Red Hat Shows You Can Make Money from Linux
by Timothy Prickett Morgan
Wall Street was especially jumpy last week as Red Hat announced that its chief financial officer, Kevin Thompson, is leaving the company. Thompson turned in a stellar quarter for Red Hat at his final briefing with analysts last week, with the company throwing off big piles of cash. Linux may be free, but a commercial version with tech support certainly is not. And if Red Hat's numbers are any indication, there is a huge appetite for commercial Linux.
In its first fiscal quarter of 2005, which ended May 31, Red Hat's shipments of licenses to its Enterprise Linux offerings, which are available for workstations and servers, continue to outpace the growth of the booming X86 server market by a few percentage points, said Red Hat's chairman and CEO, Matthew Szulik. He said that the company is seeing expanded installations of Linux Enterprise 3 shipments into new accounts and an upgrade cycle among customers who have deployed dozens or hundreds of licenses of its prior Advanced Server Linux 2.1. Red Hat now has over 900 applications certified on Enterprise Linux 3, and the availability of real-world business applications and databases to drive them is pushing new installations of Linux on two-way and four-way X86 servers. Szulik also said that Red Hat is seeing an uptick in demand for servers based on Intel's 64-bit Itanium processors as shops using RISC/Unix boxes shift to Itanium/Linux boxes for core data processing applications. The use of Linux as a replacement for Unix may not surprise anyone, but the adoption of Itanium servers might.
The Linux operating system provider sold 98,000 subscriptions to Enterprise Linux in the quarter, with 75,000 of them going into the commercial market and 23,000 going into the high performance computing (HPC) and hosting markets. Red Hat's HPC and hosting business is going to be choppy, warned CFO Thompson on the call, and by our math that business declined sequentially in the first fiscal quarter from levels set in the fourth quarter of fiscal 2004. Szulik said that renewal rates for Enterprise Linux licenses (which run for a year) were 85 percent, but cautioned that Red Hat expects that level to settle in at 75 percent. (Some companies buy Red Hat, then decide to support it themselves, which is an option with open source software, since Red Hat provides all the patches and updates for its software for free.)
While 98,000 licenses may not sound like a lot, it is over four times the license ship rate that Red Hat had a year ago, and it is even up 13 percent sequentially. That is serious growth, and Red Hat does not expect the numbers to slow down. Sales of Linux licenses into corporations were up 23 percent, and it seems likely that the commercial side of Red Hat's business will continue to dominate as the company builds a distribution channel. Red Hat has all but abandoned the retail Linux business, and dabbles in the embedded market, but commercial Linux is where it is going to make money. "The momentum behind the enterprise adoption of Linux is still accelerating," said Thompson on the call. "We are still at the infancy stage of this market." He pointed out that in the November 2003 quarter (Red Hat's fiscal third quarter), the company pushed only 33,000 new licenses. Red Hat has tripled its ship rate in six months time. And as it builds out its channel, which only pushes 45 percent of its sales today but is expected to account for 70 percent of sales by the end of fiscal 2006, the license numbers should keep climbing. Right now, Red Hat has 301,000 active licenses to Enterprise Linux installed. If Red Hat can continue to get 85 percent renewal rates and ship at least 100,000 licenses a quarter, it should have an installed base of around 650,000 active licenses this time next year, and should break a million active licenses by the end of calendar 2005. If the rate of shipments continues to accelerate, it could hit the million license milestone considerably earlier.
What Szulik and the new CFO, who is expected to be found and named by the second quarter conference call with Wall Street analysts in September, want to show from here on out is revenue and profit growth like that which Red Hat demonstrated this quarter. Red Hat booked $41.6 million in sales, up 53 percent compared with last year. Net income was $10.7 million, up 603 percent from a not-so-great quarter a year ago. Red Hat added $15.2 million in deferred revenue to its hoard in the quarter, which stood at $86.1 million at the end of May. Cash flow from operations was $30.1 million, which was 72 percent of sales. Red Hat now has $964 million in the bank, thanks in large measure to going public in 1999, but it is adding cash to as it brings in profits. Part of the reason why Red Hat is throwing off cash is that gross margins across the Enterprise Linux products are 93 percent; across the whole company's line of software and services, gross margins drop to 80 percent. Anyone who says you can't make money from operating systems is not paying attention. With that said, however, the amount of money that Red Hat can make is limited, in that the value of a system has shifted away from operating systems and toward support services.