On January 25th 2010 VMware reported earnings for the fourth quarter of 2009 and for the full year of 2009. While we are not a financial analysis site focused upon earnings and stock prices, there is important information contained in these earnings numbers about the success of VMware. This is a critical issue, as many people expected the release of Microsoft Hyper-V R2 to significantly eat into the growth of VMware, and perhaps even start to eat into VMware’s dominant market share position. These earnings numbers provide a critical insight into how well VMware is doing, which helps us understand how impacted by Hyper-V VMware was in the fourth quarter of 2009.
At first blush, the numbers might appear not so good. If you compare license revenue from new sales of VMware for the fourth quarter of 2009 to the fourth quarter of 2008, those numbers were down. VMware had $315M of license sales in the fourth quarter of last year and only $304M of license sales in the fourth quarter of 2009, a 3.5% decline. License sales for the entire year of 2009 were $1,029M vs. $1,178M for all of 2008, a decline of 12.6%. So if license revenue is down, then sales must be down, and VMware must be experiencing enormous pressure from Microsoft Hyper-V, right?
Well it turns out that there is more to the story than license revenues. As we have written about before, there was a deal announced when VMware announced vSphere with the Enterprise Plus Edition. That deal was that there were some special one time incentives to upgrade from Enterprise to Enterprise Plus and that those incentives expired on 12/15/2009. To understand the impact of this special deal, we have to look beyond the license revenue numbers. The key number to look at is how much deferred revenue in the form of maintenance agreements did VMware book over time. This is important because it gives us another data point on the success that VMware had with its sales efforts. Deferred revenue is a liability that gets created on the balance sheet of a company when it sells a multi-year maintenance agreement. The reason this liability gets created is that the agreement contains a promise to provide maintenance and support in future years, which is a liability until that maintenance and support is actually delivered.
What VMware did on the maintenance front throughout 2009 and especially in the fourth quarter of 2009 was very interesting (and impressive). At the end of 2008, deferred revenues (revenue tied to an obligation to deliver future maintenance and support) stood at $160M. At the end of Q3/2009 they stood at $212M and at the end of Q4/2009 they stood at $246M. So the sales of maintenance agreements grew by 54% year over year and by 16% in just Q4/2009 compared with Q3/2009. What appears to have happened is the following. VMware was apparently willing to severely discount the license fees to get customers to both upgrade to Enterprise Plus, and to license vSphere in the first place if they had fallen off of maintenance. However, VMware did not discount the maintenance fees in proportion to how they discounted the license fees. In essence, VMware traded off up front license fees for market penetration and longer term sustainable recurring revenue in the form of maintenance agreements.
This shows us two things about VMware. The first is that Q4/2009 was a great quarter for VMware. VMware was able to get a substantial number of customers to upgrade to Enterprise Plus and able to get a substantial number of customers who had dropped V3 and even V2 maintenance back on maintenance in order to get them the rights to upgrade to vSphere. This means that the sales of vSphere went very well indeed, despite the lack of growth in top line license fee revenue. The second thing that this tells us is that if Microsoft Hyper-V gained traction in Q4/2009, most of those gains did not come out of the hide of VMware, but were most likely in the form of customers who had not virtualized at all yet. Therefore whatever success Microsoft may have had in Q4/2009 probably grew the size of the market instead of taking customers from VMware.
Stepping back from this it is clear the VMware has a two part strategy. The first part of the strategy is to get its platform embedded into enterprises worldwide. It is our belief that once the VMware platform is embedded in a production data center that it is “sticky” and that customers would incur substantial switching costs to change to a different virtualization platform. In this sense the VMware battle with Microsoft is very different than the Netscape battle was with Microsoft as there was nothing “sticky” about the Netscape browser that made it hard for customers to switch once Microsoft’s Internet Explorer became “good enough”. It is our belief that the more VMware continues with its penetration deeper into data centers and across more data centers, the more it creates a long term and durable systems software franchise of the type last seen when Microsoft successfully built the Windows franchise.
The second part of VMware’s strategy is to follow up the creation of a new systems software platform with a new management stack that VMware will sell on top of its platform. The jury is still out on this part of the VMware strategy and will likely to remain out for the next two or three years. Configuration Management, Performance Management, Backup, Security, and Extended Provisioning are all areas where there are excellent solutions from third party vendors today, and areas where these solutions offer features and in many cases cross virtualization platform support that VMware does not offer. Therefore for the next two or three years, the continued success of the VMware platform is going to create more opportunities for these vendors then will VMware’s own management offerings create competitive issues. We are just going to have to wait and see how VMware’s own management offerings mature, and as they mature how they compare to offerings from vendors focused upon these areas, and how they compare to the offerings from EMC Ionix (VMware’s parent company, EMC has a division – Ionix that is also focused upon providing a management stack for virtualized environments).
There is one data point that is important to remember as this unfolds. Not since the mainframe has the vendor of the platform also been the leader in the management software for that platform. Developing, marketing and selling a platform is a different business than developing, marketing, and selling a management stack. Mastering both may be too much to ask even for a company like VMware that continues to have great success in a very difficult economy.
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