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Tickers in this Article: VMW, EMC, MSFT, ORCL, IBM, CTXS
In these tough times, budget conscious IT managers have been quickly embracing a new angle in computing known as application virtualization. This little bit of tech wizardry helps companies boost the efficiency of their existing server hardware by splitting it into multiple "virtual" machines capable of performing a lot more functions. It's a cost efficient way of getting a vastly bigger bang out your existing hardware investment.

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Virtualization Software: A Sweet Spot in Otherwise Sluggish Tech Spending
For the last few years, the top-dog company in this business has been VMware (NYSE:VMW) which is 84% owned by data storage giant EMC (NYSE:EMC). The company virtually owns the space, holding down about 80% market share. Its revenues effectively doubled in 2006 and 2007 and were still up 42% in 2008 even as the recession was making a major dent in corporate IT budgets.

Demand for virtualizations software is expected to remain strong this year as well. According to IT market researcher Gartner Group, total industry sales should be up another 43% this year hitting $2.8 billion.

Sizzling Competition in the Virtual Space
That kind of growth has attracted the attention of other big tech names, including such heavy hitters as Microsoft (Nasdaq:MSFT) and Oracle (Nasdaq:ORCL) who plan to carve off sizable chunks of VMware's market share for themselves.

In the case of Microsoft, it's seen as a matter of recovering what is rightfully theirs. VMware dominates Microsoft-based servers, and Microsoft's plan to recover this market involves offering its own virtualization software for free with the next release of its Windows operating system for servers. Shipments are scheduled to begin this month. Even before adopting this ploy, Microsoft had already picked up about 15% share in this market.

In the meantime, VMware has made its own aggressive move against relative newcomer Oracle, whose Virtual Iron product is still seen as a niche item. VMware is now offering Virtual Iron clients a 40% discount if they switch to VMware's product. Competition could heat up even more in this space as IBM (NYSE:IBM) recently announced that it was entering the fray.

Analysts Wary But Company Manages To Stay On Track
With so many players scrambling to take a piece of the virtualization pie away from VMware, analysts have been cautious on the stock, fearful that its lofty valuation (it trades at over 30 times 2010's expected earnings per share of just over $1) could come crashing down to possibly the 14 times forward earnings level sported by rival Microsoft.

However, the company's recent quarterly results appeared to have put those concerns to bed as the company reported slightly better than expected earnings, but, more importantly, raised its revenue guidance for the year. The company's visibility, which can be translated to mean client purchase intentions, seems to have gotten a lot better lately.

Parent EMC also recently reported the same improvement in "visibility" in its recent quarter results, citing stabilization in overall IT budgets as a key reason for the improved outlook.

Meanwhile, Citrix (Nasdaq:CTXS), another virtualization rival, reported a slump in the sales of its virtualization product, a sign that it may be unable to take share from VMware. All this good news sent VMware shares into overdrive, prompting a more than 8% gain the after-market post announcement. (Explore the controversies surrounding companies commenting on their forward-looking expectations in our article, Can Earnings Guidance Accurately Predict The Future?)

The Bottom Line
While increased price competition is likely to shave a few margin points off all the players' results in the virtualization market, now that IT budgets appear to be turning the corner, profit momentum should continue on the strength of a pick-up in sales. VMware's premium multiple should hold in this improved environment.

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