Rethinking Red Hat Through Its 10-K Filing

The recent release of the Red Hat (RHT) 10-K filing contains no great surprises but led down a few paths that might have IT investment research potential.

As my posting over at ebizQ.net earlier this week pointed out about the size of the open source software [OSS] market opportunity, Red Hat’s playing in the big leagues now. Or the big leaguers such as HP (HPQ), IBM (IBM) and Oracle (ORCL) have come over to Red Hat’s ball park if you prefer. So it’s interesting to me to see that this “overnight success” is almost 15 years old, including its beginnings in ACC Corp.

Cofounder Bob Young’s book and a short essay by Young tell the story. His essay includes a great explanation of the OSS business model using comparisons with selling catsup and bottled water. So first investment research food for thought: Don’t be afraid to invest in a private company with a few years under its belt (as Red Hat was 10 to 12 years ago) and a good idea that hasn’t taken off yet. Such an investment might lead to a better return than a buzzword-of-the-day but totally unproven concept presented with reams of charts and graphs by a brand new startup.

Interestingly, in its 10-K Red Hat added Oracle but dropped IBM as among those that “offer hardware-independent, multi-user operating systems for Intel (INTC) platforms.” This particular Competition section of the financial filing does not have to be definitive but it typically reflects the most effective competitors and it is most revealing when wording is changed from one year to the next as it did in this case. Adding Oracle makes sense although the database market leader was only in the operating-system market for the last quarter of Red Hat’s fiscal year, which ended February 28, 2007. What might be more meaningful from an investment perspective was dropping IBM. Maybe Red Hat just wanted to save ink.

Finally, I guess I already knew this next item but hadn’t thought about it: Red Hat has already gone through the “CA syndrome.” The syndrome is named for the very difficult transition Computer Associates (CA) is currently completing whereby it moved from a license-revenue model to now recognizing almost all its software-related revenue as subscription, deflating for a few years in the process from a GAAP perspective.

That is, unlike all of its big-league competitors’ revenues, most of Red Hat’s revenue is already recognized on a subscription basis vs. a front-loaded perpetual-license basis. (Note: Red Hat calls the big leaguers “proprietary” software providers in its 10-K but that’s unfair since all have also now embraced OSS.)

A perfectly fair apples-to-apples comparison of Red Hat with BEA (BEAS), the IBM Software Group, SAP (SAP) or Sun (SUNW), for example, would either increase Red Hat’s market share by 5 or so percentage points or cut back the other companies’ shares proportionally. From an investment analysis perspective, this means that Red Hat is not as small as the traditional market-research-firm taxonomies and methodologies would imply.

The annual Research 2.0 Red Hat analysis is in process now, and our report will be released in July or early August. It will go into depth about Red Hat’s and OSS’s future, and put a lot more meat on the bones than I did here in this blog post.