Technology October 25, 2007, 12:01AM EST

VMware Proves Its Value

The maker of "virtualization" software has beaten the market's expectations, becoming the most successful recent tech IPO

VMware president, CEO, and co-founder, Diane Greene

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IPO-darling VMware handily beat analysts' expectations in its first quarter as a public company, tripling profits. And though investors had already priced a powerful quarter into VMware's lofty share price, which has more than tripled since the software company's initial public offering in August, the stock surged 5% after the report.

VMware (VMW), which makes "virtualization" software that helps companies pile the work of multiple computer servers onto a single machine, nearly doubled its third-quarter revenue compared with a year ago, generating sales of $358 million. Orders for new software licenses, a key measure of future revenues, also nearly doubled, to $248 million.

Top-Tier Market Value

Third-quarter net income totaled $64.7 million, or 18¢ per share. Wall Street's consensus estimate was that VMware would earn 17¢ per share on $334 million in revenues, but the unofficial "whisper" estimate had investors looking for $355 million to $360 million in sales. As such, the results managed to vault the especially high hurdle analysts had set in advance of the Oct. 24 report. Investors bid up VMware shares in after-hours trading following the update, though some of that gain may have been driven by short-sellers forced to cover their positions after betting the company wouldn't meet the market's outsize expectations.

A spin-off from data storage supplier EMC (EMC), which still owns 86% of the shares, VMware dominates the fast-growing market for virtualization software that can cut hardware costs and reduce electricity bills (BusinessWeek.com, 9/10/07) for computer data centers. With IT departments wrestling with server sprawl and soaring energy prices to cool those servers, VMware has created a market niche virtually from scratch. "Virtualization is driving what is turning out to be a complete refresh of the data center," VMware CEO Diane Greene said during an Oct. 24 conference call with investors. "We see more opportunity than we have staff to build to and market to."

A day after VMware's report, EMC announced that its own third-quarter earnings rose 74% to $493 million, or 23 cents per share—boosted in two ways by VMware. About a tenth of EMC's profit came from its share of VMware's earnings. But nearly a quarter of EMC's income came from a $115 million capital gain from selling, a month before the IPO, 6 million VMware shares to Cisco Systems (CSCO). By selling that stock to Cisco for just $25 per share, or $150 million overall, EMC has missed out on roughly a half billion dollars of appreciation in the value of those 6 million shares.

At more than $108 a share, VMware now fetches nearly four times the $29 asking price from the company's $1.1 billion offering on Aug. 14 (BusinessWeek.com, 8/14/07), the technology industry's most successful IPO in years. With a market value of $41.6 billion, VMware has quickly become one of the world's most valuable software companies: nowhere near Microsoft's (MSFT) $294 billion market value or Oracle's (ORCL) $108.5 billion, but close behind Adobe Systems' (ADBE) $42.34 billion value.

"Runway Left"

Another striking contrast: VMware's stock is now trading at 157 times this year's expected earnings—a big premium to other leading tech stocks. Even Google (GOOG), with a price-earnings ratio of 43, doesn't command as high a multiple.

"They're running on all cylinders right now, and it's hard to refute, in the short term, the trajectory of the business," says Israel Hernandez, head of software research at Lehman Brothers (LEH). "The reason the stock is trading at a significant premium by any metric is the tremendous opportunity VMware has in front of it."