Red Hat: Slow, Steady Progress

By Hal Plotkin Silicon Valley Correspondent

Mar 29, 2001 04:14 PM

Red Hat stock performance since IPO

Despite a low share price and a lack of attention from many institutional buyers, industry analysts say Red Hat Inc. {RHAT} is making the type of slow but steady progress that should make the leading seller of the Linux operating system an increasingly important player in enterprise computing and related wireless markets.

Red Hat surprised analysts last week by reporting better-than-expected earnings at a time when most earnings surprises have been going the other way. The company posted a break-even performance on a per-share basis in its fourth quarter, ended February 28, on revenues of $27 million. Analysts had been expecting to see the firm lose a penny a share on slightly lower revenues.

“I think it means the Linux market is consolidating around the leaders,” says Stacey Quandt, an analyst at the Giga Information Group, which advises firms on major technology purchases. “Red Hat is leading from a market and mind share point of view.”

There’s been more than a little skepticism about whether Red Hat can build a profitable business around the free Linux operating system, which is a rival to Microsoft’s Windows software. Red Hat’s business strategy calls for the company to make money by selling service, documentation, and support to corporate customers who don’t want to pay for an operating system. On the other hand, Microsoft’s strategy is primarily focused on selling or licensing the use of its operating system and related software applications.

Many industry experts, however, contend that recent movement toward Linux in some computing environments could signal a critical turning point for the still maturing software industry.

“Software is a service industry that has been masquerading as a manufacturing industry,” says software programmer Eric Raymond, whose influential pro Linux essay “The Cathedral and the Bazaar” is gospel for many Linux believers.

While the debate rages on about which strategy is best, several recent developments appear to be putting more wind behind the Linux sails.

In addition to Red Hat’s surprisingly strong performance in an otherwise down season for many software firms, there are also indications the Linux operating system, on which Red Hat’s hopes rest, is making important inroads in two critical areas: servers and new wireless applications. Although the Linux server operating system can be obtained free of charge, Red Hat sells it along with documentation, manuals, and a variety of service options.

The official tally isn’t in yet, but according to preliminary figures released to by International Data Corporation (IDC), Linux was the fastest growing server operating system in 2000. Sales of the Linux OS for the server environment grew by an estimated 24 percent during 2000, as compared with just over 20 percent for Microsoft’s competing product, Windows 2000. (Servers are powerful computers that serve as the hub of corporate networks and web sites).

Linux’s progress on the desktop has been much slower, with paid shipments for client, or desktop, operating system software leading to market share growth from just 1.3 percent in 1999 to a still-paltry 1.5 percent last year, a period during which Microsoft’s grip on the desktop market grew from 90 percent to 92.5 percent.

But analysts say the recent introduction of a new graphical user interface, called the Nautilus network user environment, by Silicon Valley start-up Eazel Inc. could provide an added boost to Eazel partner Red Hat over the coming months. In particular, the alliance is expected to crack open new opportunities for Red Hat in the emerging market for a wide variety of handheld wireless devices.

Eazel’s Nautilus software is the brainchild of company founder Andy Hertzfeld, the legendary programmer who gained fame as one of the key original creators of Apple’s groundbreaking MacIntosh software. Eazel’s goal is to bring the Linux operating system to the masses by making it easier to use than either Apple or Window’s competing based PC operating systems. But several industry watchers think Eazel’s most immediate contribution will be to give manufacturers a better and less expensive software platform on which to build new wireless devices and related services.

“Our goal is to enable a ubiquitous Internet ranging from handhelds to servers by providing reliable, secure solutions at the lowest total cost,” said Howard Jacobson, Red Hat’s vice president of corporate development in a statement released when the arrangement with Eazel was announced in January.

“The reason Linux hasn’t taken off on the desktop is that people don’t buy an operating system for the operating system, they buy it for the applications,” says Dan Kusnetsky, an analyst at IDC. Kusnetsky notes that today’s most popular desktop software applications run only on Windows, not on Linux.

“But the reverse is true on the server side,” he says. “Linux already has most of the software applications that are needed today for [corporate] infrastructure and high performance technical computing applications, and as an added benefit, it’s free.”

Those applications include security-oriented network firewalls, email routing, and sophisticated database applications. More importantly, they also include new wireless applications, such as online banking, which interface with those internal corporate networks.

“Red Hat already has an imbedded Linux strategy, so Nautilus gives them lots of potential for doing more of that,” says Quandt.

“The developers of wireless devices are looking at licensing fees [from other vendors] that could make it difficult for them to make a profit on their machines,” says IDC’s Dan Kusnetsky.

“So [Nautilus] is important, not only for cell phones and intelligent personal digital assistants,” he says, “but also because I suspect the biggest uses are yet to be realized because no one really knows where all this is going yet.”

In the meantime, Quandt says Eazel brings an added dimension to the Linux market.

“Eazel’s profile is very high within the Linux community,” she says. “They’re focusing on usability, and that is obviously a high-promise proposition.”

The doesn’t mean the stock of its more well-known partner, Red Hat, will shoot back into the stratosphere anytime soon, given the still-nascent nature of the firm’s market and overall approach. One reason for that is remaining skepticism from mutual fund managers, most notably value fund managers, who typically like to see a longer track record before they’ll buy a stock.

“We don’t like to have to guess what a company’s earnings will look like,” says Bill Lippman, president of the $85 million Franklin Value Fund {FRVLX}.

While he won’t guess at earnings either, IDC’s Dan Kusnetsky says he is reasonably certain of something else.

“It’s pretty likely that if the trajectory stays what it has been, Linux will hold a mainstream position in almost every corporate and web server market by about 2004,” he says.

“My sense is that Linux growth will continue to be sustained by the top tier of Linux suppliers,” he adds, noting that Red Hat is at the top of that list.

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