Red Hat's Red-Hot Deal

The outfit's purchase of JBoss is the strongest indication yet that the open-source player is ready for prime time

Red Hat's announcement that it would buy JBoss for up to $420 million came as a surprise to many in the software industry. It wasn't because JBoss got sold. Reports swirled for months that JBoss, which specializes in software distributed at little cost over the Internet, was in talks to be bought. Would-be suitors included Novell (NOVL), Oracle (ORCL) and Red Hat. And judging from the surge in Red Hat shares, there was scant concern JBoss would be a good fit.

The surprise? That penny-pinching Red Hat was willing to pony up what some saw as a steep premium for a company that did $16 million in revenue in the last year. Raleigh (N.C.)-based Red Hat (RHAT) is a company whose executives are known for riding the subway when meeting with investors and customers in Manhattan. Red Hat Chief Executive Matthew Szulik is awfully proud of that reputation, and Wall Street has rewarded him for it.


  But on Apr. 10, investors and analysts applauded Szulik for breaking with that penny-pinching tradition. Sure, it's sizable chunk of change, goes the argument, but it represents an investment in Red Hat's future. "The acquisition has effectively expanded Red Hat's market opportunity in one of the fastest growing sectors of software," Credit Suisse First Boston analyst Jason Maynard wrote in a research note. Red Hat shares closed at $29.85, up nearly 9%.

Szulik says the move is an offensive one. It's been a long slog, but Red Hat has emerged as the market share leader in sales and support for the Linux operating system, which is also based on open source and it's becoming an increasingly popular alternative to Microsoft's (MSFT) system. And Red Hat is the only large, publicly traded pure-play open-source company. Yet after 40% growth last year and a stock price than more than doubled, some analysts were starting to wonder how long the good times could last.

JBoss gives Red Hat a strong foothold in another part of the business software market, middleware, which connects disparate applications and programs, and one that's increasingly attractive to companies. Companies are warming to open-source middleware, the way they have done with Linux in years past. Revenue at JBoss is on track to triple to $48 million this year.


  But that only tells part of the story of JBoss's success, since the vast majority of its customers aren't paying customers. Red Hat says its broader global reach will help it convert JBoss users into paying customers more quickly. Red Hat told analysts it expects JBoss to generate $80 million in revenue in 2007.

To do that, Red Hat will try not to mess with a good thing. JBoss will remain an independent entity with Chief Executive Marc Fleury in charge and reporting directly to Szulik-a key term for Fleury to agree to sell to anyone (see BW Online, 4/10/06, "An Open-Source Lightening Rod"). And $70 million of the deal is contingent on JBoss meeting some pretty high goals.

Still, it's a good deal for JBoss employees who own nearly two-thirds of the company, according to Fleury. They get to stay independent and cash out some of their shares now, instead of waiting around for an IPO. "This was an instant IPO for some of my guys, while remaining almost independent," he says. "What tipped the balance in favor of Red Hat is the clear non-conflicted business model, our shared mission in leveraging open source."


  The move was also a savvy defensive one. JBoss was clearly in play (see BW Online, 2/09/06, "Oracle's Open-Source Shopping Spree". Red Hat did well to keep it out of the hands of Linux competitor Novell, which already has a relationship with JBoss and has talked about branching into other areas of open-source software like middleware. Oracle has already acquired several smaller open-source companies and has been open about its intention to get more aggressively into open source. While a possible deal with Oracle soured recently, sources say Novell was actively courting JBoss.

The new challenge for Red Hat will be navigating existing partnerships that could become thorny as a result of the JBoss deal. Red Hat has key relationships with companies like IBM (IBM) and Oracle that have worked hard to evangelize Linux and Red Hat -- but will now compete more directly with Szulik & Co. Szulik says such concerns are overstated. "(Software companies partnering and competing) goes on everyday," he says. "This is a [sign] of the maturing aspect of Red Hat's management and model."


  He's right. At the upper levels the software industry has long been a delicate balance of simultaneous cooperation and competition. After all, Oracle is a sworn enemy of Germany's SAP (SAP), and the bulk of SAP's applications run on Oracle databases.

Another challenge facing Red Hat: where to go from here. Over time it developed leadership in Linux and overnight acquired heft in middleware. There's talk the company will make further deals to expand in database software. Would be targets include Enterprise DB and MySQL.

When asked whether he's mulling more acquisitions, Szulik says only that he might be tempted if "another JBoss" comes along. It's hard to draw many conclusions from coy words like those, but Red Hat's dealmakers shouldn't be surprised if and when JBoss look-alikes come calling.

Before it's here, it's on the Bloomberg Terminal. LEARN MORE