The next big Silicon Valley IPO

(Fortune Magazine) -- As soon as this summer, a Silicon Valley company called VMware will offer shares to the public for the first time in what could be the biggest and buzziest IPO in the hotbed of technology since Google went public in 2004.

The 3,000-person outfit is easily the fastest-growing software maker in the rarefied billion-dollar-plus sales category. Its IPO is already the subject of intense anticipation among professional investors. And yet, despite its catchy name (lighten up - that's a joke!), almost no one outside of tech circles has ever heard of VMware.

The company, based in Palo Alto, is relatively unknown for two reasons. First, it sells an arcane but increasingly in-demand product called virtualization software, a business application few consumers would ever use. The letters "VM" in the company's name stand for virtual machine, and the software allows corporate IT departments to meld various underutilized server computers by running the same programs virtually on each of them.

VMware also flies under the radar because for the past three years it's been hidden inside EMC (Charts, Fortune 500) the $33-billion-market-cap storage computer maker located outside Boston.

Until recently EMC's stock had been stuck for years between $11 and $14 despite the runaway success of VMware, which EMC bought at the beginning of 2004 for $635 million. By carving out a 10 percent stake of VMware that analysts believe will be worth more than $1 billion, EMC is hoping to get its own stock moving again.

The first question is whether to buy VMware. The answer, unless things get totally out of hand when the company prices its IPO, almost certainly is yes. VMware is a formidable company. It boosted revenue last year by 82 percent, to $704 million, and it's on track to hit $1.2 billion this year. And in the same way Google (Charts, Fortune 500) was remarkable for combining supercharged growth with solid profits, VMware has a healthy bottom line as well. Operating income hit $120 million last year, and that's only half the story.

"They're not only extremely profitable, but the cash generation is phenomenal, and it was even before EMC bought them," says Michael Kwatinetz, a partner with Azure Capital, the only VC firm to invest in VMware before its sale to EMC. Indeed, VMware generated $280 million in cash last year, a whopping 40 percent of revenue. (Cash flow exceeds profits because VMware gets paid upfront but recognizes the revenue over the course of a contract.)

Perhaps the biggest danger to investing in VMware's IPO is the exuberance of the institutional investors who get the first shot at it. (Six investment banks, an unusually large number, are leading the offering.) Toni Sacconaghi, an analyst who follows EMC for Bernstein Research, reckons that a $10 billion valuation for VMware won't be unreasonable given its growth rate and the valuations of similarly torrid companies like Salesforce.com (Charts), Akamai (Charts) and Check Point (Charts). A group of ten such companies trades for an average of eight times their estimated coming-year sales, says Sacconaghi, a level that would get VMware to $10 billion.

He's even penciled out a share price, $27, based on that valuation and his guesstimate of the number of shares VMware will offer. A price significantly below $27 could be an opportunity; anything far higher might suggest frothiness. Pricing won't be known for several weeks, as VMware waits for the Securities and Exchange Commission to bless its filings.

So what about EMC itself? In short, the older company that made a brilliant acquisition now threatens to be overshadowed by its own protégé. If VMware is truly worth $10 billion, then EMC's valuation - minus its VMware stake - is only about twice as big; that's stunning considering that VMware accounted for 6 percent of EMC's revenue and 9 percent of its operating profits in 2006. Still, you won't hear EMC complaining. (You won't hear anything, actually, from EMC or VMware in this article. The companies declined to comment, citing securities-law restrictions around IPOs.)

Calling attention to VMware as a hidden jewel is precisely what EMC was hoping to accomplish, and it has said it has no intention of selling off additional shares in VMware anytime soon. "Our contention has been for some time that once people homed in on VMware, they'd see that EMC is undervalued," says Goldman Sachs analyst Laura Conigliaro, who thinks EMC's shares are worth $17.

Indeed, the better VMware does, the more EMC prospers. VMware has disclosed that it will pay a one-time dividend of $800 million to EMC in the form of a note payable within five years. Bernstein's Sacconaghi estimates that every additional $1 billion in market value achieved by VMware is worth another 50 cents to EMC's share price. He foresees EMC conceivably getting to $17.50 on VMware's success, not including any plans EMC may have to buy back shares with the money it collects from the dividend. Considering that EMC traded below $14 when the company announced the VMware plan in February, already it has traveled some distance toward achieving its goal.

That makes EMC's purchase of VMware a rare bird in the tech business: an undeniably successful acquisition - most fail - that still offers upside to investors. All without a goofy name to generate excitement.

Peer Pressure According to Bernstein analyst Toni Sacconaghi, ten big stocks in VMware's peer group trade at an average price-to-sales ratio of 8, a valuation that would give VMware a market value of $10 billion.