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How Red Hat Is Improving Its Top Line

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Tech company Red Hat (NYSE: RHT  ) has become the face of Linux, an open-source operating system used by most corporations and hosting companies on their servers, including Rackspace Hosting (NYSE: RAX  ) and's (NASDAQ: AMZN  ) Amazon Web Services.

The company, which generates most of its revenue from selling server technology, has been challenged by the rise of cloud computing. But despite increasing competition from public cloud vendors, Red Hat surprised investors on Dec. 19, when it announced that earnings from its enterprise software business unit grew 45%, year over year, on a 15% revenue increase. This caused the stock to jump by as much as 20% overnight. Considering there's a fierce war for the cloud going on, how did Red Hat manage to improve its top line by such a significant amount?

The Red Hat way
Red Hat's all about competitive advantages. The company, aware of fast-growing competition in the cloud space, is using its open-source advantage to develop better server software and provide more efficient data-center solutions.

Red Hat gives away its software, but charges for support and services. This is essentially the razor-and-blades business model. By not charging anything for its software, Red Hat provides a strong incentive to use its technology. Potential clients get accustomed to Red Hat's system, and it later collects profits from support and other related services.

This has allowed Red Hat to build a strong franchise. Further, to protect its reputation as the face of Linux, the company hires thousands of developers and engineers, who are engaged in more than 100,000 open-source projects, most of them related to server technology.

Source: Red Hat Investor Relations

Strong demand for Linux
The company is also active in promoting the use of Linux over Windows and other operating systems. Linux has been the fastest-growing server operating system over the past decade. Red Hat has more than 60% of the Linux server operating system market.

In the latest quarter, Red Hat experienced healthy demand for its core products, including the JBoss middleware platform -- a set of cloud-friendly products that are used to automate business processes in servers -- and the Red Hat Enterprise Linux operating system.

One of Red Hat's strongest competitors is Rackspace Hosting, a global leader in hybrid cloud, which grew its revenue by 3.4% last quarter. 

Rackspace is also aware of the importance of open-source contribution in the server space. That's why, together with NASA, the company developed OpenStack, the world's fastest-growing open cloud platform and developer community. It involves more than 13,000 engineers across 140 countries. As an operating system designed specifically for the cloud, OpenStack has become popular quite quickly. Due to its robustness, it is already being used by PayPal, MercadoLibre, and Workday.

Red Hat has built a partnering foundation with OpenStack. The company released the first version of its Red Hat Enterprise Linux OpenStack platform only a few months ago, but it has already seen a number of initial OpenStack wins, including several six-figure deals, according to James Whitehurst, Red Hat's CEO, who identified this platform as a serious growth driver.

Amazon is another strong competitor. The company has developed its own operating system, Amazon Linux. To promote cross-selling, this software has been optimized for the Amazon EC2 cloud servers, which the company sells to developers via Amazon Web Services. Early reception has been quite positive, with customers praising its regular maintenance, optimization for Amazon EC2 environment, and usability.

Foolish takeaway
Red Hat continues using its open-source advantage to improve its execution. The company's diversified revenue -- from selling Linux support to data-center solutions -- and well-known Linux expertise, combined with the positive effect of a partnership with OpenStack, should help Red Hat to continue improving its top line.

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