The Deipnosophist

Where the science of investing becomes an art of living

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Location: Summerlin, Nevada, United States

A private investor for 20+ years, I manage private portfolios and write about investing. You can read my market musings on three different sites: 1) The Deipnosophist, dedicated to teaching the market's processes and mechanics; 2) Investment Poetry, a subscription site dedicated to real time investment recommendations; and 3) Seeking Alpha, a combination of the other two sites with a mix of reprints from this site and all-original content. See you here, there, or the other site!

29 January 2008

To Hell in a Handbasket

First things first.

The market is about to prove wrong my analysis re VMWare/VMW; stated differently, I am/was wrong. Questions:

1) How am I wrong?
I perceived VMWare/VMW as a market leader; as such, the shares should not have declined, at this time, to ~$58. Having done so, a new chart pattern emerges: lower highs and lower lows, which is my denotation of a bear market process. It is this precise point at which I lose all interest. (Recall I invest only in market leaders.)

2) What will I do, how will I proceed?
Many different constituencies comprise the market; the negative component now has primacy. So what happens next is tricky. There exist chart levels that will cause some buying from traders who know those chart points and thus purchase for short term (dead cat) bounces, however ephemeral. A key constituency that must rise to the fore now is VMW's floor specialists; it is their obligation to always take the other side of a disorderly market. (A one-way market is disorderly.) Specialists go home each day flat, and so will rarely, if ever, purchase at prices they believe subsequent action will not prove as low. (This activity will be apparent in today's 1 minute charts.)

After the next 1-5 days, I expect a bounce back to ~$68-70 (depending on the new low), so I will sell all my shares on that bounce, which should begin and exhaust itself within the next 2-5 weeks. That is, I will ignore today's massive price down gap, sit through the coming days of follow-on weakness and volatility, with the objective of selling at a higher price than available now. I will NOT single-point my bounce objective, but will monitor closely VMW's coming chart dynamics. And then sell. Period.

3) How wrong am I, really?
On its conference call, VMWare executives stated the following (from
U.S. revenue for 2007 grew 84% from a year ago to $721 million, and international revenue increased 94% to $605 million...
U.S. revenue represented 52% of total revenue in Q4; saw strength in all international markets, continued to invest globally in sales, marketing, and product support... did not receive any benefit from currency translation... overall transaction size is increasing... co repeats stance that they would not put too much weight on operating margins as they will flucuate during co's expansion...
licensed revenue and deferred services revenue from the November / December timeframe will be recognized in Q1 of 2008 ($54 mln). Q4 reflects revenue and deferred revenue reported during the quarter from OEM bookings in August and September. Like last quarter, there is some sequential increase expected which will benefit Q1 2008...
Expects operating margins in 2008 to remain in mid 20s but says there may be a slight seasonal down tick in Q1... guidance for 2008 rev growth of 50% YoY comes to roughly $1.99 bln vs $2.08 bln First Call consensus... Expects % rev growth to be higher in 1H08... co is not working in a price decrease into guidance (so do not expect competition to cause them to lower)... co notes that they have been doing guidance internally so not just a shot in the dark... 50% rev growth guidance is largely based on the scale of their business... co says did not see any notable weakness in the U.S. markets in any particular quarter... not providing a breakout between services and license in guidance...
Sees great demand, but they need to see how the market develops before they make some assumptions... says competition is not delaying sales; says customers have tried some competitors products and told the co they see no reason to switch... guidance does not take into consideration a significant upswing in desktop... Expect to continue to grow deferred revenue at a substantial rate... co says have been building guidance independently of EMC... co states that they are not providing capex guidance at this time... reiterates belief that they can maintain prices.
A number of analysts are out commenting on VMW's results this morning, with most firms viewing guidance as conservative (as I mentioned in yesterday's post) and cutting their targets...
Citigroup notes that VMW's stock fell 26% after market based on a Q4 revenue miss of $5 mln relative to Street ests, but beat their ests by $5 mln and EPS by $0.04. They note that VMW's conservative 50% total rev growth for CY08 further compounded the miss, as it was below consensus ests for 57% growth and Citi's 51% est. They believe VMW's initial 50% total rev growth for '08 will prove to be conservative based on VMW's overwhelming market share (80%+), few legitimate competitors, limited overall market penetration, no major price pressures, and a doubling of headcount in '07. They believe there could be material upside to these ests, and while they acknowledge few near-term catalysts coupled with an upcoming share lock-up in two weeks creates added volatility, they believe the pull back in the shares represents a compelling opportunity for long-term investors. The firm cuts their tgt to $83 from $134, and sees strong downside support for the stock at $50 which represents ~1x PEG on their '08 EPS est...

Jefferies lowers their tgt to $74 from $129, saying they recommend buying VMW today on weakness despite the revenue miss. They think 2008 revenue and margin guidance seems conservative, and the larger themes of cost savings and improved ROI from virtualization remain intact...

Deutsche Bank lowers their VMW tgt to $75 from $83, saying they expect VMW to remain volatile after a 4Q07 that missed elevated consensus expectation, a premium valuation and guidance that implies an unanticipated deceleration in growth profile of the business in 2008. They expect the co to gain/maintain market share as virtualization penetration increases...

BMO Capital lowers their tgt to $60 from $75, saying guidance looks conservative, since they have not seen a change in customer interest, competitive dynamics, or pricing. However, they are concerned about slowing license revenue, and have stated previously that they have no interest in getting constructive on VMW...
Hmm, I discern a theme: this immediate price weakness is a result of the perception of company weakness rather than its reality; that is, these numbers are trememdously positive, but the stock is (being) punished for the seeming timidity of company executives and their 'conservative' outlook. I suspect that, given sufficient time, the stock will recover; say, 1-3 more quarters of bullish earnings reports that show no slackening of demand for the company's products.

None of the foregoing helps "Lu/vmw/Being Sad" who writes...

"So sad... This is like gambling... You are right that entering a bad stock at a good time is better than entering a good one at a wrong time..."

"I cut it AH... I guess it won't come back to 80 for a long long time... I am worried it might go lower to 30-40 in a bear market... I guess everything is right... But, just it hit a bear market and PE is too high..."
I hate to admit it, Lu, but, yes, investing is akin to gambling... but only insofar as to the investor's reliance on odds; that is, there is no sure thing when investing, as in life itself.

Chad Brand offers interesting comments (Thank you!) in his note...

This kind of thing happens all the time when you are dealing with stocks that are so overpriced. A stock trading with a P/E of 100 with large companies gunning for them has a lot to lose. Price erosion is just going to get worse as new firms that can undercut them on price enter the market. Looking at charts works to some degree, but you can't ignore valuation, as that is what tells you how high the bar has been set. Good luck everybody.
Yes, Chad, "this kind of thing happens all the time" -- but for all stocks, not solely those "that are so overpriced." I agree that high P/Es, increasing competition, and a reliance on chart analysis all to be fool's gold; and which I addressed previously. I also suspect you recall your many "value" opportunities that have declined a similar number of points after your recommendation / purchase. So the distinction arguably is not value vs growth, but market dynamics.

There are many ways to skin the cat of consistent success when investing. For me, however, a value stock is merely a growth stock that has stopped growing (rapidly). The former high-flyer falls back to earth, its valuation shrivels, and a new phase begins for the company's shares. To purchase only one class of shares solely because the investor believes the stock has no more deep price plummets in its future is equal folly; in effect, the investor owns a portfolio of investments he or she believes cannot decline precipitously, but whose share price rises will match, at best, the market's return; a coeval. Contrast that methodology with the opportunity to participate in a company's rapid growth and a commensurate rise in its share price -- but with such opportunity also comes the risk of sudden dramatic share price declines.

Of course, I prefer my favored opportunities would never decline 25% in one fell swoop; not to expose myself to that risk, however, means I would never have the opportunity to purchase the leaders -- leaders in the market, leaders in their product space, etc. Consider the many outstanding opportunities (Apple/AAPL, Chipotle/CMG, Google/GOOG, Intuitive Surgical/ISRG, etc) that value investors have passed on largely because they feared a sudden share price drop (ala what occurs now with VMWare/VMW). The investor can mitigate this risk ("He who lives by the sword shall also die by the sword") via sound money management, as one arrow among the many arrows in his or her quiver. Anything else is merely Babe Ruth pointing to the center field wall.

Full Disclosure: Still long the shares of VMWare/VMW... for the nonce.
-- David M Gordon / The Deipnosophist

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