Editor’s note: Wariness about how the forthcoming Dell-EMC merger will affect VMware and news in Tuesday’s earnings call that the storage technology company is cutting hundreds of jobs are short-term headwinds, writes analyst Andrew Smith of Technology Business Research. Why? In an in-depth analysis, Smith explains why TBR believes VMware is “on the right track.”EMC owns VMware.

HAMPTON, N.H. – VMware earned $1.87 billion revenue in 4Q15, growing 10% year-to-year. The quarterly performance caps off a strong year for VMware, the company grew annual revenue 9% from 2014, totaling $6.57 billion. However, VMware was challenged in 2015 to accelerate revenue growth and simultaneously expand presence in cloud, software-defined networking, storage, and end-user computing markets.

VMware realizes the growth trajectory for its traditional virtualization business is slowing, and spent much of 2015 investing in emerging products like NSX and its End-User Computing (EUC) business, which bolster VMware’s capabilities outside the traditional hypervisor and virtualization market. We believe VMware is on the right track, and new products continue to show traction with customers. The vendor reported 100% year-to-year growth for NSX in 4Q15, and 30% year-to-year growth for its EUC business.

However, VMware’s expansion into cloud, mobility, and networking markets puts it into more direct competition with vendors like Amazon, Microsoft, Cisco, and Citrix who have formidable resources and investments dedicated to competing offerings.

2016 will be a formative year for VMware, as it continues to pursue a “no naked vSphere” sales strategy designed to build revenue contributions from its cloud and Software as a Service (SaaS) solutions. VMware’s greatest challenge will be the execution of this transition under the scrutiny of shareholders and investors focused on improving VMware’s value over the short term and influencing VMware’s strategic direction under the uncertain terms of the proposed Dell/EMC merger.

We believe VMware is taking effective steps to transform its financial and portfolio strategies in order to deliver long-term growth. However, we expect this process to continue through 2016 and 2017, and do not anticipate significant shifts in VMware’s revenue allocation or recognition over the short term for two reasons:

  1. First, VMware earns the majority of its current revenue through server virtualization and management products within the vSphere suite. License bookings for products beyond stand-alone vSphere continue to rise, reaching 65% of total license bookings in 4Q15 and indicating positive traction. However new license bookings attributable to products like vCloud Air, AirWatch, and NSX will take longer to be recognized according to new billing cycles, many of which will be transitioned to a subscription-basis, further complicating matters. This challenge is not unique to VMware. Vendors like IBM, CA, Microsoft, and HPE also face multi-year transitions for their own software and cloud portfolios. Given this reality, we expect the majority of VMware’s revenue to come from virtualization solutions and the vSphere portfolio for the next two to three years.
  2. Second, VMware’s hybrid cloud and SaaS revenue growth has normalized over the past several quarters, indicating a more regular pace of growth moving forward. The vendor’s Hybrid Cloud and SaaS revenue grew 80% year-to-year in 4Q15 as reported, bringing quarterly revenue in this category to approximately $112 million. Continued growth of this metric will be an important indicator of VMware’s success in 2016, as the vendor looks to sell hybrid cloud solutions across its existing customer base. There is still opportunity for growth, VMware’s cloud management solutions have been adopted by just 17% of its installed base, indicating ample cross-sell and upsell opportunities.

Inconsistent messaging and direction of the Dell/EMC merger puts VMware in limbo, creating market confusion and customer uncertainty

In October EMC and VMware announced a new joint venture based around the Virtustream brand and IP. Reacting to investor discomfort with VMware assuming the planned operating losses of Virtustream’s business, VMware appeased the short-term orientation of the investor community by walking away from the agreement in December. The stop-start motions around VMware’s public cloud strategy and which brand will lead the charge (Virtustream or vCloud) will create uncertainty among customers and partners in the short term, presenting additional barriers to adoption. Meanwhile, competitors like Microsoft and Red Hat are increasingly making cloud platforms (Azure and OpenShift, respectively) integral to their virtualization and management strategies. Vendors with cloud management and orchestration ambitions like HPE have also aligned their strategy with core platforms like AWS and Azure.

VMware risks falling further behind its competitors if it does not clearly articulate the value and position of vCloud Air moving forward. CEO Pat Gelsinger addressed this issue head-on during VMware’s earnings call, defining a narrowed strategy for vCloud Air which will focus on service delivery to enable the extension of private cloud workloads into the public cloud via the vCloud Air Network and vCloud Air platform. In other words, VMware will focus on perfecting its vCloud Air services for hybrid cloud, data center extensions, networking, and disaster recovery in order to win, and will leverage its vCloud Air partner network in order to cost-effectively deliver more services to market outside the existing customer base.

VMware continues to expand its container capabilities and moving up the value chain to secure and automate cloud application layers

We expect strategic initiatives such as Project Bonneville, and new products like Photon and the VMware Photon Platform to redefine VMware’s approach to application containers across virtualization and cloud environments, providing customers with intuitive tools and a clear migration path for cloud-native applications and workloads. VMware’s commitment to Photon and the development of container management capabilities and frameworks which integrate with the wider VMware portfolio will be critical as VMware looks to transition existing customers to new hybrid cloud management and orchestration environments.

Emerging container formats, such as Docker and Rocket cannot address all enterprise IT needs; they need the help of additional orchestration, management and networking technologies to supplement the growing application container ecosystem and make the technology feasible to enterprises running live applications. We believe this will drive increasingly heated competition during 2016, as management and orchestration providers scramble to protect their legacy install bases with container-friendly management and migration options, while also providing net-new infrastructure constructs that cater to new, cloud-native applications designed to run in containers. Incumbent firms such as VMware must continue to invest in its container capabilities in order to protect its install base and facilitate customer migrations to hybrid cloud.

Newly announced headcount reductions are designed to reallocate resources to high-growth opportunities and bolster margins

During VMware’s 4Q15 earnings call the vendor announced a new headcount reductions plan for the first half of 2016. The internal restructuring plan will eliminate 800 jobs over 1H16, and VMware will reallocate resources in the development of field, technical, and support resources associated with its emerging, high-growth products. We believe these new resource management initiatives will help VMware expand its operating margins during 2016 while also sustaining investments necessary to spur growth and development of its emerging products. We do not expect this reduction plan to be expanded on significantly over the short term.

(C) TBR