IBM and VMWare Looking Expensive

Monday, IBM (NYSE: IBM) reported better-than-expected earnings and raised its guidance for the rest of 2011. With deference to its former CEO, Lou Gerstner, his successor is proving that elephants still can dance. But a big technology company has trouble growing very fast -- perhaps you should consider VMWare (NASDAQ: VMW) instead.

IBM's earnings grew and it beat expectations. Its net income rose 7% to $3.84 billion and it reported a 15% increase in EPS to $3.28 a share -- six cents higher than expected.

Two big factors are driving IBM's growth -- emerging market demand and new products. Countries like China, India, Brazil and a few dozen other emerging nations contributed to 19% growth and now represent nearly a quarter of  IBM sales.

Customers are also buying new products from IBM such as business analytics -- a tool that let companies find the needle in the haystack of corporate data to pinpoint sales opportunities and cut operating costs.

Meanwhile VMWare -- it provides so-called virtualization software that boosts the performance of corporate data storage systems and provides a way for corporations to operate in the so-called cloud -- is growing very rapidly. Tuesday after the market closed, VMWare reported a 146% rise in net income to $178 million while adjusted EPS of 53 cents beat by three cents the Thomson Reuters analysts' earnings projection for the quarter.

VMware's 32% revenue increase to $949 million is due to two factors: rising corporate IT spending and higher revenue per customer. Recently, for example, major VMWare customers have signed more early license renewals and bought more add-on products. And VMWare is boosting guidance for the fourth quarter -- to a range between $1.03 billion and $1.06 billion -- ahead of Wall Street's expected $1.03 billion.

Does this mean that you should invest in both IBM and VMWare? I'd be reluctant to invest in either company. How so?

• IBM: growing and profitable; with pricey stock. Revenues for IBM have grown 4.3% in the last 12 months to $106 billion while net income has jumped 10.5% to $15.6 billion --- earning a substantial 14.7% net profit margin. In addition, its price/earnings to growth ratio of 1.48 (where a PEG of 1.0 is considered fairly priced) is expensive on a P/E of 15.2 and expected earnings growth of 10.3% to $14.76 in 2012.
• VMWare: rapid growth, profitable; but expensive stock. VMWare 's revenues are up 41% in the last 12 months to $3.5 billion while net income jumped 81% to $643 million --- yielding a net profit margin of 18.4%. Its PEG is a pricey 1.92 on a P/E of 46 and expected earnings growth of 24% to $1.79 in 2012.

If forced to choose one of these stocks, I'd go with VMWare because based on its recent performance -- e.g., 81% earnings growth, there is a some chance that its 2012 earnings growth forecast could prove to be way too low. If VMWare keeps growing at that rate, its P/E will look low to investors.

IBM, on the other hand, is highly unlikely to be able to sustain earnings growth faster than the 15% that would be required to make its stock look reasonably priced. IBM's financial performance is impressive given its size.

Despite this, investors have driven up IBM 35% in the last year to VMWare's 18%. Thus a decision on whether to invest in either company depends more on what happens in the future than on what they've done in the past.