The Company

The News

Last year's smoking IPO became Tuesday's smoldering wreck when shares of

VMware

The Palo Alto, Calif., company makes virtualization software, which lets one computer function like multiple machines running a variety of operating systems. The technology, which economizes on servers and improves the performance of corporate computer networks, is so hot that Microsoft and Oracle have decided to get in the game. VMware's results cast doubts on its ambitions to maintain market dominance.

The company posted fourth-quarter earnings of 26 cents a share late Monday. Deducting the penny derived from a lower income tax rate, VMware still beat Wall Street's 24 cents a share consensus estimate.

But it fell a little short of Street expectations on sales, reporting only $412.5 million in revenue versus the consensus projection of $417.4 million.

Sixty-nine percent of that came from licenses and the rest from services sales, said VMware CFO Martin Peek. License revenue was $284 million, an increase of 75% compared from the year-ago quarter. More than 60% of that came from transactions of less than $50,000, Peek said. Services revenue grew 90%.

Peek said 2008 revenue would grow "grow approximately 50% compared to 2007," when the company posted sales of $1.33 billion. That was an 88% increase from 2006, and the Street was counting on revenue growth of about 56% for the current year.

Caris & Co. analyst Shebly Seyrafi downgraded the stock to Average from Buy and cut the price target from $135 all the way to $60. He wasn't alone: Jefferies & Co. lowered its sights from $129 to $74, while Bear Stearns retrenched from $132 to $106.

The Analysis

Nothing succeeds like success, and VMware enjoyed plenty of it when it was spun off from parent

EMC

Allan Krans, an analyst at Technology Business Research, an independent research firm in Hampton, N.H., says the market is still attempting to sort out the premium valuation VMWare has enjoyed relative to EMC, which retains an 86% stake in its offspring.

"I think there's been a question since the IPO, looking at it in the context of EMC, where there's a disparity," he says. "Is EMC undervalued, or is VMware overvalued? I think it's partially overvalued, and you're starting to see these numbers come in line and make more sense."

But when hot stocks disappoint, there's often no going back. Canaccord Adams analyst Mark Kelleher wrote Tuesday that "these levels are approaching a more reasonable valuation for VMW shares; however given the lack of visibility to the slowing license revenue trend, we believe investors should look elsewhere for gains within the enterprise infrastructure sector."

That could be Microsoft, which is expected to release a competing product this year, or Oracle, or Citrix, all of which also want a piece of the virtualization pie, which could grow to $5 billion in the next several years, according to Krans.

The more charitably inclined could take solace from Jefferies & Co. analyst Katharine Egbert, who suggested Tuesday that VMware may have tried to keep expectations in line. "This the first time VMware has given revenue guidance and, although the EMC board signed off on the figures, the numbers could prove overly conservative," she wrote.

The Bottom Line

Information technology spending is a big worry in the current economic climate, but at least VMware is selling the right stuff for tough times.

"I don't think any area is really recession-proof, but I think virtualization is in a good position regardless of what happens with the economy," Krans says. "It allows you to take existing infrastructure investments you've already made and leverage them to gain additional efficiency. You can gain more capacity from what you already have, and that will still represent a cost-saving measure for most customers. Demand is going nowhere but up."

If VMware's share is not going up as fast as before, that's just part of the maturation process for the business. At least this dose of reality has given fans a better entry point. And the growth prospects remain very real.