With a recent record of positive earnings surprises and heightened demand from majority owner EMC Corp. (NYSE: EMC), VMware Inc. (NYSE: VMW) has enjoyed significant price run-up in the past year. But I have to wonder whether the company can sustain this price level -- and question whether there are enough further growth prospects to keep the share price moving skyward.
VMware, a California-based provider of virtualization and cloud infrastructure solutions, has been on a tear. Early last year, it acquired Zimbra as well as software product technology and expertise from EMC's Ionix IT management. Last month, it bought SlideRocket.
But with a P/E ratio of 103, sirens are sounding that it's time to take a closer look at what is happening under the hood. Obviously VMW is looking at significantly more growth than Microsoft Corp. (Nasdaq: MSFT) or Hewlett-Packard Co. (NYSE: HPQ) (trading at 9.8 and 8.9 P/E respectively). Still, I have to wonder: Is VMW really worth as much of a premium as it's commanding?
From a fundamental valuation perspective, the company is trading just above my three-year (optimistic) price target, appearing significantly overpriced from this perspective.
I arrived at my valuation using a Discounted Cash Flow model, assuming a consensus revenue growth rate of 23.92%, discounted back at 10.5%. Margins are more or less in line with the industry average at 14.9% to 22.4%.
Adding in the tangible value of the company (Cash - Debt + Asset Liquidation Value) of $3 billion, we get a target market cap of $33.1 billion to $41.2 billion. Because the diluted share count has gone up 5.2% annually in the past five years, I'll project that factor onto my near-to-far price targets to get a range of $75.08 to $93.64.
Because the price target is above the optimistic end of that range, the stock is fundamentally overvalued, with no upside to buy.
Let me pause to make a quick note on the limitations of fundamental valuation. If the price of a stock were solely reliant on fundamentals, there would be no change in price in between news and announcements that affected future cashflows. Because the stock market is just that -- a market -- made up of buyers and sellers, we have to consider supply and demand as well as the psychology and activity of the buyers and sellers. The fundamental value of a stock is simply the center of gravity for these pricing gyrations.
Glancing at the recent insider buyers and sellers, we see what appears to be a very healthy purchase-to-sale ratio of 5.9. Digging deeper, however, we see that 100% of the insider purchases are by EMC Corp., and 100% of the sales are by officers, which has ramped up significantly since the April 20 pop. Buyer beware: The insiders are taking the profits.
During the last quarter, institutions have cut 4.5% of their VMW holdings, certainly taking profits after the longer-term run-up.
Finally, looking at the technical factors, VMW is approaching its established price ceiling just under $100, with the last run in April on very high volume. Since we see below-average volume in this ceiling, we can interpret that as a slowing demand to buy VMW at this premium. This is a sign of trend exhaustion, which, more often than not, results in a price reversal back towards the true fundamental value.
My conclusion: It's time to get off the cloud.