VMware’s Strategy of Any Application, Any Cloud Resonating With Customers

Mark Cash
Equity Analyst
mark.cash@morningstar.com
Take
 2020/03/26

No-moat Dell Technologies and its subsidiary narrow-moat VMware both withdrew their fiscal 2021 guidance, which were provided in their fourth quarter earnings calls in February. Both firms stated that they plan on providing more information during their first-quarter earnings calls that are currently scheduled for May 28. Although we lowered our fiscal 2021 expectations for both companies' revenue growth and earnings results due to impacts from COVID-19, we expect demand to return after some challenging quarters. In turn, we are maintaining our $65 fair value estimate for Dell Technologies and $202 for VMware, and we view both companies as undervalued.

In its announcement, Dell stated that it is seeing heightened interest in its work from home solutions, is continuing its execution in its global supply chain, and that the company remains confident in its liquidity position. However, the extent of COVID-19's impact cannot be calculated at this point, and VMware made a similar point in its 10-k that was published today. While we now model fiscal 2021 to be challenging for both companies, with Dell's revenue contracting by 1% year over year and VMware's sales only growing by 8% year over year, we expect fiscal 2022 to return to nice sales growth (5% for Dell and 14% for VMware). Our expectations will be updated as more information is provided by both firms in May.

In our view, Dell will be able to weather the impacts from this global pandemic and we do not expect the firm to trip a debt covenant. Since its massive EMC acquisition in 2016, Dell has restructured its debt six times to establish a more favorable payment schedule and investors should note that of its $52.7 billion in debt, $33.8 billion is considered core, $4 billion is a margin loan, $9.3 billion is Dell Financial Services, and $5.6 billion is from VMware. We expect the firm to meet its interest coverage or total leverage covenants through cash flow and its $9.3 billion of cash and equivalents.


Business Strategy and Outlook 2020/02/27

VMware, a pioneer of virtual machines, dominates the maturing data center server virtualization market. Private and public clouds are becoming ubiquitous among enterprise networks as on-premises server virtualization apexes. After shedding its cloud provider business in 2017, VMware created a robust cloud provider partnership portfolio, which we think helps the firm handle the changing market landscape. VMware's next wave of growth should stem from software solutions for hybrid clouds, hyperconverged infrastructures, and network virtualization.

Our view of cloud networking, akin to VMware's assessment, is that most enterprises will utilize hybrid cloud solutions. Public clouds can precipitously augment network growth but enterprises face integration complexities among on-premises networks and private and public clouds. Beyond hyperscale cloud provider partnerships, VMware's Cloud Provider Program offers thousands of cloud partners collaborating with VMware software. In our view, this allows VMware to remain ingrained in networks while becoming the commonality between private and public clouds.

Perhaps the biggest VMware investment risk lies within its ownership structure, as Dell Technologies owns 81% of the combined firm. VMware's $11 billion one-time special dividend helped finance Dell's buyout of its VMware tracking stock, or DVMT. A different possible outcome was a Dell and VMware combination, and although this didn't happen, we cannot rule it out in the future. Our take is that VMware's operations can be viewed outside of Dell's balance sheet, but an underlying risk remains.

VMware's vSphere and ESXi hypervisor are virtualization gold standards, and its hybrid cloud platform creates a consolidated view across multicloud environments. We believe VMware's hyperconvergence, network function virtualization, digital workspace and end-user computing products should keep VMware as a trendsetter. VMware's Kubernetes embracement can provide growth with containerization, and expand VMware's reach into the developer side. We think software cohesion across on-premises and clouds along with nascent networking products should give VMware sustainable growth.


 2020/02/27

We designate VMware as having a narrow moat, which we believe originates from customer switching costs. As the dominant player in machine virtualization, VMware has an extensive installation base in mission-critical enterprise data center servers. In our view, customers are likely to stay with VMware because of knowledge of its product ecosystem as well as the risks and complexities associated with changing virtual machine providers.

VMware's revenue stream consists of selling software licenses and supplemental services that include software maintenance and support offerings. The company revolutionized the enterprise data center market in 2001 with its first virtual machine offering for servers. Enterprises utilizing virtual machines through a hypervisor, such as the industry gold standard ESXi by VMware, enjoy higher server utilization rates due to the software's ability to segment the hardware into multiple instances of itself. Information technology professionals found value in the hypervisor's ability to lower the quantity of costly physical hardware required to accomplish data server services.

The firm is a dominant vendor of virtualization infrastructure software, controlling the preponderance of the market. Including vendors such as Microsoft, which bundle free virtual machine capabilities with other server offerings, we estimate VMware still owns 60%-75% of the market. The server virtualization market can be considered saturated, and we expect VMware's market share to remain stable in server virtualization. We note that VMware is diversifying itself away from server racks. Products like NSX enable VMware to capture network virtualization and security customers, vSAN opens up hyperconverged networking for firms, and Workspace ONE and AirWatch are considered best-in-class for network edge management and monitoring. VMware shed its attempt to become a cloud provider in 2017 and has embraced the strategy of supplying hybrid cloud virtualization solutions. We believe that VMware will further interweave itself into customers' networks via products for the nascent networking trends of hyperconverged infrastructure, hybrid cloud virtualization, and containerization.

Over the previous decade, VMware's software being installed throughout enterprise server racks created a barrier to changing vendors. VMware created a widespread virtual machine and hypervisor market and then flourished with its first-mover advantage. We believe networking teams are reticent to change vendors because of VMware's superiority in feature suites, user-friendly graphical user interfaces, and potential network disruption. Moving to a VMware alternative requires significant overhauling of an enterprise's network backbone. We believe that VMware's customer stickiness is reinforced through its ecosystem of virtual machine products, including virtual storage, security, and routing. In our view, potential disruptions to displace VMware within networks is not worth the risk to enterprises.

IT professionals have spent considerable time becoming fluent and accustomed to VMware's product offerings over the past decade. Entrenched VMware product knowledge creates a tendency for professionals to evolve with VMware offerings instead of uprooting the incumbent solution. In our view, VMware's customer support and services provide it with an advantage over competing opensource options. We also believe that VMware's user-friendly product design created a wider customer audience versus technically challenging opensource software.

In our view, VMware's largest advantage could be its ability to offer one interface for a company's entire networking infrastructure. Many companies have struggled with migrating to public clouds but want to reap the benefits of outsourcing workloads. Conflicting private and public cloud software systems and the desire to keep certain items in private clouds for speed, security, and cost concerns have been problematic to many enterprises attempting to fully adopt public clouds. Most IT professionals are accustomed to using VMware on-premises or in their private clouds but were not afforded the same familiar interface within public clouds. VMware's hybrid cloud efforts, through partnerships with cloud providers, gives IT teams a sense of familiarity between private and public clouds. We believe enterprises will continue to pay for VMware software while expanding operations to public clouds due to commonality between existing VMware product entrenchment and new offerings.

Containers, which split up instances of the operating system instead of dissecting the hardware, are becoming popular alternatives to virtual machines. Compared with containers, virtual machines are considered resource-hungry and slower but offer superior security. We believe that enterprises developing applications and migrating resources to the cloud will utilize a mixture of the two technologies. VMware acquired container orchestration and management assets, and has melded those technologies into a holistic view for developer and operation teams. We believe VMware was quick to see the disruptive nature of this technology, and will benefit from the growth of container-based workloads.

VMware is well entrenched in one of the most mission-critical pieces of networking operations, and we believe its burgeoning product offerings will be on customers' short list of potential vendors during network upgrades. To protect its moat as technology evolves, VMware is expanding from its dominant position in machine virtualization and into adjacent markets of hybrid clouds, hyperconverged infrastructure, and containers. A notable example beyond the server room is VMware's network function virtualization software licensing agreement with Vodafone showcasing how VMware's virtualization has value with telecommunication firms as 5G networks are rolled out. We assess that VMware will not command such dominant market share as it enjoys in server machine virtualization; however, the company's strategic plan is sensible for continued growth.

We note that our moat thesis is based on the stand-alone VMware business, which is 81% owned by Dell Technologies. Although unlikely in our view, it is feasible that Dell Technologies completely absorbs VMware into Dell Technologies Class C public stock. This could result in a less moaty businesses than VMware's virtualization stronghold. If substantial business changes were to occur, we would revisit our moat rating accordingly.


Fair Value and Profit Drivers 2020/02/27

We are maintaining our fair value estimate at $202 per share, and we expect VMware to continue its robust growth as the commonality for hybrid-cloud ecosystems. This fair value estimate represents fiscal 2021 enterprise value/sales of 7 times. Our revenue compound annual growth rate of 10% through fiscal 2025 assumes that VMware's subscription and SaaS products overtake its traditional license sales, while being supported by services revenue. While VMware's core business of selling virtual machines for servers is a maturing market, we believe growth arises from VMware's hybrid cloud-computing portfolio, including cloud partnership licensing and SaaS offerings, along with hyperconverged infrastructure, network function virtualization, security, and end-user computing products. Although public cloud adoption should create headwinds for virtual machine license sales in general, we think the dominant public cloud providers offering VMware products should help the company's overall business. We agree with management that public cloud adoption is hindered by complexities in integrating public clouds with on-premises and private cloud infrastructures. We think the different networking infrastructures provide an opportunity for VMware to capitalize on enterprises desiring software commonality between their private and public clouds. Beyond software-defined data center offerings for hybrid clouds, we anticipate VMware will see growth through its expanding portfolio of software-defined networking, security, and storage products. We believe VMware's gross margins will remain in the mid 80% range and operating margins should increase a few hundred basis points into the mid 20% range in the long term. Our forecast assumes operating leverage gained through R&D efficiencies and as the firm's SaaS revenue rises at a faster pace than marketing expenditures.


Risk and Uncertainty 2020/02/27

We assign VMware a high fair value uncertainty rating based upon perils associated with public cloud providers, containerization technology, networking supplier competition, and unknowns surrounding Dell's management of VMware. VMware faces competition from public cloud providers moving toward on-premises servers with virtual machine offerings and traditional hardware suppliers creating virtual networking software suites. Enterprises adopting open-source and public cloud virtual machines and containers would be to VMware's detriment. Also, VMware will face new competitors as it moves away from the data center server toward the network edge and software-defined networking. Hardware companies that are VMware partners are developing their own software solutions that compete against VMware. As nascent industry trends become standardized, we note potential concerns about VMware's ability to sell a premium product in a competitive marketplace.

VMware management expects to realize $1 billion of annual synergies with Dell through preloading VMware software on Dell hardware and collaborations in marketing and sales efforts. Even though VMware expects to remain a separate identity under Dell ownership, access to public markets provides Dell with capital to take over VMware if it chooses. The risk of being folded into Dell could be detrimental to VMware's nimbleness, future product roadmaps, and investor interests.


Stewardship 2020/02/27

We consider VMware's stewardship of shareholder capital to be Standard. Dell owns 81% of VMware as of February 2020 and has majority voting power. Dell controls VMware's board of directors and some of VMware's board members have overlapping presence between the two entities. Dell's high ownership of VMware can be a shareholder concern, but we believe VMware's board strives for the best interest of its minority shareholders. Even though VMware's $11 billion one-time special dividend was mostly for Dell's benefit, we believe the other possibility of a VMware and Dell combination could have been worse for VMware minority shareholders. Under a business combination, we postulate that Dell could drain VMware's cash balance and cash flow to pay down its debt balance instead of investing in projects for VMware's future growth or shareholder returns.

EMC owned 81% of VMware when Dell acquired EMC for $67 billion in 2016. To finance the deal, Dell utilized $50 billion in debt, $4 billion in cash, and issued a tracking stock, DVMT, that followed EMC's 81% economic interest in VMware to help bridge the gap. During the EMC acquisition, Dell's DVMT issuance tracked a 53% economic interest in VMware as Dell also retained 35% of EMC's 81% interest. In December 2018, DVMT was retired through Dell Technologies returning to the public market with a Dell Technologies Class C common share listing.

The company's only dividend was completed in December 2018 as a special one-time dividend that was part of Dell's return to the public market through repurchasing and replacing its tracking stock. Dividends are not a core part of VMware's strategy, and we believe future capital allocation will be reinvestments into the business for future projects and share buybacks. Acquisitions remain a strategy for VMware, and recent purchases focused on cloud-based software, containers, and security companies. VMware completed eight acquisitions in 2019, with notable mergers including endpoint security company Carbon Black for $2.1 billion, application development and runtime firm Pivotal for $2.7 billion, and application delivery company Avi Networks for $326 million. VMware's 2017 and 2018 acquisitions include Wavefront for cloud monitoring and analytics, E8 Security for network security, and VeloCloud for software-defined networking, alongside other cloud-based technology companies. The company sold its cloud provider offering business, vCloud Air, and decided to focus on partnering with cloud providers. As of November 2019, VMware had $1.1 billion remaining on its share-repurchase program, and we expect VMware to fully utilize the buyback authorization.

We believe that VMware's management team is investing in projects and acquisitions that provide shareholder value. Management's incentive structure is highly correlated to company performance via stock price, revenue, non-GAAP operating margin, and efforts in hybrid cloud and SaaS. In our view, the incentives of management are aligned with shareholder gains.




VMware, a majority-owned subsidiary of Dell, is an industry leader in virtual machines for data center servers and computer desktops. The software provider operates in the three segments of licenses, maintenance, and professional services. Customers include enterprises utilizing data centers, end-user computing, cloud providers, and software-defined networking. The Palo Alto, California, firm operates and sells on a global scale, with about half its revenue from the United States, through direct sales, distributors, and partnerships.