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Probably since the day in 1991 that Linus Torvalds posted his Linux operating system on the Internet, people have been trying to figure out how to make money from it. That program has blossomed into a major competitor to Microsoft's (MSFT) Windows NT, and now Windows 2000, as an operating system for running network-linked servers. It also has become a top choice to run the new breed of so-called information appliances.
Making money from Linux is no simple task, however. Thanks to the General Public License, or GPL, under which Linux is published, it's impossible for an individual or corporation to patent versions of Linux. No patent means no such thing as intellectual property, which means forget the 80% profit margins that are typical on proprietary software.
"Everyone started out as a hardware company or a software company or a support company"
Even so, several Linux companies are on the road to profitability -- and several dozen more could soon become public. Originally, each tried to become the dominant player in a different sector of the Linux market. But now, all seem to be aiming at the same revenue source: services. "Everyone started out as a hardware company or a software company or a support company, but now they all want to be a services company," says George Weiss, a Gartner Group analyst who follows the Linux market.
That shouldn't be a shock. Even in the world of proprietary software, service revenue is preferable to licensing revenue because it's perpetual. For instance, when Oracle (ORCL) announced last year that its service revenue dropped in proportion to licensing revenue because of competition from other service providers, its stock began a free fall from which it has just begun to recover.
LONG-TERM FRIENDS.
Software services means helping companies use software and computers in the most efficient way. Services revenue is valuable because it has high margins and is recurring. When Oracle sells a license for its database software, it also sends consultants to the customer to teach it how to best use the software. While profit margins on the license might be higher, the consultants' fees are more valuable because they can lead to other software sales and to a relationship that lasts for years. It's a lesson that IBM (IBM) learned in the early 1990s -- and that has helped transform it into a computing services giant.
Linux companies figure that if it worked for IBM, it'll work for them. At the moment, Red Hat (RHAT), VA Linux (LNUX), and LinuxCare (which just filed for an initial public offering) appear to be the primary contenders for the Linux services crown. However, it's already clear that this prize will be difficult to capture.
Red Hat's expansion moves have syphoned valuable resources from its services effort
Consider Red Hat's experience. Investors drove its stock up 403%, to $26.06, on its first day of trading six months ago. Even though Red Hat wasn't making much money on software sales, it had a 60% share of the Linux market, which investors assumed it could parlay into a role as a leading services company. Red Hat quickly discovered, however, that to maintain its domination of the Linux field, it had to pour money into software development. Then it found that holding its lead also meant jumping into embedded systems -- the cheap microprocessors that run such appliances as Web phones and Internet-linked refrigerators. So Red Hat bought the market leader in Linux embedded systems, a company called Cygnus Solutions, for $932 million in stock.
Although that move preserved Red Hat's dominance of the Linux market, it also syphoned valuable resources away from the company's effort to become a services company. With its bank account looking lean, Red Hat filed on Dec. 20 for a secondary offering of 4 million shares at $95 each -- a move that has since caused its stock to drop 31%, to $92.69. Investors didn't like the fact that the company was issuing more shares, especially when Red Hat brought in only $12.6 million in revenue in the first nine months of 1999.
BEYOND LINUX.
It's possible that LinuxCare will get kinder treatment from the market. This San Francisco startup began primarily as a Linux support specialist whose staff handled calls from distressed Linux users.
As it collected venture capital, though, LinuxCare quickly changed its focus to becoming a complete services company. The transformation is so thorough that co-founder Arthur Tyde no longer defines his company as a Linux outfit. "We can look at your systems and tell you that you're better off using Windows NT or Sun's Solaris," he said in a December interview. "We could easily take the word Linux out of our name without changing the nature of our company one iota." LinuxCare isn't abandoning Linux, of course: It just doesn't want to be known as a Linux-only services shop as it prepares to go public, perhaps by March.
VA Linux has also changed dramatically during its short life. As recently as six months ago, it specialized in producing computers that were optimized for use with Linux. But the hardware market is notorious for stiff competition and low margins. So VA now casts itself as a services company. "Producing hardware systems is one way we bring expertise to our customers," says VA CEO Larry Augustin. "But we are a complete services company, not a boxmaker."
VA Linux is trying to create a community that could become open-source central for software developers
VA's strategy for becoming a services company is unusual. Rather than hiring a horde of Linux professionals, it is nurturing the existing community of open-source developers. It has created a free hosting service for open-source projects called Source Forge. VA's computers store the code that developers are working on free of charge.
VA took a bolder step on Feb. 3, when it announced its purchase of Andover.net for $975 million in cash and stock. Andover owns several Linux-related Web sites, including slashdot.org and freshmeat.com. "Eighty percent of all open-source developers use those sites as their primary means of staying in touch with the community," says VA's marketing vice-president, Brian Biles. "If you put the whole thing together, it ends up being a powerful communications complex and development center for open-source software."
The hard thing for investors to swallow is that the Andover purchase will probably generate very little revenue for VA. It will sell some advertising on the sites, though not enough to cover costs. But if VA Linux succeeds in gaining the trust of the open-source community, which numbers tens of thousands of software developers worldwide, it'll be at the epicenter of a community that'll be the prime mover of Linux. "They want to capture the eyeballs of all those developers," says Gartner Group's Weiss. "If they can, they can draw on the expertise of the entire community."
GAGA FOR VA.
Right now though, VA Linux' revenue stream isn't too daunting. In the quarter that ended in October, the company produced only $14.8 million in sales. That hasn't kept investors from going gaga for VA. Its stock, which cost $124.75 as of the close of the market on Friday, Feb. 4, has a price-to-sales ratio of 26, more than quadruple the price-to-sales ratio of the Standard & Poors 500 index.
It's easy to forget, when sizing up these companies, that the biggest competitors in the Linux services business haven't flexed their muscles yet. It's conceivable, once IBM and Sun Microsystems (SUNW) wade in, that several Linux companies will have to join forces to create a large enough beast to compete.
Which brings us back to the still-unanswered question that has puzzled some investors from the start: Can companies whose future depends on a free product make money? And until the answer to that is clear, does it make much sense to invest in them?
Jaffe writes about the markets for Business Week Online
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