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Article by DailyStocks_admin    (12-29-08 05:47 AM)

Filed with the SEC from Dec 11 to Dec 17:

VMware (VMW)
Intel Capital, a wholly owned subsidiary of Intel (INTC), reduced its holdings to 6.14 million shares (6.9%), from (7.94%), after selling 967,398 from Dec. 5 to 12 at about $23.26 to $24.50 a share. Intel Capital currently holds 6.14 million Class A shares.

BUSINESS OVERVIEW

VMware is the leading provider of virtualization solutions from the desktop to the data center. Our virtualization solutions represent a pioneering approach to computing that separates the operating system and application software from the underlying hardware to achieve significant improvements in efficiency, availability, flexibility and manageability. Our broad and proven suite of virtualization solutions addresses a range of complex IT problems that include infrastructure optimization, business continuity, software lifecycle management and desktop management. The benefits to our customers include substantially lower IT costs, choice of operating systems and a more automated and resilient systems infrastructure capable of responding dynamically to variable business demands. Our customer base includes organizations of all sizes across numerous industries and includes 100% of the Fortune 100 and approximately 90% of the Fortune 1,000.

Our solutions enable organizations to aggregate multiple servers, storage infrastructure and networks together into shared pools of capacity that can be allocated dynamically, securely and reliably to applications as needed, increasing hardware utilization and reducing spending. In the nine years since the introduction of our first virtualization platform, we have expanded our offering with virtual infrastructure automation and management products to address distributed and heterogeneous infrastructure challenges such as system recoverability and reliability, backup and recovery, resource provisioning and management, capacity and performance management and desktop security.

We began shipping our first product in 1999, and today we offer 21 products. Our flagship desktop product, VMware Workstation, is in its sixth generation and our flagship server product suite, VMware Infrastructure, is in its third generation.

We work closely with over 500 technology partners, including leading server, microprocessor, storage, networking and software vendors. We have shared the economic opportunities surrounding virtualization with our partners by facilitating solution development through open Application Programming Interface (“APIs“), formats and protocols and providing access to our source code and technology. The endorsement and support of our partners have further enhanced the awareness, reputation and adoption of our virtualization solutions.

We have developed a multi-channel distribution model to expand our presence and reach various segments of the market. We derive a significant majority of our revenues from our large indirect sales channel of nearly 10,000 channel partners that include distributors, resellers, x86 system vendors and systems integrators. We believe that our partners benefit greatly from the sale of our solutions through additional services, software and hardware sales opportunities. We have trained a large number of partners and end users to deploy and leverage our solutions.

We were incorporated as a Delaware corporation in 1998 and continued to operate in large measure as a stand-alone company following our acquisition by EMC in 2004 and following our initial public offering (“IPO”) of our Class A common stock in August 2007. During 2007, we generated $1.326 billion in revenues, an 88% increase over our 2006 results. For financial information about our business by product and geographic area, see Note L to the consolidated financial statements included elsewhere in this filing. Our corporate headquarters are located at 3401 Hillview Avenue, Palo Alto, California and we have 54 offices worldwide.

Overview of Virtualization

Virtualization was first introduced in the 1970s to enable multiple business applications to share and fully harness the centralized computing capacity of mainframe systems. Virtualization was effectively abandoned during the 1980s and 1990s when client-server applications and inexpensive x86 servers and personal computers established the model of distributed computing. Rather than sharing resources centrally in the mainframe model, organizations used the low cost of distributed systems to build up islands of computing capacity, providing some benefits but also introducing new challenges. In 1999, VMware introduced virtualization to x86 systems as a means to efficiently address many of these challenges and to transform x86 systems into general purpose, shared hardware infrastructure that offers full isolation, mobility and operating system choice for application environments.

Virtualization can be implemented using various approaches. The most prevalent approach uses a layer of software called a “hypervisor” that resides below the operating system. The hypervisor provides the capability to enable multiple applications and operating systems to share the underlying hardware safely by encapsulating each application and operating system in its own “virtual machine.” Organizations use this technology to run multiple applications and heterogeneous operating systems on the same hardware and across different hardware configurations, raising utilization and reducing costs.

The introduction of virtualization technology presents a number of opportunities for driving capital and operational efficiency above and beyond the simple benefit of safe partitioning. By decoupling the entire software environment from its underlying hardware infrastructure, virtualization enables the aggregation of multiple servers, storage infrastructure and networks into shared pools of resources that can be delivered dynamically, securely and reliably to applications as needed. This approach enables organizations to build a computing infrastructure with high levels of utilization, availability, automation and flexibility using building blocks of inexpensive industry-standard servers. Although virtualization represents the core enabling technology, the benefits associated with this general purpose computing infrastructure cannot be fully realized without virtual infrastructure automation and management solutions.

Our virtualization solutions run on industry-standard servers and desktops and support a wide range of operating system and application environments, as well as networking and storage infrastructure. We have designed our solutions to function independently of the hardware and operating system to provide customers with a broad platform choice. Our solutions provide a key integration point for hardware and infrastructure management vendors to deliver differentiated value that can be applied uniformly across all application and operating system environments.

Our Products and Technology

We offer a broad portfolio of products that spans the consumer desktop to the enterprise data center. Our products generally fall into two categories:




Virtualization Platforms. Our virtualization platforms include a hypervisor for system partitioning that provides the capability to safely, securely and efficiently run multiple operating systems simultaneously on the same physical machine. Our platforms range from free, entry-level products for the desktop and server to more feature-rich desktop and server platforms. These products represented 38% of our license revenue in 2007.




Virtual Infrastructure Automation and Management. Our virtual infrastructure automation products utilize the unique benefits of our virtualization platforms to automate system infrastructure services, such as resource management, availability, mobility and security. By deploying our virtual infrastructure automation products with our virtualization platforms, VMware customers can reduce the operational complexity of their environments. Our virtual infrastructure management products automate the interaction between various IT constituencies and the virtual infrastructure for a specific set of point solutions. These solutions range from capacity sizing and assessment to development lab management. These products represented 62% of our license revenue in 2007. Virtualization Platform Products




VMware Player. VMware Player is a free virtualization platform that enables individuals to run virtual machines on their desktops but does not allow virtual machine creation. We use VMware Player primarily as an awareness tool to familiarize individuals with the concept of virtual machines. VMware Player has been downloaded more than 4 million times since it was made generally available in December 2005.




VMware Fusion. VMware Fusion is a consumer-focused desktop virtualization product for users of Intel-based Apple Macintosh computers. Mac users can run Windows, Linux, NetWare or Solaris x86 guest operating systems on their Intel-based Mac without rebooting or repartitioning their hard drives. VMware Fusion enables Mac users to run Windows and Mac OS X applications side-by-side, as well as drag and drop files between Windows and Mac OS X environments.




VMware Workstation. VMware Workstation is a desktop virtualization product for software developers and enterprise IT professionals who need to run multiple operating systems simultaneously on a single desktop. Users can run Windows, Linux, NetWare or Solaris x86 in fully networked, portable virtual machines with no rebooting or hard drive partitioning required. VMware Workstation delivers excellent performance and advanced features, such as memory optimization and the ability to manage multi-tier configurations and multiple snapshots.




VMware Server. VMware Server is a free virtualization platform that enables simple partitioning of a server into multiple virtual machines. VMware Server runs as an application on top of an existing Windows or Linux operating system, unlike our VMware ESX Server platform, which runs its own microkernel. VMware Server is principally an awareness tool for administrators to become familiar with virtualization, though customers may opt to pay an annual support and subscription fee if they would like the product supported in a production or test environment. VMware Server has been downloaded approximately 2.8 million times since it was made generally available in November 2006.




VMware ESX Server. VMware ESX Server is our enterprise-class virtualization platform that runs directly on the hardware with its own microkernel and requires no third-party operating system. VMware ESX Server is designed expressly for the purpose of running virtual machines securely, efficiently and flexibly. VMware ESX Server’s microkernel architecture provides numerous efficiencies and performance benefits, including advanced resource management features, such as memory over commitment and share-based resource allocations to guarantee quality of service. VMware ESX Server also has built-in redundancy features, such as device teaming and storage multi-pathing, to mitigate the risk of any component failure in a high-density, shared environment.




VMware ESX Server 3i. Based on VMware ESX Server, VMware ESX Server 3i offers the same functionality as VMware ESX Server, but in a small 32 MB footprint. VMware ESX Server 3i was designed to be pre-integrated and factory-installed as server firmware from our server Original Equipment Manufacturer (“OEM“) partners. Both ESX Server and ESX Server 3i support the entire suite of VMware Infrastructure 3 products, features and solutions.




VMware Virtual SMP. VMware Virtual SMP enables a single virtual machine to use up to four physical processors simultaneously, thereby allowing customers to run processor and resource intensive applications in virtual machines.




VMware VMFS. VMware VMFS is a clustered file-system and volume manager that enables multiple ESX Servers to safely, efficiently and reliably share block-based storage. It was designed expressly for the purpose of handling virtual machines and is required to enable reliable use of our Virtual Infrastructure Automation products.

Virtual Infrastructure Automation and Management Products




VMware VirtualCenter. VMware VirtualCenter provides a central point of control to provision, monitor and manage a virtualized IT environment. VMware VirtualCenter also manages the runtime coordination of infrastructure automation products, such as VMware VMotion, VMware DRS and VMware HA, and provides outbound software interfaces for network and systems management software vendors to incorporate these technologies and other elements of virtual machine management into their user consoles.




VMware VMotion. VMware VMotion allows users to move virtual machines with running applications and operating systems from one physical machine to another with no service interruption or data loss. Our customers have used VMware VMotion for more than three years to improve service levels delivered to their end users. Customers typically use VMware VMotion to perform zero-downtime planned hardware maintenance, non-disruptive server migration or dynamic resource repurposing.




VMware DRS. VMware Distributed Resource Scheduler (“DRS“) creates resource pools from an aggregation of physical servers. VMware DRS dynamically allocates virtual machines to resource pools on demand. Once virtual machines have been provisioned, VMware DRS continuously monitors utilization across the resource pool and intelligently balances a collection of virtual machines across the servers in the resource pool using VMware VMotion. The VMware DRS resource management policies may be driven by pre-defined and automated rules that reflect business needs and priorities. VMware DRS delivers higher quality of service by managing resource commitments in a shared environment.




VMware HA. VMware HA provides automated recovery from hardware failure for any application running in a virtual machine, regardless of its operating system or underlying hardware configuration. The technology includes an in-memory, replicated database across all of the VMware ESX Servers in a resource pool that tracks the status of every virtual machine. In the event of a failure, affected virtual machines are immediately recovered onto alternate systems. This technology addresses a key need to make workloads instantly recoverable to mitigate the impact of hardware failures in a shared environment.




VMware Consolidated Backup. VMware Consolidated Backup (“VCB“) enables LAN-free, automated backup of virtual machines from a centralized backup proxy. The product includes software utilities for third-party backup products to efficiently snapshot and back up running virtual machines from a single, secure proxy server. VCB can be used to perform both file-level and full-system backup and recovery with an existing backup infrastructure. It provides a critical, zero-downtime solution to manage the increased density of backup operations in a highly utilized shared environment.




VMware Storage VMotion. VMware Storage VMotion enables live migration of virtual machine disks from one data storage system to another with no disruption or downtime. VMware VMotion is typically used by infrastructure administrators to eliminate planned downtime for storage maintenance. Using Storage VMotion, administrators can also dynamically balance the storage workload and address performance bottlenecks by migrating virtual machine disks to the available storage resource. Administrators can minimize service disruption previously incurred for upgrading storage arrays and free storage administrators to improve and manage the storage infrastructure without having to co-ordinate extensively with application and server owners.




VMware Update Manager. VMware Update Manager automates patch and update management for VMware ESX Server hosts and virtual machines. Update Manager addresses one of the most significant challenges for IT departments: tracking patch levels and manually applying the latest security and bug fixes. Integration with VMware DRS enables zero-downtime VMware ESX Server host patching capabilities.




VMware Capacity Planner. VMware Capacity Planner is a hosted application that enables VMware service providers to perform capacity assessments onsite at a customer facility. The service provider installs and runs a collector at the customer facility that conducts agent-less discovery and collection of

performance information for all servers in an environment. VMware Capacity Planner loads this performance information into a hosted data warehouse and provides web-based analytics tools and consolidation recommendations to the service provider.




VMware Converter. VMware Converter enables customers to quickly and reliably convert local and remote physical machines into virtual machines. Users may also input third-party image formats or third-party virtual machines into VMware Converter to create virtual machines that run on our platforms.




VMware Lab Manager. VMware Lab Manager automates the setup, capture, storage and sharing of multi-machine software configurations for development and staging environments. Using VMware Lab Manager, development and test teams can access multiple software configurations and virtual machines on demand through a self-service portal.




VMware ACE. VMware ACE enables desktop administrators to lock down desktop endpoints and protect critical company resources against the risks presented by unmanaged desktops. With VMware ACE, desktop administrators package an IT-managed desktop within a secured virtual machine and deploy it to an unmanaged physical desktop. Once installed, VMware ACE provides a suite of automated security policies around the virtual machine, such as encryption, expiration, network and device access policies, transforming the unmanaged desktop to ensure compliance with security policies.




VMware Virtual Desktop Infrastructure. VMware Virtual Desktop Infrastructure (“VDI“) enables companies to host individual desktops inside virtual machines running on centralized servers in their data center. Users access these virtual desktops remotely from a physical desktop or a thin client using a remote display protocol. Since applications are managed centrally at the corporate data center, organizations gain better control over their desktop deployments. Unlike other server-based solutions that do not provide a complete desktop experience or require specific architectures, VMware VDI includes full desktop environments familiar to end users and not limited by hardware or location.




VMware Virtual Desktop Manager. VMware Virtual Desktop Manager (“VDM“) is a desktop management server that connects users to virtual desktops in the data center. With VMware VDM, end users can securely access their virtual desktops using either a personal computer or thin client. The product’s easy-to-use interface lets administrators manage thousands of desktops at once, and reduces the time it takes to provision a new desktop from hours to minutes.

MANAGEMENT DISCUSSION FROM LATEST 10K

This Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) should be read in conjunction with our annual consolidated financial statements and notes thereto which appear elsewhere in this Annual Report on Form 10-K.

This section and other parts of this Annual Report on Form 10-K contain forward-looking statements, within the meaning of the Federal securities laws, about our business and prospects. The forward-looking statements do not include the potential impact of any mergers, acquisitions, divestitures, securities offerings or business combinations or other developments in our business that may be announced or consummated after the date hereof. Any statements contained herein that are not statements of historical fact may be deemed to be forward-looking statements. Without limiting the foregoing, the words “outlook,” “believes,” “plans,” “intends,” “expects,” “goals,” “potential,” “continues,” “may,” “will,” “should,” “seeks,” “predicts,” “estimates,” “anticipates” and similar expressions are intended to identify forward-looking statements, although not all forward-looking statements contain these words. Our future results may differ materially from our past results and from those projected in the forward-looking statements due to various uncertainties and risks, including those described in Item 1A of Part I (Risk Factors). The forward-looking statements speak only as of the date of this Annual Report and undue reliance should not be placed on these statements. We disclaim any obligation to update any forward-looking statements contained herein after the date of this Annual Report.

All dollar amounts expressed as numbers in this MD&A (except per share amounts) are in millions.

Certain tables may not add due to rounding.

Overview

Our primary source of revenue is the licensing of virtualization software and related support and services through a variety of distribution channels for use by businesses and organizations of all sizes and across numerous industries in their information technology infrastructure. Our virtualization solutions run on industry-standard desktops and servers and support a wide range of operating system and application environments, as well as networking and storage infrastructure. We have developed a multi-channel distribution model to expand our presence and reach various segments of the market. In 2007, 2006 and 2005, we derived over 75% of our revenues from our channel partners, which include distributors, resellers, x86 systems vendors and system integrators. We have also developed a network of nearly 10,000 indirect channel partners who fulfill orders through our direct channel partners. A majority of our revenue results from contracts that include both perpetual software licenses and ongoing software maintenance contracts. License revenue is recognized when the elements of revenue recognition are complete. Maintenance revenue is recognized ratably over the term of the maintenance period, and includes renewals of maintenance sold after the initial maintenance period expires. We also recognize revenue from professional services provided to our customers.

We have achieved significant revenue growth to date and are focused on extending our growth by broadening our product portfolio, enabling choice for customers and driving standards, expanding our network of technology and distribution partners, increasing market awareness and promoting the adoption of virtualization. In addition to selling to new customers, we are also focused on expanding the use of our products within our existing customer base, as much of our license revenue is based on a per desktop or per server arrangement. We believe it is important that as we grow our sales, we continue to invest in our corporate infrastructure, including customer support, information technology and general and administrative functions. We expect our spending in research and development to increase as we add computer scientists, software engineers, and employees involved in product development and maintenance and continue to enable choice for customers and drive standards. We believe that equity incentives tied directly to the performance of VMware will help us compete for top-level engineering and other talent. We also intend to continue to invest in hardware, networking and software tools to increase the efficiency of our research and development efforts. Our current financial focus is on sustaining our growth in revenue to generate cash flow to expand our market segment share and our virtualization solutions. Although we are currently the leading provider of virtualization solutions, we believe the use of virtualization solutions is at very early stages by customers. We expect to face competitive threats to our leadership from a number of companies, some of whom may have significantly greater resources than we do. As a result, we believe it is important to continue to invest in our research and product development, sales and marketing and the support function to maintain or expand our leadership in the virtualization solutions market. This investment could result in contracting operating margins as we invest in our future. We believe that we will be able to continue to fund our product development through operating cash flows as we continue to sell our existing products and services. We believe this is the right priority for the long-term health of our business.

In evaluating our results, we focus on operating margin excluding stock-based compensation, amortization of intangible assets, the write-off of in-process research and development, and the net effect of the amortization and capitalization of software development costs incurred in the research and development of new software products. A portion of our service revenue is recognized in periods of up to five years subsequent to the initial contract, whereas most of our license revenue is recognized within the first quarter of contract signing. As a result, variability in operating margin can result from differences in when we price our service and when the cost is incurred. Substantially all of our international revenue is for contracts in U.S. dollars to international channel partners. A portion of our operating expenses is in currencies other than the U.S. dollar. This difference may cause variability in operating margins due to fluctuations in the U.S. dollar compared to other currencies. We are not currently focused on short-term operating margin expansion, but rather on investing at appropriate rates to support our growth and future product offerings in what may be a substantially more competitive environment.

Prior to our IPO in August 2007, we were a wholly-owned subsidiary of EMC Corporation (“EMC”), and as such we relied on EMC to provide a number of administrative support services and facilities in other countries. Although we will continue to operate under an administrative services agreement and continue to receive support from EMC, our administrative costs may increase. We also are investing in expanding our own administrative functions, including our finance and legal functions, which may be at a higher cost than the comparable services currently provided by EMC. We are incurring additional costs as a public company, including audit, investor relations, stock administration and regulatory compliance costs.

Our Relationship with EMC

As of December 31, 2007, EMC owned 26,500,000 shares of Class A common stock and all 300,000,000 shares of Class B common stock, representing approximately 85% of our total outstanding shares of common stock and 98% of the combined voting power of our outstanding common stock.

In 2007 and 2006, we recognized professional service revenue of $11.8 and $1.4, respectively, for services provided to EMC customers pursuant to contractual agreements with EMC. In 2007, we entered into an enterprise license agreement with EMC to provide server and desktop products. All $4.3 of revenue related to this arrangement was included in deferred revenue as of December 31, 2007.

In 2007, 2006 and 2005, we purchased $7.2, $2.9 and $0.6, respectively, of storage systems from EMC. Through the third quarter of 2007, and for 2006 and 2005, the amounts purchased from EMC were at EMC’s cost. In the fourth quarter of 2007, the practice was changed to purchasing from EMC at a discount off of EMC’s list price.

The financial statements include expense allocations for certain corporate functions provided by EMC, including accounting, treasury, tax, legal and human resources. These allocations were based on estimates of the level of effort or resources incurred on our behalf. The total costs allocated from EMC were $7.7, $5.1 and $5.3 in 2007, 2006 and 2005, respectively. Additionally, certain other costs incurred by EMC for our direct benefit, such as rent, salaries and benefits have been included as expenses in our financial statements. The total of these other costs were $116.1, $69.6 and $27.1 in 2007, 2006 and 2005, respectively. As part of our tax sharing

39

MANAGEMENT DISCUSSION FOR LATEST QUARTER

This Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) should be read in conjunction with our interim consolidated financial statements and notes thereto which appear elsewhere in this Quarterly Report on Form 10-Q.

This section and other parts of this Quarterly Report on Form 10-Q contain forward-looking statements, within the meaning of the federal securities laws, about our business and prospects. The forward-looking statements do not include the potential impact of any mergers, acquisitions, divestitures, securities offerings or business combinations or other developments in our business that may be announced or consummated after the date hereof. Any statements contained herein that are not statements of historical fact may be deemed to be forward-looking statements. Without limiting the foregoing, the words “outlook,” “believes,” “plans,” “intends,” “expects,” “goals,” “potential,” “continues,” “may,” “will,” “should,” “seeks,” “predicts,” “estimates,” “anticipates” and similar expressions are intended to identify forward-looking statements, although not all forward-looking statements contain these words. Our future results may differ materially from our past results and from those projected in the forward-looking statements due to various uncertainties and risks, including those described in Item 1A of Part II (Risk Factors). The forward-looking statements speak only as of the date of this Quarterly Report and undue reliance should not be placed on these statements. We disclaim any obligation to update any forward-looking statements contained herein after the date of this Quarterly Report.

All dollar amounts expressed as numbers in this MD&A (except per share amounts) are in millions.

Certain tables may not add due to rounding.

Overview

Our primary source of revenue is the licensing of virtual infrastructure software solutions and related support and services through a variety of distribution channels for use by businesses and organizations of all sizes and across numerous industries in their information technology infrastructure. Our virtual infrastructure software solutions run on industry-standard desktops and servers and support a wide range of operating system and application environments, as well as networking and storage infrastructures. We have developed a multi-channel distribution model to expand our presence and to reach various segments of the industry. In the third quarter and first nine months of 2008 we derived over 75% of our revenues from our channel partners, which include distributors, resellers, x86 systems vendors and system integrators. We have also developed a network of more than 19,000 indirect channel partners who fulfill orders through our direct channel partners. The majority of our revenues result from contracts that include both perpetual software licenses and ongoing software maintenance contracts. License revenues are recognized when the elements of revenue recognition are complete. Software maintenance revenues are recognized ratably over the term of the software maintenance period, and include renewals of software maintenance sold after the initial software maintenance period expires. We also recognize revenues from professional services provided to our customers.

We have achieved significant revenue growth to date by focusing on delivering new virtual infrastructure software solutions technology and products, expanding our network of technology and distribution partners, increasing product awareness, promoting the adoption of virtualization and building long-term relationships with our customers through the adoption of enterprise license agreements (“ELAs”).

Our current financial focus is on revenue growth to generate cash flows to fund our expansion of industry segment share and our virtual infrastructure solutions. We expect to continue our revenue growth by broadening our virtual infrastructure software solutions technology and product portfolio for more uses to more users. We experienced growth in our channel partner transaction business and in the acquisition of new customers during the first nine months of 2008 as compared to the same period in 2007. However, since the end of the second quarter of 2008 we have observed that customers are subjecting large ELAs to a longer review process and in certain cases are purchasing products through the channel to meet their immediate needs, forgoing larger discounts offered under ELAs. We believe this trend is primarily correlated to the recent global economic uncertainty and will continue throughout 2008 and perhaps longer.

Although we are currently the leading provider of virtual infrastructure solutions, we believe the use of virtual infrastructure solutions is at very early stages by customers. We face competitive threats to our leadership from a number of companies, some of which have significantly greater resources than we do. As a result, we believe it is important to continue to invest in strategic initiatives related to product research and development, market expansion and associated support functions to expand our leadership in providing virtual infrastructure solutions. This investment could result in contracting operating margins as we invest in our future. We believe that we will be able to continue to meet our product development objectives through our current resources, with strategic hires and acquisitions, and from operating cash flows as we continue to sell our existing products and services. We believe this is the appropriate priority for the long-term health of our business.



17

Table of Contents

In evaluating our results, we also focus on operating margin excluding stock-based compensation, employer taxes on employee stock transactions, amortization of intangible assets, the write-off of in-process research and development when applicable and the net effect of the amortization and capitalization of software development costs. A portion of our services revenues is recognized in periods of up to five years subsequent to the initial contract, whereas most of our license revenues are recognized within the first quarter of contract signing. As a result, variability in operating margin can result from differences in when we price our service and when the cost is incurred. Substantially all of our international revenues are for contracts in U.S. dollars to international channel partners. A portion of our operating expenses is in currencies other than the U.S. dollar. This difference may cause variability in operating margins due to fluctuations in the U.S. dollar compared to other currencies. We are not currently focused on short-term operating margin expansion, but rather on investing at appropriate rates to support our growth and future product offerings in what may be a substantially more competitive environment; as a result, our future operating margins may decline from current levels.

Prior to our initial public offering (“IPO”) in August 2007, we were a wholly-owned subsidiary of EMC Corporation (“EMC”), and as such we relied on EMC to provide a number of administrative support services and facilities in other countries. Although we continue to operate under an administrative services agreement and continue to receive support from EMC, we expect our administrative costs to continue to increase. We continue to invest in expanding our own administrative functions, including our finance, legal and human resources functions, which may be at a higher cost than the comparable services provided by EMC. We are incurring additional costs as a public company, including audit, investor relations, expanded information systems, stock administration and regulatory compliance costs.

Our Relationship with EMC

As of September 30, 2008, EMC owned 26,500,000 shares of Class A common stock and all 300,000,000 shares of Class B common stock, representing approximately 84% of our total outstanding shares of common stock and 98% of the combined voting power of our outstanding common stock.

We recognized professional services revenues of $4.6 and $11.7, for services provided to EMC’s customers pursuant to our contractual agreements with EMC in the third quarter and first nine months of 2008, respectively. We recognized $1.8 and $7.8 of professional services revenues from such contractual arrangements with EMC in the third quarter and first nine months of 2007, respectively.

We recognized revenues from server and desktop products and services purchased by EMC for internal use of $0.3 and $3.8 for the third quarter and first nine months of 2008, respectively, pursuant to our contractual agreements with EMC. As of September 30, 2008, $2.0 of revenues from server and desktop products and services purchased by EMC for internal use was included in deferred revenue.

We purchased storage systems from EMC for $3.8, $0.5, $19.5 and $4.2, in the third quarter of 2008 and 2007, and the first nine months of 2008 and 2007, respectively. Through the third quarter of 2007, the systems purchases from EMC were at EMC’s cost. Since the fourth quarter of 2007, the systems purchases from EMC are at a discount off of EMC’s list price.

For certain corporate functions provided by EMC, $2.2 and $6.9 of expenses were allocated to us by EMC in the third quarter and first nine months of 2007, respectively. In the third quarter and first nine months of 2008, these amounts were not significant.

In certain geographic regions where we do not have an established legal entity, we contract with EMC subsidiaries for support services and EMC employees who are managed by our personnel. The costs incurred by EMC on our behalf related to these employees were included as expenses in our financial statements. These costs include expenses for salaries and benefits, travel, rent, insurance and service fees. The total of these costs were $33.2 and $108.0 in the third quarter and first nine months of 2008, respectively, and $33.4 and $78.1 in the third quarter and first nine months of 2007, respectively.

As part of our tax sharing agreement, we paid EMC the sum of $62.3 for our portion of their consolidated federal income taxes in the first quarter of 2008 and no payments were made in the second and third quarters of 2008, respectively, as we had a net income tax receivable due from EMC for these periods. These amounts differed from the amounts owed on a stand-alone basis and the differences are presented as a component of stockholders’ equity. In the third quarter of 2007, the difference between the amount of tax calculated on a stand-alone basis and the amount of tax calculated per the tax sharing agreement was recorded as an increase in stockholders’ equity of $10.0. In the first nine months of 2007, the difference between the amount of tax calculated on a stand-alone basis and the amount of tax calculated per the tax sharing agreement was recorded as a decrease in stockholders’ equity of $1.4. In the third quarter and first nine months of 2008, these differences were not significant.

As of September 30, 2008, we had a net income tax receivable of $82.2, which was principally comprised of amounts due from EMC; however, this amount was net of approximately $14.8 of current income taxes payable due to various governmental authorities. The receivable arose because we had a stand-alone taxable loss for the first nine months of 2008, which was primarily attributable to tax deductions arising from both non-qualified stock option exercises and from restricted stock where the restrictions lapsed. Under the tax sharing agreement with EMC, EMC is obligated to pay to us an amount equal to the tax benefit that EMC will recognize on its consolidated tax return. As of September 30, 2008, we had $41.0 due to EMC which was partially offset by $4.8 due from EMC. The net amount due to EMC of $36.2 resulted from the related party transactions described above. Balances due to or from EMC which are unrelated to tax obligations are generally settled in cash within 60 days of each quarter end.

Interest expense with EMC, net, consists of interest expense on a note payable to EMC, offset by interest income that has been earned on our intercompany balance with EMC. In the third quarter of 2008, the $3.8 of interest expense with EMC, net, recorded on the consolidated income statement consisted primarily of interest expense related to a note payable with EMC. In the first nine months of 2008, $13.5 of interest expense was recorded related to a note payable with EMC and was included in the $13.2 interest expense with EMC, net, recorded on the consolidated income statement. In the third quarter and first nine months of 2007, we incurred $6.7 and $13.3, respectively, of interest expense with EMC, net. Our interest income and our expenses as a separate, stand-alone company may be higher or lower than the amounts reflected in the financial statements.

In the first nine months of 2008, we resolved with EMC certain acquisition-related intercompany liabilities due to EMC which resulted from EMC’s acquisition of us. As a result, intercompany liabilities due to EMC of $9.7 were eliminated and recorded as an increase in additional paid-in capital without the issuance of additional equity by us or remittance of any cash.

Prior to March 2008, our employees participated in the EMC 401(k) Plan, and EMC cross-charged us for the costs associated with our employees who participated in the EMC Plan. In March 2008, our employees began participating in our 401(k) Savings Plan and ceased participation in the EMC Plan. See Note I to our consolidated financial statements.

Given that the amounts we recorded for our intercompany transactions with EMC did not arise from transactions negotiated at arm’s length with an unrelated third party, the financial statements included herein may not necessarily reflect our financial condition, results of operations and cash flows had we engaged in such transactions with an unrelated third party during all periods presented. Accordingly, our historical results should not be relied upon as an indicator of our future performance as a stand-alone company.

Income Statement Presentation

Sources of Revenues

License revenues

Our license revenues consist of revenues earned from the licensing of our software products. These products are generally licensed on a perpetual basis and are generally priced based upon the number of physical desktops or server processors on which our software runs.

Software maintenance revenues

Software maintenance revenues are recognized ratably over the contract period. Typically, our contract periods range from one to five years. Customers receive various types of technical support based on the level of support purchased. Customers who are party to software maintenance agreements with us are entitled to receive product updates and upgrades on a when-and-if-available basis.

Professional services revenues

Professional services include design, implementation and training. Professional services are not considered essential to the functionality of our products, as these services do not alter the product capabilities and may be performed by our customers or other vendors. Professional services engagements for which we are able to make reasonably dependable estimates of progress toward completion are recognized on a proportional performance basis based upon the hours incurred. Revenues on all other professional services engagements are recognized upon completion.

Costs of Revenues and Operating Expenses

Cost of license revenues

Our cost of license revenues principally consists of amortization of capitalized software development costs and the cost of fulfillment of our software. This cost of fulfillment of our software includes product packaging, personnel costs and related overhead associated with the physical and electronic delivery of our software products.

Cost of services revenues

Our cost of services revenues includes the costs of personnel and related overhead to deliver technical support on our products and to provide our professional services. Research and development expenses

Our research and development (“R&D”) expenses include the personnel and related overhead associated with the research and development of new product offerings, including depreciation expense, and the enhancement of our existing software offerings.

Sales and marketing expenses

Our sales and marketing expenses include personnel costs and related overhead associated with the sale and marketing of our license and service offerings, as well as the cost of certain specific marketing initiatives, including our semi-annual VMworld conference.

General and administrative expenses

Our general and administrative expenses include personnel and related overhead costs to support the overall business. These expenses include the costs associated with our finance, facilities, human resources, IT infrastructure and legal departments.

Total revenues increased by $114.3, or 32%, to $472.1 in the third quarter of 2008, compared with $357.8 in the third quarter of 2007. The growth in revenues in the third quarter of 2008 reflected an increase of $37.6 in license revenues and an increase of $76.7 in services revenues as compared to the third quarter of 2007. International revenues as a percentage of total revenues increased to 47% in the third quarter of 2008, from 44% in the third quarter of 2007.

Total revenues increased by $453.1, or 50%, to $1,366.4 in the first nine months of 2008, compared with $913.3 in the first nine months of 2007. The growth in revenues in the first nine months of 2008 reflected an increase of $242.2 in license revenues and an increase of $210.9 in services revenues as compared to the first nine months of 2007. International revenues as a percentage of total revenues increased to 48% in the first nine months of 2008, from 45% in the first nine months of 2007.

Our revenue contracts with international customers are denominated in U.S. dollars. The recent significant strengthening of the U.S. dollar relative to the Euro, British pound and Australian dollar increases the price of our products in markets where customers operate in these currencies. We may need to offer additional discounts, reduce prices or offer other incentives to mitigate the effects of the strengthening dollar on local demand. License Revenues

Software license revenues increased by $37.6, or 15%, to $285.1 in the third quarter of 2008, compared with $247.5 in the third quarter of 2007. Software license revenues increased by $242.2, or 39%, to $863.3 in the first nine months of 2008, compared with $621.1 in the first nine months of 2007. We believe a significant majority of the revenue growth in the third quarter and first nine months of 2008 compared to the respective prior-year periods in 2007 is the result of greater demand for our virtualization product offerings attributable to wider industry acceptance of virtualization as part of organizations’ IT infrastructure, a broadened product portfolio and expansion of our network of indirect channel partners. We expect the rate of growth in our license revenues to decelerate due primarily to the size and scale of our business and lengthened sales cycles attributable to challenges our customers may face in the current uncertain economic environment, such as decreases in IT budgets and difficulties in obtaining financing.

ELAs continue to be a significant component of our revenue growth. ELAs are core to our strategy to build long-term relationships with customers as they commit to our virtual infrastructure solutions in their data centers. ELAs provide a base from which to sell additional products, such as our application and infrastructure management suite and our disaster recovery products. Under a typical ELA, a portion of the revenues is attributed to the license and recognized immediately, but the majority is deferred and recognized as services revenues in future periods.

Although license revenue grew in the third quarter of 2008 when compared to the third quarter of 2007, license revenue remained relatively flat from the second quarter of 2008. At the end of the third quarter of 2008, we continued to observe the lengthening of the sales cycle on ELAs that we believe is primarily correlated to economic uncertainty, especially in the United States. In addition, some customers purchased our solutions in smaller quantities often through the channel to meet their immediate needs, forgoing larger discounts offered under ELAs. We believe this had a negative impact on our revenue and deferred revenue in the third quarter. We expect this trend to continue throughout 2008 and perhaps longer term.

We sell our products through a network of channel partners, which includes distributors, resellers, x86 system vendors and systems integrators. As we expand geographically, we may add additional direct channel partners. The increases in orders in the third quarter of 2008 primarily resulted from increased sales volumes through our existing direct channel partners. These increases were driven by several factors, including greater demand for our virtualization product offerings, wider industry acceptance of virtualization as part of an organization’s IT infrastructure, a broadened product portfolio and expansion of our indirect channel partner network which purchase product from our direct partners.

We have more than 19,000 indirect channel partners as of September 30, 2008, an increase of over 9,000 from December 31, 2007. These indirect channel partners obtain software licenses and services from our distributors and x86 system vendors and market and sell them to end-user customers. In the first quarter of 2008, we introduced new programs for these channel partners to assist them to quickly establish and expand their virtualization practices and drive new customer acquisition. We believe these programs encourage channel loyalty and may facilitate our ability to reach additional industry segments and acquire new customers. In addition, we have a direct sales force that complements these efforts. Our sales force works with our channel partners to introduce them to customers and new sales opportunities. Our channel partners also introduce our sales force to their customers.

We experienced an increase in the number of license orders greater than fifty thousand dollars in the third quarter of 2008, compared to the third quarter of 2007, as well as in the first nine months of 2008, compared to the first nine months of 2007. Although we remain a high-volume transaction business, we believe an increase in the number of license orders greater than fifty thousand dollars in the comparative periods is a result of broader acceptance of virtual infrastructure solutions for organizations’ IT infrastructure, a trend toward end-user customers using our products broadly across their organizations, and a result of more customers entering into multi-year ELAs, our most comprehensive volume license offering during 2008 as compared to 2007. We also experienced an increase in the number of licenses orders greater than fifty thousand dollars in the third quarter of 2008 compared to the second quarter of 2008. License orders from our distributors and end-user customers which were greater than fifty thousand dollars were approximately 36% and 28% of license revenues in the third quarter of 2008 and 2007, respectively. License orders from our distributors and end-user customers which were greater than fifty thousand dollars were approximately 34% and 29% of license revenues in the first nine months of 2008 and 2007, respectively.

Services Revenues

Services revenues increased by $76.7, or 70%, to $187.0 in the third quarter of 2008, compared with $110.3 in the third quarter of 2007. Services revenues increased by $210.9, or 72%, to $503.1 in the first nine months of 2008, compared with $292.3 in the first nine months of 2007. Given the reasons cited below, we expect that services revenues will compose a larger proportion of our revenue mix and revenue growth in 2008.

The increase in services revenues in the third quarter and the first nine months of 2008 was primarily attributable to growth in our software maintenance revenues. Software maintenance revenues increased by $60.5, or 70%, to $147.3 in the third quarter of 2008, compared with $86.8 in the third quarter of 2007, and by $167.5, or 74%, to $395.4 in the first nine months of 2008, compared with $227.9 in the first nine months of 2007. This growth reflects the increase in our license revenues, as software maintenance services are generally purchased with licenses, the benefit from multi-year software maintenance contracts sold in previous periods and renewals of existing customer software maintenance contracts.

Professional services revenues increased by $16.2, or 69%, to $39.7 in the third quarter of 2008, compared with $23.5 in the third quarter of 2007, and by $43.4, or 67%, to $107.7 in the first nine months of 2008, compared with $64.3 in the first nine months of 2007. Professional services revenues increased due to growing demand for design and implementation services and training programs, as end-user organizations deployed virtualization across their organizations.

$11.0 and $9.2 in the third quarter of 2008 and 2007, respectively and $40.2 and $25.9 in the first nine months of 2008 and 2007, respectively. The increase in the first nine months of 2008 was partially offset by a decrease in amortization of intangible assets of $7.7 from the first nine months of 2007. The cost of fulfillment of our software, which includes product packaging, personnel costs and related overhead associated with the physical and electronic delivery of our software products remained relatively flat.

Cost of Services Revenues

Our cost of services revenues increased by $13.4, or 34%, to $52.9 in the third quarter of 2008, compared with $39.5 in the third quarter of 2007. Cost of services revenues increased by $75.2, or 83%, to $166.1 in the first nine months of 2008, compared with $90.9 in the first nine months of 2007. As a percentage of revenues, cost of services revenues were 11% in the third quarter of 2008 and 2007, respectively, and 12% and 10% in the first nine months of 2008 and 2007, respectively. The increases in our costs of services revenues were primarily attributable to increased costs to support the increased direct support, professional services personnel and third-party professional services costs to support the increased services revenues. In the third quarter of 2008, we also reclassified certain costs that were previously categorized as costs of services revenue to general and administrative expenses, therefore decreasing cost of services revenues.

Research and Development Expenses

Our R&D expenses increased by $17.5, or 26%, to $85.3 in the third quarter of 2008, compared with $67.8 in the third quarter of 2007. R&D expenses increased by $124.3, or 64%, to $318.7 in the first nine months of 2008, compared with $194.4 in the first nine months of 2007. As a percentage of revenues, R&D expenses were 18% and 19% in the third quarter of 2008 and 2007, respectively, and 23% and 21% in the first nine months of 2008 and 2007, respectively. The increase in R&D expenses was primarily attributable to incremental headcount to support the growth of our business, resulting in increased salaries, benefits expense and stock-based compensation expense, resulting from the deployment of additional resources to support new product development. Stock-based compensation expense increased by $2.3 in the third quarter of 2008 as compared with the third quarter of 2007, and by $28.2 in the first nine months of 2008 as compared with the first nine months of 2007. Partially offsetting this increase was an increase in software capitalization, which increased by $18.2 to $45.8 (including $7.8 of stock-based compensation) in the third quarter of 2008, compared with $27.6 (including $5.3 of stock-based compensation) in the third quarter of 2007, and by $26.0 to $65.6 (including $11.7 of stock-based compensation) in the first nine months of 2008, compared with $39.6 (including $6.7 of stock-based compensation) in the first nine months of 2007.

Sales and Marketing Expenses

Our sales and marketing expenses increased by $42.2, or 34%, to $167.9 in the third quarter of 2008 from $125.7 in the third quarter of 2007. Sales and marketing expenses increased by $164.0, or 53%, to $475.5 in the first nine months of 2008 from $311.4 in the first nine months of 2007. As a percentage of revenues, sales and marketing expenses were 36%, 35%, 35% and 34% in the third quarters of 2008 and 2007, and in the first nine months of 2008 and 2007, respectively. The increases in sales and marketing expenses in absolute dollars consisted primarily of higher salaries, benefits expense and stock-based compensation expense due to both increases in sales and marketing personnel and higher commission expense resulting from increased sales volume. Stock-based compensation expense increased by $3.5 in the third quarter of 2008 as compared with the third quarter of 2007, and by $19.4 in the first nine months of 2008 as compared with the first nine months of 2007. Our sales and marketing expenses also increased due to marketing expenses related to our international market expansion and marketing expenses related to our branding initiative. A portion of our sales and marketing expenses is denominated in foreign currencies and thus exposed to foreign exchange rate fluctuations. Upon consolidation, as exchange rates vary, the amount of sales and marketing expenses may fluctuate in response to changes in the exchange rate between the U.S. dollar and the foreign currencies in which the expenses are payable.

General and Administrative Expenses

Our general and administrative expenses increased by $3.6, or 9%, to $43.4 in the third quarter of 2008, compared with $39.8 in the third quarter of 2007. General and administrative expenses increased by $32.5, or 33%, to $129.7 in the first nine months of 2008, compared with $97.2 in the first nine months of 2007. As a percentage of revenues, general and administrative expenses were 9%, 11%, 10% and 11% in the third quarters of 2008 and 2007 and in the first nine months of 2008 and 2007, respectively. These expenses increased in absolute dollars primarily as a result of additional salaries and benefits expense resulting from the additional resources to support the growth of our business and to expand our own administrative functions. In the third quarter of 2008, we also reclassified certain costs that were previously categorized as costs of services revenue to general and administrative expenses, therefore increasing general and administrative expenses. Stock-based compensation expense decreased by $3.8 in the third quarter of 2008 as compared with the third quarter of 2007 and increased by $5.0 in the first nine months of 2008 as compared with the first nine months of 2007.


CONF CALL

Michael Haase

Great, thank you and good afternoon everyone. Welcome to VMware's third quarter 2008 earnings call. With us today are Paul Maritz, President and CEO and Mark Peek, CFO. Following our prepared remarks, we will take your questions. Please note that this call is being simultaneously webcast on our Investor Relations website. Press release was issued today after the closing market and is also posted on the website. I would like to remind you that statements made in today's discussion that are not statements of historical facts are forward looking statements subject to the Safe Harbor Provisions under Federal Securities Laws.

This includes but is not limited to, statements regarding our financial outlook, future product offering and projected demand. These statements are based on current expectations as of today of this call and are subject to uncertainties and changes in condition, significant value and effect as well as other risk details and documents followed with the Securities and Exchange Commission including our quarterly report on Form 10-Q for the period ending June 30, 2008 that may cause actual results to differ materially from those set forth in our statements.

In addition during today's call, we will discuss certain non GAAP financial measures. These non GAAP financial measures which are used as measures of VMware's performance should be considered in addition to, not as a substitute for or an isolation from, measures of VMware's financial performance prepared in accordance with GAAP. You can find additional disclosures regarding these non GAAP measures including reconciliations with comparable GAAP measures in our earnings release for the period ending September 30, 2008 and on the Investor Relations page of our website.

The webcast replay of this call will be available for the next 30 days on our Company website under the Investor Relations link. For refining purposes, our third quarter quiet period begins at the close of business December 16, 2008. Also, unless otherwise stated, all financial comparisons in this call will be in reference to our results for the comparable period of 2007.

With that, let me hand it over to Paul.

Paul Maritz

Thanks Mike. Well, first I would like to say that I am happy to report to you that despite some very challenging conditions, VMware had a very solid quarter being able to reach the upper end of our guidance that we gave last quarter and at this part, I would ask Mark to step in and goes through the non business some detail and give you background. I will then return and make some additional remarks and then we will open up for Q&A. Mark?

Mark Peek

Thank you Paul and good afternoon everyone. Q3 was another solid quarter for VMware and despite the unprecedented global economic events during the final weeks of the quarter; we achieved quarterly revenue of $472 million, an increase of 32% from year ago. Our revenue for the first nine months of 2008 increased 50% compared to the same period last year and now exceeds our revenue for all of 2007.

Our growth during times when IT budgets are under intense pressure is a test to measure the strong value, proven quality and immediate return on investments that customers get from VMware products. Offering process measured on a non GAAP basis was a $115 million, 24.3% of revenue and an increase of 26% from last year. The third quarter was marked by improved operational execution during the time of significant economic volatility and the leadership transition.

Our trailing12 months' non GAAP operating cash flows were over $700 million, increasing over 48%. Our balance sheet remains very strong with nearly $1.7 billion in cash and cash equivalents and deferred revenue of $780 million. This quarter, revenue has included license revenues of $285 million, up 15% from last year. Deferred license revenues have not changed significantly relative to total deferred revenue over the last three quarters.

As I mentioned during last quarter's call, our third quarter 2007 license revenue included approximately $40 million of previously deferred license revenue that we recognized when we shipped lab manager last July. Factoring end of period changes in deferred license revenue and the current results, license revenue grew 35% compared to a year ago. Services revenue was $187 million, a 70% increase to last year and up 9% sequentially. Total services revenue included software maintenance of $147 million, a 70% increase from last year and professional services revenue of $40 million, up 69% compared to last year.

Continuing the trend we observed at the end of Q2, customers continue to proceed cautiously in their capital spending decision process. In some instances, customers are deciding to forego larger discounts offered by enterprise license agreements and instead are choosing to buy for their immediate needs. ELA as the percentage of total bookings were down slightly in the third quarter as compared to the second quarter and were up slightly from the third quarter a year ago.

Our US Federal sector results were seasonally strong. This is consistent with the government September yearend and we continue to see momentum in our government's adoption of our products. I want to spend a moment on the financial sector, an area of concern for investors over the past month or so.

Large businesses on the financial services industry have traditionally been leading adaptors of IT products and services to run their operation. We have long-standing relationships with most of these businesses and in fact, many of them have entered into enterprise license agreements with us over the last year and a half. Although a significant market, the financial sector averaged about 10% of our overall bookings over the past four quarters. Remember we have a diverse and global customer base that includes 95% for the Fortune 1000 and 87% of the Fortune Global 500.

Geographically, US revenue increased 24% from a year ago up to $249 million representing 53% of total revenue. International revenue grew 42% to $224 million. We believe we have significant international opportunities especially in Japan, Korea, Germany and the Brit countries and have taken significant steps to improve our international growth. For example in China, we recently hired our first country manager and are aggressively increasing our sales force.

I will now turn to our non GAAP operating expenses. Total non GAAP operating expenses increased 4% sequentially to $357 million. This included the impact from the Beehive acquisition we closed in July. The overall operating margin solution from acquisitions over the past 12 months was 80 basis points. International expenses were also $4 million higher as the result of the year-over-year decline of the US dollar. However, given the recent weakness in many currencies particularly the euro, pound sterling and Australian dollars since we reported last quarter, this was less of an impact than on recent quarters.

Year-to-date, operating expenses have been negatively impacted by the weakening dollar by over $20 million. As a percentage of third quarter revenue, non GAAP cost of revenues decline sequentially to 11.8% from 13.1%. This reduction is partially offset by cost increases in G&A to 8.4% from 7.5%. The differences are largely the result of changes we made in classifying certain cost of services revenues to G&A. Third quarter R&D expenses totaled $108 million or 22.8% of revenues as compared with 23% in Q2.

On a GAAP basis, we capitalized $46 million, $38 million in cash expenses as required by our legacy accounting policy under FAS 86. Our policy is to capitalize cost after products reached technological feasibility. We believe it is important for investors to consider both our operating results and cash close as adjusted for this item. Sales and marketing expenses were $154 million or 32.6% of revenues compared with 31.8% on the prior quarters.

The increase was largely due to seasonal marketing expenses including our very well attended VMware conference, expenses related to our international market expansion and other marketing expenses related to our branding initiatives. These increases were partially offset by the strengthening of the dollar compared to second quarter. Non GAAP operating income increased 26% from a year ago to $115 million or 24.3% of total revenue and our non GAAP diluted EPS was $0.24 on 394 million diluted shares.

Our non GAAP tax rate in the quarter was 21%, up from 20% in the second quarter. We expect this rate to decline significantly in Q4 as a result of the extension of the R&D credit by progress a few weeks ago. For the year, we expect the GAAP tax rate to be between 13% and 15%. This guidance includes stock-based compensations, amortization of intangibles and FAS 86 capitalization representing approximately 3 to 4 points.

This translates to a non GAAP tax rate that would be approximately 3 to 4 points higher than the GAAP tax rate for the full year. Our employee stock option exchange program was completed in the third quarter. In addition to the exchange offer, we also granted 5.4 million restricted stock units, a portion to our international employees who could not participate in the US exchange offer and a portion for retention purposes. While this does not significantly impact our non GAAP results, it will have an impact on our GAAP results.

Our 10-K will be filed in early November and will include additional details of the expected future GAAP expenses related to these equity actions. As you consider our waited average share accounts and the effect of these instruments on delusions, remember that option delusion is dependent on share price and our cue delusion as a function of time. As a result, on a non GAAP basis, we do not expect significant delusion in Q4 or 2009 on these equity actions.

Now under our balance sheet and cash flow statements, our balance sheet remains strong with cash at quarter end of nearly $1.7 billion, a sequential increase of $151 million. At the beginning of the year, the cash balance had increased 37%. We invested in short term cash and cash equivalents and have not experienced any declines in valuation of our holdings. Total deferred revenue increased 8% sequentially to $780 million. Year-to-date, total deferred revenue had increased 41%.

Our net accounts receivable has declined $22 million from last quarter and our DSO, which we calculate including the change in deferred revenue, is approximately 50 days. This is down from Q2 and comparable to Q1 and the fourth quarter of last year. The interest rate on our $450 million note with EMC adjusts each quarter at LIBOR plus 55 basis points. The volatility in the credit market has resulted in the Q4 rate of 4.43%, 109 basis points higher than Q3. At the same time, we will continue to keep our cash invested very short term and on the current environment expects a net of our investment income to the decline in Q4.

Non GAAP operating cash flows, which we adjust for capitalization under FAS 86 and accept tax benefits from stock compensations, was $211 million for the third quarter, an increase of 20% from Q3 2007. On a trailing 12 months basis, non GAAP operating cash flows were $707 million, up 49% compared to the 12 months ended September of 2007. These results exceed our non GAAP operating income largely driven by an increase in maintenance revenue for which we are paid upfront.

As we mentioned last quarter, we are slowing our second half hiring. Headcount at the end of the third quarter was approximately 6,500, a sequential net increase of 200 people. In the fourth quarter, we will continue to make strategic hires focused primarily in product developments and market expansion opportunities.

Now, moving on to guidance. I open the second quarter conference call by saying that we had a solid quarter despite economic head wins and once again in the third quarter, we achieved solid results despite the unprecedented events that occurred in the last three weeks of our quarter. As far in October, the US and global economies continue to be challenged but we are very confident in the long term health of our business, the global financial crisis is creating customer uncertainty around fourth quarter IT spending.

We have limited visibility on how our customers release funds in their short-term purchasing. In addition, I will remind you that we sell in US dollars around the world and we maybe impacted by high volatility in foreign exchange. Given these circumstances, we believe there is a broad range of possible outcomes for our fourth quarter revenue. We are cautiously maintaining our 2008 revenue guidance for growth of 42% to 45%. However, we are clearly more comfortable at the low end of this range and believe the overall economic mood will have to improve quickly and significantly to achieve result at the mid to high end of this range.

We are targeting our fourth quarter non GAAP operating margin to be between 22% and 24%. Non GAAP operating margin excludes stock-base compensations, payroll tax on stock transactions, amortization of intangible assets and capital at software development products which are target at 6% of revenue. This target assumes 2008 revenue to be near the low end of our annual guidance.

In addition, as I mention last quarter, our business is starting to follow traditional seasonal pattern. Therefore, we anticipate our Q1 2009 revenue to follow industry seasonal patterns and decline sequentially from Q4. Before I hand it to Paul, let me underscore that we are in this business for the long term and we believe we have tremendous opportunity ahead of us to maintain our leadership in one of the fastest growing and far-reaching technology sectors.

We are managing the business prudently, mindful of providing a reasonable return while making investments for the long term. We have great faith in our ability to execute on unique on front of us and I look forward to speaking with you again in January. Paul?

Paul Maritz

Thanks Mark. Well, I have been here to VMware for three months now and well, this is spent fair amount of time meeting with people in the Company and our customers really getting to understand the issues and dynamics and opportunities and challenges that we face. I came here expecting to find certain things. I expected to find a company that had great foundations in terms of great people, great technology and excellent relationships with our customers and significant partnerships.

I also expected to find a company that was experiencing the challenges that having undergone rapid growth, having added the 2,000 people approximately with proceeding 12 months and I did find that. I also found some unexpected things. I found that we have incredibly passionate customers who are making tremendous use of our product. These customers have been able to achieve both direct results in terms of cost savings from civic consolidation as well as indirect benefits from seeing the environment become fundamentally more flexible and manageable as they virtualized.

Accompanying to this enthusiasm from our customers was that that our VMware event in Las Vegas in September, we had nearly 14,000 customers come and attend that event. Last week I was in Australia where we ran a smaller but similar event for our customers there and that market alone, we had 1600 customers turn out to spend the day with us. Now obviously it is the primary job of management to really focus on the challenges for the business string ahead.

Over the last three months, I had begun to focus on three major challenges; first of all, our organization; secondly, our near-term execution in terms of revenue expense and product delivery and then thirdly, on looking with our organization to create strategic framework to guide our efforts going ahead. Well, I like to take few minutes now and take a step back with some heavier approach on each of the three challenges.

In terms of the organizations, my first start at business was obviously to work here and try and make sure that the transition from Diane to myself went smoothly as possible and that certainly as of any transition, we have had our challenges there but I can report that we are making our way through them and our organization is moving ahead. Despite the market turmoil and the loss obviously of Diane herself and her husband, Mendel and in addition, Richard Sarwal, our organization is stepping up in the challenges.

We are arching internal people to take on additional responsibility and I most are looking to augment our executive team with some key hires. I will return to that in a few minutes. I do not want to be complacent here, maintaining the health of our organization going forward is my first objective and I would continue to spend a lot of time as I had been doing, listening and communicating with several levels of the organization.

But on the whole, I am very pleased to be part of a team of talented, hardworking and very capable people. In terms of the challenge of near-term execution, the first is obviously to make sure that we hit our revenue targets in challenging economic times and I would really like to thank Carl Eschenbach and his sales team as well as the marketing support people in our organization who worked very hard to bring home the quarter and not only bring it home but reach the upper end of our guidance. As Mark said, it was certainly very challenging.

As we went into September, uncertainty set it on a big way. We saw this leading along the sale cycles, additional level of review as we had started to see in the second quarter as well as customers adopting the buy as they go approach as oppose to buying for the long term VM ELA. Despite that we were able to get our customers, many of whom had delayed decisions from Q2 to come into Q3 and bring in the business.

I can also report to you that during this period, we did not see any major losses to Microsoft. Currently we take Microsoft very seriously and keep our eyes very closely focused on them. We did see a couple of customers indulge in vehicles direct head-to-head product comparisons and buying a lot of stocks work to our favor. In addition, despite the series of announcements over the last quarter, Microsoft is still behind in terms of their product roadmap and we do not see them catching up to us until the next 12 to 24 months, by this time we hope to move on.

So, we are not complacent there but at the same time, we have not seen at this point any major losses. In terms of products and execution, I have been working with our product teams to make sure that they are on track to deliver products and key product development pipeline full so we have a major list of our client management sold currently that will be going on to this quarter and as we go into 2009, we will see new releases of our several product lines as well.

In terms of expenses as Mark said, we are keeping a very close eye on the bottom line. In the third quarter, we instituted what we are calling a hiring polls which is to suspend hiring except for important and strategic hires and we will continue that into the fourth quarter and quite frankly, I see that continuing into 2009 as well. In terms of helping the Company mature and be able to execute on multiple funds and deliver on the key products and initiatives that we need to do in order to keep growing, I had been working with our organization here to enable us to move forward into a divisional or business unit structure as we go into 2009.

So, we will be looking to organize ourselves at the top level along our major product lines, server and desktop, as well as major geographies, North America, EMEA and Asia Pacific. I expect to promote and hire senior people to manage these product units, so business units and as well as promoting people internally into these positions.

The third challenge is really to set and place the strategic framework. We have become strategic to our customers and partners. I am interested when I meet with customers to hear them say to us that they need to understand where we are going in order to fund their futures that they will be making decisions about how to equip and invest in their data centers and infrastructure technology based upon what they know about our roadmap. Our product is to need to know where we are going. They are making significant investments in products that work with in or around our basic product line.

And finally, we need to guide ourselves. We need to have a framework in which we can set priorities and plan as we go forward. Accordingly at VM world, we articulated the strategies that have three initiatives, all of which support the same basic theme of enabling our customers to do more with less. The first initiative builds of our current virtual infrastructure product offerings that enable several consolidation and help customers move forward to get additional benefits of flexibility and efficiency.

Often our customers articulate this need as designed to build the internal cloud. They increasingly want to look at their infrastructure, their IT infrastructure, as a single giant computer in which they can very flexibly and efficiently position application loads and a plan evolution of their application infrastructure independently from how they plan the evolution and positioning of the underlying infrastructure.

To that end, we could see a part to take on our current virtual infrastructure product line and strengthen that and harden that into what we are calling a virtual data center operating system. The virtual data center operating system will be this layer of software that effectively isolates application loads on the one hand from the underlying IT infrastructure on the other and will enable that flexible positioning and additional benefits of manageability and efficiently going forward.

So, we are engaging on a part to evolve our virtual infrastructure product line into a fully virtual data center operating system. This virtual data center operating system will allow partners to plug into it, the right products that compliment it. A good example of this is a Cisco in their development of the Nexus 1000V soft switch. What Cisco has done is take a key part of their technology and reengineer it completely in software so as to plug into our virtual data center operating system lab.

This enables Cisco trained professionals to manage both the physical and virtual network through a common council. Our next initiative leads directly of our virtual data center operating system initiative. If we during the work to enable our customers to isolate their application loads from the underlying IT infrastructure, then we will also be enabling them to take those application loads and migrate them from their own infrastructure to infrastructure provided by clog ends in the future. But we see this as an additional way that will allow our customers to have increased efficiency and flexibility going forward. To do this, we need on the one hand to make sure that we have the standards and the technology that allow application loads to be correctly described and packaged up in such a way that they can be flip walk internal infrastructure into the cloud and on the other hand we need to work with the product providers to make sure that they have the message through technology and infrastructure on the one hand to accept this application loads.

So, we are working on the one hand the status groups to further define, how to describe the application loads and make sure that they are efficiently and correctly packaged. On the other hand, we are working with the community of service providers to ensure that they have the capabilities and the correct software to accept these loads. We have at VMware over a hundred clients provider signed up to the new club initiative, small known names like Teramac, then with Sunguard, T-Systems, Telecom, etc and we look forward to working with these companies to open up this new dimension of flexibility to our customers and further increase the value of the investments they are making in our software.

Our third initiative is called the V-client initiative and this speaks to the need that our customers have to more efficiently position the depth of competing. They need to have a framework that allows them to achieve much more efficient central management of the complete resources that they provide to their users. The date that is largely met working through as end client's approach which is a very profitable way of achieving this and we will continue to invest in its end client approach. We recently announced a joint development with [Teraichi] or will be developing a new protocol to provide very efficient traffic between the server environment and its end client environment on the other hand and we will also be, as I said earlier, releasing a new release of our Sweden management software for the client environment and that will happen in this quarter or fourth quarter.

But there is also a need to extend this framework to address both thin clients and thick clients. Our customer is charged that there is certain parts of their company that can be very efficiently and effectively address various thin client approach but there are other parts of their organizations that need such capability as mobility or additional graphics capability that require a thick client instead. We need to revive them with the common way but basically satisfying the needs to manage both thin and thick clients. The correct approach we believe is to provision to user, to provide the user with a virtual environment that holds all of these information, data applications and necessary software and that virtual environment will be provisioned wherever the user happen to sit down and log on.

If he happens to sit down and log on to a thin client, that virtual environment will be made available to in view of this client approach. If he happens to sit down and log on to a thick client, that environment will be made available to him on his thick client. This unified approach of addressing both thin and thick clients actually makes full use of VMware's set aside virtualization assets as well as our client side virtualization asset and VMware is unique in having deep service side virtualization assets as well as deep client side virtualization assets.

I wanted to stress again that these three initiatives build off like we have. They are a serious steps that we need from our current products towards the future. Like I said earlier, we start with a major release of our client management software in the fourth quarter and we are expecting major releases of our service software in 2009. In terms of funding these initiatives, I expect that we will be able to fund these initiatives probably within our current resource pool with only very targeted and focused additions to it.

We have 2,500 people in our R&D organization which makes this one as the largest system software developing shops in the world but we have both deep and new risk resources that we can pull upon as we go forward into these initiatives.

Finally, I want to close by saying as Mark said that we will also be investing in geographic expansion. We have significant opportunities in the near term to grow our businesses particularly in Asia and the emerging markets. Well, into 2009 in addition to these focused investments in our product capability, we will be looking to expand in our sales and marketing capabilities in these high growth areas of the world.

Finally, I want to say that for 2009 as we look forward to that, things are uncertain and as Mark has noted, we are not going to change our 2008 guidance. We are staying with the range that we provided you last quarter for 2008 that we have to say that given on the uncertainty at this point in time, it will be very hard to divide very specific guidance for 2009. On the other hand, our products speak to fundamental needs that our customers have. They enable our customers to do more with less. Our customers report to us that virtualization remains at the top of their priorities as they look strategic IT investments going forward.

It will enable them to achieve levels of efficiency that will become only more important in the current economic environment. Well given our firm foundations in terms of technology, equal financial resources, our customers and partners, I expect that VMware will be one of the Companies that weather this current storm well and I certainly believe that we can emerge from it stronger at a more fitted company ready to exploit the opportunities that will open up.

So, with that, I would like to close and take any questions. Operator, let us start the polling process, please.

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