“There is no doubt that the cloud is one of the most significant platform shifts in the history of computing… However, as industry experience with the cloud matures — and we see a more complete picture of cloud lifecycle on a company’s economics — it’s becoming evident that while cloud clearly delivers on its promise early on in a company’s journey, the pressure it puts on margins can start to outweigh the benefits, as a company scales and growth slows.” –The Cost of Cloud, a Trillion Dollar Paradox by Sarah Wang and Martin Casado at a16z
We added VMware (VMW) to our model portfolio* in the fall of 2020 when VMW was trading at a compelling valuation. In this blog we highlight our investment thesis for VMware as an overlooked investment opportunity in technology that has a long runway for growth ahead.
VMware was founded in 1998 and is a leading provider of “virtual machine” technologies. Virtual machines, or virtual computers, allow the physical resources of a network of computers – CPUs, memory, and storage – to be aggregated, managed, and then redistributed in a centralized fashion. To run programs and applications, the end user interacting with a virtual machine is actually using software that behaves like a physical computer. At the enterprise level, this allows IT departments to manage and deploy technology resources across an organization more efficiently and securely.
VMW has over 500,000 customers worldwide and generated $11.8 billion in revenue in Fiscal Year (FY) 2021. The business fundamentals are tremendous: revenues have increased at a 10.7% compound annual growth rate over the past five years and both operating margins and free cash flow margins are consistently above 30%. These qualities in a mature business are indicative of a dominant position in the marketplace.
Despite the company’s impressive fundamentals, VMware does not trade at an expensive valuation like many software or technology companies today. Among other factors, the rapid adoption of public cloud providers (Amazon AWS, Microsoft Azure, etc.) is perceived as a threat to VMware’s virtualization business and has weighed on the stock. As enterprise IT departments move data workloads from private servers to public clouds, it is true that VMware will see some weakness in its legacy products. However, VMware is taking steps to serve and grow its customer base in this rapidly changing technology landscape.
For starters, large enterprises may not be able to move all of their digital resources and tools to the public cloud. It may be more costly, less secure, or simply too complicated for an organization to upend their entire IT stack overnight. There are also regulatory and compliance hurdles that may prevent banks, telecoms, or others from relying solely on public cloud architectures. This is where VMW truly shines by offering its customers the flexibility to run data workloads on both the public cloud and private servers.
VMW is also transitioning from a licensing to a subscription-based model. The old-school software sales model based on licensing (upfront, lump sum payments) has evolved to the current industry standard of subscription-based software delivery, a win-win for both the customer and the software provider. For the customer, there are lower risks and barriers to entry with the subscription model. For the provider, the subscription model creates a stickier customer base by embedding more robust services and seamless product upgrades into the customer relationship. Just as importantly, the subscription model makes revenues and cash flows more predictable for business operators. VMW is in the process of retooling its business to provide its solutions as subscription services. The transition is well underway, with Subscription & SaaS segment revenues compounding at 40% annual growth from FY 2018-2021.
Our view is that businesses do not take an all-or-nothing approach to their IT infrastructure. Customers will continue to leverage VMW solutions to manage multiple platforms, both on-premises and off-premises, unifying access, security, and scalability in the process. In fact, VMW partners with leading cloud providers like Amazon and Microsoft to better enable customer migrations to the cloud. Revenue attributable to its budding partnership with Amazon Web Services is growing 100+% annually.
When we made our initial investment in VMware, one of the key risks associated with it was Dell’s 81% ownership stake. Dell had said it was in the decision process to execute a VMW spin-off in the fall of 2021. The plan has since been confirmed and is expected to close in Q4 2021 pending a favorable ruling from the IRS that the transaction will qualify as a tax-free spin-off. VMW will take on debt to pay a special dividend as part of the spin-off, effectively allowing Dell to pay down debt on its own balance sheet by sticking more debt on VMW’s balance sheet. While not an ideal situation for us as minority shareholders, our analysis had included this possibility and we believe the price we paid fairly incorporates this scenario. VMW is a cash machine and will be able to comfortably pay down the increased debt over the course of a few years.
For the long-term, our investment thesis is that VMW is a wonderful business with a large customer base that will continue to benefit from secular growth in the digital economy for years to come. Most importantly, this secular growth is selling for a reasonable price, an opportunity that is hard to come by in the market these days.
*The Model Portfolio is not a real cash portfolio. It represents the core direction of our portfolio management strategies. Individual client portfolios are managed in accordance with the clients’ specific investment objectives and constraints. Historical results are available upon request.
Peak Asset Management, LLC is an SEC registered investment adviser. This is not an offer to buy or sell securities. Past performance is not indicative of current or future performance and is not a guarantee. The information set forth herein was obtained from sources which we believe to be reliable, but we do not guarantee its accuracy.
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