Much is said about the coming of the cloud. To a certain extent the cloud has already changed a lot about business and services. You can back up your devices to the cloud instead of a physical medium, and data storage was now on some company’s server instead of on a USB stick. The sector has heated up, and I abandoned regular stock updates on it when the fervor was at its greatest extent. I do not like it when potential investments are hyped, even if I think the technology has great potential. The economy has been so bad for so long it is worth considering cloud and virtualization companies.
VMware, Inc. (NYSE: VMW) is and has been insanely expensive for a while now. The P/E of 48.3 has deflated a little from when I used to check on it regularly, but only because the price went down. I put VMware out of my mind when the P/E was in the 80s and the price was around $95. The price has fallen recently, but earnings growth is taking some of the edge off the high P/E. VMware should continue that earnings growth. It will need a more realistic P/E before it can continue growing, unless it trades the same as Amazon.
VMware provides virtualization software and cloud-related software. Virtualization is an extremely important technology that gets swept up with cloud computing. They are both distinct concepts that are entangled at their most fundamental levels. The cloud is what most people are familiar with. The machines in front of us are just interfaces but the storage and processing is done at some centralized location.
VMware has about $4.4B in cash, which I really like for a company like this. With everything being about the cloud and virtualization, VMware needs to be there to scoop up incremental improvements. That cash position will come in handy when it spots an opportunity. In general, I like a strong cash position but more so in these frontier industries. It is the frontier for now. Despite how well established the technology is I consider it the frontier. It is nowhere near as mature as routers or LCD screens. The chance to grab small innovation factories while they are useful and not a threat is key to VMware’s future.
It might be unreasonable for me to want a company with a market cap around $36B to have more than $4.4B in revenues. Juniper has similar revenues, just with lower margins, and it trades with an almost $9B market cap. With low debt VMware looks like a solid company. It just seems that the market is extremely enthusiastic about it. The P/E is high, and the PEG ratio is over 1. I do not normally chain myself to those metrics to determine if a company is a good investment. However, when a sector or technology is as red hot as cloud computing was, and to a certain extent still is, I take notice of those metrics. It seems like VMware has further to fall, but recent weeks have shown a suffering tech sector. Some bad tech news should let us know whether the bottom is in, and whether the high P/E and PEG are here to stay.
F5 Networks, Inc. (Nasdaq: FFIV) provides cloud architecture. That is the same as saying they provide the IT infrastructure. It is infrastructure for the customer, and you know how important that is for companies now. As companies outsource and let people work from all over the country, having the technological capability to easily work from anywhere comes in handy. Slowly it is becoming about who is the best person for the job, rather than who is the best person for the job that is willing to relocate.
F5 also works on a larger scale than what I just described. I described virtualization and a company’s private cloud network. However, F5′s products are also used to create these public clouds and cloud as a service systems. How the hardware is deployed is up to Google and Amazon, but F5 can provide the solution they need. F5 hardware is also coupled with VMware’s software to create a complete solution.
F5 does not have as much cash as VMware does, but it is far smaller. It only has about $500M cash. I expect that is enough to keep operations chugging along, but not much else. I would be concerned if it used its cash to fund fancy acquisitions. It does have the option of using debt, but I would not want them to take out-sized loans unless the acquisition was essential. Rarely are acquisitions proven to be essential before they are made. The profit margin is better than VMware’s at around 18.5%. The $137M free cash flow is a record for the company according to the conference call. F5 has a more sensible P/E at 23.70, but its PEG ratio is very high at 1.432. The market seems to be betting that the cloud will grow at colossal levels. I would not be so certain in the current economic environment.
The same call discussed how sales bookings in India and Asia-Pacific grew, while orders less than $1M grew in North America but orders over $1M shrunk. I think its good that smaller orders are growing in North America. It is true that American companies are still tightening their belts, but having to make those small orders indicates to me that there might be pent up demand when the capital expenditure floodgates open. Obviously, there is no way to prove what might happen in the future, but I would be more concerned if orders shrank across the board. That would indicate turning to another company, or a lack of need for the technology and services themselves. Both would be bad for F5.
VMware just strikes me as so expensive. It would have to grow so rapidly to justify the valuation the market is giving it. It used to have an even larger hurdle to jump, but the stock has deflated a bit. F5 has a normal P/E, but its PEG ratio is very high as well. If you are a disciple of those metrics it would signal that all future growth is more than priced in. If I was going to pick one of the companies I would choose F5, because I think it is the less red-hot of the two. However, the economy has been in a slump for a while, and the last few years have seen all companies hoard cash instead of spend it. Should things start to improve virtualization and the cloud are high on the list of things that will receive those long socked away funds. They look expensive, but if you like the product pipeline I would not hesitate to take a controlled position for the long haul. If I already owned either of them then I would hold.
Note: Also on Motley Fool here.