Wednesday, October 25, 2006

VMware as LBO Opportunity for EMC?


EMC Corp announced their Q3 2006 Earnings last week and I listened in on the call. Very closely.

With lots of reading between the lines, a deep knowledge of their markets, and exposure to the Private Equity world, I think there is an opportunity for EMC to get some serious leverage out of their VMware asset. Let me explain in my usual verbose style.

EMC announced the VMware acquisition on December 15, 2003 -- almost 3 years ago now. It was a cash transaction valued at about $625M that closed on January 9, 2004. I remember the VC AND PE buzz at the time. Most people (except VMware employees) thought that EMC paid too much. Witness:

  • 2003 was a tough year for Venture Capital. Not nearly so bad for Private Equity.

  • Still, VMware only did about $20M in revenue in Q4 CY2003 (the quarter before the acquisition).

  • EMC was expecting to more than double that revenue run-rate -- to $175M total for CY2004 .

  • Which would give the deal a multiplier of 3.5x on forward revenue.

  • At the time (2003), that was a hefty multiple, especially since it was based on over 100% CAGR, and the economy was still somewhat sluggish.

  • If the revenues did not follow, EMC would have paid more like 7.5x -- way too much for Q4 CY2003.

  • Side note: According to the EMC 2004 Annual Report, the price paid for VMware was $541M.


The Result: EMC was incredibly smart to pick up VMware when they did. They were absolutely right. The VMware employees were also right -- EMC got a bargain.

The VMware revenues did double in the first quarter following the acquisition, as predicted, to $39M. There is certainly something to be said for combining great technology with a great sales force and strong brand. Under the EMC umbrella, VMware generated $218M in revenue in 2004. VMware continued to excel but, interestingly, was never really integrated into the EMC organization. Was that because EMC is not as good at acquisitions as Cisco, or was there some other reason?

Fast Forward to the present.

Joe Tucci, President & CEO of EMC, rolled out the current EMC strategy during the Q3 2006 earnings call (see the slides for more on this) and kept hitting on a central theme: "One EMC" -- "Except VMWare", with a footnote:
* VMWare will continue to operate as a subsidiary of EMC and is not part of this restructuring.

I do find it interesting that EMC can't capitalize VMware correctly yet, but that's not the point. The point is that Tucci laid out the "One EMC" strategy, and VMware was not a part of the 8-pronged product strategy, even though it would have been very easy to include them. Take a look:


You could spin a story around putting VMware into Resource Mgt easily. You could even put VMware in the center bubble (called "Information and Virtualization Infrastructure"), but the Storage gods that own EMC would certainly become a bit scared by that (and that is their dilemma).

Clearly, the acquisitions of Documentum and RSA fit into the "One EMC" strategy, but VMware appears to be specifically uninvited. Tucci said:
We are not creating "One EMC" with VMware. Like I talked about before, running VMware as a subsidiary and giving access to that technology to even our most fierce competitors is still what we're going to do. For the rest of the technologies, we're going to create "One EMC".

And, from the looks of the VMware web site, being a part of "One EMC" does not appear to be a very big concern for them. The following graphic:



"An EMC Company" is placed below the VMware logo. They never actually merged that graphic with their logo. Also, when they acquired Akimbi Systems (disclosure: I'm a Board of Advisors member of Akimbi), it was not an EMC acquisition, but a VMware acquisition.

Tam Taulli also covered the earnings call, and he knows a bit about M&A transactions:
Then there is the VMware division. This was perhaps one of the best acquisitions in software history. It’s an infrastructure technology that allows for virtualization of IT assets (basically, getting more power from existing servers). In the third quarter, revenues for VMware surged 86% to $189 million.

How's VMware doing with respect to revenues since the acquisition:


Nothing wrong with those numbers!

In fact, eWeek Labs recently ranked VMware #7 on its list of the Top 25 Products of the Last 25 Years. With these numbers, VMware will certainly be ranked as one of the fastest growing software companies ever (I'm talking about revenue here, not valuation -- you know, the stuff that matters). We're talking about roughly a 70% CAGR here, and the numbers are large enough that that is quite significant.

Another thing to note is that if VMware does $650M-$700M revenue this year and slows to just a 50% CAGR, they will be positioned to be a $1B revenue software business in 2007. This is significant because, as it turns out, there really aren't that many $1B revenue software businesses out there.

The VMworld 2006 Conference is November 7-9, 2006, and will have 200 Breakout Sessions, 11 Labs, 80 Exhibitors, and 5000 Attendees. Yes, VMware has grown up in the last 3 years.

Sub-total: EMC got a bargain in their acquisition of VMware. But what about the VMware employees? And, is there more that EMC can get out of VMware while giving more back to the employees?

But here's the kicker. EMC is such a powerhouse that these numbers, as great as they are, are just a drop in the bucket. In Q3 2006, VMware contributed a record $189M to the EMC total revenue of $2.82B. Or, stated differently, VMware accounted for just 6.7% of EMC revenue. It's easy to see why EMC continues to focus on their storage initiatives.

However, the Q3 2006 numbers were telling. Net income for Q3 2006 was $283.7M compared to $421.7M in Q3 2005. EMC is generating less cash, even with significant increases in the high-margin VMware business. While VMware revenue is small potatoes to EMC, in some respects, the asset itself is quite valuable.

So, let's take a quick look at how EMC stock has been doing since the VMware transaction:

  • At the time of the acquisition (January 9, 2004), EMC stock closed at $14.07.

  • At the time of the Q3 2006 conference call (October 17, 2006), EMC stock closed at $12.70.

  • In-between, EMC stock was largely flat, with a high of $15.59 one-week following the VMware acquisition and a low of $9.37 on October 25, 2006.



Bottom line: VMware has advanced significantly as a company, but EMC stock has not brought any real rewards to the VMware employees since the January 9, 2004, acquisition. (Side Note: EMC stock has not been a performer for anyone in the last 5 years, but that's a different article).

Now, the VMware acquisition was a cash transaction, so the big holders like Diane Green, CEO, and Mendel Rosenblum, Chief Scientist, (who are wife/husband, by the way) certainly made out, ahem, very well. But, how does EMC/VMware attract, reward, and retain their employees when their division is doing awesome, but the company's stock is flat? And, how does EMC get increased value out of a software subsidiary that is approaching the $1B revenue mark?

I've talked about a new model for Corporate Venture Capital before, but what I propose here is different.

Hello Private Equity. Hello Leveraged Buyout.

OK, so what have we established:

  1. VMware is kicking butt.

  2. EMC is generating less cash.

  3. EMC stock is flat.

  4. VMware employees are no longer being properly rewarded for their amazing contribution.

  5. EMC does not view VMware as a technology differentiator and is willing to offer the VMware products directly to their competitors.

  6. VMware, as an EMC asset, is not generating the amount of shareholder value that it could.

  7. There is a giant market for virtualization infrastructure products over the next 10 years (OK, I didn't establish that but you'll have to trust me on this one).


The win-win is to spin-out VMware and file for IPO, either in 2007 or shortly thereafter.

VMware needs to be a stand-alone entity. They need the cash to acquire some of the key infrastructure virtualization assets that are out there now. The virtual infrastructure market is large enough to support it, and growing like crazy (at last). The opportunity to create another $1B revenue stand-alone software company should not be missed. I certainly have specific thoughts on how this would best be structured in this market, but will file them away for now.

Sure, EMC would lose the revenue and their net revenue would drop more still, but there are many ways to structure the transaction such that EMC gains some significant cash and/or shareholder value out of this move. If VMware is not strategic to EMC, and it clearly is not just by virtue of not being a part of "One EMC", then this is what it must do.

Full Disclosure:
I was brought into VMware in January 2005 to interview for the CTO position that was soon to be open due to Ed Bugnion's impending departure (which I wrote about here). I met with the VMware Executive Staff, but we never talked about any of this. I didn't get the job. Nobody did, as it turned out. And, it looks like VMware has done just fine without a CTO. Also, as I mentioned above, I'm a Board of Advisor member for Akimbi Systems, which VMware acquired in June 2006. Nothing of these matters have been discussed with VMware or Akimbi. Finally, I was Founder, EVP and CTO of Cassatt Corporation, which is currently a key player in this space.

10 comments:

  1. [...] Finally, be sure to check out the Beta of VMware Lab Manager. This is the result of the Akimbi Systems acquisition that I’ve mentioned previously. I’m proud to have been an ever-so-tiny part of this success story. I look forward to watching the next steps of VMware’s continued maturity. [...]

    ReplyDelete
  2. [...] In October, 2006, I wrote the article, "VMware as LBO Opportunity for EMC?" The article examined the impact that the VMware acquisition has had on the EMC bottom line and speculated on some ways that EMC could benefit its shareholders by spinning out the EMC asset with an IPO in 2007. [...]

    ReplyDelete
  3. [...] Last October, I wrote an article titled "VMware as LBO Opportunity for EMC?" [...]

    ReplyDelete
  4. [...] in October of last year, I wrote an article that noted how VMware, a subsidiary of EMC, was kicking butt as a software company, but the value [...]

    ReplyDelete
  5. [...]  (For a very prophetic post written back in October 2006, read Brian Berliner’s VMware as LBO Opportunity for EMC?) [...]

    ReplyDelete
  6. [...] in October of last year, I wrote an article that noted how VMware, a subsidiary of EMC, was kicking butt as a software company, but the value [...]

    ReplyDelete
  7. [...] , Technology , Venture Capital 3 Comments In October, 2006, I wrote the article, “VMware as LBO Opportunity for EMC?” The article examined the impact that the VMware acquisition has had on the EMC bottom line [...]

    ReplyDelete
  8. [...] VMware Q42006 Results Exceed Expectations Published February 8, 2007 Software , Technology , Venture Capital 2 Comments Last October, I wrote an article titled “VMware as LBO Opportunity for EMC?” [...]

    ReplyDelete
  9. [...] Finally, be sure to check out the Beta of VMware Lab Manager. This is the result of the Akimbi Systems acquisition that I’ve mentioned previously. I’m proud to have been an ever-so-tiny part of this success story. I look forward to watching the next steps of VMware’s continued maturity. [...]

    ReplyDelete