VMware: Value in Virtualization

08/12/2014 9:00 am EST

Focus: STOCKS

Tyler Laundon

Editor, Cabot Small-Cap Confidential

It's not easy to find 30% or more upside in a dominant large-cap tech name these days. So when we find it, we have to jump on it, asserts Tyler Laundon, editor of Top Stock Insights.
 
That potential now exists with VMware (VMW), the undisputed world leader in virtualization infrastructure. Over a decade ago, the company transformed how large companies and complex organizations managed their IT. And it's still the best in the business.
 
I tend to look for companies that are somewhat smaller than VMW's $42 billion market cap for our Top Stock Insights Portfolio.
 
But it pays to stray into larger names from time to time. And stray we will when the company in question is poised to grow revenues and EPS by nearly 20% over the coming years. VMW has that potential.
 
It's hard to explain exactly what VMW does. "Virtualization" software is an intangible concept, in more ways than one. At the core, VMware's software allows large organizations to host several software applications on a single physical server.

Because that single server can now host ten or more applications instead of just one, the company has been able to save its clients a ton of money.
 
When VMware first entered the business it had first-mover advantage, and gained nearly 100% market share. It's been over ten years since, but VMW still has over 65% market share in the server virtualization market.
 
VMware is making IT infrastructure more efficient and less complex to manage. The end effect is that its clients have more reliable systems at a lower cost, and a trusted partner that maintains their critical systems. This is the source of VMware's dominance.
 
The company is currently working to provide customers with a wider array of services for mobile applications and cloud-based computing. It is also important to know that it's expensive for a client to leave VMW and go with another virtualization management company.

Given that its clients tend to be large organizations with thousands of virtual machines running really important business functions, clients often feel that the risks to shopping around are simply not worth it.
 
This is why VMW's revenues have been steadily growing. The company's five year average annual revenue growth has been 23%. Income has grown too. Over the last five years, average net income growth has been 28%. Over the past three years? It's been 42%. Those are very impressive numbers and I expect the growth will continue.
 
On Tuesday, July 22, the cloud-computing specialist reported earnings that came in ahead of estimates. VMW delivered revenue of $1.46 billion (1% above consensus of $1.44) and EPS of $0.81 (2.5% above consensus of $0.79).

Looking into the future, I expect VMW to grow revenues by at least 15% to 20% over each of the next three years. EPS growth may be in the mid-single digits this year, but accelerating again to over 20% in 2015 and 2016.
 
While VMW tends to trade at a premium to its peers, the stock is still undervalued based on its own historical valuation. It's forward PE of 24 is a meaningful discount as compared to its five-year historical forward PE of 31.4.
 
With shares trading at $101.60, many brokerage houses have just added shares of VMware to their conviction buy list. We will too. Buy VMware.

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