VMware Shrugs Off Shaky Markets

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Validating Virtualization

If successful, VMware's IPO could further validate use of virtualization technology, which is changing the way companies manage their computer systems. Sales of the knowhow is one of the tech industry's fastest-growing areas, according to market researcher IDC. VMware controls about 85% of the market for the software on x86 servers using Intel and Advanced Micro Devices (AMD) chips. Using the software, companies can stack more programs onto each computer server, increasing the machines' efficiency.

That has led to impressive results: VMware booked nearly $704 million in 2006 revenues, and it's on track for $1.2 billion in 2007. Over the coming year, VMware's revenues could grow by another 62%, outpacing fast-growth firms Salesforce.com (CRM), Research in Motion (RIMM), and even Google (GOOG), according to Sacconaghi, who said VMware's sales could exceed $3 billion by 2010. During the quarter ended June 30, revenues grew to $296.8 million and profits more than doubled to $34.2 million.

VMware also has been able to charge premiums for add-on products, including one coveted capability that lets customers move computing workloads from an overtaxed machine to a less busy one without interrupting users' work. About 45% of VMware's customers license that product, according to John Humphreys, a vice-president at IDC.

Meanwhile, companies are getting new incentives to virtualize their data centers. Pacific Gas & Electric is offering customers credits of $150 to $300 for every server they remove as a result of using virtualization software. So far only a handful of companies, including software maker Autodesk (ADSK), have taken the rebates, but PG&E is simplifying the paperwork in hopes of attracting more takers, says Principal Program Manager Mark Bramfitt. California's two other public utilities have started similar programs, and Austin Energy in Texas plans to launch a virtualization incentive program modeled on PG&E's work in October, says Bramfitt.

Corner on the Market…for Now

But how much longer can VMware keep up the pace of growth? IDC estimates that less than a million of the world's 24.6 million Intel-based servers use virtualization technology, according to VMware's prospectus. By 2010, 17% of the 8.7 million servers shipped are forecast to run virtualization software, compared with just 5% of servers in 2005. VMware plans to keep growing by introducing new products that could apply similar efficiency techniques to desktop computers, striking new industry partnerships, and possibly making acquisitions, it said in the prospectus.

Taking investments from Intel and Cisco could help the software company retain its technical edge. By September, Intel plans to release a new processor and chipset for business PCs that let programs running in virtual environments take advantage of higher network speeds, says Steve Grobman, Intel's director of business client architecture. Down the road, customers could use VMware or other virtualization software to dedicate some of the processing cores on a chip to specific tasks, such as running security software in a way that better protects a PC from viruses, he says.

Cisco plans to work with VMware on technology that would help companies store employees' programs and files on a server instead of a desktop PC, letting them log in from any location, according to one person with knowledge of the deal between VMware and Cisco. A Cisco spokesman says the company invested in VMware for financial reasons, but declines to discuss details of how the two companies would collaborate.

Of course, VMware's continued dominance of the virtualization market isn't a sure thing.

Open Playing Field

On the desktop, Microsoft has adhered to a licensing policy for some consumer versions of Windows Vista that prohibits users from running virtualization software, which could check VMware's expansion into PC software. What's more, Microsoft plans to deliver software called Viridian in the middle of 2008 that will let users of its upcoming Windows Server 2008 operating system run programs in virtual machine environments. The virtualization market is still "extremely wide open," says Microsoft General Manager Larry Orecklin. But IDC's Humphreys says Viridian won't include a planned feature that lets users move programs from one computer to another without taking them offline, which could limit the product's utility. "That's a killer," he says.

Other competitors are trying to gain market share as well. Virtual Iron Software has gone from 50 customers at the end of 2006 to 750 accounts today by undercutting VMware on price, says CEO John Thibault. And XenSource has inked distribution deals with Linux vendors Red Hat (RHT) and Novell (NOVL). Dell's (DELL) chief technology officer, Kevin Kettler, demonstrated XenSource's software enabling a PC to run a variety of programs on Linux and Windows at the same time, during a speech at the LinuxWorld conference in San Francisco Aug. 7.

Hot Commodity

VMware's operating margins are also declining as it spends on research and development and other areas in order to keep growing. Operating margins were about 17% in the second quarter, vs. nearly 21% a year earlier, according to Bernstein's Sacconaghi. What's more, virtualization software could become more of a commodity as Intel and AMD build the capability into their chips, he said. Some analysts have forecast that virtualization could crimp demand for x86 chips (see BusinessWeek.com, 5/17/07, "Virtualization: Real Trouble for Servers?").

If VMware can keep cranking out sales and profit growth amid looming competition, generate a stock market value that keeps its best employees on board, and make its products a commonsense addition to back-office computers, perhaps it can begin to stake out a reputation on par with some of the tech-industry heavyweights with which it's being compared.

Ricadela is a writer for BusinessWeek.com in Silicon Valley.