VMW: Q4 Preview and A Closer Look at Citi’s Recent Downgrade to Sell

by Dan January 23, 2012 3:05 pm • Commentary

VMW $85.57 

No New Trade

Event & Implied Move:

VMW reports tonight after the close, the options market is implying about a 9% move vs the 4 qtr average move of about 6.5%.  Don’t forget that VMW was down 10% on massive volume on Dec 21st following ORCL‘s disappoint results and guidance.

-VMW trades at about 35x next years earnings on expected earnings and sales growth of 16 and 19% respectively.  

Sentiment & Recent Analyst Downgrade:

-Wall Street analysts are a bit mixed on the name with 25 Buys, 14 Holds and only 1 sell, while short interest is about 5% of the float.

Last week Citgroup downgraded VMW from a Hold to a Sell (the only Sell on the Street) with an $80 12 month price target.  They had the following to say in a note to clients on Jan 13th:

Downgrading from Hold to Sell, lowering price target to $80 — Our revenue estimates are below consensus for FY12 and FY13 and we expect the company to guide initial 2012 revenue mid-point below street 20%.

Incremental concern about slowdown in core server business — Server refresh activity has been strong for two years and is showing signs of slowing. At the same time, server virtualization penetration is now over 50%, making it difficult for an up-tick in penetration to pick up the slack. Lower server growth was the main catalyst to our lower price target.

ELA (enterprise license agreements) renewal activity is peaking; street may under-estimate this impact — We expect ELAs up for renewals peaked on a Y/Y basis in Sep. 2011 and this is likely to be up single digits in 2012. We believe the company has been successful at up-selling customers at the time of ELA renewal driving new license. With fewer renewals, this driver of license revenue growth diminishes.

Lack of new product drivers near-term to make up the difference — Our inputs continue to suggest that outside of some ELA bundling, sales of management and desktop products are lagging. While promising long-term, the vFabric app stack isn’t a near-term driver and we believe management products are still not mature.

Not well positioned for tougher macro environment — Perpetual license model,ties to hardware refresh and relatively high Europe exposure put VMW among the most exposed if IT spending conditions worsen. Virtualization remains a priority on our CIO surveys but this was the case through the 2008 downturn as well. During the 08-09 downturn, VMW’s revenue decelerated among the most in our coverage universe

Technicals & Price Action:

-The stock is sitting 1% above the December low which was also essentially the 52 week low, and about 22% below the 52 week high made in July.

-When you back the chart out a bit, you see that the stock has been basing btwn $80 and $100 and a ton of room below that $80 level.  Obviously this thing could go either way, But I don’t believe that a company like this will ever grow int o its high valuation.  That said, given IBM‘s recent performance after it’s brief period of under-performance, I think you have to be careful being short stocks like this in a market that is looking appears to be wearing rose covered glasses.

[caption id="attachment_8205" align="aligncenter" width="300" caption="3 yr VMW chart From Bloomberg LP"][/caption]


MY TAKE: I don’t short stocks purely on valuation and frankly since ORCL’s report in Dec, VMW has outperformed the Nasdaq by a few % but has under-performed year to date.  Citi’s downgrade may be in the stock at current levels and this could set up not to differently to IBM’s expectations and market reaction.

As many of you know I am a contrarian and don’t buy stocks like this unless I am convinced that the stock is miss-priced into the events, which I honestly can’t say I have any strong reason to believe that.

Looking at a handful of potential trades nothing really pops out to me without conviction on direction, and buying the move seems downright silly as the Feb 85 straddle (stock ref 85.57) is offered at 10.30, which means you need the stock at 74.70 on the downside or 95.30 on the upside on Feb expiration to break even….seems a bit rich.

So without a feel for direction I think this is a good one to avoid, as the options market is not giving you a lot of margin for error.