Will Linux Investors Be Left Out In The Cold?

Red-hot IPOs are losing their sizzle

Probably since the day in 1991 that Linus Torvalds posted his Linux operating system on the Internet, people have been trying to figure out how to make money from it. Linux has blossomed into a rival to Microsoft's Windows NT and now Windows 2000 as an operating system for network-linked servers. It also has become a top choice to run the so-called information appliances. Two companies that base their business on this software--Red Hat and VA Linux Systems--went public in the past six months with jaw-dropping results. And at least two more Linux companies may tap the initial public offering market this year.

This is all the more impressive because Linux is nonproprietary--and free. Any developer who adds a wrinkle to it must, as a condition of getting the software for free, provide the source code for any changes he has made. Linux thus seems destined to stay in the public domain. And the puzzle it poses remains: Can companies whose future depends on what's essentially a freebie prosper?

The Linux companies, some of which have cobbled together a market by selling their versions of the software paired with technical support to corporations, say they have an answer. Their strategy is to make money selling Linux services and support, a business they figure will generate recurring revenues. But so far no one has earned much from services, making shares in Linux companies mighty risky.

PUMMELED RED HAT. Consider what's happened to Durham (N.C.)-based Red Hat, which went public last Aug. 11. Despite Red Hat's record of losses and measly revenues, investors jumped on the stock, driving it up on its first day of trading to $26.06, from its offering price of $14, and later to a high of $151.31. Investors figured Red Hat could parlay its 60% share of the commercial Linux market into a role as a leading services company.

Red Hat has, indeed, made inroads, winning clients such as Amerada Hess. But the company quickly discovered that to sell itself as an all-around services provider, it had to extend its expertise to embedded systems, the microprocessors that run such appliances as Web phones and Internet-linked refrigerators. So Red Hat bought the market leader in Linux-embedded systems, Sunnyvale (Calif.)-based Cygnus Solutions, for $932 million in stock. Meanwhile, it needed more cash to fund its shift into services, so Red Hat filed in December for a secondary offering of 4 million shares at $95 each. Investors pummeled the company, causing its stock to drop 31%. Red Hat now trades at around $71. In the nine months ended Oct. 31, the company posted losses of $8.7 million on revenues, mostly from software sales, of $12.6 million.

INSIDE VIEW. VA Linux is also tying its fortunes to services, a recent change that hasn't done wonders for its stock, either. The Sunnyvale (Calif.) company, which went public on Dec. 9, saw its stock rise from $30 to as much as $320 before falling to $115.50 on Feb. 18. As recently as six months ago, VA Linux specialized in making computers that would run quickly and efficiently with Linux. But with the hardware market notorious for stiff competition and low margins, VA recast itself. "We are a complete services company, not a box maker," CEO Larry Augustin now says.

But rather than hire a horde of Linux professionals, VA Linux hopes to enlist an army of unpaid software experts to help it serve corporate clients. With that in mind, it is nurturing the community of open-source developers--Linux advocates who spend their free time writing Linux codes--by sponsoring some of their favorite Web sites. They want to "draw on the expertise of the entire community," says George Weiss of technology-consulting firm Gartner Group.

For example, VA Linux has created a Web site called Source Forge, which hosts open-source projects for free. Although VA won't get any proprietary rights to software that's hosted on Source Forge, it gets an inside view of those projects--a possible advantage in servicing corporations. In addition, on Feb. 3, VA acquired Web-site operator Andover.net for $975 million in cash and stock, a purchase that's not expected to bring much revenue. What VA is getting instead is access to open-source developers because Andover owns popular Linux-related sites, including slashdot.org and freshmeat.net. "Eighty percent of open-source developers use those sites as their primary means of staying in touch with the community," says VA's marketing vice-president, Brian D. Biles. "If you put the whole thing together, it ends up being a powerful communications complex and development center for open-source software."

According to VA's game plan, the company can post knotty problems on, say, the freshmeat site, which thousands of programmers visit at least once a day, and solicit answers from them. Other companies won't be able to do that. Right now though, VA's revenue stream isn't at all impressive, despite such clients as Hewlett-Packard. In the first three fiscal quarters ended Oct. 31, the company reported losses of $24 million on sales of $27 million.

Also pursuing a service strategy is San Francisco startup LinuxCare, which plans to go public in March. But LinuxCare, which began primarily as a support specialist whose staff handled phone calls from Linux users with technical problems, doesn't want to be known as a Linux-only services shop. It has quickly changed its focus to becoming a complete services company. The transformation is so thorough that co-founder Arthur F. Tyde III no longer defines his company as a Linux outfit. "We can look at your systems and tell you that you're better off using Windows NT or Sun's Solaris," he said. "We could easily take the word Linux out of our name without changing the nature of our company one iota."

IBM ON THE WAY. One company that has resisted the services strategy is TurboLinux, which plans to go public sometime this year. The Brisbane (Calif.) company expects to continue to focus on selling modified versions of Linux in Asian languages. None of the other distributors have taken on that niche. "We can add enough value to the software to make decent margins off of it," says TurboLinux CEO Cliff Miller. "The growth of Linux in Asia is incredibly strong." Although the company doesn't release revenue and profit figures, it says that 30,000 computers a month with preinstalled TurboLinux operating systems were shipped in Asia last year. Miller expects that number to increase sharply, thanks to deals with Chinese PC makers Great Wall, Langchao, and TCL Communication, and an agreement with Dell Computer to produce TurboLinux boxes in China.

It's easy to forget when sizing up Linux companies that the biggest rivals in the services business haven't flexed their muscles yet. IBM, for instance, is already creating a Linux division. When such big players weigh in, several Linux companies may have to join forces to compete. And that brings us back to that puzzling question: Does it make sense to invest in overvalued Linux companies when it's not clear that Linux can be a commercial success?

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