IBM Keeps Backing Linux

The continued endorsement of IBM certainly bodes well, but can Linux companies be successful investments? A company like Red Hat is one way for investors to measure the success of Linux companies. And while I even have my own doubts on the company's ability to achieve success, considering that it sells something that can be gotten for free, investors continue to keep these stocks on the radar.

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By Mike Trigg (TMF Tonto)
December 13, 2000

On the heels of several other victories, Linux backers had cause for additional celebration yesterday after IBM (NYSE: IBM) announced it would spend $1 billion on the open source system in 2001 and a Linux clustered computer win with grease digger Shell Oil, a division of Royal Dutch Shell (NYSE: RD). And while the news shows continued momentum for the alternative operating system, its path toward commercial acceptance remains lengthy.

At the eBusiness Conference and Expo, an industry trade show in New York, Big Blue CEO Louis Gerstner asserted that his company's commitment to Linux propels its efforts to break computing resources free of proprietary systems. IBM has made a commitment to Linux across all platforms, from personal computers to servers. To date, the company employs nearly 1,500 developers who are consulting customers and producing Linux versions of its products.

The deal with Shell entails IBM building a bundle of Linux machines that can be linked together to act as one giant computer. Joining multiple computers is a much cheaper means of computing than building one gigantic supercomputer. According to CNET the super computer will consist of 1,024 servers compacted in 32 racks and running on Red Hat's (Nasdaq: RHAT) Linux system.

Just last week, there was an announcement that the largest telecommunications company and Internet service provider in Scandinavia, Telia, would switch to an IBM mainframe to run its business and consumer Internet services operations. According to the press release, Telia will replace its 70 existing Sun Microsystems (Nasdaq: SUNW) servers with a single IBM enterprise server, which will host more than 1500 Linux servers at once.

What does this mean for Linux companies?
While today's news clearly indicates Big Blue's efforts to combat its slowing growth against competitors like Microsoft (Nasdaq: MSFT) and EMC (NYSE: EMC) in software and storage, respectively -- and the biggest pain of all, Sun Microsystems -- perhaps the more interesting question is to examine what all of this means for the Linux companies, such as Red Hat and VA Linux (Nasdaq: LNUX). Monday, I noted that many Linux companies are banking on growth in embedded software, attempting to thwart the current leader Wind River (Nasdaq: WIND)

The continued endorsement of IBM certainly bodes well. Today and in the past, IBM has acknowledged that the shift toward Linux is customer-driven and the byproduct of the unavoidable evolution of computing resources. That all sounds great, but the question remains: Can these companies be successful investments? Not long ago, Red Hat CEO Matthew Szulik spoke with the Motley Fool's David Gardner and identified several metrics -- including application availability, path-to-profitability, and the top-line -- as keys to measuring the company's success.

Red Hat is arguably the cream of the crop among Linux companies, and with it due to report earnings Thursday, investors will be provided another opportunity to measure those factors. It will be critical to examine the number of application developers that are switching over to Red Hat Linux. I'll also be paying close attention to top-line growth, which will help indicate the commercial acceptance of Linux. In the most recent quarter (ended Aug. 31), Red Hat grew revenues year-over-year 76% and sequentially 15% to $18.5 million.

Yesterday, shares traded up as much as 25%, ultimately gaining 17% on the IBM news and speculation that it would meet or exceed estimates. The Street consensus calls for Red Hat to report a net loss of $0.02 per share, and the company predicts it will reach profitability sometime in calendar year 2001. It's important to point out that Red Hat appears to be making solid progress toward this goal with gross margins improving over the last four quarters. Check out this sequential progress: 41.1%, 47.4%, 54.0%, and 57.8%. A company like Red Hat is one way for investors to measure the success of the Linux companies and the operating system itself.

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