Virtual Machines, Hard Cash

The market values tiny VMware at $26 billion

These days, most techies' attention seems locked onto the Web and consumer gadgets. But the hottest tech stock offering since Google Inc. (GOOG ) is being driven by a far more basic need: to save money. Shares of VMware Inc. (VMW ), a little-known company in an unglamorous corner of the computer industry, have shot up 135% since their Aug. 14 debut.

VMware dominates the fast-growing market for "virtual machine" software, a decades-old concept that the company updated to let the work of a dozen or more computer servers be piled onto a single machine. That helps cut hardware budgets and soaring electric bills at data centers.

Some experts believe virtualization could fundamentally alter the computing landscape as companies cope with storing and transmitting ever-growing piles of data. "If the average investor could have understood Moore's Law 30 years ago, he would have invested in it. This is like Moore's Law," says Ray Lane, a managing partner at venture capital firm Kleiner Perkins Caufield & Byers, referring to the concept that chip and computer performance rise while prices fall. (Kleiner Perkins has a stake in a rival virtualization outfit.)

Companies gorged on low-priced servers to handle tasks such as delivering Web pages and planning production schedules. The result: a data-center obesity epidemic, with thousands of machines running way below capacity.

That's a huge opportunity for VMware. Its shares opened at $29, jumped to $51 after their first day of trading, and closed on Aug. 29 at $68.20. That gives VMware a price-earnings ratio of 213 and a market value of $26 billion, making it the world's fourth most valuable software company behind Microsoft, Oracle (ORCL ), and SAP (SAP ).

A big beneficiary of the runup is EMC (EMC ), a Boston area data storage company that bought VMware in 2004 from investors and founders, including current CEO Diane Greene and her husband, Mendel Rosenblum. EMC still holds an 86% stake and controls most voting rights. Soaring demand from big customers such as Merrill Lynch (MER ) and Chevron (CVX ) should nearly double VMware's revenue to $1.3 billion this year, says Dan Renouard, an analyst at Robert W. Baird & Co. Operating profits are expected to jump to $300 million, from $121 million last year.

Can VMware maintain its lofty perch? Microsoft Corp. (MSFT ) has been slow to bring out a compelling rival product in large part because the technology might crimp demand for its software by helping put servers out to pasture. But starting next year it plans to give away virtualization software as an add-on to Windows. Industry analysts consider VMware's technology more robust, but Microsoft could hurt its ability to charge premium prices or may persuade customers to choose a good enough product that's free.

By Aaron Ricadela

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