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Morningstar | We Expect VMware's Tremendous Growth to Continue Through the Clouds; Increasing FVE to $194

Narrow-moat VMware reported record quarterly revenue of $2.6 billion (16% year-over-year growth) in the fourth quarter, exceeding our expectation of $2.5 billion, driven by 21% annual growth in license revenue. Our investment thesis that VMware is a preferred common platform for multi- and hybrid-cloud environments is playing out, and we expect revenue strength to last longer as its products deliver a wider array of solutions for networking and clouds. After rolling our model and expecting VMware's products to further penetrate IT teams' cloud-based ecosystems, we are increasing our fair value estimate to $194 per share from $150. The shares are trading in 3-star territory, and we recommend investors hold their position.

Supporting strong growth in license revenue, service sales grew 12.5% year over year, mostly driven by software maintenance growth of over 13%. Growth was seen across the portfolio and all geographies, and hybrid cloud subscriptions and software-as-a-service sales were about 10% of total revenue (35% year-over-year growth). Operating income grew 10% versus the previous year, but operating margin decreased to 25.6% from 27.2% (non-GAAP operating margin increased to 37.3% from 36.8%). Compared with last year, unearned revenue increased 19.5% to $6.98 billion at the end of the quarter. In the quarter, VMware posted 23 enterprise agreement deals over $10 million, a new record. These large deals contain multiple VMware products, which inhibits enterprises from readily changing vendors and creates sustainable revenue streams, in our view.

VMware guided to 11.8% revenue growth for next quarter and fiscal 2020. For the first quarter, total revenue guidance of $2.25 billion includes a 11.7% year-over-year increase from license sales. We model operating margin and EPS to come in at the high end of VMware's 16.6%-18.2% and $0.68-$0.75 projections for the quarter on a GAAP basis, and for its non-GAAP projections of 29.2% and $1.27 to be achieved.

Enterprise agreements represented 51% of total bookings for the quarter. Beyond their large monetary value, we like that VMware is showing cross-selling strength. In its largest ten deals, all customers purchased management and end user compute products, nine purchased VMware NSX, and eight purchased VMware vSAN. VMware Cloud on Amazon AWS had its largest deal of about $20 million in the quarter. These larger deals are impressive, and we believe these customer commitments showcase customers looking to VMware for more products beyond machine virtualization. Fourth-quarter NSX bookings exceeded $500 million as VMware continues to make progress with network virtualization. VMware has made its products available across the leading cloud providers, and we expect Amazon AWS to be the leading revenue source for VMware for public cloud deployments. VMware announced the availability of VMware Cloud on Amazon AWS GovCloud (U.S.) in the quarter, and we believe this should help be a boost to winning more government-based workloads.

VMware's networking and security products showcased 50% year-over-year growth in license bookings and now has over 10,000 customers. Growth in these areas are showing us that VMware is successfully moving from outside the data center into customer networks. Additionally, we like how VMware has been a large supporter of Kubernetes, once thought to be the downfall of VMware's core virtualization business. VMware closed the acquisition of Heptio, a firm that assists enterprises with building and running container workloads via the Kubernetes platform. We note that the two founders of Heptio helped created Kubernetes, and we like that VMware was not too proud to see a disruptive technology as a venue for future growth.

For fiscal 2020, VMware projects a 12.8% year-over-year increase in license revenue to $4.275 billion and total revenue growth of 11.8% to $10.03 billion. Operating margin is guided to be 21.4%-22.8% on a GAAP basis and 33.0% on a non-GAAP basis. Fiscal 2020 EPS projections are $4.24-$4.54 for GAAP and $6.49 for non-GAAP. We believe the non-GAAP values are achievable and that VMware should be on the high end or exceed its GAAP-based projections.