SAN FRANCISCO - VMware ( VMW) must walk a fine line between revenue growth and price cuts to remain the market leader in virtualization.

A report released Wednesday shows the company's market share is eroding quickly as competitors close the technology gap with lower-priced products. But the report's author says new leadership at VMware may help stem the trend.

The stock was recently up $2.18, or 6.2%, to $37.41, surpassing its one-year price target of $36, according to Thomson Reuters. The stock has enjoyed a two-day gain of 12% since closing at $33.33 Tuesday.

Virtualization software helps corporate data centers drastically cut hardware, energy and cooling costs by making more efficient use of servers and desktops.

Yankee Group analyst Laura DiDio estimates the entire virtualization market will take in about $12 billion to $14 billion in 2009, growing at a 25% to 30% compounded annual rate over the next three years. In 2011, the worldwide market will be worth about $20 billion in revenue, she says.

VMware has 75% of the market, but lowered its growth forecast at its most recent earnings call, in part due to Microsoft's ( MSFT) early release of its virtualization hypervisor technology in late June. The Hyper-V is loaded onto Windows Server 2008 -- a move that is expected to make deal closure more difficult for VMware.

Oracle ( ORCL), IBM ( IBM), Hewlett-Packard ( HPQ), Sun Microsystems ( JAVA), Virtual Iron and niche player Parallels are all chipping away at VMware's dominance, according to DiDio.

"Oracle in particular is poised for explosive growth in the application virtualization and virtual appliances segments given its recent acquisition of middleware vendor BEA Systems," DiDio wrote.

DiDio's report indicates VMware has already lost some ground to Citrix ( CTXS), whose XenSource now accounts for 17% of installed hypervisors. The figure includes XenSource hypervisors embedded into open source servers from Novell ( NOVL) and Red Hat ( RHT).

DiDio notes that XenSource, which Citrix acquired in 2007, accounted for only 3% of hypervisors in 2006. Hypervisors have become commodity software. Developers earn higher margins on the tools that perform a variety of high-level management functions.

Yankee Group's 2008-2009 virtualization usage report surveyed technology officers at 750 businesses in 20 countries, primarily in North America and Europe.

The virtualization stakes are high: Only 20% of large businesses worldwide have completely virtualized their data centers, DiDio said in an interview Thursday. Some 72% of businesses surveyed said they plan to virtualize their data centers; another 16% are studying it. Only 12% have no interest.

According to DiDio, some 22% of businesses polled say they plan to use Microsoft's 64-bit version of the Hyper-V -- a product that has not shipped yet.

Despite the competition, DiDio says VMware can hang onto its No. 1 position due to the recent change of leadership. The board appointed Microsoft veteran Paul Maritz as CEO in early July.

"With Paul Maritz, the outlook is much more positive," DiDio says. Maritz immediately changed VMware's strategy by announcing that a key product would become free. "He's in this for the long term. He'll make it up on the higher end. He's willing to sacrifice this revenue because he knows the higher up the software stack you go, that's where the profit margins are the fattest," DiDio says.

Competitors have already shrunk the virtualization leader's head-start on the development of advanced technology to only six to nine months, from a two-year lead it held in 2007, according to DiDio.

Competitors "are closing the gap by acquisition," DiDio says.

"Rivals now offer many of the same advanced features such as live migration ... and provisioning as VMware, which users interviewed by Yankee Group say are enterprise-ready and extremely competitive with VMware," she wrote. Live migration refers to the ability to move open software applications among servers to prevent disruption of services.

The onslaught of lower-priced competitors has eroded VMware's revenue growth, which was nearly 90% in the last quarter of 2007, adding pressure for it to cut prices. Competitors' prices are 40% to 75% lower than VMware's, she noted.

"In the past year, all the other virtualization vendors charged between $700 and $800 per socket for their commercial server products, while VMware's product retailed for a whopping $3,000 per socket, a 75% premium," DiDio wrote. VMware is adjusting its pricing and package bundles to hang onto market share, she added.

Without price cuts, VMware risks a backlash from current customers who will demand bigger discounts once their current contracts expire. At least 50% of the businesses surveyed indicated they might switch vendors over price, the report concludes.

DiDio's report will not help VMware's position: she recommends VMware clients that are under two-year contracts with onerous terms leverage their buyer's-market position by renegotiating now that market prices have dropped.

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