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VMware Inc. (VMW - Snapshot Report) reported third quarter 2012 non-GAAP earnings per share of 70 cents, which improved from 53 cents reported in the previous-year quarter. However, including stock based compensation, earnings came at 39 cents per share, missing the Zacks Consensus Estimate of 42 cents. The year-over-year earnings growth was primarily due to solid top-line expansion.

Quarter Details

Revenue for the quarter increased 20.4% from the previous-year quarter to $1.13 billion, which was in line with the Zacks Consensus Estimate. Reported revenue was within management’s guided range of $1.11 billion-$1.15 billion.

Revenue for the quarter was positively impacted by higher service revenues and license revenues. Moreover, strong demand for VMware solutions across international and domestic markets also helped revenues.

License revenue increased 10.7% year over year to $491.1 million. Enterprise License Agreements (“ELA”) were approximately 24.0% of third quarter bookings boosted by the prudent mix of new ELAs and renewals.

Service revenue was $642.6 million, up 29.0% year over year. It includes two segments, namely Software maintenance and support and Professional services. The revenues of both these segments increased 29.0% from the previous-year quarter.

U.S. revenues increased 25.0% year over year to reach $554.0 million, while International revenues witnessed a year-over-year growth of 16.0% to $580.0 million in the reported quarter.

Non-GAAP gross profit came at $997.9 million, up 21.1% from the previous-year quarter. Gross profit (including stock based compensation) increased 21.0% from the previous-year quarter to $989.6 million. Gross margin was 87.3% versus 86.8% in the prior-year quarter. The year-over-year increase in gross margin was due to higher revenue base.

Operating expenses increased 21.2% from the previous-year quarter to $756.5 million due to 16.7% increase in the research and development expenses, 24.6% increase in the selling and marketing expenses and 19.5% increase in the general and administrative expenses. Operating expenses as a percentage of revenue increased 40 basis points.

Non-GAAP operating income increased 28.0% from the previous-year quarter to $365.2 million. Operating income (including stock-based compensation) in the reported quarter jumped 20.4% year over year to $233.1 million. Operating margin remained flat on a year-over-year basis at 20.6%.

Non-GAAP net income increased 31.8% from the previous year quarter to $303.4 million. However, including stock based compensation, net income came at $171.2 million.

VMware exited the quarter with cash and cash equivalents (including short-term investments) of $4.39 billion, compared with $5.35 billion in the previous quarter. Cash from operations was $436.2 million versus $391.3 million in the previous quarter. Free cash flow was $385.9 million in the quarter versus $379.7 million in the previous quarter.

Guidance

VMware expects fourth quarter revenue to range from $1.26 billion to $1.29 billion, reflecting an increase of 19.0% to 22.0% on a year-over-year basis. Moreover, revenue from license agreements is expected to grow in the range of 14.0% to 18.0% from the previous-year period. Non-GAAP operating margin is expected in the range of 31.5%-32.5%.

For fiscal 2012, revenue is expected in the range of $4.572 billion to $4.602 billion, an increase of 21.4% to 22.2% from fiscal 2011, primarily driven by strong license revenue growth. License revenue is expected to increase within 12.8% to 13.8% range.  Operating margin on non-GAAP basis is expected in the range of 32.0% to 32.3%.

Recommendation

We believe that VMware’s strong and innovative product pipeline along with its strategic acquisitions will enable the company to drive its top-line growth over the long term. Moreover, the company’s continued strong performance in international markets and focus on emerging markets will also be a crucial factor over the long term.

However, we believe that sluggish North American and European markets coupled with modest IT spending environment and competition from Microsoft Corp. (MSFT - Analyst Report) and Citrix Systems Inc. (CTXS - Analyst Report) are the headwinds going forward. Moreover, the company’s continued investments in emerging markets, product innovations and acquisitions are expected to weigh on the margins in the short term.

We have a Neutral recommendation on VMware over the long term. Currently, VMware has a Zacks #4 Rank, which implies a Sell rating on a short-term basis.

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