Apps & Software

VMware's Magic Is Becoming Wizardry (VMW, EMC)

Douglas A. McIntyre

VMware Inc. (NYSE:VMW) shares managed to cross the century mark of $100.00 on Tuesday.  This has been an unbelievable stock with a premium IPO pricing at $29.00 (under our projected IPO price target) and the stock never seeing a sub-$50.00 print.  Shares even managed to trade over 5.8 million shares on Tuesday’s 6.8% gain to its highest post-IPO close of $101.61, making this the busiest trading day in the stock since September 12.

There is no doubt that this one is a beneficiary of ongoing window dressing and the tech-markup with the other key tech stocks outlined as we enter the end of the year for many fund managers in October.  But even with what we labeled as the “VMWARE CONUNDRUM” because of a low float exaggerating it’s price moves, money managers’ and traders’ demand for stock in the virtualization king seems tireless.

There is no doubt that the company is the leader in virtualization and there is no doubt that the company wants to exceed its targets and will do whatever it can to beat targets.  It has already made itself an acquirer and will likely do so at each new virtualization conference it attends.  But at a closing price of $101.61 what does this stock look like in valuation?

Wall Street has estimates set at $0.65 EPS & $1.27 Billion revenuesfor fiscal December 2007, and has $0.92 EPS and $1.84 Billion revenuesfor fiscal 2008.  With the hype of virtualization and the ever-cheaperprices of multi-core processors and ever-cheaper DRAM prices, you knowthose numbers are probably way too low if you are like myself and muchof Wall Street that believes virtualization is “the next next thing”for the IT sector and investors. So lets pretend that the companymanages 30% better earnings and 20% better growth in revenues using thecurrent expected growth rates.  You’d have nearly  $0.84 EPS and $1.6Billion in revenues for 2007, and then using the same upside surpriseAND the expected growth rates on top of these new hypothetical numbersyou would end up with a magical $1.54 EPS and $2.78 Billion in revenuesfor fiscal 2008.

Forget the 2007 projected P/E ratio of 156right now and the 2008 projected P/E ratio of 110.4.  Use the newmagical “upside surprise” numbers and the new forward P/E ratio is120.95 for 2007 and ‘only’ 66-times for 2008.  These almost becomeacceptable at this point.  But with a roughly a $38.9 Billion marketcap and even with the sustained upside surprise to revenue growthmodels, this would have an implied forward revenue multiple of 24.3 for2007 and 14 for 2008.

At today’s current valuations, it ispossible that VMware stock is trading at anywhere from over 3-times tounder 5-times the sales of the entire virtualization marketindustry-wide to 2010.  These levels aren’t just starting to look likemagic.  They are starting to look like wizardry.  It is even nearlyimpossible to blame traders for using stock options as a “less risky way” of having  exposure to the stock.

This isn’t one of Cramer’s “new four horsemen of tech”but it may be the horse trader.  When you start calculating EMC Corp.’s(NYSE:EMC) 86% ownership valued on paper before flooding the marketwith VMware shares at $33.45 Billion and compare it EMC’s own marketcap of $45.7 Billion, you will begin to scratch your head evenconsidering EMC ran more than 50% since announcing the partial spin-off.  The math starts getting fuzzy.

Keep in mind that with extremely low-float stocks of this sort, logic may not prevail for quite some time yet.  Even after lofty analyst projections,it has continued. Very soon, analysts may have to either boost their targets or make the dreaded “downgrades based upon valuation” calls that would be rather unpopular.  If the company doesn’t vote to allow employees tobreak the lock-up dates early or if EMC doesn’t vote to release Inteland Cisco (and maybe even some of its own VMW shares) early from the180-day lock-up periods, then you could literally see another 4-monthsor more of this.  Stranger things have happened, and in the stockmarket you can still go bankrupt even if your thesis ultimately provestrue.

We are getting ready to release our updated “watch list” of small cap Internet stocks to subscribers of our Special Situation Investing Newsletter,and trials are available.  Our watch list is not all only made ofactive buyout targets today, but under the right circumstances any ofthese could easily become subsidiaries of larger web-based properties.This year alone we have discussed how aQuantive, 24/7 Real Media, and were acquired off this list;and you can see samples of this.

Jon C. Ogg
October 10, 2007

Jon Ogg can be reached at; he produces the Special Situation Investing Newsletter and he does not own securities in the companies he covers.