Monday, January 28, 2008

VMware earnings report - a case study in pricing

VMware shares are down 26% to 61.18 in after hours trading following its earnings release. But what exactly did they do wrong? Was it the tone of the conference call (I haven't heard it yet)? They posted an 80% rise in 4Q revenue but missed by 1% ($412M instead of $417M). Their earnings were 0.19 versus the consensus estimate of 0.24 but this included -0.07 of non-recurring line items.

From all metrics, this company is executing well. The problem is that they missed expectations. This is where risk vs. reward trade-off analysis comes in. At a price of 125 (the 52 week high), VMW was incredibly risky because all the upside is priced in. That doesn't mean it can't go higher in the short term. But in the long term, it's hard to see VMware (as it is now) as a $48B company. Some day, valuation ratios will come into play.

As I am sure everyone is already aware, there's a famous Benjamin Graham quote that goes "In the short run, the market is a voting machine, but in the long run it is a weighing machine."

Another interesting thing about the VMware drop is the correlation with the EMC drop. I have seen many articles about using EMC as a way to get VMW cheap. The argument usually goes as follows. Each share of EMC owns 0.155 shares of VMW. With VMW at 85, it accounted for 13.18 of EMC's price.

So with EMC at around 17, you would expect to see 78% of the move in VMW in EMC. But today, EMC dropped 13% while VMW is down 26% (about 50% correlation). So what's wrong?

This is where the Graham quote comes in; in the short term, the market is a voting machine. The market price for a share of stock is the price necessary that balances the number of buyers with sellers. It doesn't necessarily correspond to the long term value of the shares.

At any given time, there are many who are willing to sell, but only at a price above the market price (otherwise they would have sold). This is why most takeovers, LBO, etc. clear at 40% premium to the market price before the deal (or the rumor). This also explains why Countrywide Financial (CFC) dropped after the Bank of America (BAC) offer. It was below the market price.

The bid price is only valid for the bid size and the ask price is only valid for the ask size. To assume otherwise would be foolish. The market capitalization is a poor valuation metric. Stock being heavily sold will dip below the long term price and stock being heavily bought will go above the long term price. This is the same reason why technical indicators work. By looking at price action, you get a view of the supply and demand imbalance.

I think EMC is a good deal at these prices. The stock is supported by their core business. EMC has traded at a high of 14 for years. EMC was at 14 when they bought VMware for $635M of cash in December, 2003. Their business has gotten stronger as they acquired other franchises (like Mozy and Documentum). They are ready for the future reality of managed storage. If VMware is any indication, they are good at buying businesses.

VMware on the other hand is a risky proposition. Their business has great potential but there are also many competitors emerging. They promote the model of paying for licenses once whereas many other software companies are moving towards SaaS (Software as a Service). But the part I worry about trading short term options is that we are going to see a lot of selling pressure from EMC and other holders. EMC's cost basis in VMW is about 1.95 (if we ignore the money the put into it after the purchase). It's hard to compete with them. I may think that VMware is a good stock at 30 a share. For EMC, it's completely different. They need to sell (at least some) to raise cash for other acquisitions. They also need to diversify their assets while focusing on their core business. Buying VMW before EMC starts selling is dangerous. Profitable maybe, but dangerous.

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