A steadfast VMware bear says that the $4.8 billion it's spending on big acquisitions doesn't change its stagnating growth: 'We still have concerns'

• VMware confirmed the speculation that it was buying its sister company Pivotal - and surprised Wall Street street by announcing a second multi-billion acquisition of Carbon Black, as well.
• The Pivotal deal is valued at $2.7 billion, and the Carbon Black deal is valued at $2.1 billion.
• Often when a billionaire has total control over multiple companies and one of his companies buys another when it hits a rough patch, it's not a good sign. In this case, there are some good reasons for VMware to have bought Pivotal.
• And Carbon Black speaks to a growth area for VMware: End-user computing.
• Unfortunately, the deals won't help some troubling signs in VMware's main business, Nomura Instinet analyst Christopher Eberle says, who rates the stock a "sell."
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On Thursday, VMware shocked no one by confirming that it was re-acquiring Pivotal, the software company it spun out in 2012, not long after it confirmed that it was in acquisition talks. It agreed to pay roughly $2.7 billion for the company, which, like VMware, is a Dell subsidiary.

VMware did shock everyone by announcing a second multi-billion acquisition the same day - specifically, endpoint security company Carbon Black, in a deal valued at $2.1 billion. That's $4.8 billion total for both companies.

All of this was on the tail of reporting a respectable Q2, 2020, in which VMware beat expectations slightly on profits and handily on revenue: It reported quarterly revenues of $2.44 billion when $2.43 billion were expected (up 12%); it reported non-GAAP EPS of $1.60 per share, when $1.55 was expected, up about 4% from the year-ago quarter.

For the most part, Wall Street did not seem thrilled with the acquisitions. While many analysts reiterated their buy ratings, RBC, Citigroup, and Merrill Lynch also lowered their share price target.

The stock dropped almost 10% on Friday, the day after VMware reported earnings. That could have come from a few different factors: It's true that VMware executives offered a tad softer-than expected Q3 guidance on the earnings call ($2.4 billion, versus $2.45 billion expected) - but it could have also been a part of the broader market sell-off on Friday, after tweets from President Trump apparently spooked investors.

But one of VMware's few steadfast bears, Nomura/Instinet's Christopher Eberle, pointed out in his research note the elephant in the room. Often when a company announces a spectacular acquisition during its earnings call, it's an attempt at slight-of-hand: look at this shiny new object we bought, and don't look at these other, less pleasant areas.

Eberle points out that both of the new companies have less-than-spectacular growth, and that some of VMware's own business units are also experiencing a slowdown in growth.

"Deal or no deal(s), we still have concerns," Eberle writes. "VMW announced not one, but two acquisitions in conjunction with 2Q earnings, both of which are among the largest in company history ... however, a concerning aspect that both deals have in common is steadily decelerating top-line revenue coupled with uncertain product strategies."

Eberle reiterated his "sell' rating and lowered his target price from $130 to $114. That's extremely low, mind you. The average target price for VMware is $188, as determined from the 26 analysts tracked on Yahoo Finance.

Tepid growth = slowing growth = bearish outlook

Pivotal offers software for developers to build, test and deploy their apps on a variety of cloud platforms. It's also known for its services business, where companies can hire its consultants to help them build their cloud apps.

The modern incarnation of Pivotal was born in 2012, when it spun out of VMware and EMC. It landed in Michael Dell's possession when he bought EMC, which, in turn, owned most of VMware. It went public in April 2018, about 16 months ago, opening at $15 per share.

VMware offered $15 a share to buy it back on Thursday. While a premium over Pivotal's $13.70 closing price on Thursday, it was basically a Hail Mary break-even price for the institutional investors who bought in at the IPO.

This, even though in June, Pivotal's shares crashed 40% to under $11 when it reported an okay quarter but then cut its full-year revenue outlook to 15% growth, year over year.

That's the kind of tiny growth expected of mature companies in aging industries, not newly public cloud players with less than $1 billion in revenue. Pivotal expected to end the year at about $760 million in revenue.

Meanwhile, Carbon Black's outlook was to hit just under $250 million in annual revenue for its current fiscal year and its expected growth at about 17%.

To give a comparison, Salesforce, which also announced earnings this week, hit quarterly revenue of $4 billion and is growing at 23% in constant currency, it says.

And that's the bear-case that Eberle sees. He believes that VMware is itself seeing slowing growth in some of its most promising areas, including its networking product NSX and its storage product vSAN.

And he thinks the VMware just spent over $4 billion to buy two startups with tepid growth.

"The financial impact of both deals combined is likely to weigh on operating margins over the next few years," he dourly predicts.

So why buy Pivotal?

Michael Dell may have wanted VMware to take this struggling public company off his hands and work it into its bigger cousin.

Interestingly, Pivotal's last proxy statement filed in June doesn't even pretend that Michael Dell, his company, Dell Technologies, and VMware are separate entities.

Pivotal's most recent proxy statement says that because Dell Technologies controls these companies, and Michael Dell controls Dell Technologies, "Mr. Dell may be deemed to be the beneficial owner of all of the shares of our common stock beneficially owned by Dell Technologies."

Often when a billionaire wants one company he owns to pay a premium to buy another one he owns it's not a good sign for anyone but the billionaire.

Read: Oracle is suing Larry Ellison and Safra Catz over the $9 billion NetSuite deal, thanks to letter written by 3 Oracle board members

But this deal doesn't really shift power between VMware and its overlord Dell, nor does it shift cash into Dell's hands (as much as he needs it with $54 billion in debt on Dell's books).

VMware is paying just over half a share of itself for each Class B share that Dell owns. That will increase Dell's stake in VMware a smidge, from just under 30% to just over. But Dell already owns all of VMware's super-voting right class of shares, with 10 votes of shares, controlling 97% of VMware votes anyway.

Now, one could argue - as VMware's executives are doing - that what VMware really needs is at least some of Pivotal's technology, especially a product called Kubernetes. This is a mega-popular method of managing cloud software "containers." Containers are the preferred method for running software in the cloud.

Containers are viewed as the technology that will make VMware's 20-year-old, bread-and-butter software management tech, known as virtualization, obsolete. So VMware is sort of looking at Kubernetes like a Motorola flip phone might look at an iPhone.

VMware needs to be seen as a major containers/Kubernetes player if it's to have a future in the cloud.

"Kubernetes is driving the biggest shift in enterprise architecture since Java virtualization and cloud, and Pivotal has begun a major shift to Kubernetes," VMware Pat Gelsinger told analysts on Thursday.

On the other hand, VMware and Pivotal had collaborated to create VMware's current Kubernetes offering and they were sister companies. So one could also argue that VMware had no real compelling business to buy Pivotal instead of to continue to partner with it, if it were free to escape Dell's will.

Why buy Carbon Black?

As for Carbon Black: It makes security software that helps software run securely on any device. It has all the buzzwords: cloud, AI, advanced threat detection. VMware has been increasingly running secure software on devices, not just computer servers, ever since it bought a major mobile device security vendor called Airwatch some years back.

Just like VMware needs the next-new thing Kubernets to stay relevant in software, it needs the next new thing in cloud-based security to stay relevant in device management.

This deal was likely the brainchild of VMware's resident dealmaker Sanjay Poonen, who made his marks with the Airwatch deal and has since worked his way up to COO.

Even the bear Eberle notes that Poonen's area of VMware, known as end-user computing, has been "a bright spot" for growth at VMware.