Jun 16 2020 - VMware: A Diamond Hidden In Plain Sight

Summary

The markets were slow to appreciate VMware's growth potential from hybrid cloud growth.

Despite delivering triple-digit revenue growth in hybrid cloud revenues, the stock hasn't fully priced in the possible upside.

We dig deep into the numbers to show that not only is the revenue growth from the hybrid cloud about to become a rocket ship but also the company has.

VMware is likely to see sustained double-digit growth on the back of technology prescience, leading it to become a potential multi-bagger.

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VMware's (VMW) growth as a virtualization provider, hybrid cloud provider, and, more recently, as a platform of choice for containers has been often difficult to see due to the company's foresight around technology. As we look through the multiple restatements that VMware has made over the last few years, we find a discernible trend of underlying growth that is feeding into an exponential growth trajectory over the next many quarters. The company is also developing a pipeline of similar technologies to keep ensure that the baton of growth passes over seamlessly. In our opinion, neither is the market appreciating the growth potential just from hybrid cloud nor is the market trying to envision what the VMware management has achieved by the launch of Tanzu. We think another quarter of strong revenue growth will lead to the valuation play catch up with the underlying fundamentals, translating into a 2x or higher return.

Understanding VMware's Technology Roadmap

The move to the cloud has been a significant tailwind for VMWare, especially the company's position as a leading provider of hybrid cloud solutions and VMware's anchor relationship with Amazon Web Services (NASDAQ:AMZN) (AWS) for its hybrid cloud offerings. Due to the company's leadership in the data centre market for virtualization, VMware has also been able to attract the likes of Microsoft (NASDAQ:MSFT) and Google (NASDAQ:GOOG) (NASDAQ:GOOGL), among others wanting to partner with the hybrid cloud enabler. In addition to the hybrid cloud, VMware's core proposition virtual machines or VMs have seen disruption with containers coming into the play.

50190104-1592224257904181.png

Source: Docker

Without going deep into the technical differences between the two, containers are a lighter and more efficient way of running many apps that previously would be run using VMs. In 2017, VMware also caught on to this wave and partnered with Pivotal to develop Pivotal Container Service (PKS). Containers also brought about with them the challenge of managing them, and thus VMware bought Heptio. Since VMware's customers have Kubernetes (Kubernetes is an open-source system to manage containers and was developed by Google) clusters across different environments, VMware focussed on the development of a unified control platform known as Tanzu. The idea behind Tanzu was to create a platform that could not only help manage containers within VMware's ecosystem across various clouds but also containers from competitors such as OpenShift. Considering that Pivotal was also gravitating towards a container-focussed ecosystem, and it was also a part of Dell, the VMware management went ahead and merged it within itself to benefit from scale and synergies.

In December 2019, we completed the acquisition of Pivotal Software, Inc. ("Pivotal"), a subsidiary of Dell, to enhance our cloud native applications portfolio. The purchase of Pivotal was accounted for as a transaction between entities under common control and required that we recast our prior period financial statements and financial data to include Pivotal for all periods presented in this Annual Report on Form 10-K, as if the combination had been in effect since the inception of common control.

Source: VMware 10-K - 2020

The recast financials present a couple of observations. First, VMware's own hybrid cloud business was mostly dependent on AWS. Secondly, VMware management has dared to keep giving a more in-depth look into their financials by restating their financials many times over the last few years which should provide investors with a lot of confidence around the quality of numbers.

50190104-15922243523628178.png

Source: VMware 10-K filings, Author analysis

The company's association with AWS primarily sponsored the growth from the core VMware Cloud Provider Program or VCPP, and per the last reported numbers was around the 25-27% mark.

50190104-1592224390084182.png

Source: VMware 10-K filings, Author analysis

After the reclassification, the non-Pivotal revenue growth was mostly unaffected, with a marginal decline of 50 bps to 30.5% for 2019 and an 8% growth to 39% for 2020. A large part of that 8% incremental tick in non-Pivotal revenues is likely to have come from hybrid adoption due to VMware adding support for other public cloud providers and benefiting from a secular trend towards digital transformation (which will possibly see a pull forward due to the COVID-19 pandemic). In fact, the VMware Cloud on AWS saw a triple-digit revenue growth rate in 1Q21. However, it is worth putting this growth rate in context - by the management's admission, the product has matured over the last couple of years and has thus started witnessing rapid growth. The hybrid cloud business contrasts with the container business - Tanzu was launched in March this year and could again take a while to mature.

50190104-15922244012221532.png

Source: VMware 10-K filings, Pivotal Software S-1 filing, Pivotal Earnings Presentations, Author analysis

Note: VMware did not provide the split of its Subscription & SaaS between Pivotal and non-Pivotal for 2020. The numbers presented here are based on the author's analysis.

Taking Pivotal revenues to be a proxy for the growth of the broader container business for VMware, growth has fallen to 57% in 2020 versus 73% in 2019. While the management talked about strong traction with Tanzu, the competitive intensity in this space cannot be ignored. In the hybrid cloud business, VMware possibly had an early mover advantage. However, with OpenShift, VMware has a formidable competitor in the container market.

Not only has OpenShift been shipping for the last five years across nearly 1,700 customers but it also was one of the major motivations for IBM's billion buyout of RedHat. Considering RedHat has been a vocal critic of VMware for using VMware proprietary platform to offer Kubernetes offerings and VMs versus containers, we see the alpha in the VMware stock purely coming from the adoption of its container business.

Estimating the growth of VMware's business

Due to the change of VMware's financial year at the end of 2016, ASC 606 adoption in 2019 and recast of financial statements due to the Pivotal acquisition in 2020, it is quite tricky to get a sense of how a new product could grow under the company's fold. We use the historical numbers from previous filings and the split of non-Pivotal revenue numbers to arrive at a sense of how the revenue from hybrid cloud and SaaS have grown over the quarters.

50190104-15922244541689203.png

Source: VMware filings, Author estimates

The most recent tick-up in revenue looks like the inflection point in a typical S-curve.

50190104-15922244782336714.png

Source: Author's depiction on an S-curve

The inflection point has come after 12 quarters. We note that this points towards a relatively steep curve for the non-Pivotal / hybrid cloud revenues. We assume that this trajectory could easily continue for the next 5-6 quarters, and then revenue growth could cool down. Consequently, we arrive at the following expectation for the hybrid revenue.

50190104-15922245248208992.png

Source: Author analysis

And I'll say a couple of things about the AWS offering where you've heard me talk in the past, Matt, where it takes two years for a new product to become mature enough that customers really trust them and start to build on it. And when we first launched the VMC service at AWS, we thought we could do better than that. Well, guess what? It took two years. And starting late last year, the two-year anniversary, we saw really start to take off nicely in the market. Seeing the triple-digit growth this quarter was really exciting."

The - overall, the response to the Tanzu launch, which we did in March, was very strong. We just shipped the new version of vSphere a few weeks ago.

Source: 1Q21 Earnings Call

Assuming Tanzu revenues could follow a similar trajectory with the launch on March 20, we arrive at the following curve.

50190104-15922245487601225.png

Source: Author analysis

It is worth noting that we expect VMware's container revenues to thrive and grow in a market that is currently dominated by RedHat and OpenShift. There are two important considerations for our expectation of growth:

  • VMware's offers Tanzu a large target market: Per Michael Dell, there are close to 600K VMware customers to whom this product will be rolled out to. Additionally, the March 20 rollout had received a strong response.
  • OpenShift has been shipping for quite a while: Typically, the shelf life of such technologies cannot exceed eight to ten years. With OpenShift already having run for five, after around another three years it could see a flattening of growth, which coincides with the start of our growth phase expectations from Tanzu.

While the race for technology standard ownership remains the holy grail in the container market, some customers are adopting an approach to hedge themselves by adopting competing technologies.

We think the universe is big enough for a couple of players to co-exist….

A multi-supplier strategy has always been part of our approach because technology moves so fast.

There's no such thing as winners or losers because, at some point, a particular technology will become dominant, and the rest will catch up eventually. So, using a diverse set of technologies will give us the best innovation from leading suppliers and, as others improve, we can still reap the benefits of their improvements.

Source: Computerweekly April 20

The way VMware has been able to ride the hybrid cloud adoption wave and appears to be getting ready to ride the container orchestration adoption, despite the current pandemic, we think the company is likely to ensure growth looking many years out.

Financials

The core virtualization business is likely to continue and eventually roll up into subscription, which should peak out by the end of F2022-23. Subsequently, the mantle of growth will be picked up by the container business to again deliver stellar returns for the next few years.

50190104-15922258647470222.png

Source: Author analysis in the Base Case

Base case: Revenue growth expectations for the Subscription and SaaS business have been modeled as an S-curve, based on the trajectory for the VCPP business

  • Revenue from Pivotal / Tanzu is expected to grow from 4 million in F2020 to .1 billion in F2025 at a CAGR of 64%
  • Revenue from ex-Pivotal / Hybrid / VCPP is expected to grow from .3 billion in F2020 to billion in F2025 at a CAGR of 44.1%
  • Revenue growth expectations from Pivotal / Tanzu and ex-Pivotal / Hybrid / VCPP imply Total Subscription and SaaS could grow from .9 billion in F2020 to billion in F2025 at a CAGR of 51.6%
  • Revenue from License is expected to grow from .2 billion in F2020 to .1 billion in F2025 at a CAGR of -0.8%
  • Revenue from Services is expected to grow from .8 billion in F2020 to .1 billion in F2025 at a CAGR of 9.6%
  • Total revenue is expected to grow from .8 billion in F2020 to .2 billion in F2025 at a CAGR of 20.2%

Bull case: Revenue growth expectations for the Subscription and SaaS business have been modelled above the S-curve, based on the trajectory for the VCPP business

  • Revenue from Pivotal / Tanzu is expected to grow from 4 million in F2020 to .6 billion in F2025 at a CAGR of 74.4%
  • Revenue from ex-Pivotal / Hybrid / VCPP is expected to grow from .3 billion in F2020 to .4 billion in F2025 at a CAGR of 54.8%
  • Revenue growth expectations from Pivotal / Tanzu and ex-Pivotal / Hybrid / VCPP imply Total Subscription and SaaS could grow from .9 billion in F2020 to billion in F2025 at a CAGR of 62.1%
  • Revenue from License is expected to grow from .2 billion in F2020 to .9 billion in F2025 at a CAGR of 4.2%
  • Revenue from Services is expected to grow from .8 billion in F2020 to .3 billion in F2025 at a CAGR of 14.6%
  • Total revenue is expected to grow from .8 billion in F2020 to .3 billion in F2025 at a CAGR of 27.4%

Bear case: Revenue growth expectations for the Subscription and SaaS business have been modelled below the S-curve, based on the trajectory for the VCPP business

  • Revenue from Pivotal / Tanzu is expected to grow from 4 million in F2020 to .1 billion in F2025 at a CAGR of 53.6%
  • Revenue from ex-Pivotal / Hybrid / VCPP is expected to grow from .3 billion in F2020 to .4 billion in F2025 at a CAGR of 33.3%
  • Revenue growth expectations from Pivotal / Tanzu and ex-Pivotal / Hybrid / VCPP imply Total Subscription and SaaS could grow from .9 billion in F2020 to .5 billion in F2025 at a CAGR of 41.1%
  • Revenue from License is expected to grow from .2 billion in F2020 to .4 billion in F2025 at a CAGR of -5.8%
  • Revenue from Services is expected to grow from .8 billion in F2020 to .2 billion in F2025 at a CAGR of 4.6%
  • Total revenue is expected to grow from .8 billion in F2020 to billion in F2025 at a CAGR of 13.1%
  • Our expectations of returns even in the bear case are higher than those of consensus.

50190104-15922260235340142.png

Source: Yahoo! Finance

The primary difference in our revenue expectations versus those of the consensus appears to be in the market understanding of the hybrid cloud revenue growth and the pickup in the container business. These differences in revenue also manifest in the valuation with a significant upside across different valuation multiples and across cases.

Valuation

We value VMware using two multiples - P/S and P/FCF

ChartData by YChartsChartData by YCharts

Using the P/S and P/FCF values for the companies shown in the above charts, we arrive at the following averages:

50190104-15922918056893418.png

Applying the average multiples to our estimates in the three cases, we arrive at the following valuation scenarios of VMware.

50190104-15922260735268133.png

Source: Author analysis

While P/S talks about valuation as a growth company, P/FCF lends itself amenable to more mature companies. We see VMware as a mix of both.

In the worst case, we see a doubling of the stock and going all the way up to 4-5x the current price in the more bullish scenarios. We also acknowledge the risks to our thesis as follows:

  • Inability to follow up on the growth of hybrid cloud and the container businesses: Our upside thesis rests on the breakout in hybrid cloud growth and the subsequent wave of growth from the container business. If VMware shows a weaker than expected growth in its hybrid cloud division next quarter or talks of potential weakness in demand, our thesis would need to be revisited. We, however, think this is unlikely given how the revenue in the division has been building up to culminate into a triple-digit growth for 1Q21. Given the way VMware has been able to manage the uptake in the VCPP business while building relationships with other prominent cloud players, coupled with the demand pull-forward due to the COVID-19 pandemic is unlikely to let growth weaken for the company's hybrid cloud solutions. Also, considering Pat Gelsinger's prescience about technology, the launch of Tanzu is likely to be well in time to peak over the next two to three years to coincide with the focus shifting away from pure hybrid to more efficient usage of hybrid infrastructure.
  • Dell overhang: Whether it was the deal with Azure or the deal with Pivotal, the rumors of Dell applying pressure is well known. Much of the growth that VMware is now likely to see will come through from subscription-first offerings, and if Dell does not get another billion of a special dividend, VMware's business could benefit from the lack of distractions.
  • Competition: VMware competes in the hybrid cloud and increasingly in the container orchestration market. Given that the company is a leader in the hybrid cloud market and is likely to see its container technology maturity over the next 2-3 years, the risk from competition is limited.
  • COVID-19 pandemic: This unfortunate event has led to a demand pull-forward for VMware's hybrid cloud offerings and thus has been positive. Due to the subscription nature of the hybrid cloud, a pull forward will be positive for cash flows and in case the demand begins to wane earlier than expected, growth in Tanzu should help ensure growth.

Conclusion

An investment in VMware is less about buying an expensive technology stock and more about investing in the future of enterprise technology. The company has demonstrated time and again how well ahead of the curve VMware has been when it comes to understanding the cycle of centralization to decentralization in technology. VCPP was a program that took many quarters of labor and has now started bearing fruit. The Tanzu platform also comes from the same stable with multiple acquisitions and meticulous development of the last many quarters culminating into a shippable product. While easy money has been sloshing around in the wake of the COVID-19 pandemic, it will be difficult to find better quality names than VMware, who not only benefit from the liquidity but have rock-solid foundations.

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