Morningstar | Hybrid Cloud Model Driving VMware's Strong Quarter and Expected Growth; Raising FVE to $176. See Updated Analyst Note from 29 Nov 2018
Narrow-moat VMware's third-quarter earnings exceeded consensus expectations for revenue and the firm provided an unexpected 12% revenue growth plan for fiscal 2020. After revising our longer-term growth assumptions and modeling an increased operating margin expansion as VMware becomes further ingrained within enterprises' hybrid cloud environments, we are increasing our fair value estimate to $176 per share from $151. With shares trading in 3-star territory afterhours, we recommend for investors to maintain their positions.VMware's license revenue in the October quarter grew 17% year over year to $884 million while service revenue increased by 12% to $1.3 billion. Additionally, the hybrid cloud portfolio grew by 35% and is now over 10% of total revenue. The company kept gross margins around 86% while increasing operating margins to 22.5% compared with last year. Although the company is benefiting from a strong IT spending environment, we believe its strong placement with on-premises data centers and cloud provider partnerships are causing VMware to outpace the market. In our view, VMware is wisely expanding into adjacent markets, from its market dominance of virtual machines, into areas that help enterprises migrate and operate cloud-based network environments.
The company increased its fiscal 2019 revenue target to $8.88 billion from $8.82 billion and increased non-GAAP diluted EPS to $6.22 from $6.14. Moreover, VMware fiscal 2020 guide included a non-GAAP operating margin target of 33%, which is about flat from earlier 2018 guidance. We believe that VMware will be able to surpass its fiscal 2020 guidance as more customers look to VMware for solutions beyond virtual machines. In our view, VMware's partnerships with the hyperscale cloud providers, wider product offerings, and focus on growing recurring revenue will start to drive operating margin expansion in the coming years.
Within the quarter, VMware announced its acquisition of CloudHealth Technologies, a cloud operating platform, and its intention to purchase Heptio, a provider of Kubernetes deployment and optimization solutions. These bolt-on purchases strengthen VMware's cloud offerings by now being able offer a cost and resource management plane for their cloud systems and helping IT teams migrate between on-premises and public clouds for Kubernetes deployments. We posit that VMware's is becoming the commonality for enterprises migrating from on-premises into cloud environments; additionally, we like that VMware's cross-selling and upselling opportunities for its customer base.
VMware is scheduled to pay a special dividend of $11 billion as part of Dell Technologies purchasing its shares of the VMware tracking stock DVMT. VMware management stated the company expects to operate independently after the dividend, but VMware and Dell Technologies are aligned closely on key strategic initiatives like hyperconverged infrastructure. We believe VMware is wise to forge cloud partnerships with the leading cloud providers while using Dell's vast and sales and marketing staff to further reach into enterprise network ecosystems.
VMware is engaged in the development and application of technologies with x86 server-based computing, separating application software from the underlying hardware. The company's product and service solutions are organized into three main product groups: Software-Defined Data Center, which is designed to transform the data center into an on-demand service that addresses application requirements; Hybrid Cloud Computing, which is comprised of VMware Cloud Provider Program and VMware Cloud Services; and End-User Computing solution, which consists of VMware Workspace ONE, its digital workspace platform, that includes Unified Endpoint Management and VMware Horizon application and desktop virtualization.
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