VMware: The Start Of Something Big In Virtualization?

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Includes: BEAS, DVMT
by: SoundView Technology Group

A couple of years after co-managing the IONA (IONA) IPO in 1997, one of the company founders, Annrai O’Toole, tipped us off that a little company called VMware had some “wicked cool” technology we should pay attention to. We were in the running to be a co-manager for its original planned IPO, no doubt proposing some valuation in excess of $1B.

After the market collapse the company was acquired by EMC (EMC) in early 2004 for $635M. So where do things stand now? VMware is again on track for its IPO of sorts. Is this the start of something big, or is virtualization and VMware locked in a technical/engineering niche?

By nature VMware started out as a tool for development and testing and is now moving into a much broader market thanks to the seduction of server consolidation. The real question is whether virtualization will shift the center of gravity from physical servers to the “cloud” of computing resources. Most investors want to find the “next BEA” (BEAS) in the infrastructure software space. BEA was indeed a spectacular growth story but it too was based on technology that was many years in germination.

When distributed transactions hit the mainstream, BEA was there. As transactions expanded into JAVA application servers, BEA shifted too. But the underlying technology had been around for a long time, in some cases 20 years, before being broadly adopted. And even BEA stalled out at $1B in revenues. So, is virtualization set to push a company like VMware into a sustained growth market above $1B in revenues? Thanks to the recent S1 filing we can all see that:

  • VMware reached $704M in revenues for 2006.
  • Its growth trajectory suggests revenue estimates just above $1B for this calendar year.
  • Operating expenses grew rapidly last year, up 100% vs. the 80% revenue increase.
  • Using some simple back of the envelope figures we’re guessing the stock will trade off of a 50c earnings number and could enjoy a 40x P/E multiple. That means a $20 stock drives a $6.6B market capitalization, and if that scenario plays out EMC will have a nice 10x return on investment over just three years. Still, investors should be concerned over what their equity stake is really buying.

    Dennis Byron posted an analysis that clearly shows the equity being offered is less than meets the eye. Furthermore, there remains an open question as to how bundling of virtualization functions by the major OS vendors, including Red Hat (NYSE:RHT) and Microsoft (NASDAQ:MSFT), will impact VMware.

    For now VMware clearly leads the market, and it’s interesting to note that searching job postings using “virtualization” turns up 2,800 openings vs. a search using “VMware” which yields 4,600. The results for VMware are also growing faster. The major question to answer for investors will be whether VMware can execute well enough to create a new fundamental category of infrastructure software as BEA did, or whether it will be stuck in a promising but smaller market segment. So far there isn’t much evidence to support the former, but the possibility is clearly there.

    Lastly the CEO of the company, Diane Greene, has yet to be tested as the leader of a large public company. BEA certainly benefited from the leadership of Bill Coleman, along with his other co-founders Alfred Chuang and Ed Scott. Scaling up and running a $1B+ software company is no easy job. Fortunately for Ms. Greene, she’s right next to one of the best sales and distribution infrastructures on the planet, and EMC can certainly help VMware in that department. Taken all together, we’re not sure how much investors will focus on the undesirable structure of the deal vs. the exciting opportunity offered by a rare, rapidly growing, large infrastructure software company.