Red Hat takes on the recession

The open source revolution may have yet to happen, but with company budgets on the line, change is in the air.

By Michael V. Copeland, senior writer

SAN FRANCISCO (Fortune) -- Remember about five or six years ago when the open source software movement was going to beat the stuffing out of software giants like Microsoft, Oracle and Sun? That hasn't exactly happened.

Only one company, Red Hat took the open source approach: Hundreds (if not thousands) of volunteers work on a piece of software -- in this case the Linux operating system for the corporate world -- develop it in a money-generating subscription package, and turn it into a large enough business to go public.

Fair or not, Red Hat is the best proxy for how open source software has been received during this economic downturn, and guess what? It's doing pretty well.

Red Hat (RHT) shares were battered brutally during last year's market slide, falling from around $22 last August to $7.50 when the market tanked in November. That kind of free-fall happens easily when you are company that size -- about a $4 billion market cap, with shares concentrated in a handful of investors. From today's vantage point, however it looks like the market overreacted.

Since November, Red Hat shares have marched steadily upward, even continuing to rise when the rest of the market slid again in March. That decoupling occurred because Red Hat's business has continued to show relatively healthy top-line and bottom-line growth through the recession.

While other software companies including Microsoft (MSFT, Fortune 500) and Oracle (ORCL, Fortune 500), have seen net profit drop in recent months, during its most recent quarter, which it reported June 24, Red Hat profit rose 7%. Revenue grew 11% during the same quarter year over year. And that's what investors have been latching onto. In late July, Red Hat hit a 52-week high of about $23. Shares continue to trade in a range between $20 and $22.

I sat down with Red Hat CEO James Whitehurst on a visit to San Francisco this week, and asked him why his company seems to be bucking a trend. Whitehurst, who managed a difficult turnaround for Delta Air Lines before joining Red Hat at the end of 2007, has certainly been keeping a lid on costs.

"But you can't save your way to continual growth," he says. "In a down economy we have performed well. Budgets are tight, and people are looking for ways to save money -- they turn to us."

The open source model, with its army of free coders, lets Red Hat offer its subscription-based software package for much cheaper than say Oracle, or the soon-to-be acquired Sun (JAVA, Fortune 500). Of course Linux and Red Hat's JBoss middleware is also available free, but Red Hat's business is to make sure the Red Hat-approved software works with a customer's particular implementation and guarantee support and further development for years to come. One way to look at what the company does is to think of it as a Wikipedia that is guaranteed to be accurate.

Before the economy headed south, companies that may have been toying with the idea of an open source solution for their software problems didn't have a compelling reason to switch from the more expensive proprietary software of Red Hat's competitors. Then the recession gave them one.

"Now CIOs are saying, 'We better look at this open source stuff again,'" Whitehurst says. "They come to me with budgets that have been cut 20%, and want help."

Thus far, Red Hat has been focusing that help on the infrastructure side of corporate IT, so the kind of behind-the-scenes software on top of which applications run. It has branched out from its core Linux OS into all kinds of infrastructure software that enable things like clustering and virtualization.

If you subscribe to Red Hat, you get it all as part of the service. That buffet of guaranteed software is what keeps customers coming back and paying for what they can in theory get for "free." Not only did Red Hat's 25 largest customers up for renewal last quarter re-up, they bought 20% more.

Whitehurst says his company has no immediate plans to deviate from offering more in the corporate infrastructure layer. One emerging market that seems ripe for Red Hat business, he says, is so-called cloud computing. Since much of the Internet runs on Linux, and Red Hat is all about Linux...well you can connect the dots.

But are the shares worth it? The business side of Red Hat is humming along, but from a valuation perspective with an estimated 2010 P/E of about 50X, it's pricy. Buying in at $21, you are betting the economy doesn't tank again any time soon, and Red Hat's business continues to grow. Then again, so far it has. To top of page

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