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Red Hat Lives To Fight Another Day

No doubt due to the massive pressure put on them by Oracle and Microsoft, Wall Street fund managers had piled up 20.4 million shares short going into today's earnings announcement.  These same managers were forced to cover their bearish bets when Red Hat posted subsription revenue of $88.9M, up 48% annually, a positive surprise.  EPS came in at $0.14 compared to the Street's expected $0.12, and cash flow boomed at $59.7 million - well above the expected $45 million. 

Terry Tillman from Suntrust summed up guidance, "The company gave guidance for 4Q07, with total revenue in the range of $112 million to $113 million. GAAP operating cash flow for the full fiscal year is unchanged, suggesting a midpoint range of $41 million - $42 million, representing a significant downtick sequentially. Adjusted EPS is expected to be between $0.14 - $0.15."

CEO Matt Szulik was reserved in the face of some welcome good news for his company.  He attributed the success in the quarter due to the fact that customers don't find value in saving $5 per OS simply because some new player entered the market. 

To my mind, this is reminiscent of the outstanding/outrageous run of heroic quarters PeopleSoft put up in the face of Oracle's takeover offers.  In hindsight, the threat from Oracle focused the management at PeopleSoft to such a degree that sales execution was well above the norm.  It didn't hurt that PeopleSoft was also offering massive concessions to customers in order to get deals done.  It should be noted that PeopleSoft eventually drained the swamp dry, and finally imploded just prior to the board reversing their stance and accepting the Oracle bid. 

Jason Maynard from CSFB poked around this theme during the Q&A on the call, wondering aloud if perhaps there had been some special discounting going on.  Katherine Eggbert asked if special spiffs had been implemented to stimulate the bookings.  In both cases, management denied doing anything special and attributed the success to customer loyalty and a healthy demand environment.

I am not buying that at all.  There is no such thing as bad publicity, and the Oracle move certainly put the spotlight on Red Hat for a while.  That kind of brand awareness usually costs a pretty penny and Red Hat picked it up for free.  I also think that execution probably improved as the folks at Red Hat realize they are fighting for their lives.  Ultimately, I do not believe that discounts were not impacted by this.  Even if Oracle was a disaster in executing their support offering, I think savvy purchasing agents would leverage the heck out of the announcement to obtain more favorable pricing from Red Hat. 

In summary, we must acknowledge the strong numbers the company put together.  But even so, they will have to string together several more to make me a believer. 

Red Hat Under Siege!

In a move that I still can’t totally figure out – more on that later – Microsoft and Novell announced a partnership that resolves a potential dispute between the two vendors over intellectual property in Novell’s linux distribution. The announcement also touched on the two firms working together to enhance technical interoperability between the OS’es, and it mentioned that Novell would be paying Microsoft royalties for this “patent peace.”

The winners in this situation are the customers who have both SuSE linux and NT servers in their IT system. It eliminates the threat of a legal war erupting over who owns what IP, a fight that would both retard Linux expansion and do no favors to Microsoft’s image as a bully.

Novell is also a big winner here (stock up 14.65% at press time). They have managed to do about nothing relevant or interesting since Chris Stone went on the open source buying spree in 2003. New CEO Ron Hovsepian didn’t take long to shake things up at Novell and was credited during the Q&A as initiating the dialogues with Redmond. Suddenly Novell goes from circling the drain to the owner of the Linux distribution that has made peace with Microsoft. And that’s a huge differentiator.

So why did Microsoft do this? Because of the customers? Bah. Consider they could have done this a year ago but didn’t. The relevant landscape hasn’t changed much in that time. If you buy that, you have to explain the sudden change of heart.  And just how many customers are tearing their hair out because they can’t get their SuSE server to interoperate with their NT server? 

So why did Microsoft do this? Because of the royalty? Pshaw. A drop in the ocean to Microsoft.

So why did Microsoft do this?  A response to Oracle?  The irresistable urge to kick Red Hat while they're down?  Amusing to consider yes, but is that enough of a reason to legitimize the principle threat to the Microsoft cash cow(s)?

So why did Microsoft do this? Because they suddenly look in-step with reality for a change? That, combined with the previous two reasons probably gets us halfway there. But again, Microsoft had no visible compelling reason to do this TODAY. Deals just don’t get done unless they have to. And I am too dim to see why Microsoft HAD to do this.

There just doesn’t seem to be enough benefit to Microsoft to justify this move. They don’t need the money. Their customers are beholden to them already. Despite Linux’s runaway success and threat to their core business, Microsoft could chug away for years without a noticeable dip in their earnings.

The big loser, of course, is Red Hat. The Raleigh, NC outfit has taken two huge shots in the past few weeks from two of the heaviest hitters around. First Oracle threatens 95% of all their revenue by undercutting Red Hat’s support by half AND indemnifying users at the same time. Then Microsoft lends legitimacy and competitive differentiator to their biggest competitor. I can’t recall two such shots being absorbed by a single entity in such a short amount of time.

You know Oracle and Microsoft approached Red Hat. I can’t help but wonder what on earth the head of Business Development was thinking in failing to close these deals. Red Hat missed opportunities to partner with Oracle and/or Microsoft, eliminate IP issues, and put a stake through the heart of Novell. Of course we don’t know the offers extended to Red Hat, but as I mentioned in another post, they really didn’t have much choice in the first place. Red Hat is left with a Linux distribution that is cheaper to be supported by Oracle and isn’t indemnified by either Microsoft or Oracle.

Ultimately, what happened is that Microsoft has legitimized Linux, Novell is the principle beneficiary, Red Hat looks pretty bad, and Microsoft looks aggressive again.

Red Hat Defiant!

Matthew Szulik, CEO of Red Hat, essentially tells me to stuff it.  He is not, repeat not cutting prices to deal with Oracle's move. 

I do agree there will be loyalty to Red Hat, but at 2x the cost of a world-class support organization I wonder how long that will last.  I would suspect most people in charge of this decision will be asked to at least investigate what Oracle can do. 

The End of the M&A Road in Sight for Oracle? Go long?

The Financial Times paper edition today has a story where Larry Ellison is quoted as musing aloud that it makes sense for Oracle to own the entire stack, including a Linux distribution.  Novell and Red Hat are mentioned as takeover targets.  Story here.  And here. 

I keep wanting to buy Oracle at these levels because I hope the M&A binge is nearing the end and I theorize that the discount applied to their stock due to the integration risk will melt away.  That alone should buoy the stock, and God help all shorts if they put together a complete quarter for the first time in ages (succeed with Tech AND Apps in NA AND EMEA)! 

Let's say they do buy Novell or Red Hat.  That leaves BEA Systems as the last obvious mega-purchase, no?  But Alfred Chuang, CEO of BEA, simply refuses to sell to Larry which means the only avenue would be hostile which would most likely be a non-starter in Redwood Shores. 

So longing Oracle here might be the cheapest it will be for a while due to the M&A discount and the looming bogeys of a Linux deal or a BEA deal.  I think the latter is unlikely for a while, and the former a real possibility.  It makes sense to me to take a small position in Oracle at these levels, then add to it after they take out Novell.

Chercher de l'argent!

Marc Fleury was not always so enamored of Red Hat, eh?

(Hat tip: Mongo)

JBoss finds financial exit

Red Hat acquires JBoss in a $350M in a cash and stock transaction, which could have an additional $70M included if JBoss reaches certain performance goals.  That's about $140M in cash and $210 in stock, which is about a 17.5x multiple on revenues (estimated) of $20M. 

The bulls are running with this as RHAT is up 8.9% as of 12:30 EST to $29.96.  Speculators are hoping NOVL will do something similar and the stock is up 1.8% to $7.60. 

The deal makes a lot of sense for Red Hat, but is not without some challenges.  Red Hat's application server was announced in 2004 and failed to make any sort of discernable impact while JBoss reached a critical mass of distribution and downloads.  Red Hat enhances their value and defensibility by building an open source stack, and JBoss is a nice arrow in their quiver - not to mention it deprives IBM, Novell, HP, or anyone else from that same arrow. 

The main challenge is how will these two very different open source companies gel?  Red Hat is a "purer" open source model in that they have very low R&D and S&M costs because they leverage the existing Linux developer model.  They do not spend a ton of money writing their flavor of linux, rather they certify and support a version that the community created.  Sure, they do write some code but the bulk is off balance-sheet R&D.  By the same token, they have a low cost distribution model that does not rely on Red Hat employed sales people. 

JBoss, in contrast, looks a lot more like a traditional software company in that they do most of the writing of their product (about 80% of the code is written by JBoss JEMS employees according to my notes from their recent roadshow) which has two implications.  The first is that they have some developer resources they can absolutely not afford to lose.  I am sure Red Hat locked these men and women up, but you can't account for productivity and attitude.  The second implication is the higher R&D cost associated with JBoss.  This cost will also be matched by the higher S&M cost due to the enterprise salesforce JBoss has.  Between the two, RHAT will need to make a call- do they try to cut those costs or do they leave JBoss entirely alone?  And beneath that is the fundamental issue between two companies with two models and two cultures that are not as similar as some might say.  If they opt to cut costs they will have to open up the development of the JBoss code to the entire universe, and change the entire sales distribution model- something that is fundamentally opposite of how JBoss has found success to date. 

But before I make a bear call on this, let me say that I think that even assuming some bumps in the road of integration, Red Hat will do fine.  What I understand less is why JBoss went this way.

One commenter to this site, Mongo, said there was no way JBoss would go IPO and he get's the "I told ya so" high ground today.  I would love him/her to post more on that.  I saw a chance to tap the excess demand for pure-pay open source companies in the capital markets.  Some have pointed out to me that there is so much capital available today that RHAT would not have been negatively impacted and JBoss the publicly traded company would have no assurance of a premium valuation just for being a pure play.  But if they are eating BEA's lunch like they claim they are, why not go public and build out your stack with the proceeds?  At Red Hat they get a reduced role in determining their future in exchange for another slice of the stack as well as stability and cash. 

To me, this indicates that JBoss did not have the confidence or faith in their ability to go horizontal and vertical.  I suppose this is the safe move for them, but I always associated JBoss with derring-do and a brash "us vs. the world" mentality.  Perhaps that was all marketing!