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VMware's Ambitions Cause Near-Term Issues

High-flying virtualization company VMware showed that it's not immune to the current malaise gripping the IT industry, reporting lower-than-expected revenue on weakness in sales.

The company reported net earnings of $69.9 million, or $0.18 per share. Before one-time charges, earnings rose to $0.25 per share, above analyst expectations of $0.20.

More concerning for investors were sales. Overall revenues came in $470.3 million, up 7 percent but just shy of average estimate of $474.38 million, according to Reuters Estimates. But VMware's license revenue declined steeply, falling 12.6 percent to $257 million, and making matters worse, the company said next quarter's sales may even be down further.

Shares of VMware (NYSE: VMW), which had traded upward during the day to close at $32.55, fell in after-hours trading to 28.75 at press time.

The company is still majority owned by storage vendor EMC and provided EMC a net of $15 million in cash during Q1 2009.

VMware's strategy is to move from licensing to services, and much progress has been made, but little of the services income is professional services -- most of the services income is software maintenance. Services income increased to $213 million for the quarter, up from $144 million a year ago, but only $37.5 million of that was professional services.

Mark Peek, VMware's CFO, said on the company's earnings call that selling maintenance packages lowers sales costs because the sales force gets no commission on maintenance package revenues. He said that as a result, sales expenses were 27 percent of revenues as opposed to 39 percent of revenues a year ago.

He added that the company does not expect to rely on professional services revenue. "We are helping our partners build a consulting business around VMware," he said. "We expect only a modest growth in professional services revenue."

The company said it has plenty of cash to survive the economic situation, but noted that the outlook is not necessarily good. "Our operational execution has resulted in strong cash flow, and enables us to continue to make the strategic investments needed to grow our business. However, due to the tough economic conditions, we expect customers will continue to keep a very tight rein on their IT spending, particularly new investments," Peek said in a statement.

VMware launched an ambitious new product yesterday, vSphere 4.0, that connects its core virtualization product to cloud computing.

The company may be walking a fine line with the upgrade, allowing customers to gain some of the benefits of vSphere for no extra charge as part of existing software maintenance agreements, but hoping to sell them some licenses, too.

"Customers are entitled to an equivalent set of functionality in vSphere, but not the new higher end features," said Tod Nielsen, VMware's chief operating officer.

The top package for vSphere is called Enterprise Plus, and customers will have to pay to upgrade to it if they want the features it offers.

VMware will also be offering some features to customers that did not have those features before. "We've done a good job of migrating our technology down in the stack to extend our competitive lead," Nielsen said. "But we'll be encouraging our existing customers to upgrade."

vSphere 4's impact still to come

That new product may help in the long term, but in the short term, it's keeping the company and its partners busy with significant technological change, the company admitted.

"During this quarter, we and our extensive ecosystem of partners will begin the transition to VMware vSphere 4. As a result, we expect our second quarter revenues will be flat, or even down, compared to the second quarter of 2008," Peek said in a statement.

Its VMworld conferences remain huge, but their size illustrates the scope of the challenge: VMworld Europe had 4,700 attendees, and Europe is the market in which the company saw its most rapid decline.

Education is ongoing, Peek admitted. "We launched a series of training programs in the past few weeks and will launch more through May and June," he said.

Competition

While VMware's officers insisted that the macroeconomic situation was responsible for VMware's mild difficulties, analysts pressed the executives to talk about the effect of competition. Maritz said that the company has three customer segments and eventually admitted that the company faces a challenge in one of them.

He said that demand is relatively inelastic among VMware's largest customers and that the company has taken steps to address the SMB market but that customers that are neither large nor small present a challenge to the company. "The competition in the future will focus there," he said. "We need to make sure we harvest value from the customers who appreciate it but do not inadvertently open up beachheads for the competition."

That doesn't completely agree with a Forrester Research report on the virtualization market released last month that said that although VMware's position in the large enterprise market was secure and VMware was still far ahead in the SMB market, SMB customers were taking a long, close look at Microsoft.

Maritz did acknowledge Microsoft, but only in passing. "Microsoft is prepping Windows Server 2008 [Release 2]," he said. "I hope vSphere will further move the bar for us." Release 2 will have several virtualization features but it is still in beta at this time.

The economy

VMware provided few signs that it sees the economy moving in a positive direction, contrasting with other reports this week.

IBM predicted record Q2 earnings, AT&T said it was "well positioned for the next wave of growth" and Apple said it was "in a great position". Among recent reports, only eBay acknowledged that 2009 would be grim.

VMware executives, however, did not use euphemisms. "We're not calling the bottom," Peek said.

In fact, said Maritz, IT managers have adopted a "just enough, just in time" mentality: They are hanging on to cash for as long as they can each quarter, and are spending it in smaller amounts. He also said customers are cutting back now at the expense of future costs, for example, opting for single-year maintenance contracts that carry higher annual costs than multiyear contracts.

When the line of business managers want to spend, the CFO may stop them, he added.

"We've seen contracts get to the desk of the CFO and get turned into a lesser purchase order," he said.

IT managers want to spend because they continue to recognize the value of virtualization, the executives added.

"We are not seeing a declining demand for virtualization," Peek said. "We are seeing the size and scope of projects decline. Customers are buying in smaller increments."

The only bright spot is in the federal government, which signed one of two major deals that the company closed in Q1 2009. The company defines a major deal as being worth over $20 million. One deal was in the government and the other was with an undisclosed major outsourcing operation.

"If there is any silver lining in the current situation," Maritz said. "It's that the federal government has money and is spending it. While we cannot guarantee another deal like this in Q2, there will be an opportunity for more deals in the federal sector."