4 Reasons for VMware Not to Fear Microsoft

Harsha Reddy writes...

"The competition will be intense. Microsoft (MSFT) will make virtualization a feature in their upcoming Longhorn server operating system [OS]. Microsoft's share of server OS is also steadily increasing, >60%. VMWare (VMW) leads this space, but the lead is less than a year, in my opinion."

It seems I have a different perception re competition, both in general and specifically re Microsoft. To wit...

1) I consider competition to be good. Healthy competition generates imagination, creativity, and innovation. Consumers benefit from better products at less expensive prices. Of course, and as we each note, the perception by investors of potential shriveling profit margins and thus a possible declining share price is a legitimate concern. Nonetheless, I cling to the notion that Microsoft's entry into the virtualization space will improve VMWare's products. Whether VMWare proves successful at branding its product remains an unknown. Should this come to be, the company's success will endure for more than a mere season or two.

2) Microsoft is a tough competitor, but it is not, nor will it be, the sole competitor in virtualization. It might not even rank as the key competitor.

3) When VMWare's founders discussed the notion 10 years ago of creating the company and its products, do you think they failed to discuss that competition would arise as a direct result of their success? The more successful the company's virtualization products, the more competition the company would self-create. I suggest the company's founders considered in advance the probable competition, and how the company would respond.

4) I believe Microsoft stretches itself kinda sorta thinly these days:
• Its continuing battle for desktop supremacy;
• Its battle with Google (GOOG) in online search (advertising);
• Its battle with Apple's (AAPL) iPod (its Zune MP3 player);
• Its battle in gaming software (its xBox vs Nintendo's (NTDOY.PK) phenomenally successful Wii, et al);
• Its battle with Cisco (CSCO) for network applications, as Pat Trolan shared ('tis odd, I believe, that Microsoft claims these applications need not be network applications, but they claim the opposite re its virtualization product, as you note, Harsha).

How many things can one company do especially well? And how good is any one of the company's 'solutions' when the company has no consistent corporate raison d’etre? Microsoft runs the peril of confusing itself more than being a confident competitor. It lumbers now, as it always has, with its me-too products.

Should VMWare investors fear Microsoft's virtualization product? Perhaps, as caution always is a good thing. I suspect, however, that >Microsoft's product will come late, will not offer the the same quantity and quality of solutions that VMWare's products deliver, and will not be an organic, customer-driven solution to a pressing need, but instead a company-driven solution to corner yet another market. Or at least attempt to do so.

In any great (enduring) growth story, competition helped each company to innovate continually, to focus on the customer, and sometimes even lowered the price for the company's product in a beneficial form of price deflation (especially true in technology). And the company's share price rose, and rose, and rose some more. The share price rise was sometimes due to the company's success, and sometimes because the company was purchased... by its competition. Hmmm.

Consider, for example, Chipotle Mexican Grill (CMG)...
• The company competes in the restaurant segment of the economy, in which there are many, many competitors;
• Its segment is, specifically, fast food restaurants, in which there, too, are many, many competitors, many of whom are better-financed, or have deeper pockets.
Among fast food restaurants, its precise space is Mexican food; in particular, burritos. Here, too, are many, many tough competitors.

Guess what? Despite the competition, the company quickly rises to the fore, to become the creme de la creme.

Is a similar future possible for VMWare...? Only time will tell, but I like the odds.

Comments

[ashb]

David,

Sure, no one is writing off VMWare yet. Most people agree that it will continue to be the leader of the pack in the virtualization space for at least a few years.

That said, I am not sure if it is a good buy at the current price ($80.5 on Jan 4, 2008), even though it has fallen close to 35% from its peak. Its traling 12-month P/E is about a 100, and it is hard to argue that there is a lot of upside left. Not many companies with $30 billion market-caps go for those P/Es (and sustain them over 2-3 years).

Consider this: The most optimistic estimates have VMWare growing earnings at about 70% in FY08, and 50% in FY09. At a stock price of $100, VMWare in Jan-2010 will be commanding a P/E of 50, when presumably the competition would have gotten at least some of their game together.

My gut says that 50 P/E is about the limit that VMWare will hit over the next 2-3 years. Unless, of course, they can continue to grow 70% a few years into the future, which I strongly doubt.