Wall Street Lets Some Air Out of VMware

Published: February 6, 2008

by Timothy Prickett Morgan

Server and workstation hypervisor maker and Wall Street darling VMware got its first taste of how investors react to financial surprises from public companies this week. While the company was able to grow revenues in the fourth quarter of 2007 ended December 31 by 79.7 percent to $412.5 million and net income more than doubled to $78.2 million, Wall Street was expecting about $5 million more to fall to the bottom line and a brighter outlook for 2008 than VMware's top brass offered. And so, VMware's high-flying stock price, which was up in the $80 to $90 per share range for the past several months and hit a high of $125 in late October 2007, dropped to $57 in trading last Wednesday morning.

Last week's stock price haircut, a drop of $25, has caused VMware's market capitalization to drop to $21 billion. This has also pulled down parent company EMC's value on Wall Street.

In the third quarter of 2007, VMware's first full quarter as a public company, sales rose by 89.5 percent to $357.8 million in the third quarter of 2007 ended September 30, and net income more than tripled to $64.7 million. By any measure, VMware had a pretty good kicker in the fourth quarter following the third. But expectations have been pretty high for VMware, which has more or less had a monopoly in server virtualization for the X64 server platform. But with the Western economies having a case of jitters and the U.S. economy perhaps in recession and Microsoft, Citrix Systems, Virtual Iron, and Parallels all trying to get a piece of the action with respectable alternatives to VMware's products and aggressive prices to boot, the heat is on VMware in a way that it has not yet been in its ten-year history.

VMware booked $284.3 million in product licensing sales in the fourth quarter of 2007, up 75.5 percent, while services sales rose by 89.7 percent to $128.2 million. For the full year, VMware's sales rose by 88.4 percent to $1.33 billion, and net income grew by a factor of 2.5 to $218.1 million. The company had sales of $721 million in the United States during 2007, with $605 million in sales overseas. During the fourth quarter, U.S. sales growth slowed to 67 percent, hitting $215 million, while sales elsewhere in the world for VMware's products in Q4 rose by 96 percent to $197 million. The company burned a little of its cash in the quarter, and ended with $1.23 billion in cash and equivalents in the bank. Mark Peek, VMware's chief financial officer, said in a conference call with Wall Street analysts on Tuesday that basic hypervisor products accounted for 38 percent of license revenues in 2007, compared to 57 percent of license sales in 2006; management and automation tools that ride atop VMware's hypervisors accounted for 62 percent of sales in 2007 compared to 43 percent in 2006. If you do the math on those numbers, that means hypervisor sales rose by about 26 percent to $505 million in 2007, compared to 172 percent growth of management and automation tools, which hit $825 million in sales during 2007. With the pressure on VMware from competition--particularly when Microsoft's Hyper-V hypervisor comes to market--you can predict that VMware's hypervisor sales will be flat or down in 2008 and maybe down bigtime in 2009.

Diane Greene, VMware's president and chief executive officer, said in a statement accompanying the financial results that the company had over 100,000 customers (many of them using its Workstation product, you will remember, and double 2006's levels), almost 10,000 partners, and more than 5,000 employees. This is a very large software company by any measure, and clearly one of the most successful ramps in the history of the software business. Greene said in the call that VMware was at a $1.6 billion annual run rate in Q4, but of course, 2008 is a whole year with its own ups and downs each quarter. Peek said in the call that VMware has been consistent in holding its price bands for years, adding in new features to justify the price against competition, and has no plans for price cuts in 2008. That said, VMware is projecting only 50 percent growth in 2008, which means VMware is expecting to kiss $2 billion in sales for the year.

And that is what really made Wall Street start selling chunks of VMware's stock and taking some profits. No matter how much VMware leads the market, a valuation pushing $40 billion was just utterly stupid. And I don't think even $10 billion, much less $20 billion, makes any sense, either. But, then again, I think stock valuations should bear some tight resemblance to revenues and profits, not just the muttering of a few million people, which makes me old fashioned, I guess.

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