August 18, 2008

Open Source: An Open Question for Red Hat and Others

Software supplier Red Hat is racking up growth figures that much of techdom might envy. Sales rose 32%, to $157 million, in the quarter ended May 31, and profits climbed a respectable 7%. So why is Wall Street so bearish on the stock?

A day after Red Hat (RHT) reported results, Oppenheimer & Co. (OPY) downgraded the shares, citing few opportunities for growth. Three other investment banks had lowered their Red Hat ratings in the previous nine months, and the company's shares, which on Aug. 15 dipped 22%, to 22.75, have been parked between 21 and 23 for a year. "There's a concern that our growth rate will slow," Red Hat Chief Executive Officer Jim Whitehurst says. "We've been in that funk the last couple of years."

So have many other companies that, like Red Hat, specialize in software whose code is "open source," or freely modifiable by users and a vast community of developers. The arrangement can lead to software products that are more customizable, more readily available, and often cheaper than comparable products from the likes of Microsoft (MSFT) and Oracle (ORCL), which closely guard the underlying code to their most important products.

Yet it's tech sector titans -- companies including IBM (IBM), Hewlett-Packard (HPQ), Oracle, and Intel (INTC) -- that profit most handily from companies' desire to run open-source products by selling lucrative hardware, databases, and consulting services alongside them. Meantime, life has been rough for many of the companies that have bet their business more specifically on open source.

No "Get-Rich-Quick Scheme" Shares of Novell (NOVL), a vendor of the open-source Linux operating system, have slumped 15% this year and are trading below 6 despite the company's attempts to diversify through acquisitions [, 2/5/08]. Open-source support company SpikeSource, headed by Silicon Valley veteran Kim Polese and backed by Kleiner Perkins Caufield & Byers, has chugged along for more than four years without breakout success. And for every MySQL, the open-source database maker that was bought by Sun Microsystems (JAVA) for $1 billion in January [, 1/17/08], plenty of startups have failed to deliver.

"Open source is not a get-rich-quick scheme," says Marten Mickos, the former CEO of MySQL and now a senior vice-president at Sun. "You have to have patience." He adds that the company was 13 years old when it sold.

Many investors won't wait that long. Venture capitalists invested $196 million in U.S. open-source software companies last year, after pouring in $265 million in 2006, according to market researcher Dow Jones VentureSource (NWS). The venture market has partly recovered this year, with VCs investing $150 million during the first half, but returns remain elusive. Only a handful of open-source acquisitions the last two years have netted investors at least 10 times their money.

Trying to Reverse Trends What's ailing open source? Vendors often lack access to a broad array of distribution channels. Their business is typically based on selling tech support rather than offering unique, must-have technology that customers will keep craving even when budgets are tight. And many suffer from low brand awareness.

Whitehurst and his counterparts are taking steps to reverse the trends. Whitehurst, who was chief operating officer of Delta Airlines (DAL) before arriving at Red Hat in January, is shifting engineers and marketers away from nice-to-have projects toward areas where Red Hat gets paid. He's pulling resources out of consumer desktop Linux, and he shuttered an online store that sold other companies' open-source programs. "I took a look at that and said, 'We're not eBay (EBAY),'" he says. "Red Hat is open source, but that doesn't mean we do everything in open source."

Red Hat is also directing resources toward expanding sales in Asia and developing business-ready versions of Linux that work with hot-selling virtualization software. Whitehurst is putting the kibosh on discounts. If his bets are correct, they could spur growth at the company, which has yet to crack $1 billion in sales, despite proffering Linux for well over a decade.

SpikeSource on Aug. 19 plans to announce a partnership with Intel, an investor, to sell certification for software programs that run on computers powered by Intel chips. Applications that pass muster get a SpikeSource badge and access to 160,000 Intel resellers, Polese says. The service carries a $25,000 annual subscription fee, though SpikeSource is offering discounts to early adopters. "Our focus has always been about scale," she says. "A lot of the pure-play open-source companies have had scaling challenges."

Takeover Target? At least for Red Hat, time for turnaround may be of the essence. Speculation is rife that the company is a takeover target. "It makes no sense that they're still hanging out there," says Eric Gebaide, a managing director at investment bank Innovation Advisors.

One possible suitor is virtualization software company VMware (VMW), which some industry executives says is on the lookout for an operating system to add to its portfolio. Former VMware CEO Diane Greene, ousted by her board in July, had set up meetings with Red Hat in part to position VMware as friendly to open source and possibly as a prelude to a buyout discussion, according to a person familiar with the conversations. Representatives of both companies declined to comment.

To be sure, open-source software continues to be popular. Sales of computer servers preloaded with Linux are growing faster than the overall market for servers based on chips from Intel and Advanced Micro Devices (AMD). And a handful of small open-source software companies -- including collaboration software maker Alfresco Software and SpringSource, which sells tools for writing Java programs -- are seeing rapid sales growth, according to industry executives.

Open-Source Haves and Have-Nots Still, the market is polarizing into open-source haves and have-nots. IBM sells billions of dollars worth of hardware, middleware, and IT services associated with Linux each year, says Inna Kuznetsova, the company's director of Linux strategy. And Oracle has made Linux an important platform for running its database and applications. Yet sellers of Linux tech support are often left in the lurch as companies pay for support only for the servers that run important corporate databases and applications, while choosing free versions of the software for Web servers, which are far greater in number.

Worse for open-source companies, big markets don't necessarily translate into big opportunities, because their software can be had for free. Take the market for ultraportable "netbooks." Taiwanese vendor AsusTek Computer has done well selling the stripped-down devices, and Dell (DELL) is planning to enter the market in the coming months. Linux would seem like a natural for netbooks since it runs quickly on the Intel chips inside. But Whitehurst says Red Hat is still figuring out whether there's a business case for jumping in, since hardware makers likely wouldn't pay for supported versions of Linux inside the machines.

"A pure service business is not particularly defensible," says Whitehurst. "Some open-source companies have not truly figured that out." If the open-source movement, now in its second decade, is to realize its promise for vendors and investors, more of its purveyors will need to get the message soon.