Red Hat Unaffected By Oracle Unbreakable Linux in Fiscal Q3

Published: January 2, 2007

by Timothy Prickett Morgan

Just after we went on holiday at the end of 2006, commercial Linux distributor Red Hat posted its financial results for its fiscal third quarter ended November 30. Red Hat was able to shake off the effect of Oracle's Unbreakable Linux, which was launched in late October as a pseudo-clone of Red Hat's own Enterprise Linux. Sales were up 45 percent to $105.8 million in the quarter, and software subscription sales rose by 48 percent to $88.9 million. But there was one effect of the Oracle launch.

In the question and answer session following the announcement of Red Hat's financial results, Charlie Peters, Red Hat's chief financial officer, gave the traditional top 25 renewal statistics that Red Hat gives out each quarter. This time around, in fiscal Q3, Peters said that Red Hat was able to get renewals on 24 of the 25 largest deals in the quarter. And when pressed on why the one company did not renew, Matthew Szulik, Red Hat's chairman and chief executive officer, only gave a short explanation as to why that customer did not renew. "They became a competitor during the quarter," he said, which was a strong implication that the big customer who did not renew was, in fact, Oracle. Which stands to reason, since Oracle thinks it can provide better services for a nicked version of Red Hat Enterprise Linux--which it calls Unbreakable Linux--than Red Hat itself.

When baited by Wall Street analysts to say something negative about Unbreakable Linux or the effect that Oracle's upstart announcement had on the quarter, Szulik did not take the bait, which is why he is chairman and CEO. One analyst on the call said that people were complaining that Unbreakable Linux was buggy, and that Oracle partners were not even sure of where to find the software on Oracle's site.

"We are focused on our customers, and we are focused on expanding the opportunity for open source software through projects like OLPC, RHEL 5, RHN 2.0, and the expanding JBoss middleware stack," explained Szulik. "I have to be frank with you. I don't spend a whole lot of time thinking about the operational issues of the Oracle operating system product."

Red Hat stuck to its task of getting RHEL 5, which will include an integrated Xen hypervisor for server virtualization, to market and to selling what it already has in RHEL 4. Szulik said that Red Hat added over 12,000 net new customers in the quarter, bringing the total for the three quarters in fiscal 2007 up to 32,000 new customers. New customer adoption rates are accelerating even as Red Hat is later than expected with the delivery of RHEL 5, which was expected at the end of the year. But, then again, because what Red Hat is really selling is support contracts for licenses of open source software, it doesn't matter when RHEL 5 ships. Companies who need Linux today can get RHEL 4 now and move to RHEL 5 at their convenience without paying any incremental costs. (The same holds true for Novell's licenses and support contracts for SUSE Linux Enterprise Server.) Which is why a delay in a product launch--like the several-year delay in the delivery of Vista and Longhorn Server by Microsoft--doesn't hurt Red Hat or Novell as much as it might. Still, customers shop based on features, and they want the virtualization features these days.

While software subscription licenses rose 45 percent to $88.9 million during the quarter, training and services sales only rose by 32 percent to just under $17 million. Red Hat posted a gross profit of $88.3 million, and after significant increases in sales, marketing, research, and development areas--nearly double from the year-ago quarter, in part due to the acquisition of open source middleware provider JBoss--and paying its taxes and stock-based compensation, Red Hat brought $15.5 million to the bottom line, or about 7 cents a share. That was down 42 percent from the $24.6 million net income (12 cents a share) that Red Hat posted on a quarter that had a lot less revenue a year ago. Absorbing JBoss came with some costs, as Red Hat always said it would. But the company is building for the future, and believes that an integrated operating system and middleware stack is what customers will increasingly want.

Red Hat exited the quarter with $976.9 million in cash and equivalents, up from $804.9 million in at the end of February 2006; the company also had a stack of deferred revenue that was $311.7 million high at the end of fiscal Q3, up 10 percent compared to the end of fiscal Q2.

Peters said that the company's sales in fiscal Q3 were split evenly between channel and direct sales, even after accounting for the fact that JBoss sold mostly directly prior to the merger. He reiterated Red Hat's expectation that, over time, an increasingly large portion of Red Hat's sales would come through its OEM and channel partners, but for this quarter, at least, direct sales took back a slightly bigger piece of share. In fiscal Q2, the channel accounted for 56 percent of the company's sales. On a geographic basis, about 60 percent of Red Hat's sales came from the Americas, with 24 percent coming from EMEA and the remainder coming from Asia/Pacific. This is virtually unchanged from the prior quarter.

Peters also said that 28 percent of the contracts that Red Hat signed during the quarter were for terms longer than one year, which is the highest penetration of sales for long-term contracts that Red Hat has posted in its history. That made people on the call start asking if there special deals on long-term subscriptions, or if Red Hat had changed its discounting practices to promote this. Both Peters and Szulik said that Red Hat has not changed any of its playbook in the quarter. What the Wall Street analysts seemed to have not understood is that a longer-term contract has a built-in discount, and if you have made a commitment to Red Hat Enterprise Linux, it is stupid not to take the discount. This trend would seem to suggest that Red Hat's relationships with customers--either a small number of customers with lots of machines, a larger number of customers with a small number of machines, or somewhere in between--have deepened.

Szulik said in the call that RHEL 5 is slated for delivery on February 28, and said that the company was still working out how it would cope with pricing in a virtualized server environment. Red Hat had been hinting in early 2006 that it might try to charge a premium for virtualized servers in some way, but with Microsoft and Novell giving away virtualized instances along with their operating system licenses, this seems unlikely. What does seem likely is that Red Hat will not charge for virtualized instances of RHEL 5 running in conjunction with a single physical server, but that it will try to charge a premium for the Red Hat Network support services for those virtualized instances. In other words, the price premium will shift from a license cost to a patch support cost. That's just a guess, of course. But in a world where Novell is saying unlimited instances per physical machine, Red Hat doesn't have a lot of options. And customers who want to support virtualized RHEL 5 machines on their physical servers will be able to do it, no matter what Red Hat charges.

It is hard to see how server virtualization will affect operating system sales on any platform over time, and even Szulik said on the call that he did not expect the full force of virtualization to be felt in the market for at least five to seven years.

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