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VMware: Good product, uncertain times

The virtualization leader helps company save money. But in a recession, will companies spend money to save money?

By Jessica Shambora, reporter
Last Updated: January 20, 2009: 3:42 PM ET

NEW YORK (Fortune) -- VMware hopes virtualization becomes a reality for corporate America in 2009.

It has good reason to be hopeful: As businesses look to cut costs (and maybe do something nice for the planet in the process), virtualization - the idea of using a single server to run many operating systems and applications - would seem like a no-brainer to implement. As the leading purveyor of virtualization software and systems, Palo Alto-based VMware certainly would be poised to profit. And just this week, router giant (and VMware investor) Cisco Systems (CSCO, Fortune 500) said it would enter the $50 billion server market, and Cisco reportedly will bundle VMware's virtualization software on its new machines.

But the same economic conditions that are buffeting potential customers also affect VMware: It can't be certain that clients will have the cash to spend on virtualization, no matter how good it might be for their balance sheets in the long run. The company also faces fresh competition from the likes of Microsoft and Oracle, and an increasingly skeptical analyst community. And employees are recovering from the ouster last year of VMware's founding CEO.

In other words, uncertainty abounds.

If the non-tech community knows VMware (VMW) at all it is because of the company's hugely successful initial public offering in August 2007. The company raised more than $1 billion and achieved the highest valuation since Google went public in 2004. Its product isn't sexy -- it sells mostly to corporate customers that operate big data centers- but it quickly attracted a raft of competitors, including Ft. Lauderdale-based Citrix (CTXS) and Sun Microsystems (JAVA, Fortune 500). Still, VMware has managed to hold on to 85% market share.

Then Microsoft showed up last year, offering virtualization software for free.

Redmond-based Microsoft has succeeded - in forcing VMware to lower prices. Enterprise companies seem to still be choosing VMware over Microsoft, but they are asking for discounts.

VMware says it will invest heavily in research and development to ensure that it maintains a strong lead. But investors already are concerned about Microsoft's impact on VMware's results. UBS analyst Heather Bellini recently dropped her rating on VMware from neutral to sell. Last January, just three months after it reached a high of $125, VMware stock plunged 34% due to a disappointing fourth quarter and 2008 revenue forecast (50% growth versus 88% in 2007). The stock continued sliding to its current price of $25 - a 69% drop over the year.

Now VMware is predicting a decline in first-quarter 2009 revenues due to what CFO Mark Peek calls the "business starting to follow traditional seasonal patterns."

"Whenever a company says that, that's a sign of maturity," says Bellini. "It's not the macro [environment] so much that's impacting them." VMware has already grabbed all the low hanging fruit, she says.

All this is happening as VMware's 6,300 employees are still reeling from the loss of former CEO Diane Greene who founded the firm with engineer husband Mendel Rosenblum in 1998. Last July Joe Tucci, CEO of VMware parent company EMC (it owns more than 85% of VMware) replaced Greene with Paul Maritz, an EMC executive. Rosenblum and two senior R&D executives later resigned.

Investors and tech insiders concede that Greene's successor, Paul Maritz, is a strong candidate to lead VMware as it transforms from overgrown startup to Valley fixture. He's been talking up hot technologies like cloud computing and desktop virtualization.

He also has a key advantage as he goes out to talk to potential partners and customers: There's definitely demand for what VMware is selling.

Virtualization has been around since the 1960s when IBM first used it to partition mainframe computers. Since then, the computing power of servers has grown exponentially, while the power required by the application running on the server has not. This resulted in machines running at as little as 10% capacity, sucking up enough energy to run at the max. Virtualization puts that energy and processing power to work. According to VMware, within six to nine months, customers will save at least 50% on hardware and operating costs and 80% on energy.

For a company like Nationwide Auto Insurance, which has virtualized 1500 of its 5000 servers over the last three years, that's a savings of $3 million. The company plans to virtualize another batch this year to save an additional $1.4 million over 2010 and 2011. "The project will pay for itself this year," say Scott Miggo, VP of infrastructure engineering for Nationwide.

With numbers like these, it's no surprise that 97% of Fortune 500 companies are VMware clients And there's still room for VMware to grow: A recent survey from research firm Yankee Group showed the average enterprise running less than 30% of its servers as virtual machines. As companies look for ways to cut costs in 2009 that should number rise. IDC predicts the $6 billion industry to nearly double over the next four years.

Whether companies make that investment in 2009 remains very much to be seen. Investors looking for a little clarity into VMware's uncertain outlook may get their first clues about VMware's future on January 26 when the company reports year-end earnings. To top of page

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