Love in the Time of Linux

As the first person you ever kissed can tell you, it doesn't always pay to be at the front of the line.

In the fall of 1999, a market full of gawky, frustrated would-be open-source software investors wanted a piece of the Linux action. They'd been taunted for months: Linux was cheap, easy and everybody could have it. Bobby-soxed, pony-tailed Red Hat (RHAT Quote) brought their fantasies to life Aug. 11, 1999, and investors went nuts.

As the hormonal frenzy climbed, big-nosed VA Linux (LNUX Quote), bucktoothed Caldera (CALD Quote), knock-kneed Andover.net and big-boned Cobalt (COBT Quote) joined the scene.

In December, VA Linux's IPO went off the charts as the stock kissed 320 before declining to 239 1/4. In that same month, Red Hat hit a high of 302 5/8 during intraday trading and announced a 2-for-1 stock split. Investors stayed dazzled long enough to allow Red Hat to push through a 4 million follow-on offering only six months after the IPO at 95 a share. Today, those Red Hat shares are a cold, acned 19 3/8.

Is the Love Gone? Linux stocks have suffered, but three have promise.

Cold, Cold Heart

Welcome to Wall Street heartbreak.

Now that investors have banished Linux-related stocks to the outer circles of junior high society, it's time for a softened, but restrained look. Are there any companies worthy of a wan embrace? Prakesh Patel of W.R. Hambrecht tells us to hold on: "Focus on the business model, regardless of the operating system."

His favorites, and many other analysts', include Red Hat, VA Linux and Cobalt. (W.R. Hambrecht hasn't performed underwriting for the three companies, though it handled open-source community Andover.net's sale to VA Linux.) All three companies are growing at impressive clips and expect to be profitable not too far in the future -- Cobalt in the first quarter of 2001, Red Hat in February 2001 and VA Linux by the end of 2001. During their market exile, these three stocks have solidified what could be future prom queen status.

Red Hat used its elevated stock wisely to buy Cygnus Solutions and WireSpeed for an invite into the popular crowd of mobile-device markets, and network-performance monitor Bluecurve. Going public as a company that packaged up Linux pretty for corporations, Red Hat now has a formidable service side and is leading Linux into the embedded world -- providing a small, thin operating system for your phones and pagers in a July deal with Ericsson (ERICY Quote).

Server-vendor VA Linux expanded into the developer and services arena with a $1.04 billion purchase of Andover.Net in February that slouched to a renegotiated $279.3 million deal in late April and closed in June. VA Linux runs an open-source network 6,000-projects strong into which it hopes to outsource programming.

Cobalt, meanwhile, sells server appliances -- cheaper servers that require less technical oversight because they are devoted to specific functions -- with thicker profit margins than Dell (DELL Quote), and it doesn't rely solely on Linux customers.

Nice 'N' Easy Does It

But let's take the puppy love nice and slow this time.

Deutsche Banc Alex. Brown's Phil Reuppel went so far Wednesday as to upgrade VA Linux to a strong buy from a buy rating (the banking side helped take VA Linux public). He argues that at 4.9 times estimated fiscal 2001 revenue, VA Linux is trading at a discount to alternative server vendors Cobalt, Cacheflow (CFLO Quote) and Network Appliance (NTAP Quote), which are trading at 15 to 20 times 2001 revenue.

"VA is entering the strong part of its business cycle," Reuppel says. "My sense is that it's going to report a strong July quarter the week after next. Its visibility in the latter half of the year has improved, and investors can be more comfortable with its ability to beat estimates and achieve profitability before its stated goal of the end of 2001."

In short, it's safe to share a Ho-Ho with VA Linux at lunchtime -- but only one. Don't get too chummy, ABN AMRO's Keith Bachman says VA's 17.8% gross profit margins need to increase this quarter. (ABN AMRO hasn't done underwriting for VA Linux, though Bachman helped engineer its purchase of Andover.net at W.R. Hambrecht.)

Keep Your Feet on the Ground

If you must stay bitter, however, then keep your heart frozen to the lust-filled 1999 assumption that Linux would promptly unseat Microsoft (MSFT Quote) on company desks. Don't repeat the mistake! "You never heard that from my mouth," Bachman says. "The desktop is still Microsoft's domain. If people are really expecting Linux to take the desktop, they'd better move out five years."

Instead, think of open-source as a server power. According to a July 24 International Data Corportion study, Linux elbowed aside Novell (NOVL Quote) to become the second-most popular server operating system -- IDC expects Linux server growth to hover around 28% each year through 2004. And Web server software Apache -- maintained through the same free, community-based open-source development model as Linux -- runs two-thirds of all Web sites. Not mad passion material, but good enough for a blushing crush.

And, as you go forward into a more mature, stable relationship with open-source stocks take a few words of advice: not all of them are winners by association. Several leading open-source companies are expected to go public soon, market permitting. Neither Bachman nor Patel thinks tremendously highly of Linux distributor Caldera, which turned in $1.4 million in revenue in the quarter ended April 30.

"I think Caldera's gonna really struggle," says Bachman, who doesn't quite understand how Caldera's recent purchase of SCO will help the company. He sees Red Hat ruling distributors, along with regional players like SuSE in Europe and TurboLinux in Asia/Pacific, which are poised to go public. "That's the problem in the distribution market. ... Caldera, is it going to fit in?" (ABN AMRO hasn't done any underwriting for Caldera.)

Now to go forth and show we've learned the lessons of love.