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VMware's Success Is its Own Worst Enemy

Tickers in this article: VMW IBM RHT HPQ MSFT
NEW YORK ( TheStreet) -- As much as Wall Street seems to love virtualization giant VMware (VMW) , the stock remains priced for perfection, a point of contention for many investors. The question has always been can the company grow into its valuation and maintain the sort of momentum needed to justify its price-to-earnings ratio of 50.

With each passing quarter, VMware has replied, "yes, we can." This has been despite stiff competition from rivals such as Microsoft (MSFT) and Citrix (CTXC) .

However, during its most recent quarter, its numbers suggest that things were less clear than the usual slam dunks.

A Virtually Good Quarter, but...

For the period ending in September, VMware reported net income of $156.8 million, or 36 cents per share on revenue of $1.13 billion. On an adjusted basis, the company earned $303.4 million, or 70 cents per share when excluding stock-based compensation as well as other items. The company met revenue targets while beating EPS estimates as analysts were expecting adjusted earnings of 63 cents per share.

As expected, the company produced revenue growth of 20% -- helped by a 29% surge of services revenue, which registered at $642.6 million. Revenue from licenses climbed 11% to $491.1 million. While the pace was relatively slower, it was still impressive.

Likewise, the company did well in terms of profitability -- reporting 25% increase in operating income. But on the other hand, VMware reported an increase of 24% in operating expenses, which came in at $943 million.

The company reported an increase of 24% in sales and marketing while its R&D expenses grew by 30%. It seems these rising expenses contributed to the company's 11% year-over-year decline in net income. But should this be cause for concern? Likewise, although the company is still growing at an impressive rate, there continues to be evidence that the competition is gaining some ground -- as minute as it may be.

Where's the Growth Coming From?

I think VMware understands the challenge it is up against and realizes it has seen a stable decline in license revenue over the past several quarters. By and large, this has contributed to the central question -- can the company continue to grow into its valuations? I think this is what growth investors are looking to answer.

As a result, the company has since turned its attention to growing sales to fight off the likes of IBM (IBM) , Hewlett-Packard (HPQ) and Red Hat (RHT) . The company is willing to do this now even at the expense of near-term profits.

But will the strategy pay off? The company is willing to spend to grow, but it also needs to answer from where the growth is going to come.

VMware is the undisputed market leader in virtualization -- this much is a given. But how about the other markets in which it competes, which include desktop virtualization, servers as well as system administration tools. Investors are left to speculate how well the company can grow market share in these areas -- particularly as rivals are projecting tougher quarters ahead.