The VMware Rout May Not Be Over
Slowed tech spending and more competition take a toll on the once superhot IPO. Shares fell 34% in one day, and may not have stabilized yet
by Aaron Ricadela
Shares of software maker VMware (VMW) had reached such nosebleed levels in the past five months that even a hint of doubt about its prospects threatened to bring the stock closer to earth.
That finally happened Jan. 29, when the shares lost 34% of their value in a sell-off triggered by a fourth-quarter sales shortfall and the disappointing outlook for 2008. Analysts slashed their target prices and cut their ratings on the stock as it plunged during the day.
Pressures May Drive Stock Lower
The worst for VMware shares may not be over. While some analysts see the decline as a buying opportunity, others point to the prospect of insider selling come Feb. 15, when a ban on such sales lifts, as well as possible competition from Microsoft (MSFT) and Oracle (ORCL). Factor in a bearish outlook on U.S. tech spending, and further drops may be in store. Analysts say the shares could trade between $50 and $60 in the months ahead, compared with more than twice the high end of that range last year.
"There was a lot of excitement around the story, and people needed validation of the excitement to keep the premium on the company," says Peter Kuper, a vice-president and research analyst at Morgan Stanley (MS). VMware shares debuted Aug. 14 in the tech industry's hottest initial public offering in years (BusinessWeek.com, 9/10/07), pricing at $29, opening at $57, and soaring as high as $125 in October. The shares plummeted $28.13, or 33.9%, Jan. 29, to close at $54.87.
VMware's stock has been trading at nine times 2008 revenues, more than double the valuation of the rest of the software sector, according to Kuper. And VMware provided tech investors shelter as the stock market whipsawed throughout the second half of 2007 and early this year. Now that the numbers are falling on an already pricey stock, those days could be over. "Especially in this environment when stocks are very volatile, investors are going to shoot first and ask questions later," Kuper says.
A Victim of Its Own Success
VMware dominates the fast-growing market for "virtual machine" software, which lets companies combine the work of several servers onto a single computer, saving hardware, power, and cooling costs at a time when data-center budgets are soaring. The approach has proven enormously popular, furnishing VMware with more than 100,000 customers, and nearly doubling its 2007 revenue to $1.33 billion. But VMware's success has attracted powerful competitors. Microsoft is including its own virtual-machine software (BusinessWeek.com, 1/22/07) in an upcoming version of its Windows operating system for servers. Oracle has also entered the virtualization market (BusinessWeek.com, 11/15/07) for customers running its database and applications software.
VMware may also be a victim of comparisons with its own early success, evidenced by fourth-quarter results that disappointed Wall Street. Revenue grew 80% from a year earlier, to $412.5 million, but fell short of analysts' consensus estimate of $417.4 million. Fourth-quarter earnings per share of 26¢ beat analysts' estimates by 2¢. Then VMware delivered the kicker: 2008 sales would grow only 50%, vs. Wall Street's expectation of a 55% increase. That would give VMware 2008 sales of $1.98 billion, rather than the $2.08 billion forecast by analysts.
VMware shares tumbled in extended trading Jan. 28, and continued their descent the following day. Shares of data-storage company EMC (EMC), which acquired VMware in 2004 and spun out 10% of it in the $1.1 billion IPO, fell in tandem. The 6% drop Jan. 29 came in spite of news that EMC's fourth-quarter revenues and profits surpassed analysts' expectations. EMC owns 86% of VMware and controls most of the voting power.
More weakness could be in store later this month, when company insiders become eligible to sell 3.5 million shares Feb. 15, six months after VMware's IPO. They'll be able to sell another 18 million shares throughout the year. EMC may distribute a chunk of its VMware stock to its shareholders as a dividend in 2009, all of which could dilute VMware's price.
Buy, but Beware
Analysts are advising clients to expect shares of VMware to settle into a more reasonable range. Jason Maynard, an analyst at Credit Suisse (CS), told clients in a Jan. 28 note not to "jump in and buy the stock." He cut his target price from $85 to $60, and lowered his first-quarter sales and profit estimates for the company. But VMware shares will still trade at a premium to other software companies, he wrote.
Brent Thill, an analyst at Citigroup (C), cut his price target from $134 to $83, but advised long-term investors to buy on the drop. "Expectations are now set conservatively for VMware to succeed," he wrote in a Jan. 29 note to clients.
Others on Wall Street warned investors to brace for more volatility, however. Heather Bellini, an analyst at UBS (UBS) downgraded the shares from buy to neutral, and slashed her target price from $120 to $60. "We have no choice, however disappointing, [other than] to lower our rating," she said in a Jan. 29 note to clients. "The momentum story will evaporate from the shares in the near term." VMware's rate of signing up new customers could be slowing, and its sales staff may be closing deals less rapidly, she wrote. "With a stock priced for perfection, it is in for a rough ride."
Ricadela is a writer for BusinessWeek.com in Silicon Valley.
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