VMWare/VMW: The actuality of virtualization

Mail comes flooding in asking my opinion re this or that trading opportunity. A trade, to me, connotes a short term time frame; days to weeks. Why even purchase an investment opportunity that has a specific, near-by price objective and finite life? And why purchase shares of secondary or tertiary opportunities? Would it not be better to trade, if trade you must, the shares of a leader that you view as a long term investment opportunity? This method assures the likelihood of larger gains and consistent success. In addition, the desire to trade one's portfolio, rather than invest, typically proves to be a treadmill to (investment) oblivion. Only one reason is that short term gains suffer an onerous tax burden when compared to long term gains. Another is that... well, as Stephen Swid famously remarked, "Being rich is having money; being wealthy is having time." My road to wealth recognizes the importance of time; I sure do not want to sit chained to a computer all day fearing the next tick, and the one after that.

Consistent investment success requires creativity, discipline, imagination, intelligence, patience, and vision. Proper money management is all about seeking maximum rates of return (return on investment, or ROI) while minimizing risk; some money managers reverse that objective to minimize risk while maximizing rates or return. An important difference between money managers is the style of investing; e.g., small cap vs large cap, growth vs value, the purchase of declines vs breakouts, etc. Each style has equal value; there are a 1,000,001 ways to achieve consistent success when investing.

Prices always oscillate, but one-way plummets are hard on the soul as much as the wallet. After the upside fireworks of October, November could be summed in one word, dispiriting. I took defensive action during late-October and early-November, selling almost all non-Core holdings, in the attempt to limit exposure to the downside and to raise cash for new opportunities. Despite the ferocity of the decline, I note with happiness that my Core Opportunities (AAPL, CMG, GOOG, ISRG, etc) declined only marginally, and now achieve new highs or, at worst, build short or intermediate term bases. This type of action from the market's leaders is very bullish. In the end, the markets' November decline increasingly appears to be the leading edge (left side) of a new base, and not a top as many investors fear. Declines allow investors the opportunity to identify new investment opportunities; certainly, several new opportunities tickle my fancy.

One of these opportunities is VMWare/VMW, which is "the world’s leading provider of virtualization solutions for x86-based servers and desktops. Through a pioneering approach to virtualization, VMware technology works to separate the software from the underlying hardware. This allows a single computer to run multiple operating systems and applications, delivering significant improvements in efficiency, availability, flexibility and manageability." Whew, that quote (from the company's website) might say a lot, but offers little understanding. (There also is a company fact sheet, available here.)

My explanation of virtualization, and VMWare, begins by way of telling a tale...

VMWare/VMW developed and marketed a virtualization solution. This means that a server can be made to function as many distinct "virtual" computing environments, but all inside one physical machine. Of course this means little by itself. The key to the company's success lies in understanding the problem that virtualization solves for companies. To do that, it is necessary to understand the information technology (IT) regimes that preceded it.

Approximately 15 years ago, the IT environment looked pretty much like a monolith. At that time, large corporate servers (or server farms) held all the large, server-based corporate applications and data. Sure, there were PCs on almost every desk, but these were for running personal applications. If a corporate department wanted resources for a group project inside the department (for example, large graphics files for an advertising campaign), then it had to petition the centralized IT department for space on the corporate server. Since IT departments were overwhelmed with such requests and had limited resources themselves, such requests could take a long time for fulfillment. This situation often would jeopardize key projects, unless upper management got directly involved, a solution that no department enjoyed. Failing that solution, the department would have to allocate space on somebody’s personal computer, and these rarely had the resources required to handle to storage and access needs of the group.

But, at approximately the same time, some especially tech-savvy worker, definitely outside the IT department, realized that the department, which typically had control over its own budget for purchasing desktop computers, could simply purchase a beefed-up PC and set it up as a departmental server. Since it had no need to serve as some worker's PC and since it could be purchased with larger than normal amounts of disk space, this machine could act as a server for departmental projects holding common files and projects that required coordination among several people in the department.

Thus was born the departmental server. While IT departments hated to see these things proliferate, they often had little ability to stop them from doing so, except for a refusal to support the machines. That became less and less of a problem since, increasingly, most departments had some people with enough technical capability to support the minimal requirements of a small server.

This state solved immediate problems, but created others. The most important new problem, arguably, was that while these solutions worked for project-oriented departments they often led to a great deal of sub-optimization of corporate resources, since many such servers were grossly underutilized, and many came to serve projects that were long since either completed or abandoned. And all while the departmental managers were either unaware of the misuse of resources or more likely didn't care, instead preferring to hoard that resource to serve future needs. Thus begat a proliferation of departmental servers with attendant problems of uneven support and gross under-utilization of total corporate technology spending.

It is precisely this problem that VMWare/VMW solves. In effect, it allows for the quick provisioning of virtual departmental servers. They reside physically on the server farm run by IT, but beyond their provisioning and support should something go wrong. Instead, their utilization is under the control of the department to which that virtual server is assigned. This accomplishes several things.
1) It allows for quicker, less expensive deployment of departmental servers;
2) It automatically takes care of under-utilization, since resources are assigned dynamically to the virtual servers.

As the need for a server grows, so do the resources assigned to it; as utilization of that server subsides, resources are "virtually" removed. Virtual servers, running on much higher-end equipment, run faster and better than on physical departmental servers. And since it is the IT department’s resources that are physically used, IT departments are not forced into the uncomfortable position of dealing with problems that crop up due to inadequate support of physical departmental servers. Inefficiency is reduced, less manpower is needed, and better performance is achieved. All in all, a much better, if not elegant, solution to the problem.

VMWare/VMW has obviously hit the ground running. VMWare’s product is a solution that is much in demand and driven by the needs of IT departments that have the most clout when it comes to technology spending inside corporations. In fact, VMware’s customer base consists of more than 20,000 organizations of all sizes, including 100% of Fortune 100 companies and 91% of the Fortune 1000. No denying the obvious: Virtualization is a very big area, and with a great deal of growth potential. This is readily apparent in the company's stock chart since its IPO of 14 August 2007...

[click on chart to enlarge]

Long time readers know I seek leaders as my investments; companies that are leaders in their field of endeavour, and whose shares act as leaders of the stock market. The few companies that pass my stringent filters comprise my Core Opportunities. VMWare, its products, and its stock (VMW) each appear to justify my investment interest.

The company's IPO price was $29/share; the lowest price subsequent is $48 on the offering day. The stock then enjoyed a powerful price uptrend (trend #1) that garnered a lot of interest among investors, me included. I believe the stronger the up trend, the better, but rarely purchase a trend that has become obvious to all investors. Stock prices always oscillate, so the market would grant me my turn, my time, to invest, which manifests itself as an intermediate term base within a long term uptrend. And, typically, at a share price less than when I first noticed the opportunity, despite the power of its price rise. Such is the case with VMWare/VMW.

What do I seek in the stock's trading behavior in advance of my purchase?
1) A powerful uptrend that exceeds expectations (trend #1). Check.
2) Price declines that fail to meet downside expectations (trend #2), Check. (I expected low $60s)
3) Subsequent price rallies that again exceed upside expectations (trend #3). Check. (I expected ~$90, possibly $95, but never $103!)
4) Subsequent declines that again fail to meet downside expectations (trend #4). Check. (At least, to date.)

The decline and subsequent basing action since 31 October has been all that. Now ~2 months into an intermediate term base, the stock could again decline as low as $71... and yet retain its bullish setup. I suspect, however, that dearer levels of price support (~$85-83, and ~$78), will stem deeper declines. Especially if the interior 123 pattern resolves itself bullishly, as I expect.

VMWare/VMW appears near the end of this portion of its base, despite its recent price weakness, and relatively weak when compared to the market's late-week upside fireworks. Nonetheless, I expect an upside reversal to occur soon, and a breakout above the chart pattern's internal setup.

Opportunity thus limned, the unresolved question re VMWare/VMW is how protectable is its solution -- are there proprietary components? It does not appear to be so. While specific algorithms might be patentable, the virtualization idea itself has been around for some time; other companies will almost certainly enter the field. In fact, Microsoft/MSFT announced recently the beta availability of its Hyper-V server virtualization technology, which came earlier than expected. Réza Malekzadeh, VMWare's Senior Director of Product Marketing & Alliances, offers his perceptions here re this topic.

The question might resolve as to whether VMWare/VMW can capitalize on its first-mover advantage to create a brand sufficient to keep IT departments insisting on the VMWare solution over its competitors. For investors, the November share price decline and subsequent presumed base assuage a large measure of price and time risk, and help to create a maximum reward opportunity.

The likelihood exists that Q4 will be a barn-burner, but with increasing competition comes decreasing profit margins, so the risk is very real to the company... and its stock. Recall that just as capitalism bids away excess returns via increasing competition, so too does certainty serve to bid away opportunity via, perhaps paradoxically, an increasing share price. Conversely, the greater the uncertainty, the greater the potential reward. Thus, I am a buyer soon of VMWare/VMW, despite the prevailing level of uncertainty. Well, really, because of the uncertainty. I am, after all, an investor.

Full Disclosure: Soon to be long the shares of VMWare/VMW.
-- David M Gordon / The Deipnosophist