Year of The Hat

Will 2007 be The Year of the Hat? We’re well into the second quarter and so far Red Hat is making all the right moves. Even the financial analysts are starting to trumpet the firm’s praises, with one Credit Suisse analyst upgrading Red Hat shares from “neutral” to “outperform” just last month.

There are solid reasons for optimism. Red Hat has regained much of the market value shed after Oracle announced the launch of their competing ”Unbreakable Linux” initiative. On the heels of Oracle’s aggressive move, a skittish market cost Red Hat 25% of their share value. Now, 6+ months later, Unbreakable Linux is looking more like Unthreatening Linux, as clients have proven less fickle than was originally feared. Support and subscription revenues, it would seem, are not quite so easy to cannibalize…

But Red Hat’s present strength has less to do with the competition than with what Red Hat themselves are doing right, that is, diversifying their income flow and creating a broader revenue base. The subscription and support fees for their flagship product are of course the most significant money spinner, but as commentators (including myself) have always been quick to point out, sales and support revenues for a Linux infrastructure product are a slim reed on which to hang a company’s future.

Red Hat has responded to the challenge nicely with a number of moves to address this concern, including the JBoss purchase and more recently, the launch of the Red Hat Exchange. JBoss was purchased more than a year ago for US$350 million and has slowly but steadily been brought into the Red Hat product mix. Incorporating a strong and distinctly personality-driven operation like JBoss would have been a challenge for any firm, but Red Hat has handled it well. JBoss subscription revenues are now starting to contribute to Red Hat’s bottom line and this will strengthen across time.

Looking long, the key for Red Hat (or Sun, or Microsoft, or any promoting a platform strategy) is the ability to deliver a unified stack of applications which serves the clients’ needs across a broad range. If Red Hat wishes to compete with Microsoft on any serious level they must clear this hurdle. The Microsoft / Novell deal makes it even more imperative that Red Hat provide more than an OS.

The JBoss and Red Hat Exchange moves show clearly that Red Hat understands well the issues in mastering a platform strategy. The Red Hat Exchange, launched in May, is a subscription play similar to what we’ve seen from SpikeSource and BitRock. Not content to let third parties offer open source stack creation and management, Red Hat wisely decided to offer the service themselves. Launching the Exchange was smart for three reasons: First, it’s yet another source of subscription revenues; second, when Red Hat provides their clients access to a managed stack, Red Hat retains the client relationship; and third, the Exchange allows Red Hat to test drive potential acquisition targets. (On the latter point, the Exchange includes open source contenders Zimbra and Alfresco, among others, and people have already started to speculate whether they are on Red Hat’s shopping list.)

But let’s add a dose of realism: Despite all the positive signs, nothing is ever 100% rosy. Profit performance has not been stellar despite strong revenue growth. Red Hat share prices are still down from where they stood twelve months ago and are quite a bit off their 52 week high of more than $29 a share. Dell’s recent decision to go with Ubuntu was a disappointment. JBoss, though moving the right direction, still represents only a small fraction of Red Hat revenues. Monetizing the majority of the JBoss customer base is still a distant goal.

The Red Hat Exchange also remains unproven. The business model of offering packaged OSS application stacks still faces an uphill struggle against proprietary packages; success in this area will hinge on the ability to offer a sufficient range high quality applications and to support them. The jury is still out on how well Red Hat can execute in this new arena.

Nonetheless, despite the challenges that remain, I am very bullish on Red Hat and feel they stand an excellent chance of overcoming these obstacles. They have built the company into The Brand Name in Open Source and I don’t see that changing in the near future. Here in Asia-Pacific, where Red Hat is truly dominant in key markets like India and Japan, I see the firm going from strength to strength. China remains a challenge for Red Hat, but wisely they are not gambling the company’s fate on dominating that notoriously difficult market.

Originally published June 2007 in ComputerWorld (HK).

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