Virtual Iron CEO Calls VMware Dominance Bad For All In I.T. (VMW, EMC, CTXS, SAP, GS, MSFT, DELL, HPQ, IBM, INTC, AMD, SYMC, SUNW)... 24/7 Wall St. Exclusive

The CEO of Virtual Iron, Ed Walsh, spoke exclusively to 24/7 Wall St. partners in two separate interviews.  Virtual Iron is the virtualization company owned in part and backed by Goldman Sachs (NYSE:GS), Intel (NASDAQ:INTC), and SAP (NYSE:SAP). It would seem to have little reason to speak well of VMWare (NYSE:VMW), since the much larger company is its rival and competition.  But, Walsh makes the point that his company is the only real obstacle to VMWare moving into an entirely dominant position in the server software business. This could hurt other tech companies in the pocket book. Walsh came to Virtual Iron out of EMC Corp.’s (NYSE:EMC) Information Management Software Group after being CEO of Avamar Technologies, Inc. which was acquired by EMC in 2006.

Microsoft (NASDAQ:MSFT) has a virtualization product of its own called Veridian, coming out later in 2008. But Ed Walsh notes that the product is at least a year behind VMWare and is aimed at lower level functions in server operations—server consolidation and provisioning which cuts operations costs. These are functions useful to smaller business but are less likely to fit the bill for large enterprises.

So, who plays where the real money is, and where the revenue per customer is highest?  Walsh contends that only Virtual Iron and VMWare have products that can handle complete disaster recovery, server capacity management, and the movement of tasks from application to application in a server cluster. He readily admits that VMWare is the Cadillac of the business. But, he claims that his software is easier to install and manage. 24/7 Wall St. asked if Citrix Systems’ (NASDAQ:CTXS) XenSource acquisition is coming on strong in the space and Walsh noted, “We never come up against XenSource. Just VMware.”  This was something similarly questioned by 24/7 Wall St.

When 24/7 Wall St. asked Walsh about what we have referred to over and over as “The VMware Conundrum” regarding valuation, we were surprised about the potential metrics Walsh was willing to discuss.  Walsh referred to the virtualization market on its own and gave some lofty multi-billion figures from IDC and even loftier figures from Bear Stearns What he added was all of the overlaps and secondary and tertiary operations that virtualization leads into that have been under the control of traditional I.T, software, security, and hardware firms.  The potential increase in the value of VMWare, if it can take over OS and security functions, could be substantial.

If Virtual Iron does hold such a critical place in the virtualization industry, the question is still open about how it can compete with VMWare which has a nearly mystical market cap of $33 billion and revenue of almost $360 million in the September quarter?  The smaller rival contends that it is the only other full answer available, and any field dominated by only one player can stifle development, efficiency, security, and interoperability.

Part of the answer is that Virtual Iron has a good product, and a significant difference in pricing. The other issue is that if VMWare ends up with a huge percent of the virtualization business, it will do some real damage to hardware and software vendors who do business in servers.  Walsh also noted, “Anyone can put a bunch of O/S’s on a server, but that won’t cut it, and now anyone can do that.” But with future virtual appliances, the O/S selection won’t be as critical.  He attests that the tipping point was when Microsoft recently cried “uncle” with its Veridian.

A recent survey by Goldman Sachs shows that IT executives expect virtualization to allow them to cut-back sharply on spending money for software from Microsoft, IBM (NYSE:IBM), and Hewlett-Packard (NYSE:HPQ). Even more important, tools that VMWare adds to its software package will allow it to take large pieces of business from Oracle (NASDAQ:ORCL) in the clustering part of the business, Symantec (NASDAQ:SYMC) in data protection, and configuration management revenue from HP. What is more than obvious is that EMC’s fairly recent acquisition of RSA Security is going to make RSA more prominent in the coming I.T. wars in 2008 to 2011.  Since there are three layers of server operation and more that have to be secured, it will make proper security a must.

Based on a model where VMWare takes over functions done by other companies, its market cap may be supported not only by potential virtualization revenue.  As noted above, this is part of what is driving VMware’s valuation as other pieces of the revenue pie held by large software vendors could come up for grabs. Sanford Bernstein puts virtualization software market share at 26% of revenue spent on the global installed server base in 2012.

Another by-product of virtualization is that it allows companies to operate with fewer servers, and more functions may run at the desktop level.  Why does the movie-inspired term “Skynet” come to mind where applications are teaming simultaneously on millions of computers rather in servers and mainframes? Over time, perhaps three to five years, this should start to cut into the server revenue at companies like Dell, HP, and IBM if these companies do not fully line up their partnerships upfront. It could also be devastating to operations like Sun Microsystems (NASDAQ:SUNW) because of the reliance on high-end servers.

The trend also could undermine chips sales for servers, effecting Intel (NASDAQ:INTC) and AMD (NYSE:AMD). If the “power player” in the server business is the virtualization provider and not the supplier of the operating system or hardware, it could quite easily turn the industry on its head..  The year 2008 is going to be the first of many for monumental changes from software to hardware to desktops to servers.

Virtual Iron is making what appears to be an intelligent gamble. Over time, VMWare may allow companies to save money, but it takes bread from the mouths of a number of other important IT suppliers. Those suppliers need an ally, and it isn’t too late for the industry to keep a system of checks and balances in place that insures mutual survival and mutual success. That ally is not likely to be Microsoft. It does not have a reputation for playing nicely with other tech firms. But, it could be Virtual Iron. Bargaining for a better seat at the table is more likely to work with the smaller private company than it is with VMWare. Virtual Iron may not just have good software. InfoWorld recently wrote “Virtual Iron is the closer match to VMware, boasting a rich set…”

End-user customers are apparently already pulling away from some of the traditional long-term spending plans to accommodate more spending around the aspects of virtualization.  A virtualization world ruled by one company could be bad for a number of others. Microsoft certainly did not do competitors any favors, nor does it now, in the server and PC OS worlds. Virtual Iron is not just a competitor in its field. It is a blocking play for IT to prevent the business from being taken over by VMWare, or, potentially Microsoft, although Redmond seems fairly far behind.

Can Virtual Iron financially support being a strong presence? It may have to go public to raise the war chest. But, VMWare showed how hot the business is, at least in the eyes of Wall St. And, Goldman is a shareholder. The company will be able to command high valuations, and the earnings and revenue multiples will depend on forward revenues and expectations rather than what was sold in 2007.

It is obvious with a ten year look back that Windows had too large of a jump on Linux, and Linux was too esoteric, unclear, and lacking unification for it to be an immediate threat or an immediate alternative.  Hardware, software, and IT Vendors need to take heed of the lesson of Windows.

Douglas A. McIntyre & Jon C. Ogg
November 12, 2007

These companies are all under constant review by 24/7 Wall St. for the Special Situation Investing Newsletter, and some in the "10 Stocks Under $10" letter.