By Aaron Ricadela
Monday, August 20 2007 03:48 PM
URL: http://www.zdnetasia.com/news/software/0,39044164,62031078,00.htm

The virtualization-software maker's initial public offering is generating plenty of interest. Can it live up to the expectations?

In what could become one of the most successful initial public offerings of the year, software maker VMware went public Aug. 14 with an offering that valued the company at close to US$20 billion, rewarded shareholders of majority owner EMC, and could prove a barometer of investors' appetite for new issues during a summer of volatile stock market swings.

VMware, a subsidiary of computer storage and software company EMC, is selling 33 million shares in an IPO on the New York Stock Exchange. The shares surged early on, rising 76 percent to US$50.95 in late-morning New York trading. That gave the company a market value of US$19.1 billion. The shares had traded as high as $55.

VMware said late on Aug. 13 that shares would go for US$29 apiece, at the high end of the company's forecast range. Citigroup, J.P. Morgan Securities, and Lehman Brothers are the lead underwriters, and the shares traded under the ticker symbo "VMW". Sanford C. Bernstein & Co. analyst Anthony Sacconaghi had said in a Jul. 31 report that VMware shares could soon rise to US$34 or even US$39.50, which would value VMware at US$13 billion to US$15 billion.

Anticipation for VMware's offering has mounted in recent weeks. On Aug. 9, VMware raised the target price range of its shares by US$4, to US$27 and US$29 a share. And two of the tech industry's biggest names have bought in. Intel on Jul. 9 invested US$218.5 million for a 2.5 percent stake in VMware, and will add an executive to VMware's board. On Jul. 27, Cisco Systems said it was paying US$150 million for 1.6 percent of the software maker. VMware technology helps IT departments make more economical use of servers, the powerful computers that run Web sites and corporate data networks.

A Leader in the pack
VMware's rapid growth and escalating value have led analysts to compare it to software industry high-fliers like Microsoft in their early days. But VMware Chief Executive Diane Greene said in an interview that the landscape has been changed dramatically by the rise of Internet-delivered applications and open-source software. "The tech industry is very different from what it was when they were growing," says Greene. VMware's exacting standards for hiring and product quality have let it stream out "major new innovations on a regular basis", she says. "If we keep executing on that model, it's promising, but it is a different world."

Brent Bracelin, a senior research analyst at Pacific Crest Securities, said he is bullish on VMware because of its large available market, dominant share, and technical advantages over competitors. VMware's sales rose 89 percent in the second quarter. "This is one of the most important software companies since Oracle, Microsoft, and companies that ruled the last decade,"he says. "This is going to be a hot deal."

The scant number of VMware shares on offer could also buoy demand. The offering could raise US$957 million. By contrast, the median amount companies have raised in IPOs through the second quarter of this year has been US$83.6 million, according to market researcher VentureOne, a Dow Jones company.

The IPO could be a boon for investors in EMC, which will own 87 percent of VMware's shares. The company has said it plans to use proceeds to buy back shares of its stock, and EMC could also pay its shareholders a future dividend in VMware shares, Bracelin added. Shares of EMC stock rose 7.5 percent, to US$19.05, on Aug. 13.

Navigating a Competitive Market
As desirable as VMware's shares may be at the outset, the company will need to use proceeds from its sale to navigate an increasingly competitive market characterized by rapid growth, profit margin pressure, and the imminent entry of software giant Microsoft.

In particular, the sale gives VMware, which already has 3,000 employees, new currency to attract and retain top talent in Silicon Valley, where it is based. VMware employees had been issued options to buy EMC stock, which has languished over the past three years, said Bracelin. "You're trying to recruit the same pool of talent that Google's in, but you're issuing stock that's been dead money for three years," he said.

EMC is spinning out part of VMware into an uncertain environment on Wall Street. Since late July, stock markets have gyrated amid concern over subprime mortgage malaise. Investors have feared that tightening credit could slow corporate growth. That has led the Federal Reserve, the European Central Bank, and other central banks to inject hundreds of billions of dollars into global markets to prop them up.

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 percent of the market for the software on x86 servers using Intel and Advanced Micro Devices 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 US$704 million in 2006 revenues, and it is on track for US$1.2 billion in 2007. Over the coming year, VMware's revenues could grow by another 62 percent, outpacing fast-growth firms Salesforce.com, Research in Motion, and even Google, according to Sacconaghi, who said VMware's sales could exceed US$3 billion by 2010. During the quarter ended Jun. 30, revenues grew to US$296.8 million and profits more than doubled to US$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 percent of VMware's customers license that product, according to John Humphreys, a vice-president at IDC.

More reasons to virtualize

Meanwhile, companies are getting new incentives to virtualize their data centers. Pacific Gas & Electric (PG&E) is offering customers credits of US$150 to US$300 for every server they remove as a result of using virtualization software. So far only a handful of companies, including software maker Autodesk, 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 percent of the 8.7 million servers shipped are forecast to run virtualization software, compared with just 5 percent 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 is not 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 is 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" said Microsoft General Manager Larry Orecklin. But IDC's Humphreys says Viridian will not 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 said.

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 and Novell. Dell's 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 percent in the second quarter, versus. nearly 21 percent a year earlier, according to Bernstein's Sacconaghi. What is more, virtualization software could become more of a commodity as Intel and AMD build the capability into their chips, he said. Some analysts have forecasted that virtualization could crimp demand for x86 chips.

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 is being compared.