Summary #VMware has returned to accelerating revenue growth in 2017 after years of relatively flat performance. The company has successfully pivoted its traditional on-premise datacenter offerings to emphasize hybrid cloud deployments. @VMware has generated impressive earnings and cash flow growth as well. It's in the unique position of being a large legacy vendor that can still gain traction with new customers. With the market reaching another fever pitch as we head into the final month of 2017, many headlines (and investors) are sounding off warnings about valuation again. What follows next is the question of how to position your portfolio - as stock selection becomes critically important as the market reaches new highs. Against this backdrop of an expensive market, VMware (NASDAQ: VMW) is an excellent mission-critical IT software company. While it's true that the company's ~48x P/E and 50% rise year to date doesn't make it look like a value stock, VMware is generating massive free cash flow - $2.3 billion in the trailing twelve months, or a 18x EV/FCF multiple, representing a 5.5% FCF yield. Companies with this sort of financial profile are typically slower-moving industrial companies with modest growth potential - and while VMware did look like that for a while, it has returned to double-digit revenue growth in FY17. Add that on top of the fact that its software business makes it a high-margin, capital-light operations with plenty of opportunities for profit expansion, and the company looks like a winner.  VMW data by YCharts VMware has had an impressive (57%) run this year, recovering from its lows in late 2016 when the Dell-EMC acquisition cast doubts on VMware's future, as it's a "controlled company" with roughly 80% of its shares owned by its newly merged parent. The merger seems to have been extremely successful, however, and has increased VMware's capacity to cross-sell across different IT product lines. VMware reports earnings on November 30. The company has a long history of beating expectations (see below from Seeking Alpha), so it's a good time to enter a position to hold through 2018 for additional gains. I believe an expensive market will cause growth-oriented investors to rotate more into larger-cap, cashflow-positive companies like VMware that are still capable of modest growth; and these types of names will likely outperform higher-growth startups in 2018. Figure 1. VMware earnings beat history   A look at VMware's evolution within IT infrastructure VMware is the pioneer behind "virtualization" technology, which allows companies to provision shared computing hardware to so-called "virtual machines." Perhaps the most familiar application of this technology is VDI, or virtual desktop infrastructure, which many office workers use to access a server that is in a physically different location. The company's flagship product is called vSphere, consisting of a software layer called a "hypervisor" that allows users to provision computing resources across a pool of virtual machines. The screenshot below, taken from VMware's website, shows a sample pricing tier for one edition of vSphere. Like other legacy software providers, VMware primarily derives revenues from perpetual and term license sales, supplemented by fees for technical support and professional services:    Source: VMware website Other VMware products, such as vSAN and NSX, allow for virtualization of storage and networking resources, respectively, while vSphere focuses on the compute layer (running applications and operating systems). Now let's take a step back. A lot of the concern swirling around VMware was whether it could survive through the advent of the cloud era. VMware's products are largely considered "on-premise" technologies, which has become something of a dirty word around the technology industry as well as financial analysts covering the tech sector. Its hypervisors and other virtualization products, after all, are installed on client-owned datacenters. With Amazon's AWS (NASDAQ: AMZN) and other public cloud services taking on an increasing number of workloads from corporations, and with public cloud services no longer bearing harsh criticism for lack of security, are VMware's products even relevant anymore? With the growth we've seen in VMware's first half of 2017, the answer is clearly yes. The company has had to pivot its offerings and its value proposition, but it's taken a few steps to ensure its relevance in the cloud era. VMware announced it was partnering with AWS in fall 2016, with the joint solution, "VMware Cloud On AWS," fully live in summer 2017. This solution allows IT customers to leverage their existing VMware setup and retain their virtual machines in a seamless migration to AWS-backed infrastructure. Prior to this rollout, IT pros were either having to choose one over the other, or self-build methods to make VMware and AWS cooperate, attempts which were often unsuccessful. TechCrunch hailed the move as: "A huge lift for VMware as a company. While they boast almost 100% penetration in on-prem datacenters, the company has struggled over the last five years to find its place as customers began to shift workloads to the cloud. This gives them a way to integrate with #AWS " In the on-prem world, #VMware isn't giving up its core chops, either. Recent IPO #Nutanix (NASDAQ: NTNX) has made waves in the IT world for its hyper converged infrastructure (HCI) offerings which offer cloud-like agility for on-prem environments, which it's branded as a "private cloud" offering. Nutanix is growing its revenues at roughly 2x per year and is expected to reach a $1 billion revenue run rate within the next year. Not one to be outdone, VMware has released its own HCI offering; and while it's a few years behind Nutanix in this effort, the move shows that VMware refuses to step out of the spotlight in the innovation sphere.  Another key VMware development is the vSphere Integrated Container, which supports the growing trend toward "containerization" made popular by unicorn startup Docker Technologies. Containerization takes the concept of virtualization into an even more granular level, putting individual application into "containers" with their own computing resources, rather than entire operating systems, as VMware's classic vSphere does. Supporting containerization is a huge growth vector for infrastructure software companies - Red Hat (NASDAQ: RHT), another large-cap software company that provides enterprise Linux operating systems, has seen major traction in this space. Incidentally, Red Hat has also seen prodigious stock appreciation this year, outstripping even VMware. Infrastructure software has become a hot topic again - no longer is the spotlight shining exclusively on frontend applications and Internet companies. With more complex software increasingly revolutionizing front-end business processes through application software, the backend datacenter has had to undergo rapid upgrades as well, which has fueled growth in stocks like Red Hat and VMware. Given that IT spending shows no signs of slowing down, this trend is likely to continue well into 2018.  RHT data by YCharts Financial overview: modest growth, tremendous cash flow VMware has seen a return to accelerating revenue growth this year, surpassing analyst estimates. After posting just 8% y/y growth in FY17 (on $7.1 billion in revenue), VMware grew at 9% and 12% in Q1 and Q2 of this fiscal year (FY2018), respectively. Q2 revenues were particularly strong at $1.90 billion, surpassing analyst consensus of $1.88 billion, driven by 14% y/y growth in license revenues. Though it's clear that VMware is no longer growing at startup-like pace, the fact that it's managed a return to double-digit growth is an impressive feat, especially after a period in which markets considered VMware doomed. A similar situation played out with Microsoft (NASDAQ: MSFT) in the Steve Ballmer era; now, the Windows maker has posted 13% y/y growth in its most recent quarter, on par with VMware, and saw a massive bump in the stock price. These two companies are in the same boat: legacy software companies that are experiencing a second renaissance driven by new cloud-friendly technologies. VMware's billings also showed impressive growth in Q2, with growth of 18% y/y surpassing revenue growth, marking a good forward indicator of VMware's revenue pipeline. The company has $5.5 billion in deferred revenue as of the end of Q2, which are billings waiting to be recognized as revenue - of this total, $3.5 billion is short term (revenue to be recognized within the year) and $2.0 billion is longer term.  The below table, taken from VMware's Q2 earnings release, shows its year-to-date revenues in the first half of FY18:   Source: VMware investor relations Earnings are growing at an even faster pace than revenues, as the company is driving earnings growth as well as margin expansion. The company earned $334 million in GAAP net profits in Q2 (17.6% net margin), up 26% y/y versus $265 million (15.6% net margin) in the prior year's Q2. This translates to EPS of $1.19, a four-penny beat over consensus of $1.15. When considering the pace of VMware's earnings growth, its elevated P/E multiple is easier to grasp. Cash flow, however, is the most attractive element that VMware offers. Primarily because the company's billings provide cash (but is not yet recognized as revenue), VMware's cash from operations is actually much higher than its net income. Cash flow is also helped by the fact that a large portion of VMware's expenses lie in stock-based comp, which is a non-cash expense. VMware generated $620 million of OCF in Q2, up 7.5% y/y. Netting out capex of $57 million (as an older software company without any real need for facilities expansion - its Palo Alto headquarters is already sufficient - VMware is a fairly capital-light business), the company generated $573 million of free cash flow, almost twice higher than its GAAP net income and representing a huge 30% FCF margin. This is a marker of a company that has come close to reaching long-term operating margins and is still growing while harvesting massive amounts of cash from its core business. If we apply a 10% y/y growth rate (roughly the same growth rate as its revenue growth in 1H18) to VMware's free cash flow in FY17 ($2.38 billion), we estimate that the company will generate $2.62 billion in free cash flow in FY18. This puts the company's current market cap of $50.9 billion at a 19.4x P/FCF multiple. Given the company's extremely strong balance sheet ($8.9 billion of cash and only $1.5 billion in debt), its enterprise value multiple is even lower, at a 16.6x EV/FCF multiple. Considering that VMware is still a company in quasi-growth mode and as well as expanding its earnings margins, these are fairly cheap multiples to pay. Key takeaways VMware is a top-tier software company, one that has rediscovered its center of gravity after the rapid rise of the public cloud temporarily threw it off course. Going into 2018, investors will likely become more choosy about the tech companies they invest in, given how bloated valuations have become. VMware offers good value for a dominant, market-leading business that is still managing to innovate and grow its top line.  I'm long with a price target of $147, representing a 20x EV/FCF multiple. We'll get some more details on VMware's performance to date in its upcoming Q3 release, but given its spotless track record, a beat is more than likely in the cards. Disclosure: I am/we are long VMW. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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