How VMware Stacks Up

I'm a believer in growth stocks. As an analyst for our Motley Fool Rule Breakers service, I think you should be a believer too. But even I have to admit some growth stories are bogus, hence this regular series.

Next up: VMware (NYSE: VMW). Is this Rule Breakers pick and maker of virtualization software the real thing? Let's get to the numbers.

Foolish facts

Data current as of Sept. 25.

If Fools have mixed feelings about the sustainability of VMware's virtualization business, it's because of competition from Microsoft's Hyper-V and the open source Xen, which fellow Rule Breakers pick Rackspace Hosting (NYSE: RAX) uses in its own data centers.

"Xen is going to undercut VMware in the cost-conscious Enterprise-class market, at about 20% of the cost given the feature set. Meanwhile, virtualization features are being pushed into the operating systems. Microsoft's Hyper-V and Linux KVM are going to undercut both Xen and VMware in more highly cost conscious datacenters," wrote Foolish investor lamontcq in June.

The stock has rallied nearly 20 points since, and that's led some Fools to question VMware's valuation. I can appreciate the skepticism. No stock looks cheap trading for near 200 times normalized earnings.

Trouble is, VMware has routinely traded in the triple digits throughout its history as a public company. The stock is up more than 50% in that time, versus a 21% loss for the S&P 500.

The elements of growth

Source: Capital IQ, a division of Standard & Poor's.

There isn't much to like about the data in this table. Let's review:

• Normalized net income is down less than it was in 2009, but I'd rather see profit and revenue grow in tandem. That's not happening here, yet.
• Receivables, on the other hand, have grown faster than revenue over the past two years. A bad sign that's counterbalanced by VMware's generous and rising free cash flow.
• Last and definitely least is dilution. VMware's shares outstanding are up 5% since 2008. This is, to a degree, expected since tech firms generally issue dilutive stock options to pay employees.

Competitor and peer checkup

Source: Capital IQ, a division of Standard & Poor's. Data current as of Sept. 25.

Judging by this table, the dilution's worth it. Not only does VMware outperform all peers in terms of net income growth over the past three years, but per the table above, it also boasts some of best margins: better than 82% in each of the last three years. Competition hasn't damaged VMware neatly as much as the bears expected it would.

Grade: Sustainable
So is VMware a great growth story, deserving of our Rule Breakers portfolio? Yes, I think so, if only because the competitive threats the skeptics point to have yet to manifest themselves in the underlying numbers. Cash flow is strong and rising. Margins are good. And return on capital (ROC) are on the rise once more. Add it up, and I see a stock worthy of my CAPS portfolio.

Now it's your turn to weigh in. Do you like VMware at these levels? Would you make it one of our 11 o'clock stocks? Let the debate begin in the comments box below, and when you're done, click here to get today's 11 o'clock portfolio pick.

You can also ask Tim to evaluate a favorite growth story by sending him an email, or replying to him on Twitter.