VMware: Worst News Is In

After being bearish on VMware, Inc. (VMW) for quite some time now, it is interesting to see the stock was off sharply yesterday morning following the earnings release.  The company reported revenues of $456 million compared to consensus expectations of $458.6 million. 

The non-GAAP earnings were directly in line with consensus at 23 cents for the quarter.  However, the issue investors are grappling with is the guidance, which was well below expectations.  The company expects Q3 revenue to be $462 to $468 million compared to consensus numbers of $497.3 million.  The lower guidance had the stock off sharply in early trading, giving traders who were short a nice profit.

One of the issues affecting sales levels is the new strategy by the company to push for long-term contracts from customers.  VMW is willing to sacrifice margins by offering customers attractive deals in return for signing these contracts.  The hope is that the revenue stream will become more stable, but in a weakening economy, executives are less likely to be willing to commit to a 3 year agreement.  It is just too difficult to forecast what the customers' business and technology will look like that far down the road.

Another important (but not published) reason for long-term contracts is the advent of Microsoft (MSFT) on the scene.  Since Mr. Softee has entered the virtualization business, VMW is scrambling to keep its competitive edge.  While management continues to state confidence in its technology lead and assert that it will be able to effectively compete against the new entrant, one must assume that VMW will need to be on its guard with respect to the new competition.

Despite the negative news yesterday, the prospects for VMW stock appears to be getting brighter.  One can note the continual growth in sales (even if it is below expectations) and healthy margins to understand the profitability of this company.  The stock is now down more than 70% from its high set just 8 or 9 months ago and with earnings expected to be over $1.00 this year (likely to be revised somewhat lower) and $1.39 next year the stock price is looking like more and more of an attractive play.

When VMW was first offered to the public in its IPO debut, the stock was priced at $29.00.  This IPO price can often serve as support to a stock, provided the fundamentals remain intact.  Now that the stock is approaching this level, there appears to be a bit of a potential floor in place and so I think the downside risk is becoming much smaller.  I would suggest taking at least partial profits on any short position at this time as the decline has been tremendous, and the gains are likely very attractive.  A long position is not out of question in the future, but for a sustained positive trend to take place, we must see economic recovery in the broader market.

FD: Author does not have a position in VMW.