The Open Road

Red Hat has been taking a beating in the stock market recently, but in a recent research note leading analyst Mark Murphy of Piper Jaffray thinks this represents an exceptional opportunity to buy into a "deeply undervalued" company. More interestingly, Murphy finds significant cause for Red Hat optimism based on Oracle's failed attempt to undermine Red Hat with its Unbreakable Linux product.

If Red Hat's model were fragile, the thinking goes, surely a behemoth like Oracle could make a dent in Red Hat revenues? Oracle got into the Linux game two years ago, hoping to cannibalize Red Hat's business for itself.

As Murphy points out, however, Oracle has completely failed to hurt Red Hat, calling into question the belief that Red Hat's demise is just a fork away. Novell, too, despite starting to build a decent Linux business of its own, as The VAR Guy has noted, has completely failed to touch Red Hat's rising revenue. The reason? Red Hat remains the default choice for enterprises looking to move off expensive Unix to high-performance and low-cost Linux.

Murphy writes:

Oracle has failed in its attempt to enter the Linux market. Our recent survey of Oracle database customers reveals that only 1 out of 32 customers currently uses Oracle Unbreakable Linux. This one customer also commented that "support is terrible, it is difficult to get an answer to my problems, Oracle's agents never understand my company." The survey reflects a very low penetration rate in the 2-year period since Oracle unveiled Unbreakable Linux with much fanfare, including live penguins running around onstage with Larry Ellison. Resellers continue to characterize Unbreakable Linuxas a failure because Oracle ultimately cannot control the future direction of RedHat Enterprise Linux, upon which it is based.

While the Street has expected Unbreakable Linux to severely impact Red Hat, its failure ironically serves as a proof-point of the underlying defensibility of RedHat's business model. In fact, in the two years since Oracle introduced Unbreakable Linux, Red Hat's billings have grown at an average rate of 31%--representing clear market share gains.

When Red Hat's biggest rivals can't hurt it, surely this is cause for optimism, and not a market slide? It turns out that being the "source of code" is a great alternative to owning the source code, at least in Red Hat's case.

Red Hat has shown no signs of slowing, with its subscription model able to weather the current recession: even if it doesn't sell any new subscriptions, it can tread water and/or grow with its existing customer base, something that license-revenue driven companies simply can't afford to do.

OStatic reported on Wednesday that public open-source companies may be vulnerable as they watch their market capitalizations get flushed down the toilet. Unfortunately, it's not just Red Hat, Novell, and Sun that are getting pulverized by Wall Street. The entire market is in free-fall.

Is there a bottom in sight?

Novell and Sun are worth more dead than alive, with more cash on hand than their market capitalizations. It's not quite so bad for Microsoft and some other technology vendors: Adobe, for example, has an $11 billion market capitalization with $4 billion in total equity.

But that doesn't tell the entire story. Keeping with Adobe, it has lost roughly 50 percent of its market value since January 2008, this despite reporting quarter-after-quarter of growth and excellent performance. Google? It has lost 56 percent of its value in 2008, despite dominating the web advertising market, a market projected to keep gaining at old media's expense, with Proctor & Gamble and others actively looking at moving more advertising spend to the Web.

This is insanity. It makes no sense, because it is a product of panic. There are many reasons for the massive sell-off on the financial markets, but they all derive from panic: I've got to sell Asset X to be able to cover my obligations to Creditor Y. If everyone decided to stop panic-selling today, things would stabilize.

Alas! That's not going to happen. So perhaps the only thing to do is laugh at our folly and the trillions invested in our house of cards. If you step back from the mess for a minute, it's plain that Wall Street's sense of valuation has been thrown askew. Best to wait until the mania subsides, then buy heavily.

Paul Kedrosky notices an impressive feat for Microsoft: for the first time in a long time, its stock has outperformed Google's this week, this month, and this year.

Granted, this is like calling Microsoft the sexiest nun in the convent, given how poor its performance has been, but it's also an indication that Microsoft may have more life in it than widely assumed.

I've commented on Oliver Alexy's research on open source's effects on stock prices before, but was gratified to see it featured in today's Wall Street Journal.

It turns out, as per Mr. Alexy's research, that open source can have a salubrious effect on one's stock price, but only if done right:

Companies saw their stock price rise if they met one crucial condition: explaining how they expected their open strategy to bring in short-term revenue. Companies that clearly communicated a short-term revenue model saw an average stock-price increase of 1.6 percent. Companies that didn't saw an average decline of 1.6 percent. This means companies can't rely on vague long-term assurances.

Ironically, this betrays a woefully naive view of open source by the market. Open source is a marathon, not a sprint. It's not a quick fix for any business.

In other words, the very thing that the companies most need to do (i.e., take a long-term view of open source's benefits for their businesses) is the thing most likely to punish them in the market. Who said markets are rational?

Both Red Hat and Oracle had excellent quarters, but Oracle's was apparently not "excellent" enough for Wall Street's tastes. Its shares and the market went south this week on fears that technology spending is in decline.

In addition, Wall Street apparently didn't notice that Red Hat actually raised its fiscal year 2009 guidance this week.

Consolidation is one way to improve earnings in a down market, but open source may well be a better way as The New York Times opined.

Oracle's total software revenue was up 21 percent, to $4.2 billion. Pretty good. Unfortunately, it was well under the 30 percent growth Wall Street was expecting.

More unfortunately, Oracle's third-quarter application license revenue only increased by 6.6 percent, to $451 million, which was well below the 30 percent growth ($553 million) that Wall Street expected.

As Sarah Friar explains in The Wall Street Journal,

...(C)ompanies typically buy such software when they are embarking on new projects and are likely to dial back such purchases in tough economic times.

But the same affliction isn't showing up in Red Hat's earnings. Red Hat's percentages were roughly the same. Red Hat's quarterly revenue rose by 27 percent over the fourth quarter and annual revenue in fiscal year 2008 was up more than 30 percent. Red Hat's numbers are much smaller compared with Oracle's, of course, but one thing that really stands out is its deferred revenue number, which was up 40 percent.

As I read that number, Red Hat is doing more longer-term deals. Basically, it's sitting on a growing mountain of cash that is just waiting for services to be performed before it can recognize that revenue. It means that Red Hat's future is demonstrably, tangibly bright.

Here are some salient facts from the Red Hat announcement:

Total revenue for the quarter was $141.5 million, an increase of 27 percent from the year-ago quarter and 5 percent from the prior quarter. Subscription revenue for the quarter was $121.9 million, up 27 percent year over year and 5 percent sequentially. For the full year, total revenue was $523 million, an increase of 31 percent over fiscal 2007 revenue, and subscription revenue was $449.8 million, up 32 percent from the prior year.

Oracle is projecting 10 percent to 20 percent sequential quarterly growth. Red Hat, too, needs to find ways to super-charge its growth. But for the moment, I think it's enough for the company to be demonstrating a flight to value in recessionary times. Investors may bemoan the fact that it's harder to mint money with an open-source company, but this may simply be a new reality for the software industry.

We had a few decades of anomalous growth when there was a mismatch between the economics of production and consumption (i.e., write once, manufacture an infinite number of my products for roughly zero cost, but charge customers steep prices as if the economics of digital production didn't exist). Open source and the Web are going to bring things back into alignment.

For now, Oracle is a good bet in the stock market. If any company is going to weather the recessionary storm, I'm betting it will. But for those with a longer-term view on the software industry, it would be wise to bet on open source.

Some people at Google slave away at building a better search engine, or enabling social networks like Orkut, or helping people find directions to places. Not Bonnie Brown. She rubs people's backs. And she has made multiple millions doing so.

Ms. Brown didn't get rich on her salary. In fact, Google paid her a miserly $450 per week (part-time, mind you). No, it was her stock options that have crowned her queen of the massage parlor.

She's not alone, either. There are apparently lots of millionaire-masseuses-in-waiting at Google:

It is estimated that 1,000 employees, Ms Brown among them, have accrued fortunes worth at least $5 million apiece from the nine-year-old web giant's rise and rise. The money has flowed from Google's stranglehold of the hugely lucrative online advertising market (it reported revenues of $7.5 billion in the first half of the year alone) and investors? seemingly insatiable appetite for the group?s shares. Yesterday, the company, founded in a garage by two students, sported a stock market value of some $207 billion.

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