Deeper look at VMWare's results spooks investors

When software hotshot and EMC (Symbol: EMC) spin-off VMWare (VMW) went public last month at $29, demand from investors was feverish and the shares shot up 76% on their first day of trading. Since then, they’ve gained even more, peaking at $82.75 in intraday trading last week. VMWare’s final IPO filing with the Securities and Exchange Commission included preliminary results for the second quarter that looked pretty impressive including a 125% leap in net income. Yesterday, the company followed up with a routine, audited second quarter filing that repeated the same happy results. And yet VMWare’s shares dropped over $4 during the day and stand at $73.19 today, down 12% from the high a week ago.

So here’s a mystery to ponder for the next hour as you await the Fed’s big announcement: if VMWare already announced its second quarter results, what in its 10-Q filing yesterday caused the sell-off? I don’t think you haver to look very far. Last month, VMware released its second quarter revenue, operating income and net income. There was no detail provided about expenses and cash flow. Yesterday’s filing included all the details and suddenly things look a little less great.

We already knew that the company’s revenue jumped 90%, operating income 81%, and net income 125%. Now we also see that operating cash flow increased only 43% to $85.6 million. And the rate of growth in some expense lines challenged the rates of growth of the previously revealed good stuff. Research and development expenses shot up 120% to $72 million, sales and marketing costs rose 83% to $99 million and general and administrative expenses climbed 124% to $31 million. At the bottom, the percentage of revenue eaten up by these operating expenses rose 1 percentage point to 68% from 67% a year earlier. Excluding stock-based compensation, an expense that tech companies like VMWare prefer to back out, expense growth looks even worse, increasing by more than 2.5 percentage points of revenue. This is a trend that was visible back in the original IPO filing, as I noted in April. With looming competition from Microsoft (MSFT), Citrix (CTXS) and other big fish, anybody think VMware’s expenses are going to start sinking anytime soon?

One other worrisome piece of the VMWare puzzle comes from the market’s valuation of EMC, which still owns 87% of VMware shares. That stake is worth over $20 billion today, or about half of the market’s valuation of EMC itself. Yet EMC shares have barely budged since VMWare went public, rising from $18.34 on August 14 to $18.90 today, or a 3% increase. How can a company’s biggest asset almost triple in value while the market yawns? The answer lies in the shortage of VMWare shares available to the market. Just like a zillion dot com bombs back in the day, there aren’t enough shares of VMWare’s total available to investors yet. The market isn’t saying that EMC, a long-established company, is undervalued. It’s saying that VMWare is overvalued. As more shares hit the market over the next year, that shortage will evaporate and so too will the VMWare’s p/e ratio of 231.

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