Virtual computing veteran VMware (NYSE:VMW) had a rough go in 2014. While markets generally trended up, VMware shares fell 7% year-over-year. The fantastic gains of 2010 are becoming a distant memory, and VMware shareholders sure could use a strong return in 2015.
Here are three factors that may lift VMware shares in 2015, if the stars align just so.
The software-defined data center
In recent presentations by VMware executives, the company has pushed the idea of data centers becoming ever more software-defined. The basic idea is simple: Functions that used to depend on very specific -- or even custom-designed -- hardware are moving up the stack into the software layers. This might sacrifice some raw performance, but makes up for it in ease of management and incredible flexibility.
VMware is not alone in singing this tune. Rival-slash-partner Cisco Systems (NASDAQ:CSCO) is also selling its data center solutions from a platform of software-defined operations nowadays. That's actually a pretty big leap of faith for Cisco, whose traditional expertise lies on the hardware side of the equation. For VMware, the software-defined data center is in easy reach from its virtualization software expertise.
In VMware's view, this operating model lets everyone from hobbyists to enterprise-grade behemoths separate their applications from the underlying platform:
Now, Cisco and VMware are hardly the only providers of software-defined data center platforms. But they are running ahead of the pack thanks to their deep industry experience. Proving the point of flexible installations, VMware's virtual machines are often installed on top of Cisco's server hardware.
The vCloud Suite, which is VMware's top-to-bottom package for the software-defined data center, was first introduced in late 2012. But this baby is growing up quickly: VMware expects SDDC to drive significant growth over the next several years, making it VMware's largest addressable market by 2017.
Containers won't kill the virtual server
VMware investors have shown some nerve lately as the company's virtual computing platforms met a plethora of new challengers. Leading the charge is the concept known as "containers."
But these computing containers may not be the virtual machine killers that some investors and analysts had feared.
When analyst firm Jefferies started coverage on VMware with a "buy" rating a few weeks ago, the container-based threat was waved off. "We do not expect containers to be the server virtualization killer that some fear," said analyst John DiFucci in support of his $130 VMware price target.
So what is a container? Simply put, it's a highly efficient way to package a computing application. It's quickly and easily deployed on many machines -- traditional or virtual -- at a time. It comes with fine-grained control of the resources needed to run it, from memory needs, to file system access, to processing power.
Containers take the virtual computing concept another step up the ladder, installing applications on top of a virtualized version of your favorite operating system. By contrast, VMware's virtual machines put operating systems on top of virtual hardware. You can read more about containers here.
So why shouldn't VMware fear this evolved type of virtual computing, with its fine-tuned and hyper-efficient capacity management? For one, VMware is actually a major provider of container services.
VMware's virtual machines now support a variety of container environments with very simple "turn-key" deployments. The company has struck up key partnerships in the container space, and contributed code to improve several container platforms. If you're going to use containers, VMware doesn't want you to put them on a competing virtual machine after all.
Moreover, the leap from virtual machines to virtual application containers isn't huge. The expertise from one field translates easily to the other, so VMware should be a leader in containers as well. Anything less would be a terrible waste of platform-building expertise and experience. It just makes sense.
If containers end up killing virtual machines, VMware may be holding the gun. That's why containers shouldn't scare VMware investors witless. If this threat has been holding the stock back from big gains in recent years, as DiFucci implies, it's high time to remove that heavy valuation yoke already.
Valuation, you say?
As you might expect from a former growth stock that's been stalled out for several years, VMware's shares are starting to look downright cheap.
At first glance, VMware still seems expensive. The company's shares currently trade for 39 times trailing earnings. To put that ratio into perspective, Cisco shares are going for 18 times trailing earnings, and VMware parent EMC 's (NYSE:EMC) trailing P/E valuation stops at 22.
So value investors gravitate toward Cisco and EMC, barely giving VMware shares a second thought. But then, you're missing out on VMware's insane growth.
Sometimes you get what you pay for:
In short, VMware's earnings have more than quadrupled over the last five years, while EMC's income only doubled. Cisco's earnings growth sits even further back.
Past performance doesn't guarantee future returns, but these trend lines are still useful guides. Looking ahead, analysts expect VMware's earnings to grow at 16% a year over the next five years. EMC's projected annual earnings growth stops at 10% ( including contributions from VMware, mind you -- EMC still owns 80% of the virtual computing powerhouse). Cisco is supposed to follow up its 7.5% annual earnings growth over the last half-decade with 7.6% yearly improvements in the next five years.
From this perspective, VMware's high price-to-earnings ratio is justified by its strong earnings growth. In fact, VMware's balance between valuation and growth prospects has rarely tilted as heavily toward the deep-discount end as it does right now.
So VMware shares are selling at a discount to the company's expected growth, weighed down by a largely imaginary container threat and heading down the software-defined data center runway. Against this backdrop, I'd be surprised to see VMware shares suffer through yet another weak year in 2015.