VMware: Still Solid, Acquisition Or Not (NYSE:VMW)

Overview

VMware (NYSE:VMW) is a tenured virtualization and cloud services company. Virtualization in this context refers to the creation and utilization of virtual machines, which are synthetic computing environments (computers) defined through software. Virtualization is a core element of modern computing, with one piece of hardware often running multiple virtual machines; this occurs in contexts as wide-ranging as data centers to your mobile phone. Virtualization technology opens the door to emulation, allowing various kinds of computers to leverage other operating systems and tools without code having to be rewritten. Without virtualization, software would have to be written in a bespoke fashion for every type of hardware. The most well-known example of a virtual machine would be the JVM (Java Virtual Machine), the environment that all Java code runs in – no matter what computer is running it.

Founded in 1998 in Silicon Valley, VMware has a storied history of innovation in regards to virtualization technology. While less known than many of its big tech peers, it nonetheless forms a large portion of the backbone for modern computing and networking. As it has continued to mature, the company has also branched out into cloud services, bringing it into direct competition with known cloud players. Virtualization is still the core of its business.

VMware conducted an initial public offering in Q2 2007. Notably, the stock has underperformed both the NASDAQ Composite (IXIC) as well as the SP500 since then. For most of the last decade VMware was majority-owned by Dell (DELL), which continues to be a significant customer; this ownership stake was unwound in late 2021.

Furthermore, VMware is currently in the process of being acquired by Broadcom (AVGO). While this deal is facing scrutiny by regulators, the general consensus is that it should proceed as planned. This article will serve to review VMware’s financials and business performance such that Broadcom investors know what they’re getting in the context of the acquisition. In the case that the deal does not go through, owners and prospective investors in VMware should also be well-served by the review that is to follow.

Financials

VMware is undoubtedly a mature technology company. As such, we can investigate it from the perspective of standard fundamental analysis.

Starting with revenues, we see that VMware has maintained solid, even healthy, growth throughout the last decade. Putting up double-digit growth even as it crossed the $10B a year mark, VMware has now seen a slowdown in revenue growth over the last two years. This is likely due to enterprise customers, such as AWS, making progress on building their own proprietary virtual machine technology. While this isn’t economic for most entities, the largest customers (with the largest data centers) are indeed incentivized to vertically integrate in this fashion – this kind of software isn’t cheap.

It is also worth contextualizing these figures by reminding ourselves that 100% of the Fortune 500 make use of VMware services in their respective businesses. Since data processing demand has only continued to increase, I believe that it is fair to infer that the vertical integration of its largest customers is a driving factor in it seeing recent unsteadiness in its revenues.

The profitability story here is a bit more volatile, with VMware facing significant headwinds over the last several years as to its bottom line. The overall volatility is also due to the company being in what is an R&D and capex-intensive business. Virtualization technology is sophisticated and requires expensive systems-level software developers to both develop and maintain.

These numbers are evidently robust, albeit in the early stages of trending in the wrong direction. This is still very much a cash-generative entity, with a decade of positive free cash flow behind it. This likely won’t change too much even as the other variables shift somewhat. Worth noting here is the large structural increase in the company’s debt service; it is now paying roughly $200M yearly in debt service, with that figure also having increased another 40% in the current fiscal year.

This debt service stems from the large amount of debt that VMware has taken on in fiscal year 2018 and fiscal year 2021. This has completely changed the equation as to book value. Note that the firm’s book value took a nosedive in the years that it added long-term debt, with fiscal year 2021 actually seeing this go into the red. Nonetheless, the company has the cash to service this debt and actually pay it down quite readily; this is evidenced by the fact that book value returned to baseline quite quickly post-2018 and has already become positive again after the latest debt issuance. Broadcom investors should be aware that this acquisition will involve taking on VMware’s debt and will very much affect the balance sheet of the acquirer. All that being said, I don’t consider these numbers to be burdensome and retain confidence that VMware can sustain itself throughout – acquisition or not.

Conclusion

The story here is fairly simple. A core provider for the modern computing landscape, VMware has seen its growth slow and its performance across several other core financial variables get worse. The company has more debt than it has had for some time, but its cash flows remain more than robust enough for it to persist through this. While significantly impaired from a book value perspective, I believe that this figure should return to baseline within 2 years. This is, of course, assuming fairly consistent revenues – which appears to be less certain than it was before. This company’s price seems fair at present, although I would be hesitant to open a position under the current context. Investors should await to see what happens with the acquisition, which is also something far less certain with the new antitrust approach coming out of Washington; I’ll call this a hold, but a solid one at that.