EMC’s VMware IPO: Striking While the Iron is Hot

7/24/07Follow @wroush

One of the most-watched technology IPOs of the summer will be the sale by Hopkinton, MA-based storage giant EMC (NYSE:EMC) of about 10 percent of VMware, its red-hot California “virtualization” subsidiary. The division makes software that allows a single computer or server to function as if it were many machines—running multiple applications on top of multiple operating systems simultaneously. The technology is in demand at major enterprises looking for ways to save hardware costs, and the IPO, anticipated for mid-August, could raise as much as $1 billion for the company. But VMware’s golden moment could be short-lived—and analysts tell Xconomy that EMC is wise to be capitalizing on VMware’s success sooner rather than later.

In the 1990s many companies sold off portions of their most successful divisions in the form of so-called “tracking stocks” whose shares could then trade separately from those of the parent companies. Today, the tracking stock concept is one of the few leftovers of the dot-com era that retains its magic. A large, established company that offers shares in a high-flying subsidiary can, in essence, trade on the subsidiary’s success and sell those shares at a higher price than it would win if it were selling the equivalent fraction of its own shares. It can also reward and hopefully retain employees at the subsidiary by offering them options on the new shares. And sometimes, the parent company’s own stock is buoyed in the process.

EMC has all of these goals in mind for the VMware IPO. “We expect the IPO to unlock more of VMware’s value for EMC shareholders while also strengthening its ability to retain and attract the software industry’s top talent,” EMC CEO Joe Tucci said back in February, when the IPO was first announced.

But there may be more to it than that. The timing of the offering is particularly auspicious, several analysts and competitors suggest. VMware is still on an upward growth curve—revenues increased 83 percent in 2006, to $709 million, and doubled again between the first and second quarters of 2007. If EMC waited much longer to sell a portion of the subsidiary, these sources say, its growth could level off, and VMware stock might not fetch the premium prices being predicted by analysts (in the neighborhood of $23 to $25 per share, according to observers such as 24/7 Wall Street).

Because server virtualization saves money, allowing companies to buy and maintain fewer machines to do the same amount of heavy-duty enterprise computing, the technology is hot. And VMware took an early lead, launching systems such as ESX Server that can efficiently run Windows, Linux, Solaris, and other operating systems on separate virtual machines on the same system. But competitors from both the open-source community and the traditional software industry are catching up rapidly, says Daniel Kusnetzky, an independent software industry analyst formerly with IDC whose blog on virtualization is hosted by ZDNet.

“VMware has pulled of an amazing marketing coup—they’ve made the market think that when you say ‘virtualization’ you mean ‘what VMware is doing.’ But the truth is that as people start to get more experience in the marketplace, they are going to start running into other competitors who are doing similar things,” says Kusnetzky. “My sense is that EMC realized that the highest level of value they were going to receive for carving up [VMware] and making part of it into a public offering was coming right about now.”

One budding competitor is XenSource. The Palo Alto, CA, company is commercializing an open-source virtualization program called Xen that originated as a research project at the University of Cambridge in England. While XenSource has fewer than 600 customers, that number is doubling every 90 days, and the company benefits from the smarts of the scores of software developers involved in the Xen project. That means XenSource’s products are evolving more rapidly than VMWare’s and will be able to adapt to changing market needs faster, according to John Bara, XenSource’s vice president of marketing.

“Intel, AMD, IBM, HP, all of those are major contributors to the Xen project, so you get a rapid rate of innovation and a collapsing of the development cycle,” Bara says. What’s more, since hardware makers are directly involved in Xen, they’re able to turn out server chips intrinsically optimized to support the software, whereas VMware must deploy a team of device developers to make sure its system is compatible with the latest hardware and vice versa.

“The time to offer a piece of VMware is now,” Kusnetzy reiterates. “Otherwise, the competition is going to make it difficult for VMware to get a premium price.”

VMware officials contacted by Xconomy said they were unable to comment on the assertions from Kusnetzky and Bara, citing the “quiet period” rules in effect in advance of the offering.

Wade Roush is a contributing editor at Xconomy. Follow @wroush

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