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Before Red Hat Sees Blue Skies

Is it possible to make lots of money from free software? Three years after the creation of Red Hat (RHAT), the Raleigh (N.C.) company that bills itself as the "largest and most recognized provider of open-source technology," it remains an unanswered question.

For the past 14 months, Red Hat has struggled to transform itself from a mass-market purveyor of cheap Linux -- the operating system that no one owns and anyone can use for free -- into a provider of Linux-based software packages and support services to big companies. Its software now comes installed on hardware from IBM (IBM), Dell (DELL), and Hewlett-Packard (HP). And yet its revenues fell 2% in its fiscal year ended Feb. 28, to $78.9 million, as its annual loss widened to $129 million, from the previous year's $86 million. Its stock lingers at $5.40, above its 52 week low of $2.40 but well below its recent high of $9.50.

Red Hat may be heading for better times, however. The current corporate emphasis on spending tech money wisely, plus a growing consenus that Linux is finally ready for prime time, have made the software acceptable to a much broader swath of the information-technology market.

LESS DOWNSIDE? The release of a key new product should improve Red Hat's prospects in 2003 and beyond, says Thomas Weisel Partners analyst Sanjay Puri (Thomas Weisel has performed investment banking work for Red Hat and makes a market in the stock). For investors with a long-term horizon, that could mean an opportunity to make a bet on Linux -- with much less downside than they might have faced several years ago, when share prices of open-source companies were at nosebleed levels.

True, the stock likely won't move much until Red Hat's numbers start to strengthening. For that reason, Puri has a market-perform rating on it, not even a buy. But most analysts, like Puri, think a big improvement will likely come during fiscal 2004. The consensus of seven covering brokers polled by First Call is that Red Hat's earnings should jump from 3 cents per share in fiscal 2003, which ends in February, 2003, to 8 cents per share in fiscal 2004. Should Red Hat hit or surpass the numbers, the stock could rise toward the end of 2002, according to Puri.

A number of stars have started to align for Red Hat over the past six months. Big sellers of corporate software, such as SAP (SAP), Veritas (VRTS), and IBM have rolled out versions of their high-end products that work with Red Hat's Linux operating system -- the software that controls the basic functions of a computer.

LARRY'S BACKING. At the same time, prominent customers have started converting from proprietary Unix operating systems to the Linux that Red Hat sells. In the financial-services business, they include Merrill Lynch (ML), CS First Boston (CSFB), Ameritrade (AMTD), and Deutsche Bank.

Database-software company Oracle (ORCL) is another fan. CEO Larry Ellison has said several times that he's shifting as much of his internal operations as possible onto Red Hat Linux systems. Amazon (AMZN) has already moved much of its Web-server operations to Red Hat-powered machines last year. That gained the online bookseller $17 million in savings as of September, 2001, according to its Securities & Exchange filings, and likely more since then. (An Amazon spokesperson decline to disclose additional savings numbers.)

"We have a lot of Fortune 500 customers debating if their next Oracle [installation] is going to be on a [proprietary] Unix platform or a Linux Intel platform," says Randy Grove, Dell's vice-president for enterprise computing.

CRUCIAL LAUNCH. The biggest key to future revenue growth may be Red Hat's new industrial-strength product, called Advanced Server -- its most aggressive foray yet into high-end corporate software. Advanced Server competes with the likes of Microsoft's Windows 2000 server products and Sun's Solaris. The package, introduced in late March, is designed to run bigger computer systems and tackle more complex corporate functions than past versions of Red Hat's Linux.

While Advanced Server's upfront cost is cheap, compared to those other options, it still represents a significant price jump over Red Hat's earlier Linux releases. A year's license for the software, plus automated upgrades and support, costs $1,500. Round-the-clock support runs an extra $1,000. Redhat will sell the software alone with no support for $800, packaged with hardware from Dell, Compaq (CPQ), IBM, and others. Customers might want the extra support, though: Because of Linux development's rapid pace, Red Hat posted dozens of updates to its products last year.

The company claims that those prices, when added to the cost of buying the servers themselves, are still below the cost of running corporate systems with proprietary Unix operating systems or Microsoft's Windows 2000. Few contest this on the Unix side, where Sun Microsystems boxes can cost five to six times as much as servers built around Intel chips. But Microsoft disputes Red Hat's assertion, claiming that the extra support requirements down the road will make Linux far more costly to run than Windows 2000.

FAIRLY PRICED? That may be, but analysts expect Advanced Server to help Red Hat hit total sales of $93 million to $95 million in fiscal 2003. The projection is down some 5% to 7% from previous analyst estimates, but it's still a relatively strong showing amid continued tech stagnation.

How close sales come to that number will determine a lot about the company's future. "Much of the success of Red Hat's business model in [fiscal 2003] hinges on demand and successful implementation of Advance Server," wrote analyst Puri in a May 8 research note. He thinks the stock is fairly priced in the $4 to $6 range. C.E. Unterberg, Towbin has a two-year price target of $10 on the stock, a nifty appreciation considering the current tech doldrums.

Still, Red Hat faces big challenges. For one, its embedded-software business continues to lag behind. Embedded software is installed on silicon chips used in products such as cable modems and cell phones. Due to a general chip malaise, the embedded market has been in a funk. As a result, Red Hat logged just $2.4 million in sales for this unit in 2002's fourth quarter, down from $6.2 million three quarters earlier.

ATTRACTING RIVALS. Management still thinks embedded products are big opportunity, though, and believes the group will contribute 15% to 17% of total revenues in fiscal 2003. Analysts aren't so sure and have correspondingly lowered revenue estimates.

Red Hat also faces aggressive rivals, including Caldera (CALD), SuSE, and Turbolinux, which compete in providing Linux installations to the same markets Red Hat is targeting. These companies are unlikely to displace Red Hat, which, by some estimates, ships its Linux product with 1 out of every 10 servers purchased today. But they could weaken Red Hat or draw the Linux leader into a price war.

A more frightening prospect would be if IBM or HP, among others, decides to discard their Red Hat partnership and build their own open-source software packages while servicing Linux customers through existing support channels. Red Hat CEO Matthew Szulik acknowledges that this could be a possibility but professes that he's not worried about it, claiming that his company is strong enough to hold its own against anyone else trying to sell Linux software.

Finally, Red Hat has alienated some open-source developers by refusing to release an integrated version of the software code it uses in Advanced Server for free public use. These critics feel that Red Hat, by distributing for free the individual pieces without the fancy integration wrapping, is living up to the letter -- but not the spirit -- of the open-source ideal.

"A LOT OF CONFIDENCE." Considering all that could still go wrong, Red Hat's shares remain pricey, with a 12-month forward price-to-earnings ratio of well above 40, vs. the software business' average of high-teens to 20s. So don't expect the stock to break out of its current trading range anytime soon, even if it does manage to nail next quarter's earnings.

Still, with a $287 million hoard of cash and assets, Red Hat isn't going broke anytime soon. Says CEO Szulik: "Our cash position and our third-party relationships give customers a lot of confidence." Gross margins are now up in the 65% range, and Red Hat says it will pull in $99.5 million to $101 million revenues for fiscal 2003. That would be a nice rise of some 25% and a good prelude to the gangbuster year it must have in 2004 to justify its high valuation.

Linux already has an estimated 56% of the Web-server market -- an indication that it's here to stay. But can Red Hat deliver the products and services that will make it a major beneficiary of that trend? If it can -- and this year may tell the tale -- it could become the best way for investors to ride the rising Linux tide. By Alex Salkever, BusinessWeek Online's technology editor

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