Virtual computing pioneer VMware (NYSE:VMW) is set to report third-quarter results after the closing bell on Tuesday, October 21. VMware's share prices are back where they started in January, and activist investors hope to separate the company from majority owner EMC (NYSE:EMC).
Is this a good time to buy VMware stock?
There's no gentle way to say this, so let's just get to the point: VMware shares are expensive.
It doesn't really matter which way you slice it. The stock trades at 41 times trailing earnings, 7 times trailing sales, and 18 times free cash flows.
These ratios have held fairly steady over the last two years, so there's no positive momentum going on.
So if you want to invest in the virtual computing and cloud computing spaces, you'll have to hold your nose and live with sky-high starting prices. There's simply no way around this issue.
Do you get what you pay for?
Then again, investing in high-growth phenoms has never been cheap. And VMware most certainly qualifies for that title.
VMware has grown its sales at a 22% annual pace over the last 5 years, while free cash flows increased by 21% a year. These growth rates are about 4% ahead of Red Hat and 8% faster than Citrix.
Plug VMware's cash flows into a discounted cash flows calculator, using Wall Street's average estimate of 15.4% growth for the next 5 years, and the stock should be worth about $95 per share today. So if you're willing to pay a premium for rapid growth, VMware trades at a reasonable price right now.
But wait -- there's more!
The numbers rarely tell the whole story. In VMware's case investors must weigh the company's tremendous growth opportunities against the threat of a blisteringly competitive industry.
VMware isn't resting on its laurels, but developing and releasing new products in new categories at a breakneck pace. R&D expenses have soared 134% higher over the last 5 years while capital expenses doubled. That's the way to keep innovation engines humming in a bleeding-edge technology business like VMware.
As a result, VMware CEO Pat Gelsinger hopes to stake out a lot of land in the mobile cloud markets that lie ahead. "We are in the early stages of tectonic shift," Gelsinger said in the second-quarter earnings call. "Customers are realizing the dramatic benefits of the new software-defined model for IT, and VMware delivers exactly that."
Red Hat and Citrix will certainly challenge VMware's mobile cloud ambitions -- and that's just the start of a very long list. This "tectonic shift" will unleash a veritable horde of computing specialists, all chasing some part of the same market.
I believe that the market is large enough to support a large number of winners, and that VMware should carve out a bigger slice of it than most of its rivals. This company has been doing software-defined everything for more than a decade, giving VMware a head start. And while many competitors may settle for clearly defined niches -- Citrix, I'm looking at your one-on-one app delivery expertise -- VMware can play the mobile cloud market on many levels.
In the end, I wouldn't be surprised to see VMware out-executing the IT market at large, thus beating analysts' long-term growth estimates. In that case, VMware should be worth more than $110 per share today.
Do keep in mind that we're talking about virgin territory within the unpredictable tech sector, so there's always some chance that my assumptions might miss the mark 5 years down the road.
But if you agree with my analysis of VMware's target markets and the company's place therein, then the stock looks reasonably attractive right now. And, if activist investor firm Elliott Management gets what it wants, you could even see a quick jump as the separation from EMC unlocks new value and accelerated growth prospects.