Investing in Linux

You could not keep eager investors from bidding sky high prices for Linux companies back in 2000. I tried to explain that Linux was not likely to hurt Microsoft in the short run, and that something that is available for free is a tad difficult to turn a profit on.

Come 2007 and the promise of Linux to make a profit for investors looks much brighter. But the premier Linux stock, Red Hat (RHT), while recovering from $3 lows in 2001, is only worth 1/6th of its January 2000 high. Its main competitor, Novell, is also not getting high P/E ratios for its efforts. The Linux plays that are doing relatively well are seen with companies where Linux plays a supporting role, rather than being a revenue driver itself. Companies like IBM and Oracle.

Is Linux still suffering from fundamental defects in its profit model? Or are investors missing the boat at Red Hat and Novell? How should these stocks be priced?

Let's start with Red Hat, which is a pure open-source play with income primarilly from Linux. It just reported Q2 2007 results that disappointed some investors. [See my summary of the analyst conference.] Revenues were up 47% from year-earlier: sounds like a growth stock to me. Net income was $16.2 million if you like GAAP, and I do; they also claimed non-GAAP net income of $33.7 million.

So what is their market capitalization, end of day today? $4.3 billion. That is pretty hefty. Using GAAP, factoring out the Q2 income to $64.8 annual, you have a ratio of 66. If revenues are up again 47% a year from now, and if economies of scale make earnings grow faster than revenues (or GAAP EPS converge to non-GAAP EPS), the stock will look cheap in retrospect. But projecting rapid growth out more than a year or two in advance is a good way to get taken to the cleaners.

Linux has changed. It is still geek friendly, not general population friendly. But the general population is not running corporate server farms. Linux evolves faster than Microsoft Server or the IBM OS's. And you can charge enough for support and service and bundling features to make a profit. Linux can be had for free, but that works only if you are highly skilled. So corporations are willing to pay for getting a well-tested version and support services.

Oracle has proven, yet again, that it is smarter than we think. Oracle is more of a threat to Microsoft now than at any time in history. Why? Because instead of butting heads with Microsoft it went after weaker, higher-margin opponents. It is killing SAP and shoving IBM around too. Its database system is the jewel, but the strategy of creating a full service ecosystem around the database has given the company new life. Oracle's offering Linux is not so much a danger to Red Hat, or even Microsoft, as a demonstration of what the tech jungle may look like a few years from now. Oracle software runs well on Microsoft Server products. It runs well on Unix and Linux. It plays well with CRM and ERP. And if you are buying most of your stuff from Oracle, there is no need to get your Linux from Red Hat. For more dope on Oracle see my summary of their June 26, 2007 analyst conference.

So far the conversion of Unix to Linux is happening so fast that there is plenty of pie for everyone. Another player is Novell. They have a big pot of cash ($1.8 billion) and a stategy for providing Linux and other services, but have been hard pressed to show a profit on a regular basis. They generate more revenue than Red Hat, but much of that is from legacy products that are clearly in decline. If they find their footing it will probably be through acquisitions.

Another issue for investors is the swarm of small Linux players. There are lots of versions of Linux available, all of them free. Some probably have ambitions to become serious players, and nothing is in place to stop that from happening.

More data:

Red Hat investor relations page
My Red Hat page
Oracle investor relations page
My Oracle page
Novell investor relations page
My Novell page