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Red Hat Buys the Boss

For the past few months, rumors swirled that JBoss, the leader in open-source middleware, was buyout bait. JBoss lets companies deploy sophisticated Java-based applications, including e-commerce sites, via the Web. Yesterday, Red Hat (Nasdaq: RHAT  ) ended the acquisition rumors, announcing that it will shell out between $350 million and $420 million to buy the company.

Red Hat is a pioneer of commercial open-source software. It takes free software such as the Linux operating system, then bundles it with tools and services for an additional fee. This model is doubtlessly scary for traditional software players like Oracle (Nasdaq: ORCL  ) , Motley Fool Inside Value pick Microsoft (Nasdaq: MSFT  ) , and SAP (NYSE: SAP  ) , which charge up-front licensing fees and ongoing maintenance fees for their software.

Red Hat and JBoss look like a solid match. JBoss has a powerful application server, which is an increasingly important piece of technology as companies put more of their applications online. (NYSE: CRM  ) and NetSuite rely on application servers to deliver Web-based customer relationship management (CRM) and accounting software to customers via their Web browser. Red Hat's home-brewed application server didn't gain much traction, but JBoss emerged as a standout.

This deal doesn't look cheap. JBoss's revenues are expected to reach just $60 million in 2006. To be fair, they're growing quickly -- last year's revenues were estimated to fall somewhere between $20 million and $30 million. In Red Hat's favor, about $70 million of the ultimate price tag depends on JBoss meeting certain revenue milestones.

The application server market is intensely competitive; key players include Oracle, IBM (NYSE: IBM  ) , and BEA Systems (Nasdaq: BEAS  ) . These companies have a crucial competitive advantage against JBoss: They've earned the trust of major customers who demand mission-critical solutions.

But JBoss has made inroads with large companies as well, and its solutions cost less than competitors'. "Open source is very challenging for traditional software companies," said David Skok, a general partner at Matrix Partners and an investor in JBoss. "For entrenched software companies, they run the risk of cannibalizing their current business, finding themselves in a catch-22." It's a classic case of the destructive power of new technologies. Will large software companies offer cheaper versions of their software to better compete with JBoss?

The deal also puts Red Hat's customer and distribution muscle to work for JBoss, which may prove to be the biggest risk factor. While Red Hat's strengths lie in services, sales, and distribution, JBoss is composed of a group of stellar programmers. Thus, much of its value is in its human capital. Thanks to their stock options, these top programmers are much richer because of the deal with Red Hat. What's to prevent them from striking out to start their own ventures?

For Red Hat to grow -- and support its hefty $5.3 billion market cap and P/E ratio of 83 -- it must find and acquire new products. Since it's already established a solid operating system, buying an application server is the next logical step. The JBoss purchase makes a lot of sense -- assuming Red Hat can execute on the deal. Given the history of the tech industry, that's by no means guaranteed.

Fool contributor Tom Taulli does not own shares mentioned in this article.

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