VMWare's Rising Tide Won't Lift All Boats

[qi:053] When is a good thing too much of a good thing? It’s surely a question somewhere in the back of the minds of investors in VMWare (VMW). Since the stock went public two weeks ago — at $29 a share, 21% above its initial price of $24 a share — it has rocketed 150% to close Monday at $72 a share.

It’s now worth three times as much as underwriters first thought it was worth.

Did the lead underwriters mess up and leave tens of billions of dollars on the table? I don’t think so. If one were cynical, one would say Citicorp, JP Morgan and Lehman stand to gain more by priming the IPO pipeline with a superstar offering. The market for tech IPO’s now has a very appealing poster child.

Nor does EMC (EMC), VMWare’s proud parent, stand to lose much. EMC received a healthy portion of VMWare’s IPO proceeds. But its net earnings will also gain from the surging stock if it records its 87% stake in VMWare as investment income. As for VMWare itself, what it lost in potential proceeds, it could make up for in free branding.<

But anyone buying now may not be so lucky. VMWare’s price has risen so high that it’s trading at 230 times its earnings for the trailing 12 months. Given that in the second quarter of 2007 its revenue nearly doubled and its net profit more than doubled, that valuation may not be as ridiculous as it seems. But when you consider that the stock is trading at 79 times its projected 2008 earnings, we’re getting into some perilously high territory.

That high valuation seems even riskier when you consider what is happening to the company’s operating margins, thanks in large part to compensation packages that it is forced to dish out to attract top talent. Operating margin in the first quarter fell substantially to 17.9% from 23.5% a year ago. (For the first six months, margins fell to 16.7% from 19.6%.)

That’s largely because of a rise in R&D expenses, which rose to 21.1% of sales in Q1 from 17.3% a year earlier. R&D costs increased 146% to $55 million in the first quarter because of increased salaries and benefits for the staff developing software. That continues a trend that began last year. In 2006, R&D costs were equal to 21.1% of revenue, up from 18.7% in 2006.

For investors, that’s a mixed bag. On the one hand, the returns from that extra R&D could start to kick in during coming quarters. On the other, VMWare’s equity-compensation plans are likely to push these costs up even higher, whether or not those returns to kick in. At this price, that’s a lot of hope built into the stock.

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