VMware Earnings Preview: Hybrid Cloud, SDN, End-User Computing To Boost Services Revenues
VMware (NYSE:VMW) is scheduled to announce its second quarter earnings on Tuesday, July 21. [1] The virtualization and cloud computing provider has been one of the fastest growing companies in its domain, with 16% year over year growth in net revenues to $6 billion last year. The company reported a 14% increase in product license revenues to $2.6 billion, while services revenues were up by 17% year over year to over $3.4 billion. Management attributed much of the growth to fast-growing market segments such as hybrid cloud services, end-user computing and network virtualization, now often called software-defined networking (SDN). Subsequently, the company reported a slowdown in top line growth through the March quarter this year. VMware’s net revenues in Q1 were about 11% higher than year-ago quarter at $1.5 billion, in line with the company’s expectations. Although VMware continued to witness a solid 17% annual rise in services revenues to $935 million, licenses revenues were up by only 2% y-o-y to $576 million.
Management expects 2015 revenues to be 9-11% higher than 2014 at about $6.6 billion. VMware’s services revenue stream is likely to continue to witness a higher growth rate than revenues generated through license bookings (around 6%). The company has given revenue guidance for Q2’15 at about $1.6 billion or about 9-10% higher than the year-ago period. License booking revenues are expected to rise by 3-4% on a year-over-year basis, while services revenues could rise by about 13%. [2]
We have a $91 price estimate for VMware’s stock, which is slightly higher than the current market price. VMware’s stock price has fallen by 6-7% since the company reported its Q1 earnings in late April.
See our complete analysis for VMware here
Software-Defined Networking
Over the last few quarters, the company has seen a strong customer response for VMware NSX, its network virtualization platform launched by the company in late 2013. VMware’s software-centric approach to networking threatens to cannibalize Cisco’s (NASDAQ:CSCO) market share in the SDN market. The company has seen a strong customer response to the NSX, with the number of paying customers rising to over 400 by the end of December, up from 150 at the end of June last year.
What makes VMware’s SDN appealing to enterprises is that it allows them to put third-party software on cheap white-label networking hardware, making it potentially much cheaper to implement than installing Cisco’s hardware products that come with embedded software. Moreover, the NSX can be integrated with vSphere, VMware’s existing server virtualization platform.
According to IDC, more than 70% of large and mid-sized enterprises are likely to rework their networking setups over the next three years. [3] VMware’s management mentioned that the company is witnessing strong momentum, which is likely to continue over the next few years. Many of VMware’s customers continue to upgrade their networking and security requirements owing to the hardware-bound limitations in their current architectures. On the other hand, non-IT small and medium enterprises (SMEs) are likely to migrate to a newer technology once it fully matures. Correspondingly, VMware could witness an increasing mix of large-scale license agreements and implementations in the coming years.
Hybrid Clouds And End-User Computing
VMware’s hybrid cloud business grew by over 100% year over year in the March quarter last year, after which the company introduced its cloud-based disaster recovery services. The growth continued through Q2 and Q3, with this business growing by 80% year over year in both quarters. The company rebranded its hybrid cloud business to vCloud Air after Q2. The December quarter continued to be a strong period of growth for vCloud Air with a 100% annual increase in revenues. Continuing the trend from 2014, VMware reported a 100% year over year growth in its hybrid cloud business through the March quarter this year. According to the company’s estimates, hybrid cloud and Software-as-a-Service (SaaS) combined contributed over 6% of VMware’s net revenues in Q1, up from 5% in 2014 and under 3% of net revenues in 2013. Although hybrid cloud is one of the fastest growing sub-segments within the company, a stronger dollar and tougher year-over-year comparisons could limit growth in this segment in the coming quarters.
End-user computing and mobile device management has also been a key growth area for VMware over the last few quarters. This segment was boosted by the $1.5 billion Airwatch acquisition in January last year. At the end of December last year, the total number of AirWatch customers stood at over 15,000, while net revenues generated through license bookings crossed the $200 million mark in the December quarter. VMware was the clear leader in the enterprise mobile management market domain, with nearly twice the customers of its closest competitor. [4] The company reported 50% y-o-y growth in license bookings for end-user compute offerings (including AirWatch products) in Q1’15. Within end-user computing, the desktop-as-a-service business grew by a healthy 15% on a y-o-y basis, while the remaining growth was attributable to AirWatch.
Margins Could Improve In The Long Run
VMware’s licenses gross margin (GAAP) expanded by almost 2 percentage points to 92.6% through 2014. Although VMware’s licenses gross margin for Q1 was lower than 2014 levels at 91.3%, it was about 25 basis points higher than the comparable prior year period. On the other hand, VMware’s cost of services rose by 28% y-o-y to $193 million for the quarter as the company generated higher service revenues from hybrid cloud services and end-user computing. As a result, the gross margin (GAAP) for the services division was about 175 basis points lower than the year ago period at 79.3%. Moreover, VMware’s cash operating expenses, particularly sales, marketing and other administrative expenses, were 16% higher than the year-ago quarter at $723 million in Q1. Consequently, the company’s reported net income was nearly flat over previous year levels at $196 million. However, VMware’s non-GAAP adjusted net income was about 6% higher than Q1’14 at $369 million. A sustained growth in services revenues could continue to push margins lower in the near term. We currently forecast the adjusted gross margin for the services division to bottom out at around 78% in the next couple of years before rising to over 80% by the end of our forecast period.
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- VMware to Announce Second Quarter Financial Results on Tuesday, July 21, 2015, VMware Press Release, July 2015 [↩]
- VMware Q1 2015 Earnings Call Transcript, Seeking Alpha, April 2015 [↩]
- IDC Reveals Datacenter Predictions for 2015, IDC Press Release, December 2014 [↩]
- VMware Q4 2014 Earnings Call Transcript, Seeking Alpha, January 2015 [↩]