Will these virtualization stocks soar in 2013?

London, Jan 17: Richard is a member of The Motley Fool Blog Network -- entries represent the personal opinions of our bloggers and are not formally edited.

Complaining about expensive valuations in the tech sector is like being irritated because water is wet. Tech stocks carrying high expectations have become the “new normal.”

This is especially true among companies having anything to do with the cloud that also specializes in desktop virtualization. Admittedly, as a value investor I’ve missed out on some of these opportunities – shares were just too rich for me. For more aggressive investors however, these three names should do very well in 2013.

Citrix operates a sound business in an industry that seems to be in transition. Although the company is doing well now, investors are beginning to worry on the long term viability of the virtualization business. The good news is that the company has an excellent management team – one that figured out a way to make the best out of a tough spending environment in its second quarter.

Citrix posted net income of $92 million or 49 cents per share, which includes approximately $22 million related to the closing of audits with the IRS of previous tax years. Excluding this cost, the company exceeded last year’s EPS mark of 43 cents. Too, revenues of $615 topped the $531 million Citrix logged a year ago.

There’s a big “but” here however. The company has to do better than just 16% revenue growth for a stock sporting a P/E of close to 40. On the other hand despite an abysmal enterprise climate, the company was able to muster 7% growth in desktop licenses. Overall, Citrix’s earnings weren’t that bad relative to expectations.

Enterprise spending in 2013 is expected to be much improved. Citrix’s strong management team and solid enterprise presence should be able to get the company back on track to 20+ percent growth rate that investors expect. Also, the company rewarded investors with almost $400 million worth of stock buybacks. Clearly Citrix sees the value in its business and so should investors. On this basis, a $75 target by the summer is easily attainable.

VMware has become the standard in the realm of virtualization. Despite its meaningful lead in the market, the company constantly has to prove that it’s worthy of its valuation. Although growth has not been a problem, VMware has seen declines in license revenue over the past several quarters. This was also a concern in its most recent quarter, during which revenue surged 20%.

In the quarter, VMware posted net income of $156.8 million, or 36 cents per share on revenues of $1.13 billion. On an adjusted basis, the company earned $303.4 million, or 70 cents per share when excluding stock-based compensation – beating estimates of 63 cents per share. Services revenue was the standout performer, jumping almost 30% and reaching $643 million.

VMware outperformed Citrix by 4% in license revenue, which increased 11% to $491 million. Then again, profitability was mixed. Although I was impressed by the 25% increase in operating income, it was offset by 24% jump in operating expenses, including 30% increase in R&D. This can be looked upon a couple of ways: the company knows that it is growing well. But it will spare no expense to maintain its lead.

In the meantime, the stock remains an excellent investment. The company’s strong cash position and solid balance sheet coupled with a first-rate management team makes VMware one of the toughest names to bet against. Investors should expect shares to reach $105, which would represent 12% premium from current levels.

Although concerns about competitive threats remain, Red Hat insists on becoming a player in the virtualization market by dropping $100 million in cash in an acquisition deal for virtualization and cloud management company ManageIQ. In other words, Red Hat has looked VMware and Citrix in the face and said “bring it.”

Likewise, in its Q3 results which ended November 30th, the company also spoke with its execution. Red Hat posted revenues of $343.6 million – representing a year-over-year increase of 18% and 21% in constant currency. Also impressive were subscription revenue, which registered at $294.2 million - surging 19% year-over-year.

This was encouraging since Red Hat absorbed criticism for its weakness in this area. This also means that the company is outperforming both Citrix and VMware in this category. The main issue continues to be profitability. Operating income registered at $49.9 million, down 7% year-over-year.

Management said this was due to (among other things) costs related to acquisitions and stock-based compensation. On a non-GAAP basis, operating income arrived at $82.5 million – representing a 5% year-over-year increase.

Cash flow was also impressive – coming at $100.2 million, an improvement of 3.7% year-over-year with total deferred revenues increasing 21%.  If there was “red flag” in Red Hat’s report it was the 3% dip in operating margin. This suggests that the company is experience some pricing pressure. And as it stands, Red Hat does not have the sort of leverage needed to fight off the competition.

Meanwhile, both VMware and Citrix have been growing revenues and margins each quarter. The good news is that growth remains impressive – enough to afford investors the required patience as management shores up that part of the operation. On this basis, I expect the stock to appreciate, but I’m not as bullish absent clear signs of sustained profitability. $60 per share is very likely.

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