VMware Bought Into the Software-as-a-Service Market in Q3

Virtual computing veteran VMware (VMW +0.00%) reported earnings Tuesday evening, covering the third quarter of fiscal 2020. The company beat Wall Street's estimates across the board and delivered updates on its acquisition-powered plans for the year ahead.

VMware's third-quarter results by the numbers

Data source: VMware. GAAP = generally accepted accounting principles.

Wait a minute, don't adjusted earnings usually grow faster than GAAP profits?

Among standard fare such as stock-based compensation and amortization of intangible assets, VMware's adjusted earnings backed out acquisition-related charges of $0.51 per share from this report. In the year-ago period, the same line item amounted to a benefit of $0.46 per share.

In the third quarter of fiscal 2019, the value of VMware's investment in cloud computing specialist Pivotal (PVTL +0.00%) fell by $161 million; during the same period of this year, it increased by $249 million. Between these opposing non-cash accounting items, it's easy to see how adjusted earnings came in lower even though unadjusted profits nearly doubled.

Of course, VMware triggered the rise in Pivotal's value quite directly: That stock rose nearly 60% in VMware's third quarter because VMware announced its intention to expand its investment in Pivotal from 15% to 100%. Buyout bids tend to have that effect.

Image source: Getty Images.

More on VMware's recent buyouts

On that note, VMware expects to close the $2.7 billion Pivotal buyout by the end of the current fiscal year, meaning before the end of January 2020. Until then, the company continues to hold a 15% ownership stake in the developer of cloud-computing platforms.

Meanwhile, VMware closed another acquisition in early October. Cloud security expert Carbon Black is now a part of VMware, adding $10 million to Q3 revenue. Together, Carbon Black and Pivotal should generate more than $1 billion of additional sales in their first full year under VMware's wing, and that's high-quality subscription revenue with gross margin slightly above VMware's customary level around mid-80%.

To put that billion-dollar revenue boost from Pivotal and Carbon Black into perspective, VMware now expects to deliver roughly $10.1 billion in total sales in the current fiscal year. That would amount to year-over-year growth near 13%, consistent with the 13.3% increase seen in the previous fiscal year. Looking ahead to fiscal 2021, management expects sales growth to stay in the low double-digit area -- not accounting for contributions from Pivotal.

Fitting the new additions into VMware's grand strategy

These buyouts were tailored to fit VMware's focus on software-as-a-service (SaaS) and hybrid cloud solutions. Subscription sales in these two categories rose by 40% year over year in the third quarter and now account for approximately 13% of the company's total revenue.

"The investments we are making in and the strength of our growing hybrid cloud subscription and SaaS businesses will drive sustained performance and growth for us," said CFO Zane Rowe in VMware's third-quarter earnings call. "We also expect hybrid cloud subscription and SaaS to drive much of the future growth of the business and show a significant increase in its percentage mix of total revenue. In FY '21, we will continue to invest incrementally in our fast-growing hybrid cloud subscription and SaaS portfolio."

Where will VMware go from here?

Analysts were generally satisfied with VMware's third-quarter results. Several firms raised their price targets on the stock, with increases ranging from 5% to 20%.

The stock is trading at approximately 19 times free cash flow, which is quite reasonable for a company targeting 40% growth rates in the red-hot SaaS market. Given the fact that VMware is achieving double-digit growth -- and even higher rates in its chosen focus markets -- at a time of economic uncertainty on a global level, I can't wait to see how this company could perform when the geopolitical tensions settle down.