Online Extra: Red Flags for Red Hat

Though the Linux sales-and-support outfit has seen strong recent growth, some analysts think the stock is overvalued

The free, open-source Linux operating system is clearly gaining a foothold at many large companies. But that doesn't necessarily mean that Red Hat (RHAT ), the leading distributor of Linux software, has clear sailing ahead. The Raleigh (N.C.) tech company has long struggled with the central dilemma posed by Linux: How do you make money selling a product that's free? Management says it came up with the right strategy about 18 months ago and can now show that it's working. But judging from the stock's recent trends, investors want more proof.

The new approach -- and the key to Red Hat's future -- centers on its flagship product, Advanced Server, which launched as a subscription service to large corporate technology departments last June. (Initially, Red Hat focused on distributing Linux to small and midsize businesses, which didn't embrace the low-cost software because it isn't easy to manage.)

Red Hat's pitch now is that by subscribing to Advanced Server, companies can deploy an enterprise-class version of Linux and receive the daily support and service it takes to make sure the operating system -- the basic software that controls a computer -- stays compatible with other software as programs these businesses use are updated and improved. They can also sign up for some handy management tools. In the first quarter that Advanced Server was available, Red Hat sold 8,000 subscriptions. The next quarter, which ended last November, it sold 12,000.


  That's strong growth by any measure. "Our success at building subscriptions is really what investors should focus on," says Kevin Thompson, Red Hat's chief financial officer. He adds that Advanced Server is just the first in a series of new products the company will debut over the next few years for different parts of corporate tech networks and various segments of the business market.

Thompson also wants investors to focus on Advanced Server's supercharged margins. The subscription model, which generated 54% of Red Hat's $24 million in sales in the quarter ended last November, boasts gross profit margins of 85%, he says.

The other 45% of revenues in the most recent quarter came from Red Hat's services business. Combined gross margins for both parts of the business in the November quarter were a hefty 66%. The services side -- which Thompson expects to grow more slowly than subscriptions -- offers Linux training and certification to info-tech staffers, plus consulting for customers who want to migrate to Linux from the older, more established, and costlier Unix operating system.


  Red Hat also does special projects for equipment manufacturers to help them ensure that their hardware is compatible with Linux. Eventually, "subscriptions will be 70% of revenues, and services will be 30%," Thompson projects. "If we're successful in deploying the platform, the services will follow."

His predictions certainly paint a pretty picture, but burned and beleaguered tech investors are a skeptical bunch these days. While many are impressed by Advanced Server's adoption rate and margins, Red Hat's overall sales and earnings growth haven't been spectacular enough to get them to buy the stock.

"We haven't had a terribly long history with Advanced Server, so we want to be a little conservative before we jump in with both feet," says Brent Williams, an analyst at McDonald Investments in New York, who has a hold rating on the stock. A lot can change quickly in the marketplace for a small software company, notes Williams, who adds: "As far as telling people to get in before the main ramp, we're waiting."


  Red Hat earned only $305,000 in net profits in its fiscal quarter ended last November, which is break-even on a per-share basis. That's an improvement on its second-quarter loss of $2 million, equal to 1 cent per share, and the $15 million loss in the same quarter a year earlier. Still, it hardly reflects a profit boom. For the current quarter, which ends this month, Red Hat expects to earn 1 cent a share, it told analysts in mid-December.

Red Hat's sales growth looks modest as well. The $24 million it generated in the fiscal third quarter represented growth of just 14% over the second quarter and a year-over-year increase of 21%. Red Hat's guidance for the current quarter is for sales of between $26.5 million and $27.5 million, or about 10% growth sequentially. While any growth is an accomplishment for a software company at a time when tech spending is flat on its back, this isn't the kind of surge that gets the attention of emerging-tech investors, who would be among the first to endorse the stock if they were excited.

"The revenue growth isn't particularly impressive," says Paul McEntire, portfolio manager of the Marketocracy Technology Plus Fund (TPFQX ), which has owned the stock in the past. Moreover, he says, Red Hat's financial results don't persuade him that it can be solidly profitable in the future. Mostly, he worries that it would take only a little price competition from Microsoft (MSFT ), which goes up against Linux in the operating-system market, to see the return of red ink. Notes McEntire: "Microsoft hasn't really responded to the Linux threat yet."


  Given Red Hat's small profits and moderate revenue growth, many analysts think the stock is expensive. After riding the dot-com roller coaster, it was a relatively comfortable $5.49 at Feb. 20's close. From a low of $3 in late 2001, it has stayed roughly in a range between $4 and $6 for the past two years -- not bad, considering that the tech-heavy Nasdaq has fallen about 40% over that period. But that also doesn't make it especially cheap.

In a Jan. 29 research report, Goldman Sachs analyst Thomas Berquist called Red Hat's valuation "rich" and raised the specter of pricing pressure on Advanced Server. Soundview Technology analyst Victor Raisys wrote in a Dec. 18 report: "We continue to believe that the current stock price reflects an overly optimistic view of Red Hat's ability to capitalize on the Linux opportunity." Based on estimates that it will earn 6 cents a share in its 2004 fiscal year, its forward price-earnings ratio is a lofty 92. Both Berquist and Raisys rate Red Hat underperform.

One thing that analysts, investors, and Red Hat management agree on is that Linux is gaining ground in the corporate-enterprise market. To its credit, Red Hat boasts key strategic relationships with powerhouse companies such as Hewlett-Packard (HPQ ), Oracle (ORCL ), and IBM (IBM ), which are rolling out Linux applications. That will go a long way toward increasing Red Hat's potential market, says Williams of McDonald Investments. When it comes to companies adopting Linux, CFO Thompson says: "We're really still at the bottom of the wave, and it's starting to build."

Positive Linux momentum won't translate as readily into Red Hat's share price as it once did, though. While the stock may trade higher in the coming months, Red Hat's high valuation makes it vulnerable to any hiccups in its new business model, as well as to setbacks in the broader market. For long-term buyers, Red Hat remains a risky bet while it's still fighting to prove itself.

By Amey Stone in New York

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