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VMW > SEC Filings for VMW > Form 10-Q on 3-Nov-2011All Recent SEC Filings

Show all filings for VMWARE, INC.

Form 10-Q for VMWARE, INC.


3-Nov-2011

Quarterly Report


ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

All dollar amounts expressed as numbers in this MD&A (except share and per share amounts) are in millions.

Overview

Our primary source of revenues is the licensing of virtualization and cloud infrastructure solutions and related support and services for use by businesses and organizations of all sizes and across numerous industries in their information technology ("IT") infrastructure. Our virtualization solutions reflect a pioneering approach to computing that separates application software from the underlying hardware to achieve significant improvements in efficiency, agility, availability, flexibility and manageability. Our broad and proven suite of virtualization solutions addresses a range of complex IT problems that include cost and operational inefficiencies, facilitating access to "cloud computing" capacity, business continuity, software lifecycle management and corporate end-user computing device management. Our solutions run on industry-standard servers and desktop computers and support a wide range of operating system and application environments, as well as networking and storage infrastructures. Our solutions enable organizations to aggregate multiple servers, storage infrastructure and networks together into shared pools of capacity that can be allocated dynamically, securely and reliably to applications as needed, increasing hardware utilization and reducing spending. The benefits to our customers include substantially lower IT costs, cost-effective high availability across a wide range of applications, and a more automated and resilient systems infrastructure capable of responding dynamically to variable business demands. With our platform, VMware vSphere, we are helping companies along the path of cloud computing by providing compatible IT infrastructures for both businesses and cloud service providers.

Although we believe we are currently the leading provider of virtualization infrastructure software solutions, we face competitive threats to our leadership position from a number of companies, some of which have significantly greater resources than we do, which could result in increased pressure to reduce prices on our offerings. As a result, we believe it is important to continue to invest in strategic initiatives related to product research and development, market expansion and associated support functions to expand our industry leadership. We believe that we will be able to continue to meet our product development objectives through continued investment in our existing infrastructure, supplemented with strategic hires and acquisitions, funded through the operating cash flows generated from the sale of our products and services. We believe this is the appropriate priority for the long-term health and growth of our business.

Our current financial focus is on long-term revenue growth to generate free cash flows1 to fund our expansion of industry segment share and to evolve our virtualization-based products for data centers, desktop computers and cloud computing through a combination of internal development and acquisitions. We expect to grow our business by broadening our virtualization infrastructure software solutions technology and product portfolio, increasing product awareness, promoting the adoption of virtualization and building long-term relationships with our customers through the adoption of enterprise license agreements ("ELAs"). Since the introduction of VMware vSphere and VMware View 4 in 2009, we have introduced more products that build on the vSphere foundation, including in the third quarter of 2011, VMware vSphere 5 and a comprehensive suite of cloud infrastructure technologies, as well as VMware View 5. We plan to continue to introduce additional products in the future. Additionally, we have made, and expect to continue to make, acquisitions designed to strengthen our product offerings and/or extend our strategy to deliver solutions that can be hosted at customer data centers or at service providers.

In evaluating our results, we also focus on operating margin excluding certain expenses which are included in our total operating expenses calculated in accordance with GAAP. The expenses excluded are stock-based compensation, the net effect of the amortization and capitalization of software development costs and certain other expenses consisting of employer payroll taxes on employee stock transactions, amortization of intangible assets and acquisition-related items. We believe this measure reflects our ongoing business in a manner that allows meaningful period-to-period comparisons. We are not currently focused on short-term operating margin expansion, but rather on investing at appropriate rates to support our growth and future product offerings in what may be a substantially more competitive environment.

As a consequence of the timing differences in the recognition of license revenues and software maintenance revenues, variability in operating margin can result from differences in when we quote and contract for our services and when the cost is incurred. Variability in operating margin can also result when we recognize previously unearned foreign denominated software maintenance and license revenues in future periods. Due to our use of the U.S. Dollar as our functional currency, unearned revenue remains at its historical rate when recognized into revenue while our operating expenses in future periods are based upon the foreign exchange rates at that time.

1 Free cash flows, a non-GAAP financial measure, is defined as net cash provided by operating activities plus the excess tax benefits from stock-based compensation, less capital expenditures and capitalized software development costs. Each adjusting item is separately presented on our consolidated statements of cash flows. See "Non-GAAP Financial Measures" for further information.


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We have developed a multi-channel distribution model to expand our global presence and to reach various segments of the industry. In the third quarter and first nine months of 2011, we derived over 85% of our sales from our channel partners, which include distributors, resellers, system vendors and systems integrators. Sales to our channel partners often involve three tiers of distribution: a distributor, a reseller and an end-user customer. Our sales force works collaboratively with our channel partners to introduce them to customers and new sales opportunities. As we expand geographically, we expect to continue to add additional channel partners. The remainder of our sales is primarily derived from purchases made directly by end-user customers.

Our customers continue to adopt our product platform as a strategic investment that improves efficiency and flexibility for their business and enables substantial cost savings. While the overall macroeconomic environment had shown improvement since early 2010, growing uncertainty in global macroeconomic conditions may impact IT spending and demand for our products and services in 2012. We expect to continue to manage our resources prudently, while making key investments in support of our long-term growth objectives.

Income Statement Presentation

As we operate our business in one operating segment, our revenues and operating expenses are presented and discussed at the consolidated level.

Sources of Revenues

License revenues

Our license revenues consist of revenues earned from the licensing of our software products. These products are generally licensed on a perpetual basis. Pricing models have generally been based upon the physical infrastructure, such as the number of physical desktop computers or server processors, on which our software runs. License revenues are recognized when the elements of revenue recognition for the licensed software are complete, generally upon electronic shipment of the software. The revenues allocated to the software license included in multiple-element contracts represent the residual amount of the contract after the fair value of the other elements has been determined. Certain products are licensed on a subscription basis.

We have recently begun to base pricing for some of our products on virtual, rather than purely physical, entitlements, while continuing to license such products on a perpetual basis. We believe that this new pricing model better aligns with the shift to virtual and cloud-based IT environments by enabling customers to align cost with actual use and value derived, rather than purely with hardware configurations and capacity. Effective in September 2010, we began pricing certain of our management solutions on a per-virtual-machine basis. In the third quarter of 2011, we revised the pricing model for VMware vSphere 5 effective with its general availability. VMware vSphere 5 will continue to be licensed perpetually on a per processor basis. However, two physical constraints, core and physical RAM, will be eliminated and replaced with a single virtualization-based entitlement of virtual memory, or vRAM, which can be shared across a large pool of servers.

Software maintenance revenues

Software maintenance revenues are recognized ratably over the contract period. Our contract periods typically range from one to five years and include renewals of software maintenance sold after the initial software maintenance period expires. Vendor-specific objective evidence ("VSOE") of fair value for software maintenance services is established by the rates charged in stand-alone sales of software maintenance contracts or the stated renewal rate for software maintenance included in the license agreement. Customers receive various types of technical support based on the level of support purchased. Customers who are party to software maintenance agreements with us are entitled to receive product updates and upgrades on a when-and-if-available basis.

Professional services revenues

Professional services include design, implementation and training. Professional services are not considered essential to the functionality of our products, as these services do not alter the product capabilities and may be performed by our customers or by other vendors. Professional services engagements performed for a fixed fee, for which we are able to make reasonably dependable estimates of progress toward completion, are recognized on a proportional performance basis based on hours incurred and estimated hours of completion. Professional services engagements that are on a time and materials basis are recognized based on hours incurred. Revenues on all other professional services engagements are recognized upon completion. Our professional services may be sold with software products or on a stand-alone basis. VSOE of fair value for professional services is based upon the standard rates we charge for such services when sold separately.

Operating Expenses

Cost of license revenues

Our cost of license revenues principally consists of the amortization of capitalized software development costs and of intangibles, as well as royalty costs in connection with technology licensed from third-party providers and the cost of fulfillment of our software. The cost of fulfillment of our software includes product packaging, personnel costs and related overhead associated with the physical and electronic delivery of our software products.


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Cost of services revenues

Our cost of services revenues includes the costs of personnel and related overhead to deliver technical support for our products and to provide our professional services.

Research and development expenses

Our research and development ("R&D") expenses include the personnel and related overhead associated with the R&D of new product offerings and the enhancement of our existing software offerings, net of amounts capitalized.

Sales and marketing expenses

Our sales and marketing expenses include personnel costs, sales commissions and related overhead associated with the sale and marketing of our license and services offerings, as well as the cost of product launches and certain marketing initiatives, including our annual VMworld conferences in the U.S. and Europe. Sales commissions are generally earned and expensed when a firm order is received from the customer and may be expensed in a period different than the period in which the related revenue is recognized.

General and administrative expenses

Our general and administrative expenses include personnel and related overhead costs to support the overall business. These expenses include the costs associated with our facilities, finance, human resources, IT infrastructure and legal departments, as well as expenses related to corporate costs and initiatives.

Results of Operations

Revenues

Our revenues in the third quarter and first nine months of 2011 and 2010 were as
follows:



                                      For the Three Months Ended                            For the Nine Months  Ended
                                             September 30,                                         September 30,
                                       2011                2010           % Change             2011               2010         % Change
Revenues:
License                            $       443.6       $       343.2            29  %     $      1,327.4       $    979.1            36  %
Services:
Software maintenance                       426.8               314.1             36              1,176.9            871.8             35
Professional services                       71.5                56.9             26                202.5            170.8             19

Total services                             498.3               371.0             34              1,379.4          1,042.6             32

                                   $       941.9       $       714.2             32       $      2,706.8       $  2,021.7             34

Revenues:
United States                      $       443.4       $       362.3            22  %     $      1,293.3       $  1,013.3            28  %
International                              498.5               351.9             42              1,413.5          1,008.4             40

                                   $       941.9       $       714.2             32       $      2,706.8       $  2,021.7             34

Total revenues increased by $227.6 or 32% to $941.9 in the third quarter of 2011 from $714.2 in the third quarter of 2010. Total revenues increased by $685.1 or 34% to $2,706.8 in the first nine months of 2011 from $2,021.7 in the first nine months of 2010. The revenue mix in the third quarter and first nine months of 2011 reflected increases in both license revenues and services revenues as compared with the third quarter and first nine months of 2010.

License Revenues

Software license revenues increased by $100.4 or 29% to $443.6 in the third quarter of 2011 from $343.2 in the third quarter of 2010. Software license revenues increased by $348.3 or 36% to $1,327.4 in the first nine months of 2011 from $979.1 in the first nine months of 2010. License revenues increased in the third quarter and first nine months of 2011 primarily due to strong global demand for vSphere.


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In the third quarter and first nine months of 2011, we observed an increase in the volume of our ELAs as compared with the respective periods in 2010 due to growing customer interest, as well as strong renewals from existing ELA customers. We have promoted the adoption of virtualization and built long-term relationships with our customers through the adoption of ELAs. ELAs continue to be an important component of our revenue growth and are offered both directly by us and through certain channel partners. ELAs are a core component of our strategy to build long-term relationships with customers as they commit to our virtualization infrastructure software solutions in their data centers. ELAs provide a base from which to sell additional products, such as our application platform products, our end-user computing products, and virtualization and cloud management products. Under a typical ELA, a portion of the revenues is attributed to the license and recognized immediately and the remainder is deferred and primarily recognized as software maintenance revenues in future periods. In addition, ELAs typically include an initial maintenance period that is longer than other types of license sales.

Services Revenues

Services revenues increased by $127.3 or 34% to $498.3 in the third quarter of September 30, 2011 from $371.0 in the third quarter of 2010. Services revenues increased by $336.8 or 32% to $1,379.4 in the first nine months of 2011 from $1,042.6 in the first nine months of 2010. The increase in services revenues during the third quarter and first nine months of 2011 was primarily attributable to growth in our software maintenance revenues.

Software maintenance revenues increased by $112.6 or 36% to $426.8 in the third quarter of 2011 from $314.1 in the third quarter of 2010. Software maintenance revenues increased by $305.1 or 35% to $1,176.9 in the first nine months of 2011 from $871.8 in the first nine months of 2010. In the third quarter and first nine months of 2011, software maintenance revenues benefited from strong renewals, multi-year software maintenance contracts sold in previous periods, and additional maintenance contracts sold in conjunction with new software license sales. In the third quarter and first nine months of 2011, customers continued to buy, on average, more than 24 months of support and maintenance with each new license purchased, which we believe illustrates our customers' commitment to VMware as a core element of their data center architecture and hybrid cloud strategy.

Professional services revenues increased by $14.6 or 26% to $71.5 in the third quarter of 2011 from $56.9 in the third quarter of 2010. Professional services revenues increased by $31.7 or 19% to $202.5 in the first nine months of 2011 from $170.8 in the first nine months of 2010. Professional services revenues increased as growth in our license sales and installed-base led to additional demand for our professional services, including consulting and customer training. As we continue to invest in our partners and expand our eco-system of third-party professionals with expertise in our solutions to independently provide professional services to our customers, we do not expect our professional services revenues to constitute an increasing component of our revenue mix. As a result of this strategy, our professional services revenue can vary based on the delivery channels used in any given period as well as the timing of engagements.

Revenue Growth in Constant Currency

We have invoiced and collected in the Euro, the British Pound, the Japanese Yen, and the Australian Dollar in their respective regions since May 2009. As a result, our total revenues are affected by changes in the value of the U.S. Dollar against these currencies. In order to provide a comparable framework for assessing how our business performed excluding the effect of foreign currency fluctuations, management analyzes year-over-year revenue growth on a constant currency basis. Since all of our entities operate with the U.S. Dollar as their functional currency, unearned revenues for orders booked in currencies other than U.S. Dollars are converted into U.S. Dollars at the exchange rate in effect for the month in which each order is booked. We calculate constant currency on license revenues recognized during the current period that were originally booked in currencies other than U.S. Dollars by comparing the exchange rates at which the revenue was recognized against the exchange rate that was used in the comparable period. We do not calculate constant currency on services revenues, which include software maintenance revenues and professional services revenues.

In the third quarter of 2011, the year-over-year growth in license revenues measured on a constant currency basis was 25% compared with 29% as reported, and was 34% compared with 36% as reported year-over-year in the first nine months of 2011. The year-over-year growth in total revenues in the third quarter of 2011 measured on a constant currency basis was 30% compared with 32% as reported, and was 33% compared with 34% as reported year-over-year in the first nine months of 2011.

Unearned Revenues

Our unearned revenues as of September 30, 2011 and December 31, 2010 were as
follows:



                                                September 30,       December 31,
                                                    2011                2010
     Unearned license revenues                 $         269.6     $        267.1
     Unearned software maintenance revenues            1,804.6            1,461.3
     Unearned professional services revenues             159.9              131.7

     Total unearned revenues                   $       2,234.1     $      1,860.1


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The complexity of our unearned revenues has increased over time as a result of acquisitions, an expanded product portfolio and a broader range of pricing and packaging alternatives. As of September 30, 2011, total unearned revenues increased by $374.0 or 20% to $2,234.1 from $1,860.1 at December 31, 2010. This increase was primarily due to growth in unearned software maintenance revenues, attributable to our growing base of maintenance contracts. Unearned software maintenance revenues are recognized ratably over terms from one to five years with a weighted-average remaining term at September 30, 2011 of approximately 1.8 years. Unearned license revenues are recognized either ratably or upon the delivery of existing products, future products or services. Future products include, in some cases, emerging products that are offered as part of product promotions where the purchaser of an existing product is entitled to receive a promotional product at no additional charge. We regularly offer product promotions, generally as a strategy to build awareness of our emerging products. To the extent promotional products have not been delivered and VSOE of fair value cannot be established, the revenue for the entire order is deferred until such time as all product delivery obligations have been fulfilled. Unearned professional services revenues result primarily from prepaid professional services, including training, and are recognized as the services are delivered. We believe our overall unearned revenue balance improves predictability of future revenues and that it is a key indicator of the health and growth of our business.

Operating Expenses

Information about our operating expenses in the third quarter and first nine
months of 2011 and 2010 is as follows:



                                                      For the Three Months Ended September 30, 2011
                                                          Stock-         Capitalized
                                       Core               Based           Software                              Total
                                    Operating            Compen-         Development           Other          Operating
                                  Expenses  (1)           sation         Costs, net           Expenses         Expenses
Cost of license revenues         $           18.5        $    0.4       $        14.4        $     12.8       $     46.1
Cost of services revenues                    99.0             6.1                  -                1.6            106.7
Research and development                    170.9            46.7               (21.1 )             3.2            199.7
Sales and marketing                         302.6            24.8                  -                4.2            331.6
General and administrative                   65.4            10.4                  -                1.2             77.0

Total operating expenses         $          656.4        $   88.4       $        (6.7 )      $     23.0       $    761.1

Operating income                                                                                              $    180.7
Operating margin                                                                                                    19.2 %

                                                      For the Three Months Ended September 30, 2010
                                                          Stock-         Capitalized
                                       Core               Based           Software                              Total
                                    Operating            Compen-         Development           Other          Operating
                                   Expenses (1)           sation         Costs, net           Expenses         Expenses
Cost of license revenues         $           13.1        $    0.4       $        26.1        $      6.7       $     46.3
Cost of services revenues                    74.0             4.4                  -                1.8             80.2
Research and development                    135.6            43.1                (7.0 )             3.7            175.4
Sales and marketing                         230.5            18.1                  -                3.1            251.7
General and administrative                   57.0             7.7                  -                1.9             66.6

Total operating expenses         $          510.2        $   73.7       $        19.1        $     17.2       $    620.2

Operating income                                                                                              $     94.0
Operating margin                                                                                                    13.2 %

                                                      For the Nine Months Ended September 30, 2011
                                                          Stock-         Capitalized
                                       Core               Based           Software                              Total
                                    Operating            Compen-         Development           Other          Operating
                                   Expenses (1)           sation         Costs, net           Expenses         Expenses
Cost of license revenues         $           54.1        $    1.2       $        62.7        $     33.0       $    151.0
Cost of services revenues                   281.8            17.4                  -                4.9            304.1
Research and development                    486.8           134.6               (74.0 )            10.7            558.1
Sales and marketing                         866.5            70.6                  -               12.0            949.1
General and administrative                  189.3            30.6                  -                3.5            223.4

Total operating expenses         $        1,878.5        $  254.4       $       (11.3 )      $     64.1       $  2,185.7

Operating income                                                                                              $    521.1
Operating margin                                                                                                    19.3 %


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                                                       For the Nine Months Ended September 30, 2010
                                                          Stock-         Capitalized
. . .
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