VA Linux Systems (Nasdaq: LNUX), one of several proprietors of the Linux open-source operating system, issued its first earnings report as a public company yesterday. For the second quarter of 2000, the company realized operating losses of $12.6 million on revenue of $20.2 million, compared with $1.8 million in losses on $3.2 million of revenue in the year-ago quarter. Net loss per diluted share this quarter totaled $0.50, or $0.36 on a pro forma basis. Since the company held its initial public offering (IPO) about halfway through the quarter, the announced earnings followed rules by accounting for average shares outstanding over the entire quarter. This meant that, when determining per-share numbers, they only used about half of the total shares outstanding. Analysts had called for a $0.21 per-share loss, based on the total shares outstanding. The resulting confusion gave the impression that the company had missed estimates by a long shot.

Oops. VA Linux didn't need any new reasons for the Street to put the hurt on its stock. Since the calendar's odometer rolled over, the company's shares have dropped over 40%. This latest mishap only fueled existing fears that VA Linux won't be able to attain significant profitability because it simply doesn't have a viable business model. Since the Linux operating system can be downloaded for free, some think that there are insufficient avenues of revenue to produce rapid growth.

Conventional Wisdom was not always thus. Way back on December 9, 1999, VA Linux's IPO received a glorious reception from Wall Street. Though its offering price was $30, the stock opened at $299 and rose to $320 before slipping back to close at $250, up 733%. Back in those days, it seemed to investors (and others who were buying the stock) that companies offering Linux distribution and support, like Red Hat Inc. (Nasdaq: RHAT) and Corel Corp. (Nasdaq: CORL), would inherit the earth. VA Linux seemed like a lock, since the public was warming to Linux, Microsoft (Nasdaq: MSFT) appeared to be crumbling, and, well, all the other Linux companies had appreciated so much. At the time, Red Hat was up 615% since its IPO, and Corel was up 528% since the end of October.

What has changed? Linux still appears to be gaining acceptance. Shipments of the operating system rose 93% in 1999. Microsoft remains essentially in the same position it held in December, though it has released Windows 2000 as planned. Fellow Linux providers, however, have flagged with VA Linux. Red Hat has dropped about 50% since December 9, and Corel is off 62%.

If you ever thought that VA Linux was a good investment, yesterday's announcement should have solidified your position. Larry Augustin, president and CEO, noted that the company surpassed many analysts' estimates of revenue, gross margin, and net income. Revenue increased 536% over last year's second quarter and 36% over last quarter. New customers accounted for 49% of that revenue. Operating loss as a percentage of revenue is shrinking. What's more, the company is sitting on about $150 million in cash, or about $6.45 a share. Sure, they didn't blow estimates away, but without the mix-up, the company might not have suffered ill effects.

If you questioned VA Linux's valuation, however, this result does little to assuage doubts that the company's business model doesn't have sufficient income-producing potential to justify the $4.5 billion market cap, especially with the Linux market as crowded as it is. At about 225 times sales and 30 times book value, this baby's still got plenty of room to fall.

If you bought the company at the IPO on speculation that Linux would stay hot, it's high time to reconsider.

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