Linux Reality Doesn't Match Hype

Open-source software is gaining, but not nearly as fast as shares of publicly traded Linux firms.
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Almost every week, it seems, another government is jumping on the Linux bandwagon, badmouthing

Microsoft

(MSFT) - Get Report

all the way. But for all the headlines, the open-source software movement remains very much a fringe business, raising troubling questions for investors who've plowed into publicly traded Linux providers in the past year.

And plowed they have: As of Tuesday's close,

Red Hat

(RHAT)

shares were up 110% in the past 12 months, while shares of

Novell

(NOVL)

, which recently acquired Germany-based SUSE Linux, had soared nearly 150%. Those returns compare quite favorably with the 33.4% gain by the

Nasdaq Composite

and 26% rise by the Goldman Sachs Software Index in the past year.

Yet, "in spite of all the talk

about Linux, there's still not a lot happening," said Robin Simpson, a Gartner research director in the Asia Pacific region.

Investors today risk making the same mistakes as those who wholeheartedly embraced the IPOs of Red Hat and VA Linux (now named

VA Software

(LNUX)

) in 1999. Shares of both soared initially, setting all-time intraday highs of more than $150 and $300, respectively, before suffering precipitous declines in the 2000-2003 bear market.

Brazil's recent support for open-source software and

Sun Microsystems'

(SUNW) - Get Report

recent agreement with a government-sponsored consortium in China suggest Linux has evolved from its early concept phase. But the reality is that Linux is still being used only under very limited circumstances, while the revenue growth of publicly traded Linux providers has not nearly matched their stock price appreciation.

Of course, low Linux sales should not be a huge surprise given the unique open-source model, which distributes software free over the Internet and draws on volunteers around the world who offer free technical advice online.

A "weirdo competitor" is how Microsoft CEO Steve Ballmer described Linux in a recent

Business Week

interview. "There's no company behind it. You don't know exactly who builds it. It's free," Ballmer said. "I prefer to say: 'Look, what we have here is a small price disadvantage.' "

That statement might represent a rare case of understatement from the normally bombastic Ballmer. The reality is Microsoft is hardly disadvantaged in its competition vs. Linux.

Still on the Fringe

"The reality of business is that it is a Microsoft world, and if you want to do business in that world the simplest and 'safest' path currently is to use Microsoft software," Simpson said.

Owing to Microsoft's dominant position on the desktop, Linux vendors such as Red Hat have cast their sights on the more lucrative server operating system market, where Linux boasts a nearly 25% market share. Yet Linux's double-digit growth there to date has primarily come at the expense of Unix systems, not Microsoft.

Indeed, in contrast to the ubiquitous Microsoft vs. Linux chatter, "typically, we are not seeing competitive situations where Linux and Windows are considered for the same task," said Dan Kusnetzky, vice president of systems software research for market research firm IDC. "I think right now Linux is a threat to the Unix suppliers, not directly to Microsoft."

Linux proponents, including Red Hat, point to the huge growth in Linux server shipments, which doubled from 2001 to 2002 to 424,898, according to Gartner Dataquest. Linux shipments are expected to cross the million units mark in 2005, Gartner Dataquest predicts.

But dig deeper and you'll see Linux numbers are still minuscule compared with Microsoft, not to mention the market caps of Red Hat and Novell. IDC estimated the combined market for Linux on the client and the server levels at a tiny $170 million by 2007. Yes, that's million with an "m." By comparison, Microsoft reported revenue from its client and server and tools business totaled a whopping $4.7 billion in just its latest quarter, which ended in September.

One reason IDC's Linux number is so low, of course, is that it includes only licenses sold by companies such as Red Hat and SUSE Linux as part of a package that includes technical support and service guarantees. IDC does not count Linux running on servers that companies downloaded at no cost over the Internet.

Last month, Credit Suisse First Boston analyst Michele Laverty estimated only one out of every 10 Linux servers ships with a paid subscription of Linux software. That means nine out of 10 servers currently shipped are operating with a free Linux operating system.

In her note initiating coverage of Red Hat with a neutral rating, Laverty said she believes companies will increasingly start paying for Linux, so that a quarter of all Linux servers in 2006 are shipped with a paid version of Linux software. But even then, that brings her estimate for the Linux software market to a still tiny $335 million in 2006. (Her firm has done banking business with Red Hat but not Microsoft, and has a neutral rating on Microsoft.)

How, then, to justify Red Hat's current market cap of $2.26 billion -- almost seven times Laverty's estimate for entire market in 2006 -- and price-to-earnings ratio of 163 times expected fiscal year 2004 earnings? Or why Novell deserves a market cap of $3.6 billion despite posting losses in nine of the past 12 quarters on a generally accepted accounting principles basis?

Red Hat CFO Kevin Thompson defends the valuation, noting that Red Hat has generated 5 cents to 6 cents per share of cash flow in recent quarters. The company posted its first operating profit last quarter on revenue of $28.8 million. Plus, Red Hat has moved to a subscription sales model with revenue recognized over the life of a one-year contract, offering more visibility than other software companies who recognize new sales upfront, Thompson said.

But Transamerica Funds portfolio manager Chris Bonavico isn't buying the hype and has stayed clear of Linux altogether. Linux "is in its honeymoon stage of everyone chipping in and saying, 'Isn't this neat. We're working on this cool thing,'" he says. But "in the very long run it is not much of a threat because there will come a day when Linux will break down."

Bonavico believes Linux could succumb to security bugs that have plagued Microsoft and eventually will splinter into different varieties like Unix. That may be inevitable as companies and individuals throw aside their altruistic ways and seek to make money off of their work.

For investors who still want to get into the Linux game, one buy-side source notes Novell is a cheaper play on Linux than Red Hat, trading at 42 times forward earnings. The source, who requested anonymity, bought shares of Novell after it announced its SUSE Linux acquisition. Shares of Novell have climbed 31% since that announcement.

"If you believe in Linux and Red Hat, you have to believe in Novell," the portfolio manager said. While execution is a risk to Novell's success with Linux, he said,

IBM's

decision to invest $50 million in the company is a good insurance policy.

Whether that "insurance" is sufficient to compensate investors for the risks in richly valued Linux-related stocks remains to be seen.