VMware's CEO Discusses Q3 2013 Results - Earnings Call Transcript

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VMware, Inc. (VMW) Q3 2013 Earnings Conference Call October 22, 2013 5:00 PM ET

Executives

Paul Ziots - Director, Investor Relations

Patrick Gelsinger - Chief Executive Officer

Carl Eschenbach - President and Chief Operating Officer

Jonathan Chadwick - Executive Vice President and Chief Financial Officer

Analysts

Raimo Lenschow - Barclay's Capital

John DiFucci - JPMC

Kash Rangan - Merrill Lynch

Brent Thill - UBS

Brian Marshall - ISI Group

Rick Sherlund - Nomura

Walter Pritchard - Citigroup

Abhey Lamba - Mizuho Securities

Matt Hedberg - RBC Capital Markets

Shaul Eyal - Oppenheimer

Operator

Welcome, and thank you for standing by. At this time, all participants are in a listen-only mode. After the presentation, we will conduct a question-and-answer session. (Operator Instructions) Today’s conference is being recorded. If there are any objections, you may disconnect at this time.

I’d now like to introduce your host for today’s conference, Paul Ziots, Senior Director, Investor Relations. Thank you. You may begin.

Paul Ziots

Thank you. Good afternoon everyone and welcome to VMware’s third quarter 2013 earnings conference call. On the call, we have Patrick Gelsinger, Chief Executive Officer; Carl Eschenbach, President and Chief Operating Officer; and Jonathan Chadwick, Chief Financial Officer and Executive Vice President.

Following their prepared remarks, we will take questions. Our press release was issued after close of market and is posted on our website, where this call is being simultaneously webcast. Slides which accompany this webcast can be viewed in conjunction with live remarks and can also be downloaded at the conclusion of the webcast from ir.vmware.com. We have also included in earnings release and posted on our website seven quarters of historical data for revenue and unearned revenue, excluding pivotal and all 2013 divestitures.

Statements made on this call today include forward-looking statements, such as those with the words will, believes, expects, continues and similar phrases that denote future expectation or intent regarding our financial outlook, product offerings, customer demand and other matters. These statements are based on the environment as we currently see it and are subject to risks and uncertainties. Please refer to the press release and the risk factors and documents filed with the Securities and Exchange Commission, including our most recent reports on Form 10-Q and Form 10-K for information on risks and uncertainties that may cause actual results to differ materially from those set forth in such statements.

In addition, during today’s call, we will discuss certain non-GAAP financial measures. These non-GAAP financial measures, which are used as measures of VMware’s performance, should be considered in addition to, not as a substitute for or in isolation from GAAP measures. Our non-GAAP measures exclude the effect of our GAAP results of stock-based compensation, amortization of intangible assets, employer payroll tax and employee stock transactions, the net effect of amortization and capitalization of software acquisition-related items and realignment related net gains and charges.

As mentioned, we have presented historical data for revenue and unearned revenue, excluding pivotal and all 2013 divestitures. You can find additional disclosures regarding these non-GAAP measures, including reconciliations with comparable GAAP measures in the press release and on our Investor Relations website. The webcast replay of this call will be available for the next 60 days on our company website under the Investor Relations link.

Our fourth quarter 2013 quiet period begins at the close of business December 16, 2013 unless otherwise stated all financial comparisons in this call will be a reference to our results for the comparable period of 2012. With that I will turn it over to Pat.

Patrick Gelsinger

Thank you Paul and good afternoon everyone. Q3 was a strong quarter for us, as we continued our solid performance for all three quarters of 2013. I’m very pleased with our changed performance and the quarter played out largely as we expected. Q3 total revenues grew 14% year-over-year above the midpoint of our guidance range excluding pivotal and divestitures, total revenues grew at an even faster rate of 19% year-over-year.

Q3 license revenues excluding pivotal and divestitures grew 17% year-over-year exceeding the high end of our guidance range. Non-GAAP operating margin reached 33.9%. VMware continues to build momentum globally because we’re uniquely positioned to help our customers transform to the mobile cloud era of computing. With our portfolio of solutions that extend from the desktop to the data center to the cloud we’re enabling IT teams to liberate resources from the client server environments while building the mobile cloud infrastructure that will power their businesses into the future. Our strong performance in Q3 is clear validation that our customers have confidence in our ability to help them address the IT requirements of both today and tomorrow. Across the business we’re laser focused on delivering unique customer value in three strategic growth areas, software defined data center, hybrid cloud, and end-user computing. These three focus areas are powerful individually but also produce significant advantages for VMware by leveraging synergies across these three inter-related businesses.

For example we recently announced our new desktop as a service offering using technology from our Desktone acquisition. One of the keys to that offering is our ability to host that solution in our vCloud Hybrid service which in turn leverages all the speed and cost benefits of our software defined data center architecture. We’re excited about our acquisition of Desktone as they are the industry leader in desktop as a service. Together VMware, Desktone are well positioned to help our customers quickly modernize and move their desktop infrastructure to the cloud. At VMware we’re delivering against the vision for the industry that is backed up by bold customer centric innovation that will radically transform IT again. At VMworld in the United States and VMworld in Europe last week we engaged with more than 31,000 customers and partners a record attendance. We announced three game changing technologies in vCloud Hybrid service, our Virtual SAN Storage solution and our NSX network virtualization platform. In addition, we also announced an entire refresh of our industry leading cloud management suite, this was the single most impressive and impactful display of VMware innovation in the 10 year history of VMworld.

We demonstrated that the software defined data center is real with strong customer momentum. We laid out our comprehensive vision for the SDDC approximately 1 year ago and we’re now delivering concrete business value and differentiated solutions against that vision. As part of our NSX launch we were joined by IT leaders from Citigroup, eBay and General Electric, three iconic global companies whose executives spoke with conviction about how network virtualization is critical important to speeding innovation as they focus on networking as the next step on their path to the software defined data center. A critical component of SDDC is IT management and we continue to show how traditional IT management practices are giving way to automation enabling IT teams to move at a higher velocity to support top priority business objectives. VMware now ranks number one worldwide in cloud management according to IDC.

In addition to expanding our product portfolio we have been adding significant depths to our leaderships bench, Sanjay Poonen joined VMware from SAP in July to lead our end user computing business. Sanjay Mirchandani joined us from EMC to lead our Asia-Pacific and Japan business and Tony Scott joined VMware in August as CIO having previously served as CIO at Microsoft and the Walt Disney Company. In fact we have aggressively added talent across all levels of the organization with 700 net new employees hired into VMware in Q3 alone. This is the bottom line. VMware is attracting world class talent and our engineering teams continue to deliver breakthrough innovations that drive deep business value for our customers. In closing, I’d like to thank our customers, partners and employees for their passion and engagement in Q3 as we carry our momentum into Q4 and set ourselves up for 2014.

I will now turn it over to Carl.

Carl Eschenbach

Thank you, Pat. I couldn’t be more pleased with our performance in Q3. We built on the momentum of Q2 and delivered yet another strong quarter. Q3 went largely as planned removing the effect of pivotal and our 2013 divestitures both license bookings and total bookings grew in the high-teens year-over-year. For the third consecutive quarter in 2013, we are very pleased with this balanced performance across all three regions. Total bookings in each of our regions, the Americas, Asia-Pacific and EMEA grew in the mid to high-teens year-over-year in Q3.

I would also note that due to our success in helping customers both dramatically save cost and build architectures for the future we exceeded our expectations for the U.S. federal business in Q3. This was in part due to closing the largest ELA in our company’s history this quarter with the U.S. Army. This was a consolidation of what would have otherwise been a number of smaller ELAs, and a deal we had been tracking for a few quarters. We were pleased with our team’s ability to execute in what was otherwise a challenging federal environment. Excluding the U.S. Army deal, our federal business was flat year-over-year. In addition, we had record attendance at VMworld in the U.S. and VMworld in Europe. We couldn’t be more pleased with the energy and excitement of our customers and partners at both of these events. We expect to touch another 27,000 customers and partners during our vForums across Asia-Pacific and Japan.

Overall, we are outperforming on multiple fronts. We closed five deals above $10 million and once again our field teams around the world did an outstanding job of closing ELAs. Approximately, 33% of total Q3 bookings were ELAs and Q3 was VMware’s second highest in quarter renewal rate for ELAs in terms of number of deals renewed. In addition, for the fifth consecutive quarter, our vCloud Suite sales exceeded our internal plans. We also saw vSOM or vSphere with Operations Management exceed internal plans once again in the second full quarter on the market. We are continuing to make progress with our strategy to strengthen the channel and broadly see the market with our operations in management products. The combination of vCloud Suite and vSOM is enabling our customers to make long-term investment decisions with VMware and to partner with us as we take them on the journey to the software-defined data center. As we do this, we are seeing overall increases in our ASPs.

Our professional services bookings growth in Q3 was once again solid. Our customers continue to use VMware’s professional services as a strategic enabler as they make the transition from a client server environment to the mobile cloud era. Our support and subscription in quarter renewal rate was the second highest rate of all-time. This is a strategic part of portfolio. It’s highly profitable and a reflection of strong ongoing customer commitment to VMware. Management and automation license bookings were once again our strongest growing product area this quarter.

As VMware’s customers become more virtualized and adopt a private and hybrid cloud strategy that is designed to deliver more business agility, their needs increase for innovative industry defining management automation and operations products. Our customers continue to share with us their desire to get these products from their existing data center virtualization partner. Customers are also integrating management products in more parts of the business as a wider range of decision-makers are purchasing management functionality from VMware, including CIOs, CFOs, VPs of IT finance, VPs of operations, etcetera. We continue to work closely with VPs of infrastructure who had been traditionally purchasers of our management products. Based on the opportunity in front of us and the traction you’ve seen to-date we will continue building out a significant management specialist sales organization throughout the remainder of FY ’13 and into 2014. And as we announced last week in Barcelona w will be releasing new versions and updates to the entire management portfolio for vCloud, vSOM and standalone sales. These portfolio updates include major new releases for our vCloud automation center and IT business management solutions and significant updates to vCenter operations management and vCenter Log Insight solutions. These new releases significantly help continue VMware’s market momentum and leadership.

Turning to our end-user computing business after two consecutive quarters of year-over-year license bookings growth in the mid-teens our end user computing license bookings were down year-over-year, with a decrease in the low single digits in Q3. However, we believe we continue to gain market share as a result of our continuing investments such as building out an end-user computing specialist sales force in all three geographies. For example, in IDCs October 2013 Asia-Pacific Client Virtualization market analysis VMware was the market share leader in 2012 by a margin of nearly 10 percentage points and IDC expects VMware to grow market share by more than any other vendor in 2013.

We also continue to be excited about our large service provider and enterprise customer proof of concepts underway in network virtualization. Our success rate in this proof of concepts continues to be very high. Unlike many technologies in the marketplace our NSX technology is in production use today and supporting some of the largest deployments in the world. We saw strong NSX momentum coming out of VMworld and delivered more than 5000 hands-on labs associated with NSX. We also announced the general availability of NSX worldwide and an impressive list of over 30 partners that are aligned with us.

Our hybrid cloud business, including VSPP grew once again at more than 100% year-over-year, following the U.S. availability of vCloud hybrid service, we recently announced the opening of our second and third data centers in the U.S. In addition, we announced our plans to bring vCloud hybrid service to the United Kingdom as data in Q4, with availability in Q1 of 2014. Customer interest remains high because VMware is the only company positioned to deliver a seamless extension from the private to the hybrid cloud. In summary, we executed against plan in Q3. We’re pleased with our performance, but even more importantly, we’re energized by the enthusiasm coming out of our recent customer interactions at VMworld. We’re delivering industry changing innovations in the software defined data center, hybrid cloud and end-user computing, and our customers and partners are excited to continue the journey with VMware. With that let me turn it over to Jonathan Chadwick.

Jonathan Chadwick

Thank you Carl. We’re very pleased with our Q3 results meeting or exceeding all of our key goals for the quarter. We’re executing the plan we have shared with you and the year continues to play out as we expected. Q3 total reported revenue growth of 14% year-over-year was above the midpoint of our guidance range. License revenues of $564 million were up 15% year-over-year and exceeded the upper end of our guidance. Excluding pivotal and all divestitures total revenues grew 19% year-over-year in Q3 accelerating from 15% in Q2 and 13% in Q1, license revenue growth accelerated to 17% year-over-year up from 5% in Q2 and 1% in Q1. Overall services revenue grew 13% year-over-year excluding pivotal and all divestitures services revenue grew 20% year-over-year. Moving to operating expenses and profitability. Unless otherwise noted, all references to our expenses and operating results are on a non-GAAP basis and are reconciled to our gap results in the press release tables and posted on our investor relations website.

Operating margin was 33.9% another high end of our guidance range for Q3. We continue to invest in our business and we’re pleased to see that total headcount increased by almost 700 heads [ph] to a total of just over 13,600 heads at the end of September. These investments were primarily targeted to sales coverage, including our sales specialist and emerging market teams and the product teams from management, networking, hybrid cloud and end user computing. Diluted non-GAAP EPS for Q3 was up 20% year-over-year to $0.84 per share on approximately 433 million shares.

Now, moving to our balance sheet and cash flow metrics. Our balance sheet remained strong with cash and short investments at quarter end of $5.8 billion, up $514 million sequentially. Our operating cash flows remained strong as well and were $637 million, up 46% year-over-year. Our total cash spending on CapEx was $94 million and free cash flow was $543 million in Q3, up 50% year-over-year. Our cash flows this quarter reflected our robust operating performance with strong collections activities and lower expenses.

During the quarter, we repurchased approximately 1.2 million shares of our stock for a total of $90 million under our share repurchase program at an average price of around $74 per share. Total unearned revenue ended the quarter at $3.64 billion, up 21% from Q3, 2012 and of which $1.41 billion is long-term. Approximately, 89% of our unearned revenues will be recognized rapidly over future quarters. The unearned revenue mix is in line with prior periods and is primarily a reflection of our strong maintenance business. Customers continue to buy on average more than 24 months of support and maintenance with each new license purchased which demonstrates the strong commitment to VMware as the core element of their data center strategies.

Before I move on to guidance, I will provide some further updates regarding our product portfolio. As was the case in Q2, a significant portion of our high-teens year-over-year bookings increase in Q3 is as a result of our success in the category of products beyond standalone vSphere. This category includes management and automation, end user computing, vSphere with Operations Management, vCloud Suites and the VMware Service Provider Program. In Q3, over 40% of our license bookings were from these product areas beyond the standalone vSphere. This figure is up from approximately 30% in Q3 of 2012 and reflects the significant uptake in our newer products including the success of our suite strategy with vCloud Suites and vSOM. So again, we are pleased with our bookings growth overall and the momentum in our Suites and newer products.

Now, moving to guidance. Since Q3, total revenues finished according to our expectations. We are maintaining the midpoint of full year 2013 guidance of $5.190 billion and narrowing the range to between $5.175 billion and $5.205 billion representing year-over-year growth of 12% to 13%. Excluding pivotal and divestitures, our total revenue growth for 2013 is expected to be between 16% and 17%. Given our strong license revenue performance in the third quarter, license revenue for the full year is now expected to be within the range of $2.255 billion and $2.275 billion representing 8% to 9% growth as reported and 10% to 11% excluding pivotal and divestitures. In both cases, this represents an increase in the midpoint of guidance by approximately one half of a percentage point.

In addition, given our strong operating margin performance in Q3, we now expect non-GAAP operating margin to be approximately 34% for the full year. While this is ahead of the target we have shared previously, we continue to invest in our strategic priorities and still expect headcount at the end of 2013 to be up by approximately 500 people from the start of the year. GAAP operating margins for 2013 are expected to be approximately 13 percentage points lower than non-GAAP operating margins. We continue to project that our non-GAAP tax rate will be 18.5% for the year and we anticipate that our 2013 fully diluted weighted average share count will be between 431 million shares to 435 million shares.

In regard to cash flow, given our strong cash flow performance this quarter we are raising the range of our outlook for 2013 operating cash flow and increasing the midpoint by $175 million. Our new outlook for 2013 operating cash flow is between $2.3 billion and $2.5 billion. As a reminder, cash flow can be lumpy from quarter-to-quarter due to various factors, including the timing of tax payments, linearity of bookings and other factors. And at this stage we continue to expect capital expenditures on a cash basis to range between $330 million and $370 million for the year. Total revenues for Q4 are expected to range from $1.450 billion to $1.480 billion or a growth of between approximately 12% to 14%. We currently anticipate Q4 license revenue to be between $670 million and $690 million representing growth of between 12% and 16%. Excluding pivotal and divestitures total revenue growth for Q4 is expected to be between 18% and 20% and license growth is expected to be between 15% and 19%.

I will make two additional comments on revenue, firstly we expect a fairly flat year-over-year performance in the U.S. Federal and continue to monitor any potential effects of the U.S. government shutdown. And secondly given the typical seasonal strength of Q4 we’re expecting to build both license deferred and total deferred revenue but at a lower sequential dollar value increase as to compared with last year. We expect non-GAAP operating margin in Q4 to be in the range of 35% to 36%. We see a tremendous market opportunity ahead and we will continue to make investments in product development and sales expansion. GAAP operating margins for the fourth quarter are expected to be approximately 9 to 12 percentage points lower than non-GAAP operating margins. For Q4 we estimate our non-GAAP tax rate to be 18.5% and we anticipate our fourth quarter 2013 fully diluted weighted average share count to be between 431 million to 435 million shares.

Finally I will share some early comments about 2014 more detailed guidance will follow in January. We continue to see the opportunities to grow total revenues in the range of approximately 15% year-over-year. We also remain focused on our non-GAAP operating margin plan previously shared with you at the strategic forum in March and again at Financial Analyst Day in August and we expect the total year non-GAAP operating margins to come in at approximately 34%. GAAP operating margins for 2014 are expected to be approximately 10 to 14 percentage points lower than non-GAAP operating margins. This reflects continued investments in our business given the growth potential we see ahead.

As a remainder Q4 is typically our seasonally strongest quarter with Q1 typically being our seasonally slowest. With that in mind as we look specifically into Q1, 2014 we do expect to see slightly more pronounced seasonality than we experienced in Q1 2013. While we’re not prepared to specific guidance for Q1 at this time for modeling purposes on as reported basis, we are assuming approximately 1 percentage point greater sequential declines in both total and license revenue in Q1, 2014 over Q4, 2013 as compared with the sequential declines for Q1, 2013 over Q4, 2012.

Given these revenue trends and the investments we continue to make, we also expect to see non-GAAP operating margins for Q1, ’14 in the range of about 32% to 33%.

GAAP operating margins for Q1 are expected to be approximately 10 to 14 percentage points lower than non-GAAP operating margins. I encourage you all to model accordingly and I will provide more specific guidance for 2014 in conjunction with our Q4 earnings call in January. In summary we’re very pleased with Q3 our goal was to achieve significantly accelerated revenue growth and we did that in Q3, in addition we delivered strong cash flow and operating margin performance. We continue to see significant opportunities ahead and are excited about the prospects for our customers, partner, shareholders and employees. And with that I’ll turn it back to Paul.

Paul Ziots

Thanks Jonathan. Before we begin the Q&A I will ask you to limit yourself to one question consisting of one part so we can to get as many people as possible. Operator let's get started.

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