VMware's Good News-Bad News Earnings

The software company's third quarter beat expectations, but with a slowing economy and pressure from Microsoft the forecast is gloomy

Onetime tech industry darling VMware (VMW) beat tepid expectations for its first quarter under a new CEO, but the company provided a downbeat forecast for the current quarter. On Oct. 21, VMware reported revenues for the third quarter grew 32%, beating Wall Street's expectations. The software company exceeded earnings estimates as well.

The results lifted VMware shares more than 22% in extended trading on Oct. 21, after closing the day down $1.91, or 9.25%, at 18.73. Shares of VMware, which launched the most successful initial public offering of 2007, have lost more than 80% of their value in the past year amid slower-than-expected growth, competition from Microsoft (MSFT), and a management shakeup in July. By comparison, the Dow Jones industrial average has fallen 33% in the past year, and the Standard & Poor's 500-stock index is down 36%.

VMware's report heartened investors who had feared something worse, but it's clear the company is no longer a standout performer. Last August, VMware held the tech industry's most successful IPO in years, and the shares soared as high as 125 in October 2007. But now that revenues are growing at 30% or 40% instead of 80%, the stock has lost its luster (BusinessWeek.com, 1/29/08). VMware said 2008 sales will likely grow 42%, at the low end of its previous forecast, and the growth rate may dip even lower.

Pricing Pressure

"The Microsoft threat is growing, and these guys are seeing pricing pressure," says Jeff Gaggin, a senior research analyst at Avian Securities, who has a neutral rating on VMware's stock. Factor in an economy hinging on recession, and "that's going to make it doubly hard for them to meet consensus revenue estimates for the rest of the year," he says. Analysts expect VMware to report 2008 revenues of $1.88 billion.

Companies use VMware's software to combine the work of several computer servers onto a single machine, and its products have proven popular as they help IT departments cut hardware and labor costs. This year, Microsoft began including a competing piece of software in some versions of its Windows Server operating system. New VMware chief executive Paul Maritz says customers are slowing down their buying decisions to compare VMware's and Microsoft's products head-to-head. But the broader economy is causing more caution than competition, he adds.

VMware held its guidance for annual sales growth at 42% to 45%, "but we could get different data in four to six weeks as the quarter unfolds," Maritz said in an interview after the earnings report. "These are unprecedented times."

For the third quarter ended Sept. 30, VMware reported revenues of $472 million, and earnings rose 29%, to $83 million, or 21¢ per share. Wall Street analysts had expected sales of $462.7 million, and earnings of 20¢ per share. In a conference call with investors, Maritz pointed to an "extreme reluctance by organizations to approve purchases of any kind."

Management Shakeup

Maritz took over as CEO in July, and has undertaken a management housecleaning and other changes to try to jog growth. On July 8, VMWare's board, which is controlled by onetime parent company EMC (EMC), ousted VMware co-founder and former CEO (BusinessWeek.com, 7/8/08) Diane Greene, replacing her with Microsoft veteran Maritz. Shortly after, Greene's husband, co-founder Mendel Rosenblum departed. Research and development chief Richard Sarwal returned to Oracle (ORCL) in September after just a few months on the job, and product development vice-president Paul Chan has also left VMware.

On Oct. 24, VMware plans to begin a multimillion-dollar advertising campaign, the company's first, with ads in U.S. newspapers and magazines featuring VMware customers talking about its software, says vice-president Kate Hutchison.

The company also started to more aggressively market digital tools to manage its "virtual machine" software while giving away a basic version of the product, according to analysts. "The world is certainly changing for VMware," says Jayson Noland, a senior analyst at Robert W. Baird. Unfortunately for VMware, that also means a loss of gravity as a stock market star.