VMware targets long-term deals; pursues lock-in strategy

VMware's first quarter results got the company out of Wall Street's penalty box and highlighted how the virtualization leader is trying to sign customers up to long-term licensing deals to fend off a potential pricing pressure from rivals such as Citrix and Microsoft.

VMware after the closing bell Tuesday reported net income of $43 million, or 11 cents a share, on revenue of $438 million, up 69 percent from a year ago. Excluding charges, VMware had earnings of $88 million, or 22 cents a share. Those results were in line with Wall Street estimates. In the same quarter a year ago, VMware earned $46 million, or 12 cents a share.

U.S. revenue was up 65 percent as large companies standardized on VMware; international revenue was up 74 percent; and software licenses revenue was up 73 percent. VMware's outlook also was strong as the company projected 2008 revenue growth of 50 percent and second quarter growth of 55 percent.

VMware's outlook was also in line with expectations, but management indicated that the company could continue to grow at a healthy clip beyond 2008. VMware's first quarter was closely watched following a fourth quarter that disappointed Wall Street and sparked concerns about slowing growth.

Among the key takeaways from the company's earnings conference call:

VMware is pushing customers to standardize on its platform as it plays both offense and defense. Virtualization will become commoditized in the future--at least at the hypervisor level--and that creates a race to move up the software stack. The game will be to manage all the infrastructure and virtualized assets. VMware CFO Mark Peek detailed how the company is signing customers up for volume licensing agreements. Peek said:

Our most comprehensive volume license offering, the enterprise agreement, serves the purpose of establishing and building long-term relationships with our customers as they commit to our infrastructure for their data center architecture.

We're pleased by the increased demand that we are experiencing for enterprise agreements. Over the course of the past year, we have changed how we structure these agreements to put more of revenue into services to recreate a recurring annuity.

A typical agreement includes the right to use a specified set of our products under a perpetual license. We use the support and maintenance, professional service credits and training. We generally limit the number of licenses which maybe deployed, and we expect the renewal of the agreement to result in further license and service revenue as customers extend virtualization in their data centers and on to their desktops.

In a nutshell, VMware is creating a virtuous lock-in effect that can make revenue growth more predictable. In the first quarter, 20 percent of bookings were enterprise licensing agreements, triple the number a year ago. JP Morgan analyst Aaron Schwartz notes:

We think (enterprise licensing agreements) can mitigate potential price pressure and look for the company to continue to contract customers on longer term agreement given the early stage of competitors.

VMware's ESXi hypervisor will be embedded on most new servers. CEO Diane Greene said:

ESXi is expected to ship with all the major x86 vendors this quarter, eventually enabling every new server to arrive supporting server consolidation and giving VMware and our partners the opportunity to up-sell to VMware infrastructure a much more customer value along with again a higher deal size.

Virtualization could benefit from a slowing economy. Analysts asked Greene about economic worries among customers. Greene noted:

Our product suite has a very high ROI. And so that puts us in a really good position for getting share as the economy gets a little more uncertain. And I would say that we see that in our customers where they are going ahead. We increase the number of big deals we did. We were able to close big deals in the financial sector. People are definitely talking about the economy, but we don't see hesitation with our customers.

Virtualization on the desktop is in pilot stage. Greene said virtualization on the desktop has garnered a lot of interest, but added that 2008 "seems to be the year of the pilot." She predicted 2009 will be the year these pilots bloom.