Virtualization has been called a chief information officer’s best friend. That’s because virtualization, with its specialized software, consolidates the work of many servers (the powerful, pricey computers that run digital networks) on a single machine, thereby enabling organizations to cut hardware and electricity expenses and improve the efficiency of computer systems.

To be sure, chief information officers need virtualization’s help, since they are under the gun to decrease electricity and air-conditioning bills for their massive banks of computers and accommodate ever-larger data loads. Thanks to virtualization, their organizations are reducing the number of servers used and in the process are reducing the cost of using them by 25-60%, according to VMware, a company based in Palo Alto, California, that’s flourishing as the undisputed leader in virtualization.

Utilization rates soar

Forbes magazine summarized the merits of virtualization in this way: "Most traditional servers do nothing for about 90% of their lives and continue to burn about half their peak energy consumption even while idle. Virtualization turns each of those underperforming machines into pieces of software and packs them together on a single physical server that runs continuously." As a result virtualization boosts the utilization rates of servers from 5-15% to 60-80%, our industry contacts say.

Indeed, virtualization has been compared to an automotive supplier whose products not only boost the gasoline mileage of vehicles but also make possible the mass reduction of vehicles on highways. Since its efficiencies translate almost immediately into cost savings, virtualization has tended to concentrate the minds of chief information officers wonderfully. A survey conducted in May by Silicon.com revealed that about 75% of chief information officers considered virtualization their top capital-spending priority.

VMware estimates that every server in a data center that’s "virtualized" saves about $560 a year. Much of that savings is in energy; power and cooling costs accounted for 50 cents of each dollar’s worth of server costs in corporate data centers last year, according to IDC, a technology-research firm. And those costs are rising and could possibly reach 70 cents on the dollar by 2010. So running programs on fewer machines should help companies to save even more money going forward. A recent Environmental Protection Agency report calculated that as much as 55% of U.S. data-center costs could be slashed if virtualization and other state-of-the-art technologies were widely applied.

Fundamentals compelling

In light of fundamentals like these, we think the virtualization market has compelling appeal and is just starting to take off. We agree with IDC and Canaccord Capital projections that the market for virtualization software may expand from $1 billion in 2006 to about $3.5 billion in 2011. And the market for virtualization services -- consulting, integration, and support services -- is likely to double, to more than $11 billion, by 2011. According to the ISI economic-research firm, the number of servers running virtualization software may grow at a compound annual rate of 55% over the next five years. In our judgment, virtualization has the kind of exceptional commercial potential that the personal computer had in the 1980s and data networking had in the 1990s.

Up to now the virtualization market has been geared primarily to servers, but it’s expanding to include applications for desktop computers, which are hosted securely from data centers. At this point we don’t have a firm sense of how big the desktop business may ultimately prove to be.

At any rate, although virtualization may be the best friend of chief information officers, it’s proving less friendly to another group in the tech sector: computer manufacturers. IDC calculates that virtualization may cost them $2.4 billion in sales between now and 2010, as customers do more computing with fewer servers. IBM, for one, has begun to feel the pinch: in reporting its first-quarter earnings in April, the company blamed a decline in shipments of its Intel-based servers on virtualization. Even so, IBM and other computer makers can draw some consolation from this development: virtualization is stimulating demand for more high-end servers, as virtualized organizations run applications on fewer, more powerful servers instead of on many little ones.

Dominance second to none?

As we see it, the company that has done the most to alter the way organizations use servers -- and has gained a near-monopoly as a result -- is VMware. We estimate that VMware does business with more than 20,000 customers (including all of the Fortune 100 companies), representing an 85% share of the virtualization market for the popular x86 servers that use Intel and Advanced Micro Devices chips. We would be hard-pressed to identify another tech company that so dominates its market as VMware does virtualization.

What’s more, VMware is the only pure investment play in virtualization today; its competitors are either companies like Citrix Systems that are focused mainly on other businesses (for the time being, at least) or private companies such as SWsoft, Egenera, and Virtual Iron Software.

VMware enjoys the status it does today in no small part because of the technical sophistication of its software, which is as much as five years ahead of the competition, according to Bernstein Research. One sign of VMware’s clout in the industry -- and of virtualization’s significance -- is that 10,800 information-technology professionals attended the company’s annual conference in San Francisco in September; a mere 1,400 went to its 2004 conference.

Operating margins robust

We concur with RBC Capital Markets analysts who estimate that VMware’s revenue should nearly double, to about $1.3 billion, and its operating profits should increase by more than 140%, to about $300 million, in 2007 versus last year. Its operating margins, which we conservatively estimate to be about 10%, are impressive for a relatively young tech company (VMware was founded in 1998).

Such growth prospects haven’t exactly gone unnoticed by investors: VMware has been "the hottest tech-stock offering since Google," according to BusinessWeek. In the 30 days following an initial public offering on August 14, VMware’s stock rose by more than 160%. And its current capitalization of about $26 billion ranks only behind that of Microsoft, Oracle, and SAP among software companies.

VMware’s initial stock-market splash has especially enriched EMC, the big data-storage company that bought the company in 2004 and still owns 86% of its shares. And it has given VMware the means to make acquisitions to help generate future growth. Indeed, VMware wasted little time in putting its new cache of capital to work: in September the company snapped up Dunes Technologies, whose software should help automate virtualization further. (Terms of the acquisition weren’t disclosed by either party.)

Winners spend on R&D

If VMware is to keep making a splash in the stock market, it will likely need to remain innovative. As we’ve noted again and again, one hallmark of a tech winner is that it spends heavily on research and development, so as to create new products and services that allow customers to do more at a lower cost. So we think it’s auspicious that one-third of VMware’s 3,000 employees work in research and development and that more than 20% of its revenue is plowed back into R&D.

VMware may need to innovate if for no other reason than this: high-growth markets like virtualization tend to attract formidable competitors. Citrix Systems, Sun Microsystems, and the Colossus of Redmond, Microsoft, are among those coveting the virtualization market, and their assaults on that market may lead to VMware’s preeminence and profit margins eroding to some degree. Aware of the perils of complacency in the survival-of-the-fittest jungle of technology, where today’s leaders can quickly become tomorrow’s has-beens, VMware managers are inclined to downplay their company’s current hegemony in virtualization; they take pains to characterize VMware as a corporate David, not as the Goliath that some analysts have called it.

To help fan the flames of competition, Citrix Systems in August forked over $500 million in cash and stock to acquire XenSource, which develops virtualization software for servers. Also, XenSource has arranged marketing partnerships with Red Hat and Novell. XenSource’s virtualization software is considered by industry gurus to be superior to Microsoft’s and is priced substantially less than VMware’s.

A conflicted colossus?

For its part, Microsoft has seemed somewhat conflicted about competing in the virtualization market -- "in large part because [virtualization] technology might crimp demand for its software by helping put servers out to pasture," BusinessWeek speculates. But Microsoft seems to be overcoming any inner conflicts: it plans to include virtualization software in the next version of Windows, scheduled to be introduced next year.

Although Microsoft’s virtualization software may prove technically inferior to VMware’s, it will have the virtue of being free -- which may be incentive enough for some customers to forsake VMware. Previously VMware has been able to charge premium prices for its software ($3,500 and more), but that may change in response to all the new competitive threats the company faces. In an extreme case, VMware’s virtualization software could eventually become a commodity, decimating profits.

In the near future, in the next year or two, though, we think VMware’s virtualization software should continue to be embraced in a friendly manner by chief information officers. As a result VMware’s growth could remain far above average.

The views expressed represent the opinions of Turner Investment Partners as of the date indicated and may change. They are not intended as a forecast, a guarantee of future results, investment recommendations, or an offer to buy or sell any securities. Opinions about individual securities mentioned may change, and there can be no guarantee that Turner will select and hold any particular security for its client portfolios. Earnings growth may not result in an increase in share price. Past performance is no guarantee of future results.

Turner Investment Partners, founded in 1990 and based in Berwyn, Pennsylvania, is an investment firm that manages more than $25 billion in stocks in separately managed accounts and mutual funds for institutions and individuals.

As of August 31, 2007, Turner held in client accounts 1.4 million shares of VMware, 260 shares of IBM, 17.9 million shares of Intel, 783,221 shares of Google, 2,260 shares of Microsoft, 1,400 shares of Oracle, 109,250 shares of EMC, and 964,834 shares of Novell. Turner held no shares of Advanced Micro Devices, Citrix Systems, SAP, Sun Microsystems, and Red Hat.