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The Virtues of Virtualization

S&P says spending on virtualization software and services is likely to skyrocket

From Standard & Poor's weekly investing newsletter The Outlook

Amid the Web 2.0 talk of big companies acquiring little-known startups with funny names, as well as the well-publicized initiatives of search giant Google (GOOG; S&P investment rank 3 STARS, or hold) and the brisk expansion of Facebook, stands a company that will probably be around long after the market has moved on to the Next Big Thing.

The company is VMWare (VMW; not ranked by S&P), majority-owned by EMC Corp. (EMC; 4 STARS, buy) and the world's leading provider of virtualization software. The Palo Alto (Calif.) company raised an impressive $1.1 billion in its August, 2007, initial public offering, one of the largest technology IPOs since Google went public in 2004. EMC acquired VMWare in 2004 for $635 million.

According to research firm IDC, spending on virtualization software and services is expected to exceed $15 billion worldwide by 2011, up from $6.5 billion in 2006. So it's no wonder "virtualization" is becoming the new buzzword.

Simplifying Workloads

Virtualization typically refers to a single computer safely running multiple operating systems and applications simultaneously. Virtualization can reduce the number of servers and related information-technology hardware in the data center, resulting in cost savings in real estate and electricity. VMWare's software is designed to enable customers to achieve much higher utilization of the server, storage, and network resources in their operations while dramatically simplifying the operation and management of the workloads that are run on those systems.

"Virtualization is an evolutionary step in the information life-cycle management process, enhancing the management of complex disparate applications and the vast amounts of unstructured data being created by consumers and at the enterprise level," says Standard & Poor's equity analyst Jawahar Hingorani. It also meets the need of corporations to demonstrate their "green" credentials, he says. Virtualization cuts down the number of physical servers required to run applications, reducing the footprints and energy consumption profiles of data centers.

The market for virtualization, which is still in its early stages, is being driven by software license sales as well as exploratory consulting and training engagements. IDC estimates that as the market matures and penetration increases, an increasing proportion of virtualization sales will be derived from systems integration and support services.

VMWare has partnerships with more than 350 hardware, software, network, and storage companies and has more than 6,000 partnerships with resellers, distributors, and systems integrators. Revenues totaled $703.9 million in 2006. According to Hingorani, the company has increased revenues by 15% and 20% in the June and September quarters, respectively, and is on pace to boost annual revenues by more than 80%. "With the market share projections by IDC, I fully expect VMWare to contribute $3 billion in revenues to EMC by 2010," he says.

Opportunity for Competitors

EMC, which retains an 86% stake in VMWare, hasn't announced any plans to offer additional shares to the public. It's interesting to note that, prior to the IPO, investors in VMWare included Intel (INTC; 4 STARS) and Cisco (CSCO; 3 STARS), both of which cited a desire to keep abreast of developments in virtualization by investing in the leader of this space.

Another promising company is Citrix Systems (CTXS; 5 STARS, strong buy), a developer and supplier of access infrastructure software and services. In October, the Fort Lauderdale company acquired XenSource, a provider of server virtualization software, for approximately $500 million. S&P equity analyst Jim Yin expects the acquisition to add about $50 million of revenue in 2008 and $200 million in 2009. "We believe the server virtualization software market is in its infancy, with only about 5% market penetration," says Yin. "Although VMWare is the market leader, we think there is significant market opportunity for several competitors."

On Nov. 5, Dell (DELL; 3 STARS) agreed to buy EqualLogic for $1.4 billion. EqualLogic's software lets a single computer function like several machines. The acquisition is a major part of Dell's strategy to drive virtualization from Dell's enterprise portfolio.

Editor's note: An earlier version of this story incorrectly stated that EqualLogic was a provider of virtualization software.

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