Investors have long hoped to make gobs of money on free software. When VA Linux went public in late 1999, its shares rose 698 percent, setting an opening-day record that still holds. The company’s ticker, LNUX, fooled some investors into thinking the company controlled Linux, the operating system that was then seen as having a real shot at undermining Microsoft’s (MSFT) Windows empire. In fact, as an open-source project with thousands of volunteer contributors around the world, no single company controls Linux. And since its rise in the late 1990s, dozens of startups, like VA Linux, have tried to convince investors that free software can disrupt the status quo.
Only one company, though, has ever mastered the art of cashing in on Linux. That’s Red Hat (RHT), which went public a few months before VA Linux, now known as GeekNet (GKNT), to much less fanfare. Red Hat, which provides operating systems for data centers, on March 28 reported full-year revenue of $1.1 billion, marking the first time that an open-source software company crossed the $1 billion threshold. The company’s share price has almost doubled over the past two years, while its sales have risen about 25 percent quarter-after-quarter. “There really was this time when nobody could make money with Linux,” says Richard Williams, a software analyst at Cross Research. “Then, Red Hat emerged as this surprisingly profitable entity.”
Red Hat sells stability. Every couple of years, it takes a version of the ever-evolving Linux and freezes it in time. Its engineers then make sure that particular version of Linux works well with data center servers and software made by other companies. Customers pay a subscription fee, entitling them to updates and help with problems. “Our customers know that 150 or so engineers will stay with each version of the software for the next 10 years,” says Jim Whitehurst, the company’s chief executive officer. “We are the only ones who do that.”
Whitehurst arrived at Red Hat in 2007, after working as chief operating officer at Delta Air Lines (DAL). He helped steer Delta through a painful bankruptcy; it emerged as a leaner, profitable company. Whitehurst taps his background in operational efficiency at Red Hat. He’s kept the company from expanding into glitzier areas such as consumer PCs and smartphones and instead maintained a laser-like focus on the data center business. “I think they have shown real discipline by executing day in and day out to grow a real business instead of chasing some more glamorous things,” says Jim Zemlin, executive director of the Linux Foundation, the nonprofit that supports Linux.
While Red Hat’s business plan looks simple on paper, it’s difficult to pull off, Whitehurst says. The company acts as a conduit between its customers and the self-selected group of people that oversees Linux. That means Red Hat spends days selling Linux to dozens of Wall Street firms and nights working with passionate volunteer developers. Red Hat performs this dance well and has won the allegiance of Linux’s engineers by, among other things, contributing more code to the project than any other company. Oracle (ORCL) has tried to use heft and cheap prices to undercut Red Hat but hasn’t come close to overcoming the latter’s lead. “Red Hat has won and done so with premium prices,” Cross Research’s Williams says. “The data center crowd sees Red Hat as standing for a seal of approval.”
Williams wonders whether Red Hat’s business will be able to keep up with its share price, which has risen 66 percent since the start of 2010. The company has been mentioned as an acquisition target for IBM (IBM), Hewlett-Packard (HPQ), Oracle, and Intel (INTC). “Part of Red Hat’s value is based on that takeover speculation,” says Williams, who warns he finds the possibility of an acquisition unlikely because of Red Hat’s role as a neutral player. “So, then you have to ask if their growth can support their valuation,” he says.
Red Hat has been slow to enter increasingly critical areas such as virtualization, data analytics, and cloud computing. “Maybe we have missed some big, sexy things, but we have really nailed the performance around our core,” says Whitehurst. Last year, Red Hat acquired Gluster, a storage software specialist that competes in both the analytics and cloud arenas. It’s a late move but one that could keep Red Hat’s growth engine humming. “Gluster will ultimately be huge,” Whitehurst says. “It can be bigger than the Linux business.”