December 04, 2012 - 4:16pm EST by
2012 2013
Price: 91.50 EPS $0.00 $0.00
Shares Out. (in M): 427 P/E 0.0x 0.0x
Market Cap (in $M): 39,300 P/FCF 0.0x 0.0x
Net Debt (in $M): 4,400 EBIT 820 800
TEV (in $M): 34,900 TEV/EBIT 42.0x 0.0x
Borrow Cost: NA

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  • Software
  • Cloud
  • Margin compression
  • Competitive Threats



VM Ware is about to experience a very large slowdown in their growth rate, perhaps turning negative, as a new & transformative product that costs 1/10th as much finally hits quality parity, and is supported and even pushed by an alliance of many of the biggest IT vendor (Rackspace, HP, Dell, etc). 

With a 2012 EV/EBIT of > 40x and 8x EV/Revenue, the stock discounts a lot of growth (many expect ~20%/yr), and so VM Ware is vulnerable to a large margin compression, perhaps to 10-15x EV/EBIT.

What VM Ware does:   Today’s typical Intel/AMD server CPU only allows only program/client at a time to be installed.  While that is the cheaper way to make CPUs, it also means that if that program/system isn’t doing anything, the server sits idle, and in fact the average server utilization is way below 10%.   VM Ware’s virtualization technology, while not invented by them, is the standard in allowing several applications to share time on the CPU and allows one to consolidate many servers (5-10 being common) into one.

In order to make the cloud work, you need both a virtualization software to “free” the program from the tie down with the CPU (via use of the hypervisor, also called virtualization software, which sits in between the two), and cloud management software to manage the many hypervisors and virtual machines.   VM Ware sells both hypervisors and cloud management software.

Previous Competition

There are at least 6 major virtualization competitors, most of which are free/open source, but VM Ware is easy to use and with great support, so people pay for VM Ware.  

Most software, in fact, has an open source alternative, and usually open source means hard to install, and hard to support, so only the largest data centers with large IT staff such as Rackspace and Amazon have been able to really get away from VM Ware since they have huge IT staffs that can have specialized groups of people just for this software.

At the small end of company size, Microsoft’s Hyper V is pretty compelling, often a fraction of the cost of VM Ware IF you already have Microsoft Windows, and the feature set is ok.  But, for most people, VM Ware is the way to go.

Why the competitive opening: 

VM Ware has taken full advantage of their technology by charging license fees so high that it captures most of the value it saved.  For example, if a previous $3,000 server could be split into four servers ($12,000 value), VM Ware would try and charge $9,000.  The client would be better off because, even if hardware + software costs were lower, total costs were lower due to data center consolidation and less power + cooling.   Still, VM Ware’s pricing has upset many people, including a VP at a server manufacturer who told me that customers configure their products in ways just to optimize VM Ware’s licensing structure, which changes often, and not in ways that are optimal for the server maker.  It’s not uncommon to spend several times in VM Ware fees than in the hardware itself, so this is a big amount of dollars we’re speaking of and an obvious target for cost savings.

Change/ Why I’m Writing: 

So, what’s about to happen?  OpenStack, which until a year ago was mostly a Rackspace open-source project, now provide a credible free license (alternative to VM Ware.  Until very recently, it hasn’t been easy to install, and support was nonexistent, so free license still didn’t cut it to most customers because they need support, at any cost. 

But, in the last 3-6 months we’ve seen an adoption wave that is frankly incredible – HP, Dell, Intel, and Cisco (and most other heavyweights) have all in either public or private said they are supporting OpenStack and many are contributing to the actual software you use.  You can also look at reasonable tech saavy places, including Pay Pal and Mercadolibre.com (the ebay of Latin America), both of which I recently heard speak, and they are moving toward OpenStack.  What happens when many heavyweights collaborate on an opensource project – why, it gets a lot better, and my thesis is that it will get much better than VM Ware, and they last six months have really seen big step change from a near-hobbyist software to something special.

OpenStack is much lower cost – total license + support cost (assuming you buy Rackspace’s top support package) for a large cloud is 90% lower cost, and a mere 300 dual socket node cloud will save $3.5M per year. 


Why OpenStack now?

In order for free open-source software to appeal to the masses and take share from VM Ware products, it needs two major things in my opinion:  ease of use, and professional support.   

The Linux vs. Windows example is instructive, as in the US and Europe Linux dominates the corporate data center market after taking share from both Windows and Unix a while back. Linux had a very large number of developers contributing, and in addition had the following going for it:

1)      More stable than Windows

2)      Much easier to automate processes

3)      Professional Support Available (via RedHat)

4)      Lots of people know how to use it

5)      Free and saves a lot of money

6)      Easy to install, easier than Windows

I think numbers 3 – 6 are here already.  Rackspace is now offering professional support of the entire stack of the virtualization software + the cloud management software.   While you can download it for free, you have to pay for support, which is what Red Hat does with Linux today.  Finally, the latest versions are getting much easier to install, not as easy as VM Ware, but getting there.

#1 and #2 are not there necessarily (both are pretty stable) – but when you have literally all the industry heavyweights contributing to the source code, I think you’re just going to get so much better.  

There is also the obvious question – why should everyone be contributing to an open source project – public companies are not non-profits.  While Linux showed that you can get people to work on things for free, most contributors to OpenStack one way or another are on the payroll of public companies.  Why?   Well, Rackspace is trying to transform their business to cloud support, so they have a vested interest in supporting more clouds going to OpenStack, so they can support them.  Cloud providers like HP want to become the public part of public/private clouds (where you have an internal/private cloud, and “rent the spikes” as demand temporarily surges past your internal capacity) so having the private/internal clouds run by OpenStack allow them to easily integrate.  Finally, people like Cisco seem like their jumping on the bandwagon before it leaves them or at least it can help make the virtual networking component friendly to Cisco routers.

Timing:  I don’t know, but I’d say that the August – October timeframe really saw a huge surge in interest in OpenStack, and this could start holding up purchase decisions for VM Ware.   At the recent Cloud Expo conference, everyone was talking about OpenStack, not other competitors, and I barely heard about other competitors like Eucalyptus or CloudStack, even though those guys have pretty good traction.  The short interest has risen from 2% to 10% of the float this year, so this isn’t undiscovered, yet with the valuation and fairly flat stock performance this year, is isn’t widely accepted either.

In fact, a data center I have a partial ownership interest in is now looking at OpenStack, because the last 6 months had so many new features put into OpenStack that it is now is truly production ready for the masses.   Rackspace will support us at $1200/node per year with no license fee, which at scale is ~90% less cost than VM Ware’s full package for anything north of 100 dual socket nodes, and that includes the operating system + hypervisor + cloud management platform.


Risks:  EMC, the owner of ~80% of VM Ware, could buy the rest of the shares or buy back enough to prop up the price, and in fact EMC is in the market nearly every single day.   This is somewhat scary, but I believe that EMC wants VM Ware public so as to be able to offer stock options to employees, since VM Ware is still cool but EMC is way past its prime.  At some point, EMC taking VM Ware private is a risk, but since the stock dropped to $20/share in 2009 and EMC didn’t buy VM Ware back then, I think we have a decent amount of breathing room until a buy-in happens. 

Summary:   VM Ware’s prices are so high that there is an opening for new cloud management software, and the whole industry is joining forces against it with a product 1/10th the cost and with good support, good install, and probably within a year with more features. 


I do not hold a position of employment, directorship, or consultancy with the issuer.
Neither I nor others I advise hold a material investment in the issuer's securities.


OpenStack taking customers over next 4 quarters
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