White Hat, Blue Hat, RED HAT![Fool on the Hill] June 23, 2000

An Investment Opinion

White Hat, Blue Hat, RED HAT!

By Bill Mann (TMF Otter)
June 23, 2000

Summary: Red Hat stock has been clobbered over the last five months. But the company seems poised for some significant growth after inking deals with Dell and IBM.

Edward De Bono has a renowned methodology for thinking and analyzing called the "Six Hats Method." It requires, rather than the Socratic Method of problem solving, that a discussion go through a series of thought processes designated by wearing hats. White Hat, for example, is the statement of facts. Yellow Hat thinking requires that the participants focus on the benefits, Black Hat on the pitfalls. And Red Hat (Nasdaq: RHAT)? That's the emotional hat. How do you "feel" about something, and so on.

Much in the same vein, the company Red Hat has proven in its short history to be one that provokes fairly strong emotions in investors. It rocketed out of the gate at its August 1999 initial public offering, finishing its first day more than 200% above its offering price. In the following months, the company was valued as high as $16 billion, on annual revenues of less than $30 million. Since January it has been one of the hardest hit companies in the public markets, losing nearly 90% of its value through the end of May.

But June has been pretty kind to Red Hat, as it has risen more than 90% thus far in the month. (For purists, please note that the 90% gain does not wipe out the 90% loss. In fact, the 90% gain has only erased 10% of the total loss.) Critics of the company have voiced concern that it isn't doing enough to take market share away from Microsoft (Nasdaq: MSFT) and its Windows operating systems. Some of Red Hat's largest expenses have been in marketing (nearly 70% of gross revenues) to persuade corporations to use its version of Linux. I'd say off the bat that neither the huge run-up nor the rapid downturn were representative of the core prospects of the company. These were market phenomena, unrelated to the business.

Red Hat has shown considerable life this month, coming out with strong quarterly results and a topline growth rate of nearly 100% over last year. Also, in the last two weeks, Dell (Nasdaq: DELL) and IBM (NYSE: IBM) have announced increased cooperation and support for Red Hat.

Dell has decided to provide full customer support to customers running the Linux operating system, which is RedHat's largest "product." Dell expects Linux-based servers will rival those running on proprietary versions of Unix, such as those offered by Compaq (NYSE: CPQ) and Sun Microsystems (Nasdaq: SUNW). In tandem with the announcement, Dell unveiled a big fish, Toyota (NYSE: TM), which is installing Dell appliance servers running Linux at all of its dealerships.

IBM is using Red Hat Linux on many of its Netfinity servers, and although it works with several Linux providers, it will cooperate quite closely with Red Hat. For example, IBM is offering Red Hat Certified Engineer courses at its training centers.

So is it time to take another look at Red Hat? The stock's been mangled over the last few months, but the expectations built into Red Hat's market cap at its peak were such that the only direction it really could have gone was down. In fact, for all of the hype that surrounded the Linux stocks last year, and the threat they pose to King Microsoft, these companies -- Red Hat, VA Linux (Nasdaq: LNUX), Caldera (Nasdaq: CALD) -- have paltry revenues, huge losses, and, most importantly, strange relationships to their central product.

Linux is an open-source operating system, meaning that no one company can control its releases, one of the central criticisms of Microsoft and Windows. Linux was developed in 1991 by Linus Torvald (who also does not "own" Linux), and has been refined ever since, by thousands of programmers releasing their own "patches." Red Hat provides a few value-added services: It provides the Linux operating system on CD, making download much simpler; it includes several commercial applications; and it gives customer support, something of supreme interest to businesses operating in a Linux environment. But, as CEO Michael Young famously said, "The only thing Red Hat owns are our trademarks."

But its support services and the trust its trademarks provide are enough to make this an interesting company, from a service and an investing perspective. Red Hat is solidifying its partnerships with companies providing Linux platforms. Besides Dell and IBM, the company also counts Oracle (Nasdaq: ORCL) and Compaq among its vendors. Although these companies work with several Linux providers, Red Hat is carving out a significant niche with them, and open source or no, there is enough differentiation that they will be disinclined to switch back and forth between providers.

There are Black Hat (the hat worn when voicing concerns or threats) issues out there. Red Hat is still richly valued at 56 times sales, and its marketing expenses will continue to dwarf its revenues. The addressed market for open-source software is still relatively small. The company does not have the bandwidth to devise sufficient applications running off Linux. And most importantly, it doesn't own its major product. This is a business model that has never existed previously. Not that that's a bad thing.

But Red Hat has gone a long way to putting itself at the lead of the open-source revolution. And even if it finds the PC and server markets tough nuts to crack due to a huge installed base using other platforms, Red Hat is pressing toward a strategic focus on the handheld environment, where no such existing dominant operating system exists as of yet. The company has projected that it will be profitable in 2001, and it has plenty of cash on the balance sheet to fund operations. If Linux turns out to be the revolution some believe it is destined to be, Red Hat's powerful branding could make it the Gorilla in the neighborhood.

Fool on!

Bill Mann, TMFOtter on the Fool discussion boards

Related Links:

  • Red Hat stock rises on news of alliances, Raleigh News & Observer