The VMware Conundrum (VMW, EMC, CTXS, MSFT)

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VMware, Inc. (NYSE:VMW) has been an unbelievably strong IPO after the partial spin-off from EMC Corp. (NYSE:EMC).  Shares opened for trade last Tuesday and are up about 40% from the initial open.  Some were calling for as high as $60.00 after the open, and that got hit the second day before a 2 day breather.  But the stock screamed up Monday to $65.99 and now today shares are north of $71.00.

The initial offering went off at a $29.00 pricing for 33 million shares and it goes with no surprise that the underwriters exercised the 4.95 million share overallotment.  So this means there are 37.95 million shares in the free float and unless they make a huge rule exceptions there are no shares coming in the immediate future.  So the market cap of the free-float or available shares is $2.6565 Billion.  Take away the mutual fund and investment advisor shares that were bought because they felt they had to have shares on the books and you end up with a free float that is far smaller.

EMPLOYEE & COMPANY SHARES: The ex-EMC employees that converted shares got to convert shares of 1 EMC share for 0.611581 VMWare share, so these employees are sitting on more than a double.  That is also after EMC’s underlying shares had enjoyed a 50% rise since earlier this year.  Those employees are probably licking their chops for that first lock-up expiration (even if not all the eligible EMC employees converted all shares, ouch) 180 days after the IPO. Employees appear to hold roughly 11.8 million shares, but there are actually 70 million that have been stated that could be granted in the future.  EMC owns 26.5 million of the class A shares have identical rights except that Class A shares have votes of 10 to 1 compared to the free float B shares.  Intel and Cisco shares are locked-up for 1 year.

HERE ARE THE FINANCIALS SO FAR: total revenues were $703.9 million in 2006 and $387.1 million in 2005; Software license revenues were $491.9 million in 2006 and $287.0 million in 2005. The estimated pro forma EPS for 2006 was $0.22, but the earnings for Q1 2007 were listed as $0.11 for that quarter alone.  Total revenues for the six months ended June 30, 2007 were $555.5 compared to $285.5 for the six months ended June 30, 2006, representing an increase of $270.0 or 95%.  Operating income for the six months ended June 30, 2007 was $93.1 compared to $56.1 for the six months ended June 30, 2006.  Book Value per share as of March 31, 2007 was $4.93.

SHARE CALCULATION & MARKET CAP:  The pro forma numbers given as far as total shares for the A&B shares combined is 332,500,000 on all the calculation sheets.  We cannot merely combine the A shares into the market cap calculation because of the 10-1 voting right compared to B shares, but we have to for calculation purposes.  That will give somewhat of an understated market cap but otherwise we are using purely theoretical numbers. Based on a 332.5 million share count and based on a round number price of $70.00, EMC would have a total market cap of $23.275 Billion.  Once again that is a tad understated, all things being equal.

TOTAL MARKET OPPORTUNITIES & COMPETITION: Interestingly enough, it gives an IDC number of 24.6 million x86-based servers in 2006 with a growth projection to 33.8 million units by 2010.  It believes that 17% of servers will be running virtualization in 2010.  It also estimates that business client PCs reached 489.7 million as of December 2006.  Calculating these becomes arduous as far as the total market opportunity, but it would be easy to make the argument that the market opportunity for virtualization could be well north of $10 Billion in 2010, and some could easily derive a far larger number.  Security will become quite a large factor even compared to today with so many systems running, and thanks to above for cheaper DRAM and multi-core processors.  Citrix (NASDAQ:CTXS) is now a competitor after the $500 million buy of XenSource, and you can count Symantec (NASDAQ:SYMC) and Microsoft (NASDAQ:MSFT) coming on stronger next year.  There are many more of the larger companies that also are entering or want in.

FINALLY, THE CONUNDRUM:  With a $23 Billion market cap, some would argue that today’s price may reflect close to the entire market place more than 3 years out.  But the calculations are as varied as could be and we won’t commit to a single number. As long as those locked-up shares stay locked-up, the bulls have one more comfort layer.  If you make the argument that this trades close to 16, 18, or 20 times 2007 revenues it sounds unsustainable, although this value is reflective more of the future than it is 2006, 2007, or even 2008.   The true conundrum is that many feel they HAVE to own VMware shares and the true free float is less than that 37.95 million shares and is small enough that literally a few million shares bought each day could continue running this up regardless of what you want to list a forward P/E ratio or a forward revenue multiple. 

Jon C. Ogg
August 22, 2007

Jon Ogg can be reached at jonogg@247wallst.com; he produces the 24/7 Wall St. Special Situation Investing Newsletter and does not own securities in the companies he covers.