How Deep Are VMWare’s Troubles?

Implications: VMWare is doing great, so how could they be in trouble?  By having both Microsoft and open source invade their market.  Their easy growth is in the past, and now the question becomes whether they can thrive in a highly competitive environment.

Analysis: VMWare essentially created the x86 virtualization market and has been the dominant (and for a long time, the sole) vendor in the market.  As such they have been able to charge premium prices for their products and use those high margins to develop still more innovative products, as well as other plums such as an “eco-friendly” new headquarters.  Their record-setting IPO in 2007 saw their market cap ascend to astronomical heights.  2008 has not been so kind to them.  Growth rates are slowing, with two revenue forecast reductions already, capped by the recent ouster of their co-founder and long-time CEO, Diane Green.

VMWare remains the undisputed technology leader, but their premium pricing has left them vulnerable and put a damper on their continuing growth.  CIOs are quite willing to buy VMWare products in limited quantities to virtualize selected elements of their infrastructure, but not to move into mass virtualization.  Most IT shops have a few areas where the gains from virtualizing provide an immediate ROI even at the prices VMWare charges today.  Few IT shops can find a realistic ROI for virtualizing large portions of their infrastructure at today’s prices.  Consequently, most CIOs have dabbled a little in virtualization, but are playing a “wait-and-see” game before moving any further.  This is one of the primary reasons why virtualization today has only penetrated 5-10% of the available market.

Microsoft is moving aggressively to attack this market with their tried-and-true approach of providing technology that is “good-enough” at dramatically lower prices.  Perhaps even more dangerous to VMWare, however, are the various open-source efforts that are focused on the virtualization market, some of which are now under the umbrella of major software vendors such as Citrix.  Microsoft will charge commodity prices for technology to win market share, but once they have market share their prices tend to move up.  Open source, by contrast, will never charge premium prices, so the various open-source virtualization products essentially put a ceiling on the prices VMWare will be able to charge.  Many CIOs, of course, are still uncomfortable entrusting their infrastructure to open source products, but the Citrix endorsement will overcome many of these reservations.  For the rest, there’s Microsoft.  Also, the virtualization capabilities in Red Hat and SuSE Linux should not be underestimated.  While these offerings are still quite limited compared to what VMWare has, they do take away a portion of the virtualization market that VMWare would otherwise have.  The net cost of these offerings, even with full licensed support, is still zero since they are included with the Linux license.

With these factors in play it starts to become clear why a CEO change was needed.  If VMWare continues business-as-usual, they will fail.  Not today, not tomorrow, and probably not for several years, but their decline in market share and margins will be steady and inevitable.  If VMWare is to be successful they will have to accept lower prices for their current products, while at the same time continuing to innovate with new products.  Their connection to EMC is a potential advantage allowing them to offer a complete “cloud” product that allows enterprises to virtualize their entire infrastructure, not just servers.  At the same time, however, VMWare must be cautious not to burn any bridges with their other partners such as Network Appliance.

VMWare must walk a tightrope and make fundamental changes to thrive in this environment.  This requires a new strategic direction and likely new blood at the top.  Only time will tell whether Paul Maritz is the right person for the job, but certainly he understands the threat from Microsoft and has the credentials to steer the company to success.  Microsoft’s products are not truly competitive today, but they will be in a few months.  VMWare still has a window of opportunity to capitalize on their lead, but that window is measured in months, not years.