Investors are getting carried away with
Shares of the storage virtualization company closed trading Wednesday at $57.85, up another 13% for the day and nearly double its IPO price of $29 fetched last Thursday.
But despite the certain heady growth ahead for the virtualization market and VMware's high-quality, feature-rich product, a market cap of $22 billion is a bit optimistic.
Even a more modest valuation of $15 billion would require the company to keep its massive market share near current levels as the space grows, and as it continues to charge customers relatively astronomical prices for its products.
But beyond the imminent competition from
, the market is teeming with hot start-ups determined to compete on price. It's unlikely that VMware can continue to keep the market to itself while charging such high prices.
Bullish on the stock at the time of last week's partial spinoff by storage giant
, Bernstein Research analyst Toni Sacconaghi estimated that the shares were worth between $34 and $39.50 each, which would value the float at between $13 billion and $15 billion.
That valuation is based on VMware increasing its earnings per share by more than two-and-a-half times to $1.76 in 2010. This year, the company should earn 67 cents a share, according to Thomson Financial.
"In our forecast, we assume that VMware's market share will decline modestly, that their pricing will be relatively stable and that operating margins will expand significantly from current depressed levels," Sacconaghi wrote in a research note on Tuesday.
But that view could be incorporating an unrealistically rosy scenario for the company.
Given the competitive landscape, it would be extremely difficult for VMware to hang on to its 85% market share and hold the line on its top-dollar prices. That's especially true given how early it is for storage virtualization, which helps companies save money on hardware by allowing multiple operating systems and application programs on a single machine.
Bernstein estimates that penetration levels are still only at about 5%, meaning that the vast majority of the market is still up for grabs.
And while VMware investors may be aware of the threat from Microsoft -- which is launching a new product into the market in 2008 -- what may be less acknowledged is the pressure to lower prices that some top venture-backed start-ups will exert.
These fledgling companies are building on top of a virtually free, open-source platform, which allows them to keep their own costs very low.
, which announced Wednesday that it was being acquired by
, a move that will only make it more competitive by allowing it to tap into resources like the parent company's sales force.
While short of offering all the bells and whistles that VMware offers, XenSource's latest product costs less than half of the closest VMware product.
A XenEnterprise license goes for $2,499 and costs $500 a month for technical support, the company's vice president of marketing, John Bara, told
. VMware's Virtual Infrastructure 3 costs $5,750 per license plus $1,200 a month for technical support, he said.
And about 70% of XenSource's customers formerly used VMware, Bara told Bernstein Research, meaning that a lower-end, lower-cost product has appeal to initial VMWare users.
The steep prices VMware charges are even more glaring when compared to start-up
, which counts top venture capital firms like Matrix Partners and Highland Capital as its backers. Virtual Iron can do about 85% of what VMware can do, says John Thibault, but charges just $1,000.
"VMware has great products, but when we talk to their customers, the No. 1 complaint is that they are just too expensive" says Thibault. "We do 'bake-offs' against them all the time, and more often than not, we win."
Thibault concedes that it would be difficult to persuade some big companies that have already spent a fortune setting up VMware's systems to convert. But VMware already counts all of the
100 and 84% of the
1,000 among its roster of clients.
That means a good part of the growth for VMware may be among smaller businesses -- exactly where companies like Virtual Iron and XenSource will make for stiff competition by offering low prices.
At the end of the day, VMware may be forced to lower prices to keep market share, or cede market share if it wants to continue to charge high rates. Either option, though, would put its already-astronomical valuation under pressure.