Linux, Linux, Linux…buy, buy, buy. Investors can’t get enough shares
in the companies selling, servicing and supporting the radical operating
system. The numbers speak for themselves:
Red Hat (RHAT)
was priced at $14 on August 12. With Tuesday’s close at $215 per share,
the stock is up 1,435 percent and supports a market capitalization of
$14.8 billion. For Red Hat, revenues rose a modest (by Internet
standards) 89 percent to $7.2 million for the six months ended 8/31/99.
Net loss totaled $5.3 million.
VA Linux Systems (LNUX)
priced at $30 per share on December 10. Tuesday’s close at $180 per
share, means a 500 percent lift-off and a market cap of $7.1 billion.
Cobalt Networks Inc. (COBT)
priced at $22 on November 5. With yesterday’s close at $104 per share,
the stock is up 373 percent and demands a market cap of $2.8 billion.
Andover.net (ANDN)
priced on December 10 at $18 per share. Tuesday’s close at $38 per
share, represents a 111 percent climb and a $303 million market cap.
A concern Reporter@Large has with investors in this space is the
wide-spread lack of knowledge and information. That is to say,
investors can’t give the Peter Lynch “story.” (Peter Lynch, the
legendary former Fidelity Magellan Fund manager, believes all investors
should be able to give at least a two minute run-down before making a
buy/sell decision). Well, a good amount of research, a few phone calls
and an interview with an Open Source/Linux expert and
voila…Reporter@Large has made it possible for investors to tell the
story.
Linux is an underlying software code that runs a computer. Often
referred to as the “kernel,” the operating system tells a computer what
to do and how its software should behave. The common usage of Linux is
comparable to MacOS, Windows NT, Solaris, or BeOS.
It’s important to note that Linux and Open Source, while closely
related, are not synonymous. Open Source is a method of software
development where the underlying components (source code) is exposed for
review, customization, and redistribution. Developers from anywhere in
the world continually modify and improve Open Source projects. A
traditional company such as Microsoft
Corp. (MSFT)
has its own team of developers who create its software and privatize the
code (Closed Source). Linux is actually just one of many Open Source
software “projects.” Uniquely though, “it’s supported by thousands of
volunteer programmers, hundreds of millions of dollars in venture
capital, and stratospheric stock valuations” noted Fast Company’s John
R. Quain.
Like most Internet issues, Linux oriented companies carry lofty
valuations despite little or no earnings. But unlike other Internet
sectors, the financial/investing risks are greater in a space where the
main product (Linux software) is readily free for consumers.
Reporter@Large had the opportunity to speak with Steve Blood, a man at
the heart of the Open Source/Linux space. Steve founded CopyLeft.net,
an online retailer of Open Source software goods and Linux-related
merchandise. Unlike most Internet companies today, CopyLeft.net has
turned a considerable profit in only its first ten months, despite
donating 25 percent of gross revenue to support Open Source software
projects.
Reporter@Large: All this talk about Linux wiping Microsoft away.
Investors have the idea tha
t Linux competes with Microsoft and that
isn’t necessarily true.
Blood: You’re right, it doesn’t. Linux is not a company. This
is important for all investors to understand. There are companies that
sell Linux such as Red Hat, Suse, TurboLinux, etc. There are also
companies that give Linux away for free, such as Red Hat, Suse,
TurboLinux, etc. There are also nonprofit organizations that do the
same such as the Free Software Foundation, and Debian.
Then there are companies that use Linux and associate themselves with
Linux because it is a strong computing platform, such as VA Linux.
There are also companies that provide information for people interested
in Linux, such as Andover.net.
Some of those companies compete with Microsoft. Most notably and
vocally is Red Hat. The reason Red Hat can compete with Microsoft is
simple: they offer and support a product that is arguably better, for a
price that is far less. Keep in mind, however, that there is nothing
preventing anyone from competing with Red Hat and Microsoft by also
selling and supporting Linux.
So, Linux does not compete with MS, but Linux is a operating system that
is comparable (many would say better) with Microsoft NT and Windows
2000, and it is far less expensive (free).
Reporter@Large: How are the leaders addressing this emerging
market?
Blood: Red Hat sells customized distributions of Linux software
and support services for Linux. To understand that model, consider how
many companies exist just to sell and support Microsoft NT. Granted
none of them are multi-billion dollar companies, because none have a
huge competitive edge over the others, such as being the first major
player to a market that had no one.
VA Linux primarily sells and supports Linux systems. VA has a similar
business model to Sun, except that they don’t make any money off the
software, where Sun still charges huge licensing fees for Solaris.
Andover is an internet media company. They sell information about free
software. Or rather, they give the information away for free and sell
advertising. They’re most comparable to a company like EarthWeb (EWBX).
Reporter@Large: I’m an analyst who is saying “show me the
money.” Maybe not now, but at some point and the idea of the main
product being free is of natural concern. How are these companies
planning to make money?
Blood: Big question. It’s also the same old question that’s been
asked for the past 4 years. The best way to think about this is to
consider the possibility that in the future no one is going to make
money from selling software. If that’s the case, how does anyone make
money? Remember that for many years in the beginning of the computer
era no one made money off of software, either. Or cell phones? How do
you make money if you give cell phones away for free? Obviously, it’s a
bit different when you sign someone up for a monthly fee, but
nonetheless it’s the same thing as giving the software away for free and
charging to learn how to use it, install it, and fixing it. Money will
be made by selling services, consulting, information, convenience, etc.
Reporter@Large: Thanks for your time and knowledgeable answers
Steve.
When asked about the market size and growth potential, “It’s laughable
how big the growth is and has been…all through the 90’s, the number of
people using Linux doubled each year” said Steve. The growth numbers
speak for themselves: According to NUA Research Analysis, the number of
Linux users is growing by 40 percent every year and the Linux home page
receives well over 100,000 page views every day from people looking for
information on the free operating system. Linux-based operating systems
represented approximately 16 percent of a
ll new licensed shipments of
server operating systems in 1998, up 190 percent from the previous
year. Even more impressive, 31 percent of the Internet is powered by
machines running Linux, according to the Internet Operating System
Counter. “It is entirely conceivable that Linux will be the operating
system that runs the majority of the computers on the planet” says
Blood.
Yes there is an enormous market opportunity and yes we’re seeing
astonishing market growth. The problem: no single entity owns Linux and
the Open Source software is free to customize and distribute over the
Internet. In the profit elusive Internet economy, the barriers to entry
get even lower here. Red Hat, VA Linux, Cobalt, and Andover are early
movers but easy targets. Dell
Computer (DELL)
has already begun installing Linux on many of its machines, Sun Microsystems (SUNW)
has had major software success with its Linux compatible, StarOffice
5.1, and Hewlett-Packard Co.
(HWP)
and IBM (IBM)
are making major in-roads.
The argument made often by Linux investors is that pure play Linux
companies will profit disproportionately from consulting and servicing.
But how quickly can a service company realistically grow? Not nearly
fast enough to support current valuations.
Microsoft has always been rewarded by investors because of its ability
to achieve extremely high gross margins while maintaining an almost flat
marginal cost curve. The problem with servicing software is that as the
company grows it will need to hire more and more employees. It’s not
like an internet or even a software company in which sales can rapidly
accelerate and outpace hiring costs because to reproduce the product
(Web pages or CDs) you don’t need to add more and more people. One only
has to look at VA Linux’s most recent earnings call: “For the three
months ended 10/29/99, net revenues totaled $14.8 million… Net loss
totaled $15 million…Results reflect the introduction of a new Internet
server product, offset by increased personnel expenses.”
Bottom line: Linux will be extremely successful as an Open Source
operating system. Most computers will run off of Linux and this will
seriously erode Microsoft’s 90 percent market share. However, too many
companies will seek to benefit from the revolution and it will be tough
for any of the current pure play Linux companies to become significant
market leaders, with earnings that at some point justify current
valuations. Barriers-to-entry are low (increasing competition), the
main product is readily free (Linux software), and services mean
high-cost human labor, opposed to Microsoft’s nostalgic low-cost,
packaged CD software.
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