The valuation the stock market put on VMware never made a great deal of sense. I wrote about this in November (The EMC Paradox) when the irrational exuberance of the market had driven VMware shares to over $120 and it’s value was approaching that of EMC, which owned and still owns 86% of the company. Since then EMC’s share price movements have reflected those of VMware, demonstrating the market belief that VMware constituted the dominant portion of the value of EMC. In terms of stock value, it surely did, but  in terms of business value I’m not sure that’s the case.

VMware is now, in my opinion, approaching a realistic valuation. The stock price tanked when Microsoft announced that it would be releasing a hypervisor of its own, Hyper-V, bundling it in with server versions of Windows. Anyone who believed that VMware wasn’t going to face hypervisor competition from Microsoft  was living in la-la land. Virtualization revolutionizes the OS market. (If you’re not sure what OS virtualization is click here.) Microsoft was never going to stay out of this market.

You could claim that Microsoft took the air out of the hypervisor market by bundling Hyper-V with Windows, but another hypervisor, the OpenSource Xen hypervisor had been available since 2003 for free anyway and its existence was no secret. The turth is that zeppelin sprang a leak a long time ago and has been sinking to earth ever since. Admittedly the market took a lot more notice of Xen when Citrix acquired XenSource, Inc., but the simple fact is that there always was a free hypervisor for anyone who wanted to be in the game.

Both Red Hat (the Linux OS vendor) and Oracle took a seat at the virtualization table last year, providing Xen as the hypervisor on commodity Intel hardwqare. If you’re wondering whether anyone else is likely to join them in this game, you can glance in the direction of; Sun Microsystems, which has been offering its own form of virtualization on Solaris for quite a few years, or at IBM, which has had virtualization on the zSeries mainframe since god was a boy or even HP, which will could declare an interest at some point in time.

The truth is that many companies have an interest in virtualization and all of them turn out to be companies that  produce operating systems of one sort or another. VMware invented the hypervisor market for commodity Intel hardware and it had the field to itself for a long time – probably a much longer time than it expected. But in the past year, the field has become quite crowded and will probably get more crowded with time. (For more details see Is VMware Another Netscape?.)

The Departure of Diane Green

VMware shares collapsed another 30% with the sacking of CEO Diane Green, dragging EMC shares down with them. The market seems to be exhibiting an intelligent consistency, because when VMware shares were golden, if you subtracted their value from EMC, then the market was valuing EMC at about 1 x times revenue. Now that the shares have returned from the stratosphere, if you subtract them from EMC’s capitalized value, the market still values EMC at about 1 x revenues (i.e. about $12 billion.) By contrast VMware is valued at about 10 x revenues.

And if you split the two up, then in the humble opinion of the stock market, VMware would still be worth more than the rest of EMC.

As could have been predicted, many commentators depicted Diane Green as a successful start-up CEO now being replaced by a big company professional, Paul Maritz, EMC and former Microsoft executive. The announcement coincided with VMware guidance that it now expects 2008 revenue to be “modestly below” the previous forecast for 50% growth (over 2007.) Digesting this, the market concluded that VMware clearly faced some challenges – and it does.

Desktop Virtualization and Server Virtualization

VMware didn’t just invent the server virtualization software market, it also provoked a desktop virtualization market into existence. My initial expectation was that VMware would dominate this too, but Citrix (which had a great deal to lose if VMware did dominate) proved itself very nimble in response – and from a technical perspective, it has clearly overtaken VMware (see Citrix: Getting Desktop Virtualization Right for details). Because Citrix has the advantage of existing relationships with most of the buyers, VMware will likely find the competition tough. This will especially be so now that some of the VMware glitter has fallen away.

In the server virtualization market, VMware was once in the happy position of being the only game in town. Now it has to compete for business. Technically it is still ahead of the competition and it offers by far the broadest portfolio of virtualization products, but its cost of sale has to be rising. Previously VMware reps could spend most of their of time just taking orders. Now they have to go out and sell.

Will EMC Spin VMware Off?

Some commentators are urging EMC to sell VMware and get out. That would have been an excellent idea last October when the VMware valuation was beyond optimistic, but doing so now makes neither financial nor technical sense. EMC is developing and assembling a portfolio of software products that complement VMware’s virtualization management products very well – it includes the Smarts, nLayers and RSA products. EMC also has the opportunity to make more aggressive use of VMware’s technology in its storage management products. EMC may once have been the storage hardware company, and it is still a storage giant, but it is developing into a major software player too.

Diane Green had chosen to keep EMC and VMware as separate, almost unrelated operations, with EMC as little more than a silent partner. In y view, it’s unlikely that Paul Maritz will pursue that policy. It is far more likely that VMware will gradually become the lynch pin of EMC’s software division.
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