Why is VMware Acquiring Nicira?

A few weeks ago VMware announced its intention to acquire Nicira for US $1.26 billion.  Nicira enables network virtualization through the Nicira Network Virtualization Platform (NVP).  One important component of NVP is the Open vSwitch (OVS), designed to enable massive network automation through programmatic extension, while still supporting standard management interfaces and protocols. OVS uses software that is designed primarily to be deployed within a hypervisor; e.g., XenServer, Xen, KVM or ESX.  Another component of NVP is a controller cluster, which manages the virtualized network components and connections.  Together these components enable the automated creation of isolated virtual networks.

It's always dramatic to spend that much money for an acquisition.  Spending that much money to acquire a company that generates at best a very modest revenue stream is particularly dramatic.  Right after the acquisition was announced, the question repeatedly raised in the trade press was, "Why did VMware acquire Nicira?" The answer is that there wasn't a single factor that drove the acquisition.  There were actually three inter-related factors, and they will all have significant ramifications for the broad IT industry.

VMware's incoming CEO, Pat Gelsinger was asked about the acquisition at a recent VMworld conference.  He revealed that ten years ago an unidentified company was exploring the possibility of buying VMware, but decided against it because the $100 million asking price was too high.  Gelsinger said $100 million seems modest in hindsight, when you consider VMware's current revenue stream and market capitalization.  He added that VMware is expecting a similar return on investment with its' Nicira acquisition.

Gelsinger's argument sounds reasonable until you do some arithmetic that focuses just on the potential future sales of what NVP is today and its future potential.
VMware's current annual revenues are approximately $4.5 billion and its' market capitalization is roughly $40 billion.  For VMware to experience the same return on its Nicira acquisition that the previously mentioned company would have experienced if it had acquired VMware, then in ten years' time the Nicira acquisition would have to directly contribute $56 billion dollars to VMware's annual revenues and roughly $500 billion to VMware's market capitalization.  That isn't going to happen for a variety of reasons.  

One reason is that it is extremely difficult to see the annual revenues for just NVP-type solutions being anywhere close to US $56 billion.  Another reason is that the Nicira controller is not the only controller that can currently support software defined networks and network virtualization.  Companies such as Big Switch and NEC also provide controllers.  In addition, Cisco has announced its' intention to provide a proof of concept controller and it is very reasonable to expect that companies such as IBM, Dell and HP will soon be coming out with their own controllers.  The bottom line is that in the near term this is going to become a very crowded, very competitive market.  That means revenue returns of the type mentioned above are not even close to being believable.  

The fact that VMware will not get a huge bump in its annual revenues due just to the sale of NVP and whatever it becomes over time doesn't mean that the Nicira acquisition will not provide a significant impact on VMware's annual revenues.  In fact the Nicira acquisition will enable VMware to dramatically grow its addressable market.  The acquisition, which is expected to close during the second half of 2012, will allow VMware to increase the network services that it currently provides directly or through its partners.  The preceding sentences relate to one of the factors that is expanded upon in the next technote.  It seems strange to insert them here in the middle of the argument for how the acquisition will drive revenue just based on Nicira's NVP.

VMware currently provides numerous L4 - L7 services through partners such as F5.  The services are also provided directly through VMware products such as vCloud Networking and Security (vCNS) Edge Gateway, which is a border firewall, and vCNS app, which is intended to isolate and protect virtualized applications and virtual machines.  It is very reasonable to expect that on a going forward basis that VMware will leverage the Nicira acquisition to increase revenues by expanding the set of L4 - L7 services, even if that means that it aggravates some of its existing partners.

There are several other factors driving the VMware-Nicira acquisition, and these will be discussed in the next TechNote which will concentrate on the Software Defined Data Center.