Silver Lining for Linux Companies?

Gaining a foothold at major firms is key for the once-highflying operating system, analyst says.
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BALTIMORE -- The '69

Mets

. Coney Island without the crime.

Linux

stocks. Ah, the good old days.

It may seem like years ago that Linux stocks such as

VA Linux

(LNUX)

and

Red Hat

(RHAT)

were all the rage for tech investors, but it was just last year that their respective initial public offerings won the hearts of investors.

Since then, though, those stocks have crashed, and Linux, the open-source operating system that was going to change everything, has receded from investors' minds. Yet at

Deustche Banc Alex. Brown's

tech conference here this week, a panel featuring major Linux companies drew a large crowd, which may mean investors haven't totally disavowed the stocks, said Deustche analyst Phil Rueppel. (His firm has done underwriting for VA Linux and Red Hat.)

Tasks

First, though, there are some tasks at hand for Red Hat and VA Linux. "They have to demonstrate progress in their businesses' expansion and developing infrastructure at their companies," he said, before adding the standard refrain of having a business model "that will eventually become profitable."

It's a long way down from the $320 a share at which VA Linux traded before its descent to its current $13. Red Hat's fall from a split-adjusted $151 to $12 hasn't been much more pleasant.

The Linux operating system and software built for it rose to prominence over the past two years because the open-source developers behind it charged no royalties and often gave away applications. While it was popular with techies and reveled in its guerrilla persona, the open-source system may befuddle investors who wonder how such companies can ever reach profitability.

Coming Back

What will it take to bring them back into the Linux fold? Rueppel said the key development to watch is penetration into the ranks of

Fortune 500

companies by Linux-based applications like the ones in which Red Hat specializes. Acceptance of Linux technology by large, established companies is the kind of evolution that "will make investors comfortable," he said.

IBM

(IBM) - Get Report

has been one of the largest Linux backers. Rueppel said analysts and investors would like to see Linux incursion into the enterprise software market reach 25% of the companies' businesses by the end of 2001. Right now, that measure is negligible.

It's by the same late 2001 point that Reuppel said investors are hoping to see profitability from Red Hat and VA Linux. Of course, that could be hampered by crumbling Internet companies, which were early adapters of Linux and Linux-based applications.

Still, there are some developments to watch. Red Hat, he said, is rolling out a

new business model in which it sells software and upgrades on a subscription basis, a business that holds the potential to generate recurring revenues. VA Linux, which released

first-quarter results Thursday, is working to broaden its customer base beyond Net-centric clients to companies such as

Akamai

(AKAM) - Get Report

.

That Old Cautious Optimism

All this leaves investors "cautiously optimistic," Reuppel said. Maybe not, however, optimistic enough to start buying these companies yet, especially absent any quick boosts to their businesses. "Investors like to see near-term catalysts, but the fundamentals are still good, and at the right time for the right price," the stocks could become attractive again, he said.

Deustche has a few more Linux-based companies in its IPO pipeline -- names such as

TurboLinux

and

LynuxWorks

-- so the firm is obviously watching the sector closely. Reuppel declined to comment on those planned IPOs, but he did say there was a lot of Linux activity in the private sector.

And, while he concedes Linux companies have grown quickly in just a few years, he said they came public "early in their life cycles.

Now, we're all making sure companies are further along in terms of critical mass."