This is not investment advice. Do your research before taking a position in any of the securities mentioned in the post below.
Why spin-offs matter
As a rule of thumb, I tend to like evaluating spin-offs because it generally involves unlocking a company with better/worse economics than the original owner and one of the companies is better off
Whilst there are plenty of examples where haughty consultants/IBs have suggested a spin-off some relatively successful examples include
Aus: Dulux, Rinker, United Malt, South 32, Endeavour, Pendal etc.
US: AbbVie, Kraft Foods, Philip Morris, Liberty Media, Honeywell, Ferrari (Fiat)
Overview & history of VMWare ($VMW)
VMWare, for those unaware of it, was spun out of Dell last year. The rationale behind this is to separate cloud software (VMW) from the hardware/routers (Dell)
VMware has aligned itself to customers/enterprises who want "multi-cloud" (having some assets in the cloud, and some in company-owned datacenters) as their primary IT strategy
It makes its money out of licencing software/apps/security, from its multi-cloud software and maintenance for cloud operators
A super abridged history is below:
2004: EMC (later acquired by Dell) acquired VMWare
2007: At the peak, pre-GFC, EMC sold 15% of VMware to the public via an IPO and one year later a lot of the founders (Greene/Rosenblum) left
2008-11: First partnered with Cisco ('08) and released Cloud Foundry, app services and a database support suite ('11)
2012: Pat Gelsinger became CEO of VMWare
2013: Dell went private
2016: Dell made a $67bn offer for EMC (which included VMWare and Pivotal). Operationally, VMware introduced the VMware Cloud Provider website
Dell and VMW took on a lot of debt at this point; potentially at the behest of PE sponsors SilverLake
2019: Dell re-listed
2021: Pat Gelsinger left VMWare to go to Intel (to be replaced by Raghu Raghuram) and Dell spun out VMWare as a separate business
How has it performed since spin-off?
Despite this compelling business model, generally, the performance of VMWare has been ordinary, for the following reasons
SaaS, whilst strong is not outgrowing the mkt: Licencing (c.20-25% of FY22 Rev) growth has been flat and SaaS grows at >20%; in line or behind wider SaaS market (noting some of the big SaaS players are growing at bigger rates). It is worth noting in many instances these services have negative working capital (i.e. cash flow exceeds revenue)
More MW in the cloud does not mean more income: Hyperscalers (AWS, Azure, Google) have pushed the economics away from on-site data services (where Dell operates) to cloud. Whilst VMWare provides services to these clients, there is not a linear relationship between the growth in hyperscaler volume contracted and $ of services revenue
VMWare is likely to maintain its 27-30% margin on these services but will not truly benefit from the growth in cloud so cannot be priced as such
Acquisitions: Since 2015, VMWare has grown EPS by c.10-14% CAGR (between 2015-2021) partially assisted by acquisitions that have been accretive by taking advantage of cheaper costs of funding etc and selling down Pivotal business
Where does this place VMWare on a valuation basis?
DCF: Given the low near-term growth expectations; a DCF valuation of VMWare is sensitive to near term outperformance. A DCF for VMWare requires one to fully understand the following
Product split: The degree to which licencing revenue drops off vs. SaaS growing is difficult.
IDC estimates that VMware has about 85% revenue share of the x86 server virtualization market and certain mission-critical workloads may never be virtualized so there is a cap on licencing growth.
Topline growth: As a base assumption - it is best to adopt 6-7% based on the Market Research Future/JPM survey results shown below which shows higher single-digit growth
R&D/S&M costs: Level of R&D costs to assume (currently 19% of revenue) which ideally will drop given the subdued growth outlook
Customer adoption of Security/AppDev: Understanding the level of customer demand for their other products (Carbon Black - Security) and (Project Tanzu - AppDev)
Earnings multiples: The cliche from most VMWare broker "Sell ratings" is that its multiple is materially lower than the competition, however, I would say the following things regarding multiples
VMWare is not MSFT: Oracle is arguable the only comparable company in this competitor stack because the growth profile of companies like Adobe/Microsoft a much higher
Perhaps Oracle's expensive, but VMWare is not by definition cheap: Currently the 10% discount in multiple vs. Oracle may suggest an opportunity however there are many things that impact earnings in a particular period. Overall, I do consider the VMWare earning potential to be superior to Oracle's (excluding M&A)
Conclusion:
To summarise above:
VMWare is low growth, higher moat tech business trading on a c.16x forward earnings or 25x trailing P/E
Given the lack of linear exposure to cloud adoption and constraints for future growth, I think the earnings multiple does not make it materially more compelling than MSFT (35x), AAPL (30x) and GOOG (27x)
Nonetheless, the downward momentum of this company and the growing multiples of Big Tech make this one to watch
Finally - I would encourage anyone who is investing in VMWare to genuinely understand their services as non-tech analysts generally need to understand the risk of obsolescence in their business model
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