ANALYST WATCH: VA Linux finally shows signs of life

VA Linux won back some fans on Wall Street this week with its impressive fourth-quarter earnings report. While it appears to have some momentum and has carved out a nice little niche for itself, investors shouldn't expect a miraculous recovery anytime soon.

That's not to say VA Linux can't be a fine investment, short- or long-term. Those who believe in the Linux operating system will undoubtedly take a second look at VA Linux considering it's trading at an 85 percent discount from its all-time high of $320 a share.

This week, it surprised analysts when it posted a loss of $4 million, or 10 cents a share, on sales of $50.7 million.

First Call Corp. consensus expected VA Linux (Nasdaq: LNUX) to lose 15 cents a share in the quarter.

More impressive, the company managed to expand its revenue base, if only slightly, beyond its core system sales base. Sure, 92 percent of its sales came from the system software but it also posted some respectable Web initiatives and service sales.

Naturally, those service sales will improve as more and more companies adopt the Linux platform.

In fact, CFO Todd Schull told analysts to expect system sales of about 75 percent in fiscal 2001 with service and Web-related sales accounting for 15 percent and 10 percent, respectively.

In the bigger picture, Schull said sales will jump 2.5 to 2.7 times 2000 sales of $120.3 million. Long-term gross margins should be in the 27 percent range with profits by the end of calendar 2001.

That's all well and good, but the verdict is still out on Linux as a viable economic platform. There's a big difference between being popular in the developer community and popular at the cash register.

Wall Street's lore is chalked full of stories about companies that had great technology but weren't able to cash in on it.

Putting aside the whole Microsoft gauntlet, you can bet that companies such as Dell (Nasdaq: DELL), Hewlett-Packard (NYSE: HWP) and IBM (NYSE: IBM) will all be vigorously attacking this relatively new market. In fact, they already are.

Schull and the rest of the folks at VA Linux are convinced they can fend off the big boys. But the big boys have deep pockets, enormous sales and marketing teams and, most important, lots of key partnership and distribution agreements with those all-important resellers.

On the bright side, there's every reason to believe one of those huge firms might be more than a little interested in buying VA Linux and running it as a separate business unit. Why go mucking up something you don't really understand?

Even if VA Linux were to become a takeover target, it certainly wouldn't garner a $300 or even $200 a share premium. At least not yet.

But after watching the stock fall to a low of 26 1/2 earlier this month, analysts couldn't help but heap praise on VA Linux following the earnings report.

WR Hambrecht analyst Prakesh Patel upgraded VA Linux to a "strong buy" and predicted the company would reach profitability by the end of calendar 2001.

"We believe that the current valuation of VA Linux systems does not reflect the company's solid progress and renewed positive outlook," Patel wrote in the report, which placed a 52-week price target of $60 on the stock.

CS First Boston analyst Amit Chopra reiterated his "buy" rating on the company and set a 12-month price target of $65 a share. He also raised his 2001 revenue forecast from $271 million to $323 million, changing the EPS estimate from a loss of 44 cents a share to a loss of 26 cents a share.

Investors who believe in the Linux craze might want to hedge their bets a bit just in case VA Linux continues to execute as well as it did in the fourth quarter.