FBR Downgrades VMware, Cites 'Fading Tailwinds' From ELAs

Citing "fading tailwinds" from VMware enterprise licensing agreement renewal cycles, FBR Capital Markets & Co. has downgraded shares of the virtualization software kingpin from outperform to market perform.

The downgrade sent VMware shares sliding 3 percent, or $2.14, to $83.06 on Monday. The market perform rating lowers the FBR VMware shares' price target to $90, down from $96.

[Related: 12 Shocking Allegations From The VMware-Carahsoft Government Overcharging Lawsuit ]

Given "mixed checks" around VMware's "all important" ELAs, FBR analysts Daniel Ives and James Moore lowered VMware sales and earnings estimates for both the second half of the current fiscal year and fiscal 2016.

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"Overall, we believe VMware is in its 'eighth inning' in terms of VSphere penetration at the enterprise, which could limit top-line growth reacceleration, and while some investors are still holding out hope for a positive strategic move by EMC (e.g. spin-off of VMware) it appears to be a fleeting possibility as evidenced by [VMware corporate parent] EMC's dogmatic view around VMware within the EMC federation," wrote Ives and Moore in a research note.

The two analysts said they see "limited upside to further server virtualization penetration," with what they estimated as 70 percent-plus penetration of server workloads by VMware. "With the company's newer/updated offerings (e.g. VSphere, vCloud Suite, NSX, VSAN, EVO:RAIL, etc.) and the focus on providing the software defined datacenter, we believe VMware continues to hold competitive advantages in a number of key virtualization areas (compute, storage, networking)," Ives and Moore wrote. "That said, in our opinion, the company faces growth challenges at its core given our expectations for fading tailwinds from the all important ELA cycle as this area for VMware matures and as competition heats up."

The CEO for a VMware enterprise partner, who did not want to be identified, agreed with the FBR analysis. "I do see a slowing down of VMware in our accounts," he said. "All of our top accounts are already virtualized and I don't see anything else in the VMware portfolio that is going to drive the growth at the rate the VMware hypervisor was adopted. When that product came out, everyone raced to get virtualized. I just don't know where the sales growth is going to come from next for VMware."

The concerns around VMware 's enterprise licensing agreements come with VMware and federal solution provider partner Carahsoft under fire for allegedly overcharging the federal government for software. VMware and Carahsoft, in fact, paid $75.5 million to settle a civil lawsuit alleging overcharging the federal government for VMware products and services over a six-year period.

VMware and Carahsoft are alleged to have given private-sector customers better pricing and discounts on VMware products and services than it offered government customers, according to a document outlining the civil lawsuit allegations. A VMware spokesman told CRN the vendor denies the allegations and decided to settle the case to avoid a lengthy legal battle.

CRN Chief Investigative Reporter Kevin McLaughlin shined the spotlight on VMware's ELA practices in a special report titled "Army ELA -- Weapon of Mass Confusion?" The report looks at a $44.8 million U.S. Army VMware ELA, and a subsequent $33.3 million six-month extension, that led to higher costs for some Army commands because of certain aspects of the contract that appear to be tilted in VMware's favor, sources with knowledge of the deal told CRN.

Given what they called "foreign currency headwinds and our slowing license growth assumptions," FBR's Ives and Moore lowered sales estimates for fiscal 2015 to $6.61 billion, down from $6.63 billion. The two analysts lowered pro forma earnings per share estimates for fiscal 2015 to $3.94, down from $3.98.

For fiscal 2016, the two FBR analysts lowered their pro forma earnings per share estimate to $4.48, down from $4.55, while at the same time cutting their FY 2016 sales estimate to $7.28 billion, down from $7.38 billion.

FBR's Ives and Moore said that the jury is still out on VMware's ability to scale newer products. Furthermore, the analysts said, as customers purchase more products and services around the VMware software-defined data center, VMware could face margin pressure. "In our view, increasing competition from other large technology vendors (Microsoft, IBM, Citrix, Cisco) and the potential for pricing pressure at the core could add challenges to significant margin expansion," the two analysts wrote.