Opportunity Ahead: Donning the Red Hat, Part 2

Can Red Hat make money distributing free software? Will Redmond retaliate? To find out, read on.
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Red Hat

, roaring like a freight train down a steep grade toward a very big IPO early next month, has several advantages that are likely to keep it atop the

Linux

market I discussed

yesterday and lead to serious profitability.

The most important of those advantages are:

Market share.

According to

International Data Corp.

, Red Hat has about 54% of the commercial Linux market, way ahead of Germany's

SuSe

, in second place with 11.5%, and Utah's

Caldera

, in third place with 6.3%. As difficult as it is to command a majority market share over time, I see no reason Red Hat shouldn't be able to hold onto its lead, and maybe even enlarge that share.

Intel plus Linux.

One reason Linux in general has taken off is that it runs so well on

Intel

(INTC) - Get Report

x86 processors, specifically Pentium PCs. This makes for an ideal workstation or server-hardware-software buy for customers, since Intel-based hardware, adhering to industry standards and built from standard parts, is much cheaper to buy and maintain than proprietary boxes from the likes of

Sun Microsystems

(SUNW) - Get Report

,

Hewlett-Packard

(HWP)

,

IBM

(IBM) - Get Report

and

SGI

(SGI)

, among others. Although Red Hat delivers its versions of Linux for Alpha CPUs and also SunSparc processors, it has emphasized the Intel market. (Intel has been a willing partner here, of course, not only investing in Red Hat but also sponsoring a well-attended Linux Tech-Talk Day at the Santa Clara Convention Center. Intel's well-publicized and growing operating-system agnosticism irritates certain parties in Redmond, Wash., but is a key to Intel's future: It doesn't care who wins in software, so long as it sells more and more chips.)

Windows NT's slow development and limited scalability.

Many Linux shops point to the agonizingly slow development cycle for Windows NT; the next version, once called NT 5.0 but now dubbed by

Microsoft

(MSFT) - Get Report

Windows 2000, is years late. By contrast, Linux is in a constant state of updating. NT has a rep -- to a large extent, I believe, a bum rap -- about not being scalable enough. (Scalability refers to software's ability to handle very large numbers of users' demands at once.) NT is highly scalable, and Microsoft has been working furiously on the scalability issue. But Linux, as a Unix derivative, has native scalability of a very high order. Red Hat's Linux is highly scalable.

Important investors.

Eager both to assure Red Hat's survival and to hitch their stars to an increasingly well-known name, Red Hat has over the past year drawn equity investments from such powerhouses as IBM,

Compaq

(CPQ)

,

Novell

(NOVL)

,

Dell

(DELL) - Get Report

and

Oracle

(ORCL) - Get Report

.

Important software partners.

The limited availability of Linux-flavored software applications, as opposed to the massive list of apps for Windows NT, has been a problem. Now, enterprise-software firms such as Oracle,

SAP

(SAP) - Get Report

and

Informix

(IFMX)

are producing Linux versions, and their ranks are certain to increase. On the individual level, a superb, absolutely free (for personal, student and noncommercial use) productivity software suite is available from

Star Division: StarOffice 5.0 Personal Edition can be downloaded from the company's Web site. You can also buy $39 to $169 CDs of the product from that site, along with licenses for networked commercial use, starting at $499. StarOffice runs very well on Linux (as well as on many other platforms, including Windows 95, 98 and NT, Solaris and even IBM's O/S 2). Red Hat is benefiting greatly from this increase in commercial-quality Linux applications. (Another heads up: Star moved last year from Germany to Silicon Valley, and is planning an IPO later this year.)

Star programming talent.

Although Linux creator Linus Torvalds works for

Transmeta

in Silicon Valley, Red Hat has attracted three-star Linux programmers to its ranks in North Carolina: Alan Cox, David Miller and Stephen Tweedie. All are well-known names in the Linux world, and have been involved in extending and improving Linux nearly from the beginning. Red Hat also recently added former

Netscape

chief technical officer Eric Hahn to its board. In all, Red Hat can draw from an extremely deep pool of technical talent on staff.

On the negative side, Red Hat faces only a few major risks:

New competition.

Free software has to be the ultimate in low-barriers-to-entry businesses. You and I could start up a Linux-offspring company this afternoon with lunch money. But we'd have a heck of a time competing with Red Hat's big mo: its reputation, market presence, programming and management talent ... and very soon, its capitalization.

Antagonizing the Linux community.

Much is made of the risk Red Hat faces in antagonizing the Linux community -- which is, to put it mildly, tilted pretty far in the "software should be free" direction. The more Red Hat looks like a commercial success -- and the more Linux programmers and customers generally perceive Red Hat as taking their beautiful, free baby away from them -- the more it will be disliked, even reviled, in the Linux community.

Already, comparisons are being heard to their ultimate evil empire, Microsoft. I think this is way overblown. Red Hat's success and future lie not so much in the Linux world of years past, but in attracting new Linux users. The opinions of the early Linux boosters will be less important than Red Hat's emergence in the business community as a stable, well-financed, well-respected corporation. As Red Hat CEO Bob Young frequently points out, the company tries to show its respect for the Linux community by scrupulously playing by the rules in the Linux game, immediately contributing its many software improvements to the Linux community generally.

The Microsoft Factor

Never to be ignored, the threat of retaliation by Big Redmond is very real for any company that mounts a direct assault on Fortress

Gates

. But I think Red Hat is safe here, especially if it continues to follow a game plan not explicitly aimed at taking away Windows NT customers.

Microsoft has already had its dalliance with Unix, back in the 1980s, in the form of an embarrassing failure, Xenix. And "selling" free software is not exactly Microsoft's style. Yes, it does give away its Web browser, Internet Explorer; and yes, it bundles for free some tasty add-ons with Windows NT, such as its excellent Internet Information Web Server.

But Microsoft is unlikely to mount a head-on assault on the Linux market, and especially on Red Hat, in the near- to mid-term future. It has plenty on its plate now -- getting its corporate customers through the Y2K cycle, and migrating them up from NT 4.0 to Windows 2000 (as well as poaching customers from Novell Netware and, yes, various forms of Unix, including other Linux flavors).

In general, Microsoft claims to the outside world that it's not much worried about Linux because of the performance advantages of NT -- while internally using both Linux and Sun's Solaris OS as its benchmarks for ongoing evaluation of NT improvements. A much-quoted evaluation by the independent testing lab

Mindcraft

, as well as a comprehensive evaluation by

PC Magazine's

labs, which appeared in the June 1999 issue, show clear performance leads for Windows NT. (Full disclosure time: I have a continuing relationship with

PC Magazine

, as a columnist.)

But tests are always selective; Linux boosters, including Red Hat, can point to their own favorite evaluations, conclusively "proving" Linux's advantages. Despite their apparent scientific nature, choosing among competing test claims in computer software performance comes down to a "you pick 'em" decision, and most of us choose the tests that support the bias we brought to the table.

In general, Microsoft is likely to go on claiming Linux is a nuisance, a worrisome fly on the back end of its elephant -- while internally working frantically to improve the performance of NT to match or stay ahead of Red Hat's Linux performance.

Certainly there have been some funny moments along the way in the NT-Linux contest. When Microsoft paid $400 million for the free email service Hotmail last year, it was abashed to find during its due diligence work that Hotmail's 9.5 million email accounts were running on servers using ... Apache on Linux. Microsoft insiders acknowledged privately that that was not a server load Windows NT was then prepared to handle.

David, Goliath and a Big Multiple

The importance of NT in the corporate market is actually an advantage for Red Hat. The merits of NT are today widely discussed, among both IT managers and senior corporate managers not involved in IT decisions. The more attention we as potential customers pay to the stability, performance and reliability of the operating systems upon which our PCs and networks run, the higher profile Red Hat is likely to earn.

Moreover, the role of David is always a juicy one, and often a highly profitable one. Yes, I'd rather be in Bill Gates' position than in the seat of Red Hat's Bob Young. But increasingly, nearly every press mention of NT is including references to the nervy upstart in North Carolina as well. Red Hat is getting a ton of highly valuable free press -- and Young has shown he knows how to exploit that.

Perhaps the biggest and toughest job for Young & Co. is to manage expectations.

So many stories have appeared -- and we'll see thousands more before the end of the year -- positioning Red Hat as a Microsoft killer that Young has to keep the unrealistic hype down. Red Hat isn't going to topple Microsoft this week, next month -- or in your lifetime or mine. It doesn't have to in order to become a very profitable company and a heck of an investment.

But the growing perception of Microsoft as a force that must be stopped, or at least hobbled, leads to an uncomfortable, eventually unsupportable Great White Hope status for Red Hat. If Bob Young and his programmers down in Durham can keep pumping out a superior product, can keep up the company's current excellent rep for support, and can persuade the world that beating Microsoft isn't its corporate mission, those who are lucky enough to get a few shares of this high-profile IPO are likely to be very happy investors indeed over the next couple of years.

Especially at the closing price on opening day.

Jim Seymour is president of Seymour Group, an information-strategies consulting firm working with corporate clients in the U.S., Europe and Asia, and a longtime columnist for PC Magazine. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. At time of publication, neither Seymour nor Seymour Group held positions in any securities mentioned in this column, although holdings can change at any time. Seymour does not write about companies that are consulting clients of Seymour Group, or have been in recent years. While Seymour cannot provide investment advice or recommendations, he invites your feedback at

jseymour@thestreet.com.

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