VM Wares Out Its Welcome

07/15/2008 12:00 am EST

Focus: STOCKS

Tobin Smith

Founder and Chief Research Analyst, NBT Equity Group

Tobin Smith, founder of ChangeWave Research, explains why the recently recommended virtualization software maker fell from grace and what it all means for investors.

Virtualization software leader VMware (NYSE: VMW) surprised investors [last week] by replacing its CEO and saying that it expects its 2008 sales to come in "modestly below" previous estimates of 50% growth.

[The stock], which we placed on Hold [the previous week and recommended in May, fell] 14 points, or 27%, on nearly eight times its average daily volume.

VMware did not give a reason for the departure of its CEO, who helped found the company before its sale in 2003 to data storage giant EMC (NYSE: EMC), which still owns an 86% stake. EMC shares, which we also placed on Hold [the previous week], traded down 10% [on the news].

Paul Maritz, who was named to the top slot, played a key role in building up Microsoft's line of Windows operating systems [and] retired from Microsoft in 2000 after 14 years with the company.

This is an interesting twist since much of VMware's recent problems stem from increased competition from the likes of Microsoft, which recently launched a virtualization technology called Hyper-V to significantly ramp up competition [among] small and medium-sized customers.

For our part, we can't say that we were totally thrown off guard by the news. [Just a week before, we wrote the following]: "In recent weeks, VMW shares have experienced pressure as Microsoft continues to make overtures into the virtualization market, raising worries that VMware will be forced to lower its prices and consequently squeeze its margins.

"With VMW shares on another down slide, they could easily test their March lows of $43. Based on this and questions about recent market developments, we are placing VMW on Hold. If [our next ChangeWave survey] reconfirms VMware's market strength, then we will resume our Buy without hesitation."

Back in April—at the time of our most recent upbeat Alliance survey findings on VMW—the company beat analysts' estimates and said it expected its full-year sales to rise by 50% over the $1.33 billion it reported a year earlier. However, [last week] the company said nothing about its second-quarter results, and this is making investors nervous.

Questions about increasing competition from Microsoft and others, the turmoil in the board room, and lack of specifics regarding the current quarter are all conspiring against the stock, [which closed just above $40 on Monday, less than a third of its 52-week high—Editor.).

On this basis, we will keep VMW on Hold and await results from the Alliance's software industry survey scheduled for [this] week. As we said last week, once we review the results—which we will have before VMware's quarterly earnings announcement on July 22nd—we will be able to make an informed decision on whether to restore the stock to a Buy or simply sell it.

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