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No Red Flag at Red Hat?

By Brian Grow and Steve Hamm Executives at Red Hat are enamored of free-flowing information and open communications, much like the code writers of the open-source Linux operating system it sells. But on June 14, Red Hat's open-door policy seemed to slam shut. In a move that caught Wall Street off guard, the company announced the departure of Chief Financial Officer Kevin Thompson, 39, just three days ahead of a scheduled first-quarter earnings report. He was the fifth high-level executive to exit in the last two years, raising questions about Red Hat's management stability as it evolves from startup to force majeure in the enterprise-software biz.

The CFO's exit so close to an earnings release sent a shudder through the stock price. After nearly tripling in value in the past 12 months, Red Hat (RHAT) tumbled $1.14, or 5%, to $22.06 in massive trading on June 15. And the move prompted some analysts to wonder whether Red Hat faces bigger, unknown problems.

"The timing of the announcement three days prior to first-quarter earnings is at best bad," wrote Prudential Equity Group LLC analyst Brent Thill in a June 15 note to investors. He called Thompson's departure a "yellow flag" and downgraded the stock to neutral from overweight.

WINDOWS BREAKER. Still, Thill's was the only downgrade that day of 19 analysts who cover Red Hat. And the ever-nimble operator tried to soothe investors' frazzled nerves on June 14 by preannouncing strong first-quarter results, a move that helped its stock regain most of the earlier losses. On June 17, Red Hat formally said it earned $10.7 million, or 5 cents per share, a 115% increase over last year, on revenues of $41.6 million.

Red Hat sells services that package open-source software for servers and desktops with installation and maintenance. Profits were boosted by solid results in its core business, enterprise software subscriptions, which rose 23% from the fourth quarter, with 75,000 new subscribers. Total subscriptions increased 98,000, a 13% rise.

Most important, Red Hat's average subscription price, a key measure of revenue growth, was $430 -- $30 more than the company's prior guidance. On June 17, however, Red Hat stock sank 10% in after-hours trading, to $20.50, as investors took profits on a stock that some view as overvalued. First Albany analysts Mark Murphy downgraded Red Hat from "buy" to "neutral," advising investors to "step to the sidelines" until questions about Red Hat's CFO position are answered.

Still, Red Hat is buoyed by a rising tide of interest in Linux from corporate clients, as an alternative to Microsoft's (MSFT) Windows franchise. The cheap, easy-to-use software has stormed into the No. 2 slot in the operating-systems business in recent years, grabbing a 23% market share. And Red Hat is increasingly stealing sales from the makers of Unix operating systems -- including Sun (SUNW), IBM (IBM), and Hewlett-Packard (HPQ), which also sell machines running Linux.

TAKING THE PULSE. As technology spending rebounds, companies are slowly turning to open-source software as a way to avoid expensive Windows products. For example, in April, Red Hat introduced a low-price operating system called Red Hat Desktop targeted at business, government agencies, and academia. Charging just $5 per client per monthly subscription, Red Hat will sell the workstation software in conjunction with its core Linux servers. "Red Hat has its finger on the pulse of the new IT environment," says Trip Chowdhry, info-tech analyst at Midwest Research in Cleveland.

Red Hat has turned in several blow-out quarters recently, racking 87,000 new user subscriptions and 5,000 new customers in the fourth quarter of fiscal 2004, ended Feb. 29. That helped push total revenue to $126 million last year, up 36% from 2002. A growing client base of return users -- those renewing existing subscriptions -- sent profits soaring to $18.1 million in 2003, up from just $1.1 million the year before.

And 2004 could be a break-out year, say analysts, as major corporations evaluate a potential switch to Linux operating systems. CEO Matt Szulik told BusinessWeek on June 14 that demand for servers remains strong in all three of Red Hat's main markets -- hosting, enterprise, and high-performance computing -- as well as key overseas markets, such as Germany.

LEGAL CHALLENGES. "Open-source software is changing the relationship with the customer, and so the economics of the industry are changing," says Szulik. "[Chief information officers] won't write $25 million checks for a site license for a product any more."

Undoubtedly, Red Hat's hot run has risks. Foremost, the outlook for the Linux market is overshadowed, in part, by ongoing legal disputes with Unix software maker SCO Group (SCOX). SCO sued IBM in March, 2003, claiming that IBM, a former partner, improperly contributed SCO technology to the core version of Linux, infringing on SCO's intellectual property. SCO is seeking $1 billion in compensation. A win -- which, if it happens, would be at least two years away -- could threaten further adoption of Linux software, undermining Red Hat's business.

Red Hat is fighting back: Last August, it filed suit in Delaware federal court charging that SCO was engaged in an "untrue and deceptive campaign" to sow fear among Linux users. Last week, U.S. District Judge Sue Robinson rejected SCO's request to dismiss the suit, but stayed further hearings pending the outcome of the IBM-SCO case being heard in a Utah court. "Customers are increasingly skeptical of SCO's claims," says Dion Cornett, managing director of Decatur Jones Equity Partners in Chicago.

Still, Red Hat clearly has plenty to deal with in coming months: legal challenges, questions about management stability, and ever-mighty Microsoft trying to figure out how to capitalize on the open-source phenomenon. But corporate migration from Windows to Linux is chugging along. And that's a good omen for Red Hat and its investors. Grow is a correspondent for BusinessWeek in Chicago, and Hamm is a senior writer in New York

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