BUSINESSWEEK ONLINE : JULY 5, 1999 ISSUE
INFORMATION TECHNOLOGY

Can Red Hat Stay Red-Hot?
The scrappy upstart may never be more than a passing fad

Whether it's his slight frame or his low-profile career in the computer-leasing business, CEO Robert F. Young is no giant killer. But you would never guess it from the attention Young and his four-year-old company, Red Hat Software Inc., have been getting from mighty Microsoft Corp (MSFT). In confidential memos, Microsoft researchers warned Chairman William H. Gates III that Linux, the operating system software Red Hat sells, poses a threat to the company's Windows NT software. Microsoft lawyers even hoisted a copy of Red Hat's latest release during the software giant's antitrust trial as proof that it faces plenty of competition.

Make no mistake, Red Hat is red-hot these days. Young has used savvy marketing maneuvers to make the company's trademark red fedora synonymous with Linux--the freebie operating system that stunned experts by capturing 17% of the computer server market last year. Six industry giants, including Compaq Computer Corp. (CPQ) and Oracle Corp. (ORCL), have rushed to take minority stakes in Red Hat. And, according to International Data Corp., it has quickly snared 54% of the Linux market, vs. the 11.5% share of its No.2 rival, SuSe Holding in Nuremberg, Germany, and 6.3% for Caldera Systems Inc. in Orem, Utah. Now, Young hopes to cash in on all the hoopla. In August, he plans to take Red Hat public.

Still, computer experts don't think the scrappy Durham (N.C.) company will topple Microsoft. What's more, it's not even clear that the company will be able to transform Linux from a fad into a commercial success. For starters, Red Hat doesn't control Linux, which is a free program that's worked on by legions of developers around the world. So far, the company has made most of its money from retailing $40, $80, and $100 versions of its product, which include an easy-installation feature, a Windows-like interface, and a host of supporting programs. Revenues last year were a modest $10.8 million--leaving Red Hat with a $91,000 loss. And it's no wonder: Most of the estimated 7 million copies of Red Hat Linux out there have been downloaded for free off the Internet or copied legally.

Young's challenge is to persuade corporations and Web-site operators to pay from $1,000 to $60,000 a year for technical support--based on the number of users--and even more for services such as customized programming. Services represented only 7% of revenues last year, but the company expects that to grow dramatically. As a sidelight, Young also is turning the company's Web site into a portal providing information for Linux users--and making money from advertising and E-commerce. The business model is complex and unproven, but Young points out that even giants like IBM (IBM) derive the bulk of their income from services.

Besides, he argues, Red Hat's quirky business model is the best way to avoid a direct confrontation with Microsoft--with its installed base of more than 200 million Windows users. ''You have to change the rules of the game,'' he notes in an interview before the IPO filing. Young believes that as the Linux movement spreads, corporate users will jump at the chance to regain control of their computer networks from Microsoft. ''We're going after an overpriced, static operating system with a higher-quality, better-priced product,'' claims Young.

That pitch has proved compelling to some users--principally Web-site operators and college students. But analysts give Red Hat no chance of cracking Microsoft's lock on the lucrative personal-computer market. Despite its best efforts to spiff up Linux with a Windows-style interface, it remains an unfriendly program. And few desktop applications like word processors and spreadsheets run on Linux, so consumers aren't apt to switch. ''This puts a ceiling on the Linux market,'' says analyst Daniel Kusnetzky of IDC.

BIG BACKERS. Red Hat's best hope may be selling products and services for servers. According to researcher Netcraft Ltd., Linux accounts for 20% of all server shipments, just six points less than Microsoft's Windows NT. Numbers like that led Oracle--a bitter Microsoft rival--to invest in Red Hat. ''We support the leading operating systems, and Linux is emerging as one of those,'' says Mark Jarvis, Oracle's senior vice-president for worldwide marketing.

For now, all this market share isn't producing much in the way of revenue. Indeed, that may be because Linux' biggest selling point--its reliability--leads corporate users to believe they can run it without paying for support. Red Hat's largest corporate user, Burlington Coat Factory Warehouse Corp. (BCF), bought 1,250 Linux-based PCs for its 250 retail stores but didn't buy tech support. ''We already have enough Unix expertise available in-house,'' says Michael Prince, Burlington's chief information officer. ''In my mind, our experience raises questions whether Red Hat's business model makes sense.''

If Red Hat gets past all of these hurdles, it will still face Microsoft. Young shows no fear. Unlike Red Hat, Microsoft's past rivals were ''dependent on Microsoft's operating system, so Microsoft had the leverage--and used it,'' he says. Young would be well advised to remember that the computing landscape is strewn with the remains of companies that underestimated Microsoft.

By Dean Foust in Durham, N.C., with Jonathan Drew in Atlanta

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