's NSX, which functions as network devices on top its existing hardware, does the same thing. And with VMware already growing its channel partners to grow the adoption of NSX this can put a damper on Cisco's SDN strategies while at the same time accelerating the decline of its existing router and switch business.

These and other questions will be posed to management on Tuesday during the conference call. For now, purely from a valuation standpoint, I would stay away from these shares until management can outline comprehensive strategies to de-risk the growth expectations, differentiate its services and justify the P/E.

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

This article represents the opinion of a contributor and not necessarily that of TheStreet or its editorial staff.

TheStreet Ratings team rates VMWARE INC as a Buy with a ratings score of B-. TheStreet Ratings Team has this to say about their recommendation:

"We rate VMWARE INC (VMW) a BUY. This is driven by some important positives, which we believe should have a greater impact than any weaknesses, and should give investors a better performance opportunity than most stocks we cover. The company's strengths can be seen in multiple areas, such as its revenue growth, largely solid financial position with reasonable debt levels by most measures, solid stock price performance, impressive record of earnings per share growth and increase in net income. Although the company may harbor some minor weaknesses, we feel they are unlikely to have a significant impact on results."

Highlights from the analysis by TheStreet Ratings Team goes as follows:

  • VMW's revenue growth has slightly outpaced the industry average of 7.0%. Since the same quarter one year prior, revenues rose by 14.1%. This growth in revenue appears to have trickled down to the company's bottom line, improving the earnings per share.
  • VMW's debt-to-equity ratio is very low at 0.21 and is currently below that of the industry average, implying that there has been very successful management of debt levels. To add to this, VMW has a quick ratio of 2.27, which demonstrates the ability of the company to cover short-term liquidity needs.
  • Investors have apparently begun to recognize positive factors similar to those we have mentioned in this report, including earnings growth. This has helped drive up the company's shares by a sharp 29.76% over the past year, a rise that has exceeded that of the S&P 500 Index. Turning to the future, naturally, any stock can fall in a major bear market. However, in almost any other environment, the stock should continue to move higher despite the fact that it has already enjoyed nice gains in the past year.
  • VMWARE INC has improved earnings per share by 15.0% in the most recent quarter compared to the same quarter a year ago. The company has demonstrated a pattern of positive earnings per share growth over the past two years. We feel that this trend should continue. During the past fiscal year, VMWARE INC increased its bottom line by earning $2.34 versus $1.71 in the prior year. This year, the market expects an improvement in earnings ($3.52 versus $2.34).
  • The net income growth from the same quarter one year ago has exceeded that of the S&P 500 and the Software industry average. The net income increased by 14.7% when compared to the same quarter one year prior, going from $173.57 million to $199.00 million.

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