VMWare – A WallStreet Chainsaw Massacre

January 28, 2008

Watching shares prices bludgeoned is never fun. After hours Monday, VMWare (VMW) bled and the red kept on coming like a scene from a third rate horror flick. The real scare is that there could be more to come.

For some time, we have been concerned about the potential implosion in share prices for VMWare (VMW) shares, since, as of late, there has been a painful awareness of the rotation/stampede out of stocks in which investors have high expectations for enormous earnings momentum. Even so, this particular stock has a very unique story, as it is one of the few pure-plays in the technology market today. We have now come to find this is also their Achilles heel. Further adding to the concern is the fact that in the next few weeks (February 11th), the first wave of available shares will flood the market as the initial lockup period ends for IPO shareholders. The dilution will continue over the next few quarters, which will conceivably add selling pressure. This thought has obviously been weighing heavily on investors and this has been vividly seen as the earnings report of January 28th, while not horrible, sent shares tumbling.

We have held that this stock was severely overvalued when we started to research this name. At that time, it was at $102 and it immediately apparent that the catalysts for growth were in danger as several factors were converging. Immediately, we added positions of the April $60 puts to selective client portfolios and paid a premium of $2.60.

Virtualization Diagram
Before getting into those details, maybe a quick review of the incredible technology know as “virtualization” should be addressed. If you have not heard about virtualization software yet, you are obviously not paying close attention. Perhaps one of the greatest technology advances in years, it is one reason that Apple Computers are able to run Windows…within a window. It has also been a big part of the internet’s explosion as servers are able to run multiple sites under the extreme efficiency provided by virtualization software.

Virtualization technology can trace its roots back to IBM at their Watson Research Center. Back then, the original concept was dubbed: time sharing. This can be further dated to a visionary paper written by Christopher Strachey entitled, Time Sharing in Large Fast Computers (1959).

In a recently released Executive Memo from Bob Nuglia, Senior Vice President of Microsoft’s Server and Tools Business, the history and future of virtualization is explored. One particularly interesting area of the memo was his historical references to the industry’s consolidation and the fact that Microsoft has all of their technology lined-up to make a major impact.

“Virtualization is not new. IBM first introduced virtual machine technology for mainframe computers in the early 1960s. Microsoft Windows NT included a virtual DOS machine. Virtual PC was introduced by Connectix in 1997 (Microsoft acquired Connectix in 2003). EMC’s VMware introduced its first product, VMware Workstation, in 1999. Softricity introduced SoftGrid, the first application virtualization product, in 2001 (Microsoft acquired Softricity in 2006).”

Adding to that powerful lineup, Microsoft announced a new relationship by press release on January 21, 2008.

“…an expanded role for virtualization as a key enabler of its Dynamic IT vision and outlined a companywide strategy to help accelerate the broad adoption of virtualization. To help drive its strategy, the company also announced the acquisition of Calista Technologies Inc. to improve the end-user experience for virtualized desktops and applications; an expanded alliance with Citrix Systems Inc. in the areas of client and server virtualization; more flexible licensing options for virtualization using Windows Vista; and new tools that provide best practices to deploy Microsoft virtualization software.”

Since its genesis in 1959, there have been dramatic changes and giant Read more