EMC should set VMware free
Spin it off, and reward the faithful
Analysis EMC shareholders concerned about the stagnant nature of the company's shares should open up a new document file right now. They should address it to CEO Joe Tucci, and they should title it "Spinoff VMware and unlock precious shareholder value."
EMC has done a remarkable job of posting double-digit revenue gains over the past two years, while most other hardware rivals have struggled to achieve any level of consistency. Investors, however, have not rewarded EMC for this performance with its share price hovering close to $14 during the two-year span. Concerns about EMC's inability to grow software revenue without major acquisitions and to defend a slower-growing hardware business haunt the company.
This makes a spinoff of EMC's VMware subsidiary so attractive.
In its most recent quarter, VMware reported revenue of more than $100m for the first time in its history. EMC noted that it's "continuing to be one of the fastest-growing major software businesses in the world." No other start-up in the server software realm enjoys such a stranglehold on the market leader position or the incredible margins VMware achieves by selling its products for thousands of dollars per processor.
As a comparison, Red Hat recently posted second quarter revenue of $65.7m. That marked a 42 per cent year-over-year rise and sent Red Hat's shares up to 20 per cent higher in just 24 hours.
One year ago, VMware pulled in $61m, which was a 200 per cent rise over its pervious third quarter. Moving from $61m to this year's $100m also gives VMware more than a 60 per cent year-over-year revenue surge - far better than say, Red Hat.
At $100m, VMware also makes more money slicing and dicing Red Hat's operating system than Red Hat makes selling and supporting its flagship product. That's a huge edge for VMware, as its proven to be one of the few software makers that can capitalize on the open source model. The rest of the Linux server money goes to hardware makers such as IBM, HP and Dell.
Reasons to stay at home
Without question, VMware has benefitted by becoming part of EMC.
VMware's management has always been engineer rich. CEO Diane Greene is an incredibly successful businesswoman holding, with her husband, more than a 50 per cent stake in VMware, but she's a geek at heart. Before the EMC buy, VMware spent little on marketing and depended on word of mouth.
In addition, the nature of the server partitioning market demands that customers trust that their software supplier will be around for a long time. You're not going to slice up hundreds of systems and pray that VMware stays in business or has the support you need when something goes wrong. You have to know that for certain.
EMC helps on both fronts by putting its full marketing weight behind VMware, adding muscle to its support staff and slapping a big, trusted name on the VMware products. EMC gives VMware a more mature, solid presence.
Reasons to fly
There's, however, little reason to believe that VMware can't instill the same level of trust in customers and apply the same marketing savvy given its current size and the state of the partitioning market.
VMware continues to form stronger and stronger ties with the major server vendors. IBM makes millions on the back of VMware and isn't about to stop supporting customers using the software. The same goes for HP, Dell and more recently Sun Microsystems.
The real argument against a VMware spinoff would be that the company can't maintain its margins or growth given the competitive landscape.
Giant Microsoft has made server virtualization a priority and could well own the majority of the Windows market. In addition, start-up XenSource continues to garner huge amounts of attention and support from VMware's own allies with its open source product. We've seen open source options put pressure on other lucrative parts of the software market such as databases and application servers. Surely, VMware will have to lower its pricing to compete.
Such threats, however, are much further away than Microsoft would have you believe.
Unlike VMware and Xen, Microsoft's Virtual Server product does not run directly on the hardware, hosting virtual operating systems. Microsoft won't have such a hypervisor-based product until the first update to Longhorn Server, which is currently planned for 2009. That leaves Microsoft delivering a relatively low-end offering that cannot offer the performance, reliability or management gains enjoyed by VMware and Xen customers. Microsoft does have, well, Microsoft on its side, which is nice, and can access myriad Windows customers. It may well create a solid business with medium-sized customers who don't need all the bells and whistles offered by rivals.
Will this blunt VMware's growth? Hardly.
Xen is the more interesting competitor, as it seems to have the support of the Linux vendors, open source shops and industry giants Intel, AMD, Sun and IBM.
Today, the Xen product offers large performance gains over VMware's ESX server software - no matter what VMware tells you. Xen can run paravirtualized or modified guest operating systems that are tuned for maximum performance. VMware can't do that today and probably won't be able to until sometime late next year.
VMware and Xen are engaged in a squabble over which company's interface should become the standard addition to Linux for "paravirtualized guests" - operating systems with a modified kernel tuned for virtual machines. Some open source advocates say they don't want a proprietary software vendor having anything to do with Linux. They'd prefer to see Xen's approach be adopted. In the end, it won't make much difference which interface becomes the standard as both VMware and Xen would have the same access to the technology and be able to make their products work with it.
The bigger question here is the acceptance of VMware in the open source market. So you've just spent all these years working to be free of Microsoft and to have more control over your systems only to then be locked into VMware? It's a premise that's hard to swallow for some.
For these reasons and because Xen is free, XenSource stands as a major data center threat. Why would a financial services company toss VMware thousands of dollars per server when it can run Xen for nothing? If you have some very savvy engineers, then Xen makes a ton of sense.
Again, however, VMware's future prospects face little peril. It may lose a few customers to Xen's strategy and suffer some pricing pressure, but it has a more mature product and can make piles of cash from services, support and management packages.
The service and support doubts that haunted VMware in the past have been inherited by Xen. Having a young competitor just helps VMware look more like the trustworthy, reliable vendor it is.
XenSource, we remind you, has yet to announce a single customer. Meanwhile, VMware has tens of thousands of paying customers. It also has a fleet of management products with sophisticated features that will take rivals years to match.
We know for a fact that VMware has discussed the possibility of releasing a type of ESX Server Light product that would blunt the low-end attack of Microsoft and Xen's pricing model. VMware could give this crippled product away for free. VMware declined to comment on such a product.
The bottom line
When VMware first started, few took it terribly seriously. The company's x86 tools failed to compare with more storied mainframe and Unix options. In addition, most VMware customers used the products for testing or software development and not on real, hard-working servers.
This has changed dramatically over time as VMware has become the standard server partitioning product. The company has enjoyed tremendous growth and was courted by Microsoft, Veritas and server vendors before EMC paid $635m for the firm.
Few software companies have ever enjoyed such a position. VMware has a massive market at its disposal and no serious near-term threats. It counts every major server vendor as a close partner and has tremendous sales growth.
There's little doubt that if VMware were a standalone company, investors would flock to it. EMC shareholders would benefit from such a move by finally tapping into the growth potential of the company.
A decision not to spinoff VMware is either greed on EMC's part to make its overall business look healthy or a signal that EMC has more serious doubts about VMware's growth potential than we do. We'd be shocked if VMware isn't separated from EMC in the near future. ®