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| Feb 08, 2004 1:04 pm |
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An In-Depth Look at Red Hat (RHAT) |
Melanie Hollands
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I like RHAT stock long and think it can move up to around the $22 price target within the next few months. However, I expect a volatile ride on the way to $22. This price target represents a cash flow multiple of 24x consensus' fiscal 2006 Operating Cash Flow (OCF) per share of $0.93. I would be inclined to build a position in RHAT from here down to around $15 (the gap close) for a couple weeks. Then, if the broader market gets more positive the upside coming into the Spring I would add to the position. My guess is that if the stock turns up again, then $30 (or 32x 2006 OCF) is possible in the next 12-18 months. But for now, I am keeping a 3-month price level of $22 in mind.
However for a short-term trade rather than a position, there is another way to play RHAT depending on how the stock trades over the next few days. RHAT is close to the 50 day moving average (DMA) and it appears poised to bounce off of that level ($17.02). If it does bounce off the 50 DMA, then the stock could potentially move up to the $21-$22 area; and if we got a real “whoosh” down to the 50 DMA then it could potentially rebound in as short a time frame as the next few weeks. The stock just appears to be getting oversold, although I would still want to see it trade down to around the $17.20 level before I would commit. And if, under this scenario, it does trade down to the $17.20 area, I might put some short-term money to work there.
Bear in mind that the Street is not uniformly bullish on RHAT. In particular, Barron’s recently published a quite negative piece on the company and the stock's prospects. However, I remain bullish longer-term on this particular Linux play but I do expect a lot of volatility along the way. So, buckle up and be prepared for a bumpy ride in a long-term position in this name.
Red Hat's business momentum continues to be strong, and the company looks to be hitting its sweet spot in growth. Some of you may recall that I used to cover Red Hat when I was an analyst at Merrill Lynch, although in 2000 I was not particularly bullish on the name. However, both the times and Red Hat’s business outlook are different and part of my current thesis, is that as long as consumer resistance continues to build against Microsoft's relatively weaker products, then Red Hat will continue to grow. I understand that many of Red Hat’s hardware partners are likely to pre-load a higher-end version of Red Hat's Linux and this could potentially boost Red Hat’s revenues and, consequently, it’s sequential growth rates during the summer months. Red Hat's biggest opportunity for revenue growth and market share expansion lies with improving the attach rates of “paid Linux” versus “free Linux”. In its third fiscal quarter, Red Hat's attach rate of “paid-for” Linux unit shipments for servers was 15%. This left the remaining 85% to potentially migrate from “free Linux” to “paid Linux” or Linux support.
Competition in the Linux space has increased quite significantly. In particular, despite increased competition from Novell, growth rates of 25% to 30% are widely expected for Linux adoption, and this should provide allow at two (or perhaps three) primary Linux operating system distributions to thrive during 2004. Red Hat's dominant position in enterprise Linux servers continues to overshadow any available packaged Linux operating system.
Unique to the software industry, Red Hat's business momentum is led by a demand-driven product line that has high levels of awareness in it’s end-user market, and as a result Red Hat’s products require relatively little marketing to its customers. Over 2,500 new customers signed up in third fiscal quarter, up from 1,500 new customers the previous quarter and 1,000 in the previous, first fiscal quarter. From what I hear, it’s quite possible that new quarterly subscription contracts could reach around 40,000 new subscriptions, which would be up 21% sequentially from 33,000 new subscriptions in the previous quarter.
Red Hat’s competes in a high-growth software market that longer-term can deliver perhaps as much as $10 billion in annual revenue – representing, roughly speaking, $4.0 billion associated with the server, and another $5-$7 billion associated with the other layers of the operating system, such as application server, applications, database, and storage. I believe Red Hat's strategy to build its business foundation on providing a superior operating system running on the server will deliver substantial benefits in the future to the company and its network of business partners. Even competitors that I have recently spoken with -- including Novell -- acknowledge that the bulk of the profits in the initial Linux movement during the next two to three years will likely be derived from the server business, not the desktop. Although the unit volume of desktop applications is larger desktop unit prices are much lower, whereas the dollar volume associated with the server business is much higher.
Over time, I expect the basic operating system on the server to become a commodity, and therefore as unit sales volumes increase pricing of the core product will fall. Hopefully, Red Hat will be able to hold software pricing at around $500 per server per year and offset the dynamics of commoditization by adding incremental features at the edge of the server. This can be achieved by moving into adjacent layers of the server such as application server, applications, database, and / or storage. It is possible that both gross margin per server and the unit volume of servers sold should increase over time, partially or even largely offsetting the likely price decline in the core server operating system.
Another sting in Red Hat’s bow is the $585 million (ex financing costs) of newly raised capital during the last month with a convertible debenture. This war chest of new cash increases Red Hat’s balance sheet to around $913 million in total cash, up from $328 million at the end of the third fiscal quarter. Wisely and prudently spent, this can help leverage Red Hat's market leadership position beyond its core server operating system and into tangential areas.
As it moves beyond its core business, Red Hat will potentially face competition with many of its current business partners (e.g. BEA Systems). Red Hat claims that the end-markets are segmented into low- and high-end user needs, however I see potential for risk if the company becomes overly “granular” with its market segmentation. Strategically speaking, Red Hat will need to be careful, and somewhat selective, in the sub-markets it chooses to enter. Otherwise, the company could risk being “de-supported” from some of its business partners such as Oracle and BEA Systems that have enabled Red Hat to achieve the success it has achieved to date. That said, for the foreseeable future Red Hat should continue to enjoy substantial business leverage and tactical latitude on the server before management likely has to be concerned about seriously stepping on any of its partners’ toes.
Consistent with Red Hat's strategy to expand beyond its server operating system, the company is expect to introduce its own version of an open-source application server sometime during the Summer of 2004. This new server product will be based on JonAS, a pure Java open source implementation of the EJB (Enterprise JavaBeans) specification. (The current stable release is version 3.3.5.) JonAS has already been downloaded by over 150,000 people and is used in hundreds of operational applications, including e-commerce, e-portal, management systems, intranet applications, document processing, inventory systems, reservation systems, and banking applications, with various operating systems (including AIX, HP-UX, Linux, Solaris, Windows) different JVMs, and a variety of databases (including Access, DB2, Informix, Interbase, MySQL, ObjectStore, Oracle, PostgreSQL, and SQL server).
I understand that Red Hat has already advised BEA Systems, a current business partner, that this move will largely focus on more departmental needs than on enterprise deployments. Red Hat's move further validates BEA's presence inside the application server market, although in general I prefer not to think of the desirability of one company’s move as being measured by imitators but rather the desirability of the overall market segment. That said, Red Hat's application server product offering is in its infancy.
Red Hat’s biggest opportunity for continued revenue growth and market share expansion appears to be in improving attach rates of “paid Linux” versus “free Linux”. In the third fiscal quarter, Red Hat's attach rate of “paid-for” Linux running on the server was 15%, up from around 12% in the previous, second fiscal quarter. Red Hat management had originally thought the overall potential for “paid-for” Linux was 55% of the unit shipments (the other 45% would use some type of free Linux). However, that figure now is closer to 75%, based on the initial success Red Hat is having with its customers. For example, I understand that one major hosting company that originally piloted a free version of Red Hat Linux is now deploying around 12,000 “paid-for” copies of Red Hat Enterprise Linux (RHEL).
Another major driver pushing customers to deploy RHEL is the phasing out of Red Hat's older retail product. I believe there is a significant opportunity to move lower-cost users to full “paid-for” versions of RHEL. Red Hat has had strong success in late 2003 because Red Hat sold over 3,000 paid-for subscriptions to customer migrating off a lower-cost retail version. I believe there is potentially another upgrade wave as Red Hat phases out support for its retail version at the end of April 2004.
Hardware and Software Partners
In addition to the powerful resources of the open source development community, Red Hat's product line is being endorsed by a sterling roster marquee partners such BEA Systems, Dell, HP, IBM, and Oracle. Many of Red Hat's partners have yet to resell the current RHEL 3 product line. However the company’s hardware partners should begin to preload RHEL 3 in the February/March 2004 time frame. This is likely to provide yet another revenue catalyst since RHEL 3 now addresses over 80% of the available hardware devices - more than double what the earlier version RHEL 2 covered. Approximately 90% of the enhancements in RHEL 3 were generated around improvements in hardware support, with the remaining 10% of the enhancements to the new software were made based on end-user requests.
Dell Computer. Dell is Red Hat's leading business partner. Dell has also been a Red Hat reseller since early 1999, and currently resells a low-cost version of Red Hat software called R2. Toward the end of the first quarter this year, Dell is expected to start preloading RHEL 3, and over time Dell is also expected to offer Novell/SuSE as an alternative solution to Red Hat. This serves to reaffirm Dell’s commitment to Linux in general.
Fujitsu/NEC/Hitachi. From what I understand from industry sources, they are all just beginning to preload Red Hat RHEL 3.
Hewlett-Packard. HP is another marquis win for Red Hat, became a business partner only eight months ago, so it's a little early to assess progress on this front.
IBM, another Red Hat Partner, recently started preloading its X-series hardware with Red Hat 2 software in November 2003. IBMs commitment to Linux is also evident in the company's $50 million investment in Novell. This will offer IBMs customers a choice of Linux operating systems -- one from market leader Red Hat as well as Novell.
Oracle. CEO Larry Ellison recently referred to Red Hat as a "key partner." Allied to this, I understand that Red Hat has made a significant number of enhancements to its RHEL 3 software (I've heard up to as many as 40 to 50 enhancements) that are directly in support of Oracle's database and applications.
That said, in my view Larry calling any company a "key partner" plus two bucks gets you on the Manhattan subway these days. But it does point to Oracle's heavy push into the Linux world as a way of countering IBMs push in this front (Oracle versus DB2), and as a way of getting parity with Microsoft SQL Server pricing for cheapo implementations. (I'm not all that sure whether after paying Red Hat whether you're as cheap as Windows, though.)
Oracle continues to hammer away at the part of the market that's got a relatively simple set of requirements, a simple business system, and no desire to do anything fancy. I'm guessing that 25% of the enterprise market is in this category. For the upper mid-market, they're probably going to stop losing as much share to Microsoft because they've figured out a way to make a plain vanilla implementation easy to deploy and (maybe) maintain.
On the other hand, Oracle continues to have a real gap between the story management talks about and the reality of what it’s doing. In the apps business it appeals to the "I-don't-give-a-crap-just-make-it-simple" buyer, and there's nothing wrong with that. But Oracle thinks/claims its stuff is better than anyone else's, which is such a laugh. I tell ya, software marketing executives…
Success in Vertical Markets Beyond Financial Services
Red Hat is steadily gaining customer acceptance in market segments beyond its traditional and core strength in financial services. I am hearing about early customer migrations in other vertical industry markets such as consumer, government, manufacturing, media, retail and telecom; and even better, I understand that migrations to Red Hat Linux are becoming more frequent in companies operating in these, and potentially other, verticals. For example, in media industry, Red Hat seems to be gaining traction. Word around the traps is that a quite large and well-known media company will be moving perhaps as many as 6,000 Unix-based servers to Linux over the next two to three years. I am not sure whether this will be Red Hat business; I would hope so. I also understand that consumer packaged goods leader Unilever has plans to migrate its entire internal Unix installed base to Linux by the end of 2006. I have no information as to whether Unilever will deploy Red Hat, but there seems little doubt as to its commitment to Linux. Companies’ increasing levels of interest in Linux serve as additional validation of the attractiveness of Linux in the corporate environment in general.
Increasing Competition in the Linux Space
Red Hat currently estimates its market share of the server business at around 80%. The company also estimates its share of all users of Linux across all user platforms at around 67%. I love companies with dominant market share. However, as the popularity of Linux continues to grow Red Hat’s dominant position will be eroded as strong competitors such as Novell (with its acquisition of SUSE) and Ximian enter and consolidate in the space. That said, Red Hat appears clearly focused on maintaining and growing its current Linux leadership. I understand that the company is currently the dominant player in almost all the industrial countries in which it offers its products. However, in terms of dollar sales Red Hat believes Germany is the only major industrial country in which it doesn’t have dominant market share. But this makes sense given that competitor SuSE's headquarters is located in Germany. Another serious competitor in the European market is Mandrake in France. In Asia, larger competitors include TurboLinux in Japan, and Red Flag in China.
Clearly, the competition is increasing. However Red Hat's expected $125 million revenues (based on consensus’ estimates) in fiscal 2004 overshadows the reported dollar figures from Mandrake, TurboLinux, and Red Flag combined, as measured on the basis of subscriptions/license fees. For now, Red Hat is leaps and bounds ahead of the emerging and growing competition. To provide some relative color, the number two Linux player SUSE (now owned by Novell) reported around $40 million in revenue last year – approximately equal to one quarter of Red Hat’s revenues.
But market leaders invariably lose some (and sometimes all) of their dominant share position over time. Based on past and projected future Linux-based unit server shipments, the market can easily sustain more than one competitor; and I think near-term the market can support two to even three solid competitors. In fiscal 2003, Red Hat management has estimated that around 800,000 Linux servers were shipped, up a substantial 32% from 600,000 servers shipped during fiscal 2002. Management’s estimates that around 2.1 million Linux servers will likely ship in 2007 (although I personally don’t like to forecast more than 1-2 years ahead). That said, management is projecting annual unit shipment growth of around 25% from 2004 to 2007.
Novell recently closed its acquisition of German-based SuSE, globally the second-largest distributor of Linux. Novell paid $210 million in cash for the company, and as a result has added 399 additional employees as well as significant Linux expertise to augment Novell's already solid engineering staff. IBM has agreed to buy a $50 million convertible debenture from Novell in conjunction with the acquisition, with terms and pricing of the debenture to be set soon. IBM is also a Red Hat partner. However, I don’t expect any significant changes to the relationship between Red Hat and IBM as a result of IBMs investment in Novell. Rather, I see IBMs investment in Novell as complementary, not threatening, to its relationship with Red Hat. IBMs relationship with Novell seems to be more a form of validation of it’s own Linux strategy and to be in a position to offer multiple Linux solutions.
Acquiring SuSE allows Novell to be significantly more competitive in the Linux market. The acquisition will also allow Novell to penetrate different sub-segments of the market since SuSE has specific expertise in Linux for mainframes and in Linux for the desktop. Compare this with Red Hat, whose core strength is in enterprise computing, i.e. Linux-on-Intel servers running corporate applications and data center infrastructure. However, Red Hat is actively competing with Novell/SuSE to provide IBM with (I understand) Linux software for 300,000 - 400,000 desktops. But this is early days, since the initial supply deal is for pilot-sized projects. That said, Red Hat’s competition for this and other contracts is heating up.
Novell is expected to announce a software protection program for its Linux customers. I understand that the terms of the program will provide customers of SuSE Linux, who sign a licensing agreement with Novell and keep their its support contract current, will receive protection from copyright infringement lawsuits up to $1.5 million, or 125% of the software purchase price. This could make the value proposition of Novell’s Linux incrementally more attractive versus other Linux providers such as Red Hat. This could advantage Novell with respect to the outstanding IBM contract. IT could also pressure Red Hat to provide similar purchase protection for its existing and potential Linux customers. However, given the range and quality of Linux offered by Red Hat I doubt that there would be any near-term impact on Red Hat’s new and renewal contract sales.
Linux vs. Linux
Red Hat vs. SCO. Red Hat filed a lawsuit against SCO in August. The Red Hat claim is based on allegations of unfair business practices against SCO. The suit is slowly grinding its way through the legal system. Colleagues in the legal business inform me that the claim is now in front of the federal judge in Delaware awaiting a ruling on a motion to dismiss.
SCO vs. IBM. SCO has a copyright infringement legal action currently being brought, and which could threaten the broad adoption of Linux. SCO’s legal suit claims that the 2.4 kernel of Linux contains source code that infringes upon SCO’s own copyrighted version of Unix code.
Last year, IBM requested discovery and in fact won both of its motions for SCO to be compelled to provide discovery at the last court hearing, which I believe was on December 5th, 2003. Consequently, SCO was legally obligated to provide discovery to IBM. SCO recently faced (and, if I understand correctly, may have missed) its deadline to submit its discovery response to the US District Court in Utah. Lawyer colleagues of mine tell me that such discovery documents would need to detail specific copyright infringements alleged to have been made to SCO’s Linux code, since SCO owns the licensing rights to Unix System V (USV). So, discovery would need to include at least two things. Fist, specifics of the USV source code that SCO believes is protected by its copyright. Second, it should detail the specific infringements that SCO alleges IBM has made on this “copyright protected” code, and which SCO claims IBM improperly derived from SCOs Unix System V. Legal colleagues of mine doubt that the offending code -- or even pieces of it -- will be made publicly available, although there is always the possibility that some of the offending code could “leak” out during the legal proceedings. If this happens, then the code could then be rewritten by developers in the Linux community.
In return for its discovery documents, SCO has asked IBM for a bewildering amount of information. First, SCO has asked for the source code to all versions of the operating systems AIX and Dynix, two Unix versions created and distributed by IBM. Second, SCO wants details of all modifications IBM has made since 1985 to the present (yep… that’s 19 years of R&D history) together with all of IBM’s R&D records and notes pertaining to the development of the software. Third, SCO also wants a detailed and itemized list of all contributions IBM has ever made to Linux, irrespective of whether the contributed code ever made it into the Linux kernel. Fourth, SCO has asked for the names of over 7,200 current and former IBM employees who did have (or who even might have had) access to code that SCO claims infringes its copyright. Yeah, right. Absent a settlement, this treasure hunt should keep the folks at IBM busy scurrying around and delay any productive or sensible resolution to the SCO suit for a long while.
But moving back to practical business matters. I doubt that SCO's legal threats against IBM and, by extension, Linux and its developers, have had a negative impact on Red Hat's business so far.
A number of companies supporting the adoption of Linux have stepped up the plate to provide financial support for Linux users. With the last few weeks, IBM and Intel have agreed to contribute to a small fund founded by the Open Source Development Labs (OSDL) consortium to help provide legal protection for current and future Linux users. ODSLs fund is currently a small $3 million, with a goal of growing the fund to $10 million. The fund can be used for legal actions threatened against Linux users by SCO and others. Both Red Hat and Hewlett-Packard have previously contributed funds to help provide some measure of protection for Linux users against SCOs legal actions. Perhaps the protective instinct among these and other hardware companies will gain momentum, and allow the OSDL fund to become sufficiently large that it can provide a more substantial level of financial assistance.
Red Hat's Cash War Chest Boosted by a Recent Convertible Offering
Red Hat recently raised $585 million net proceeds from an offering of convertible debentures. The terms of the offering are 1) a 0.5% coupon, and 2) debt convertible into RHAT stock at $25.59 per share (priced at a 37% premium to the stock’s closing price the day before the offering). The company’s original filing was for $400 million, significantly less than the $585 net proceeds eventually raised. I believe that this serves as yet another indication of the growing level of investor bullishness on Red Hat in particular, and on the longer-term growth potential from investments in the Linux market in general.
Red Hat’s prospectus states that the cash raised is intended to fund international expansion and growth through acquisitions. By all accounts, the market for Linux outside the United States is booming. I expect new business partnerships to form the cornerstone of Red Hat’s brand building strategy. Countries such as China, India, Korea and possibly Japan seem likely places for the company to forge new partnerships.
In terms of growth through acquisitions I expect Red Hat to pursue a two-pronged strategy. First, I see Red Hat maintaining its focus on some open source technology companies. Second, I expect it will also focus on leading closed source companies in the key areas of infrastructure – such as application server, database, grid computing, security, storage, and technical workstation markets. (It is possible that Red Hat will "open," i.e. make public, any closed-source IP that it purchases. ) Focus on these closed source areas will help Red Hat build a solid revenue stream from subscription-based offerings that run on top of its core operating system business. This will help meet Red Hat’s objective of increasing revenue per server.
Red Hat’s additional cash also makes it a more formidable competitor with Novell/SuSE, which as a combined entity has over $500 million on the balance sheet.
Valuation
I like RHAT stock long and think the stock can move up to around the $22 price target by the mid-2004. However, I expect a volatile ride on the way to $22. The $22 price target is based on a projected cash flow multiple of 24x fiscal year 2006 Operating Cash Flow (OCF) per share of $0.93. Like many software companies, Red Hat's subscription model causes its income statement to understate cash flow generated from new sales of its enterprise products. Consequently, Operating Cash Flow (OCF) can serve as a proxy for operating earnings since OCF captures changes in deferred revenue. (Readers may recall my piece on Microsoft in this column late in 2003, where I used OCF as to measure Microsoft’s operations and stock valuation.) In addition, the trajectory of Red Hat's growth far exceeds any other comparable company. Red Hat's revenue growth over the next 12 months could be in the 35% to 40% area versus other comparable companies with expected revenue growth in the high single-digit to low double-digit growth.
I would be inclined to build a position in RHAT from here down to around $15 (the gap close) for a couple weeks. Then, if the market gets jiggy to the upside coming into the Spring I would add to the position. That’s one way to trade RHAT. Another is to have the stock price hold the 50-day moving average (DMA), depending on how the stock trades over the next few days. RHAT is close to the 50 day moving average (DMA) and it appears poised to bounce off of that level ($17.02). If it does bounce off the 50 DMA, then the stock could potentially move up to the $21-$22 area; and if we got a real “whoosh” down to the 50 DMA then it could potentially rebound in as short a time frame as the next few weeks. The stock just appears to be getting oversold, although I would still want to see it trade down to around the $17.20 level before I would commit. And if, under this scenario, it does trade down to the $17.20 area, I might put some short-term money to work there.
The stock has come off the recent top fairly hard. But in the process, it has made new channels. When a new channel is "formed", that is usually the most powerful move. A few weeks ago in this column, I referred to RHAT breaking $8.5 earlier in 2003, and at that time the stock had formed a new channel at that time. Shortly after the break of $8.5 the stock went on a massive tear. (Usually, it is a matter of a stock “banging" up against the top of the channel, then finally cracking it in order to enjoy a substantial up move.) My guess is that if /when RHAT turns up again, then $30 (or 32x 2006 OCF) is possible sometime in the next 18 months. But for now, I am keeping a 12-month price level of $22 in mind.
Risks to the RHAT Stock Price
Dependence on the Growth of Linux. Red Hat’s growth largely relies on the overall growth and acceptance of Linux as a viable and attractive operating system for enterprise computing applications. As enterprises and governments continue change their perception of, and increase their or acceptance and adoption of Linux and other open source software then this would continue positively impact Red Hat's business.
Intellectual Property. Red Hat contributes its source code to the open-source community. Consequently, there are no intellectual property barriers to competitors to copy and potentially improve upon Red Hat’s software model. Some of these competitors are armed with larger capital and human resources, and could potentially erode the company’s dominant market share position.
Legal Issues Present Some Uncertainty. Some level of uncertainty revolves around the copyright infringement legal action currently being brought by the SCO Group. This lawsuit potentially threatens the broad adoption of Linux in the enterprise and other markets. SCO’s legal suit claims that the 2.4 kernel of Linux contains source code that infringes upon SCO’s own copyrighted version of Unix code. (I think SCO’s claim is largely a form of “commercial brinksmanship” that will be a royal pain in the neck for everyone involved, will end up costing a ton of money in legal bills, and ultimately allow more lawyers to buy Gulfstream jets, but whatever – it’s SCO’s claim nonetheless.) The folks at SCO are a truculent bunch; they have also filed a lawsuit against IBM and, in addition, have threatened to file additional lawsuits against the users and distributors of Linux. The risk here is that a successful SCO lawsuit could limit the acceptance and deployment of Linux in the enterprise. If this happened, to some extent this would slow Red Hat’s revenue growth outlook.
Strategic Business Partners. Red Hat currently has business partnerships with other software technology companies and distribution partnerships with some major hardware vendors. Red Hat is pursuing a strategy to broaden its product offerings and, as a result, will likely offer competing products with these vendors. Consequently, one or more of Red Hat’s strategic relationships could end up being negatively affected as it competes against some its partners. This could curtail revenues that Red Hat hopes to derive from these strategic relationships.
This comment is not a recommendation to buy or sell any security. It is only intended as food for thought and to stimulate debate among like-minded Ryze members.
Cheers
Melanie Hollands
President
Koala Capital
Private Reply to Melanie Hollands (new win) |
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