VMware Vs. Microsoft: The Next Chapter

VMware's fourth-quarter earnings, reported Jan. 28, set a record and came in ahead of analyst expectations. The next day, its stock, which had been trading at $99.10 just before the announcement, took a stunning hit, losing 20% of its value within a short time after the opening of trading.

Several analysts had predictedVMware's fourth-quarter earnings would disappoint because the market for virtualization products was nearly saturated and Microsoft was moving in to steal the customer base.

Instead, VMware beat the previous fourth-quarter's earnings per share by 2% -- at $0.47 per share. But the news that it was laying off 900 and realigning resources was taken as a bad sign. Maybe the skeptics had been right about VMware's diminishing future. Or perhaps lost in translation was the statement that VMware would hire an additional 1,000 people and focus on its top business priorities.

[ Want to know more about how VMware described its "realignment" during its fourth-quarter earnings call Jan. 28? See VMware Earnings, Examined. ]

Seven investment firms lowered their ratings on VMware the day after the report, including Goldman Sachs, Sterne Agee and Morgan Stanley. Piper Jaffray analyst Mark Murphy said he reduced VMware's rating to "neutral" because "a large mix of investors assumed that license revenue growth would accelerate from 13% in 2012 to a high teens rate in 2013." The next day, VMware shares dropped further to $76.80, off 22% from its pre-earnings report high.

VMware has led a somewhat charmed life with investors up to this point. It's been presumed to be the leader of a business with a lot of potential growth. Instead, VMware came up with a conservative forecast of new license sales, a key indicator of its prospects, of 8-11% for the first quarter of 2013, as well as slower overall sales in the first half.

On the third day, its stock began to recover. VMware closed Friday at $78.79, up $2.31, or 3%, but still far below $99.10. Some investors clearly thought that VMware, under a new CEO and having just lost its CTO, was laying off employees as foretaste of things to come. Perhaps that lower-than-expected first-quarter 2013 meant the days of VMware picking virtualization's low-hanging fruit were over.

Is this the true state of the company? Was VMware's value, pre-fourth quarter earnings report, overly optimistic or was it real?

One VMware stockholder took its dip in value as an opportunity to buy more. That was parent company, EMC. In an 8K report filed with the SEC Jan. 31, three days after the quarterly earnings call, EMC indicated it had purchased nearly $5 million in VMware stock Jan. 29 and another $15 million Jan. 30. This isn't exactly the kind of endorsement a company in VMware's straits is looking for. The move had the effect of giving EMC a larger share of VMware (it already held 78% to 80%), and it was likely to have been motivated by a desire to prop up the stock.

At the same time, the VMware's adoption of the "we're part of the post-PC era of computing" slogan and its acquisition of application companies always seemed to me born of an unhealthy desire to compete on Microsoft's turf. Yes, there's a new era of mobile applications, and they largely circumvent Microsoft and its Office franchise. At the same time, no one has displaced Office -- and those who have tried have failed miserably. Why did a server infrastructure company like VMware think it was going to be the one to succeed in end-user apps?

VMware's 8-K filing with the SEC Jan. 29 said it "planned exit of certain lines of business and consolidation of facilities" by the end of 2013. The only one mentioned during the earnings call was SlideRocket, the online presentations application.

While VMware waited for Microsoft to weaken in applications, it got stronger in data center virtualization, with its System Center and Virtual Machine Manager, and the growing presence of Windows Server 2012. VMware's fourth-quarter announcement recognized this reality and vowed to swing more resources out of the skirmish line and into the main battle.

There is already some pilfering of VMware customers by Microsoft and there's more to come. Many small and midsized companies will discover they can manage quite well with the level of virtualization management that Microsoft offers. And large companies already using VMware will find they can run a department or a remote branch quite adequately with Windows Server 2012 and Hyper-V. But I don't think that's the whole story.

VMware still occupies the heart of the virtualization space at many large, virtualized data centers. It's trying to follow up success with its vSphere 5 suite with the next step, the software-defined data center as captured in its vCloud Suite, which provides for user self-provisioning of virtual machines and flexible storage and networking that moves around when the virtual machine does.

COO and president Carl Eschenbach noted during the earnings call that the fourth quarter of 2012 was the first in which vCloud Suite had been available for the full quarter. Bookings during the quarter exceeded expectations, and most of its orders were in the form of enterprise license agreements. "The vCloud Suite comes in three flavors: standard, advanced and enterprise. Our enterprise version, with a list price of $11,495 per CPU, had more bookings in Q4 than either the standard or advanced versions. The latter are the lower-priced versions, of course.

This single point speaks clearly to where VMware's continued strength lies. It's led the conversion of data center servers from one application per server, utilized at 7-15%, to multiple applications per server, with the server hardware utilized closer to 50%. And there's little doubt there's still a ways to go. The fact is, both VMware's and Microsoft's virtualization software continues to become more capable, and that means fewer licenses must be sold to manage more and more virtual machines.

VMware is now leading how virtualization changes the management of the data center into a more cloud-like environment of flexible, pooled resources where end users are able to self-provision, then IT is able to tell them how much their department will be billed for the resource at the end of each month. The software-defined data center is driven by automated processes run by IT-set policies. With such an approach, it may be possible to come closer to utilizing 80-90% of the hardware resources instead of living with them as perpetually over-provisioned.

That is, in VMware's view, virtualization is not just about subdividing servers. It's the future command post of a highly automated, policy-driven data center. Within vCloud Suite is vCenter Operations, a component that rolls up configuration management, performance management and capacity management. To get to 85%-95% utilization rates, capacity of all hardware resources will need to be monitored and carefully honed. In all likelihood, it will require standby copies of virtual machines, waiting to be fired up in the public cloud as an extension of the data center during those periods when on-premises capacity isn't sufficient. VMware has such a development in mind as it assembles the components of vCloud Suite.

Whether VMware can really sell this vision of the future remains to be seen. Many IT shops could stop well short of it, rely more heavily on Microsoft, and still be well-managed, trim and efficient operations. Or they could reorganize around open source software -- Eucalyuptus, OpenStack or CloudStack -- and expect it to move in the same direction of integrated operations as vCloud Director. Open source, while still behind, has shown a rapid pace of innovation on the cloud side of future operations.

Neither VMware customers, Microsoft customers nor open source users are sure where all the ferment in virtualization, data center re-organization and cloud computing will lead. Will one brand run off with the whole show? The possibility that it might not be VMware seemed to occur to a lot of investors at the same time after the fourth-quarter earnings report.

But between the lines of the fourth-quarter report, VMware is not doing that badly where it most wants to next establish itself. If it is selling vCloud enterprise license agreements at a better pace than the lesser agreements, that means to me it's getting buy-in for its software-defined data center concept. And by cutting back in applications, it's saying it'll put more wood behind the arrow of its primary business. So far, VMware has been about executing in incremental steps. Competitors have striven to keep up, but each time they announce they've done another thing VMware can do, they've looked up and there was VMware still several steps ahead. But 2013 may be the year when that is less true than before, and as the VMware bears have already indicated, its stock will suffer.

But VMware bulls still have an appetite for the fight. At the end of 2013, they may be the ones to say the market for virtualization products is still expanding and VMware revenues along with it. The data center of the future is still evolving, and VMware's product line along with it; the operational efficiencies and know-how of cloud computing still accumulating, and VMware's cloud system still capturing and implementing it day to day.