Broadcom’s acquisition of VMware is proceeding almost exactly as we expected when the deal was announced in May of 2022. While much of the media and competitor narrative is focused on the increased license fees Broadcom is imposing and the urgency of migrating off VMware, customer conversations and recent data suggest that while migrations are happening, the real story is that VMware’s more narrow focus and cost discipline are allowing Broadcom to integrate VMWare into its highly successful business model. Specifically, we see two seemingly countervailing trends that are both possible to be true: 1) Customers are actively moving many low value workloads off VMware; and 2) Most mission critical work is staying put, allowing Broadcom to dramatically increase the contribution from its software business and deliver a roadmap for customers that will often be more cost effective than migrating.
In this Breaking Analysis we share results from the latest ETR spending data and provide our latest thinking on the often discussed and frequently maligned VMware acquisition; and why it’s a win for customers, competitors and Broadcom specifically.
Media Backlash Fueled by Licensing Changes
It’s easy to find negative sentiment in the press, social media and reddit threads about the changes Broadcom has imposed with respect to ending perpetual licenses and limiting the bespoke options across the VMware portfolio.
Many headlines underscore the negative sentiment toward Broadcom’s moves. But the company has been unapologetic and, quite the opposite, optimistic with customers, strongly marketing the economic benefits of going all in on the VMware Cloud Foundation bundle.
One notable comment in a reddit thread highlighted above in red is that by some measures, costs are actually lower than acquisition. At first blush this is hard to swallow given the price increases that customers have seen when their its time to renew their maintenance agreements.
Broadcom Economic Analysis Doubles Down on Private Cloud
To its credit, Broadcom has done extensive total cost of ownership (TCO) and economic analysis that appears quite defensible. The caveat is a key assumption in the calculations is customers go all-in on VMware Cloud Foundation (VCF). As shown in the chart below, relative to traditional data center costs and public cloud, VCF is “less expensive.”
[VMware NOTE: This is a representative analysis only. There is no discounting applied to any of these numbers in this representative model. Native Public Cloud Numbers come from list pricing available on public websites].
The chart above shows a head-to-head comparison with traditional data centers comprising bespoke software, public cloud and VCF. What it doesn’t show is an “As-is” and a “To-be” relative to existing customer installations. Nonetheless, in an interview on theCUBE in August of this year we dug into this issue with Drew Nielsen, who leads cloud economics analysis at Broadcom. We pressed on the assumptions and methodology VMware analysts used in this chart.
[Watch the Full Discussion on VMware Economics Here].
Our bottom line is despite near term license cost increases, we found the long term economic analysis to be compelling in the sense that it will capture the attention of senior executives. It’s a classic Broadcom playbook as applied to VMware:
- Good news…we’re going to simplify your life.
- [The bad news is the perpetual gravy train is over – we can’t keep funding that and invest at the same time].
- We’re narrowing down the number of choices you have across the VMware portfolio.
- The lead offering is a full bundle of VCF with all this value inside.
- Use it and you won’t have to pay for all this other bespoke software.
- Sure it looks on the surface to be more expensive but we’re going to keep investing and make it better and better so you should stick with us and you’ll save a lot of money in the long run.
- If you buy into this, your total costs will be lower than traditional on-prem data center approaches and the cloud.
Whether you buy the pitch or not, before trying to do a wholesale migration of VMware, you’d be wise to do your own economic impact analysis.
Spending Intentions Data Requires Further Explanation
In October of this year, ETR updated its latest Technology Spending Intentions Survey (TSIS). The demographics are shown below.
The survey has a substantial N with a bias toward North American respondents. As shown above, ETR captures a nice mix of C-level titles, mid-level managers and practitioners in the survey.
VMware Accounts Report a Steep Deceleration in Spending Sentiment
The chart below highlights the Net Score granularity over time. Net Score is ETR’s proprietary spending methodology that measures momentum within accounts. The method looks at the percent of customers pursuing specific spending patterns (i.e. new adoption, spending more, spending flat, spending less, replacing or containment).
The blue line, which is decelerating dramatically, is calculated by subtracting the percent of customers replacing and spending less from those adding plus those spending more. It’s an important way to measure spending velocity on a platform. The caveat is it doesn’t measure amount spend, only the direction across accounts.
The N in the data above is substantial at 938 VMware accounts and normally one would conclude that this picture spells bad news for VMware. But Broadcom’s strategy of narrowing the account focus and increasing contract values is not reflected.
We know from conversations with Broadcom and customers that three trends are ubiquitous across the VMWare landscape:
- Bundled pricing with VCF is the lead SKU.
- Perpetual licenses have ended.
- Fees paid to VMware are increasing as reported by the vast majority of customers.
The Compelling Economic Analysis Relies on the VCF Bundle
The previous TCO analysis we described above assumes customers go all in on VCF. We know from customer conversations that the VCF bundle is not the predominant procurement model today and less than 20% of customers pre-acquisition were all in on VCF. Rather vSphere bundles, perpetual licenses and ELAs are much more common. As such, to the extent Broadcom can convince customers to stay, the company has significant upside to its VMware business.
This strategy was highlighted on the last earnings call by Broadcom CEO Hock Tan, who stated:
The transformation of the business model of VMware continues to progress very well. In fact, last week, we held a well-attended VMware Explore Conference in Las Vegas, our first as a combined company. This event was all about promoting VMware Cloud Foundation, or VCF, which is the full software stack that virtualizes an entire data center and creates a private cloud environment on-prem for enterprises.
The success of this strategy is reflected in our performance in fiscal Q3.
Customers are Both Migrating and Staying
Many narratives from the media and competitors suggest that customers are angry, they’re migrating and calls for help are numerous. All of these are true based on our assessment. At the same time, research shows that customers are not migrating their entire estates. This is the win-win we cited in our opening premise.
Customers have several choices including hyperscalers and Microsoft in particular with AVS (Azure VMware Solution); Nutanix, Red Hat, Open Source alternatives like OpenStack and KVM, Proxmox. Dell, HPE, IBM and Lenovo, along with their partners are happy to help.
Many customers have told us they like AVS as an option because its a managed private cloud offering from Microsoft that essentially bundles VCF including key elements like vSAN. From a licensing perspective, customers can acquire VCF from Microsoft or bring their own VCF licenses. The managed service aspects are compelling for many customers and allow firms to basically eliminate VMware admin staff.
The Microsoft Azure option that Broadcom allows is a dramatic shift from the previous VMware cloud strategy. Readers of this series may remember, at one point VMware tried to compete directly with AWS. When that strategy failed, the company pivoted and made AWS a preferred partner with VMware Cloud on AWS, which gained significant traction. VMware also cut deals with other hyperscalers and cloud providers but AWS was its preferred option.
Despite all the talk of migrations, our conversations with customers suggest: 1) A very large proportion of customers (more than half) either have no plans to migrate or will leave large portions of their estate on VMware; and 2) The main strategy is to isolate VMware workloads and put new workloads elsewhere.
The Importance of Private Cloud
Why is Broadcom’s change in cloud strategy significant? After years of hand wringing, navel gazing and market confusion, legacy VMware affected a strategy that relied on partnerships with cloud players, sharing the wealth. This made sense during the “cloud-first” era and supported customer wishes to run VMware in the cloud.
Broadcom has killed this strategy for the following reasons:
- Customers are much more balanced in their cloud vs. on-prem workload placement. This is a function of cost, control and AI affinity (i.e. bring the AI to the data).
- Traditional ISVs and SaaS companies must pay hyperscalers as a major part of their cost of goods sold (COGS). It’s why today’s top cloud SaaS companies have gross margins in the 70s versus in the 80-90%+ range.
- Hock Tan is going direct with his VCF bundling strategy. Instead of sharing the booty with cloud companies his COGS will be much lower than traditional SaaS companies and approach $0 at volume. This means his software operating margins will approach those of traditional SaaS companies’ gross margins.
Historically, Broadcom’s software operating margin is above 70%. We believe that over time, VMware operating margins will follow suit and be nearly as high as most SaaS firms’ gross margin.
The Misleading Narrative on VMware Migrations
Several industry surveys indicate a large percentage of customers are looking to migrate off VMware. On an account basis it’s perfectly reasonable that a large percentage are looking to move some workloads as indicated in the ETR spending data above. Interpreting that earlier data, 75% of customers indicate their VMware spend is flat to down. We’ve seen surveys that even show nearly 50% of customers are looking to migrate some workloads.
The natural reaction is to conclude that Broadcom has made a big mistake shelling out $69B for VMware.
But migrations are hard and almost always more expensive than staying put. It’s true that in legacy markets like VMware, the risk of lock-in and price gouging are real threats. Broadcom’s calculus is to construct a strategy where customers get more value by staying with the platform. Their promise is, despite the new packaging, crackdown on perpetual licenses and more revenue they’re extracting, the company will:
- Streamline the portfolio.
- Make simpler to do business.
- Invest R&D on those features that are most important to the business.
- Create an offering that is more cost effective than alternatives when considering the full picture.
Migrations are Non-Trivial
Taking into account change management, business process disruption, application portfolio impacts, skills required, error rates and the effort to abstract away the complexity of migration pain, in many cases the juice as they say isn’t going to be worth the squeeze.
By our estimates, 20-30% of current VMware workloads can be migrated relatively easily. Leaving a large proportion of workloads that either won’t move or will take several years to migrate.
The Win-Win-Win for Customers, Competitors and Broadcom
It seems counterintuitive that Broadcom, by completely altering VMware’s packaging, pricing and partnership strategy would be a win for anyone other than Broadcom. But the reality is the world needs a viable on-prem alternative to public clouds. Initiatives like Project Monterey, the Nitro-like functionality VMware continues to pursue, are necessary to keep pace with cloud innovators. Here’s the logic behind our thinking…
For Customers. You are going to pay more for Broadcom to pursue a streamlined roadmap. The downside is the checks your write to Broadcom will be larger but at the same time you won’t have the latest VMware acquisition du jour jammed down your throat; and you ideally won’t have to deal with a collection of less than ideally integrated and offerings. Not all workloads are going to yield better ROI and lower TCO over the long run so you should perform a workload rationalization exercise and decide what to keep on VMware, what to migrate, which workloads to kill immediately that aren’t delivering any value and what to let die through attrition. You may find that this exercise helps pay for the Broadcom hit.
For Competitors. Broadcom’s non-GAAP operating margins are historically above 60% and 4-6 times better those of most virtualization competitors/partners (e.g. Dell, Nutanix, Red Hat/IBM, HPE, etc.). Microsoft is the obvious exception. As such, the business Broadcom is pushing away is likely at least as profitable for these firms as their existing business. It can drive new top line revenue and open up new vectors of growth in a market that previously was untouchable with VMware’s historical model.
For Broadcom and its Investors. A price of $69B is hefty. It brings new debt to Broadcom that has to be managed, especially with today’s higher interest rates. But VMware is on track to hit $4B in quarterly revenue and $8.5B in adjusted EBITDA. Originally Broadcom promised the latter result within three years of the acquisition but is on track to achieve or exceed that goal in FY ’25.
Back of napkin math. Broadcom’s valuation is roughly 25-30X adjusted EBITDA. At an $8.5B EBITDA target, that’s between roughly $200 – $250B in incremental market value in less than the promised three year timeframe. Of course valuations can fluctuate but that’s at least a 3X return in valuation terms to shareholders in a couple of years.
Take into consideration that Broadcom’s commentary on its earnings calls and anecdotally in the field speaking with customers suggests that VMware is a long term play that will pay significant dividends in the future.
The Bottom Line
Our belief is that much of the trade press negative narrative is misplaced. While competitors to VMware are undoubtedly seeing activity, the conclusion that this spells bad news for Broadcom and VMware is also misguided.
Our advice to customers remains the same:
- Evaluate your workload portfolio. Identify those low value/low risk workloads that can be easily moved and if it will save you money than move them to an alternative (hyperscaler, Nutanix, Red Hat, open source).
- Otherwise, bite the bullet and write the bigger checks to Broadcom.
- Understand their roadmap, participate in its direction and negotiate the best deal you can get.
Moreover, customers should spend ample time understanding VMware’s AI roadmap. We’ve always had concerns in this regard due to VMware’s lack of a coherent data play. “Good” data is increasingly becoming the number one obstacle in executing successful AI strategies and it’s unclear how VMware helps in this regard. We don’t fully understand the company’s strategy and ecosystem partners approach when it comes to data that feeds AI.
On balance, however, we believe Broadcom is executing ahead of expectations on its VMware progress and is establishing the basis for a long term platform asset that will be an industry force for the next decade and perhaps beyond.
