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Tech Industry

Linux stocks burn out, fade away

The stocks looked bright two years ago, but as the general tech market tumbled, Linux companies followed.

Linux's future on Wall Street looked bright two years ago, but so did just about everything else related to the technology industry. But as the general tech market tumbled, Linux companies fell down the hill with it.

Specialists such as Red Hat, VA Linux and Caldera International sank much faster than the Nasdaq, but they had reached much higher peaks in a short period of time, so they had more room to fall.

Now Red Hat--which began its Nasdaq run so strongly that it enacted a 2-for-1 stock split only five months after going public--trades 97 percent below its all-time closing high and hasn't traded at a double-digit stock price since November.

VA Linux, the greatest opening hit in stock market history, is now worth barely 1 percent of its peak market capitalization, and the company posted a fourth-quarter loss of $267 million on revenue of $16 million Thursday. Caldera, a latecomer to the Nasdaq party, never regained the heights it reached on its first day and has been trading below a dollar for the past month.

At least Caldera made it to the market. Linuxcare withdrew its initial public offering in May of last year, not long after the Nasdaq began a plummet from which it has yet to recover. LinuxOne disappeared without generating much in the way of product, revenue or anything besides press releases. And the last Linux-related company in the IPO pipeline, LynuxWorks, pulled its offering two months ago.

A pair of Linux companies found a buyer before the market dissolved. Cobalt Networks and its Linux-powered server appliances now reside within Sun Microsystems. Andover.Net sold out to VA Linux; in fact, the group of Linux information sites that came with Andover.Net could end up being an important part of VA Linux's latest strategy.

The race to survive
VA Linux's experience is a microcosm of Linux's business run in the past few years.

The company began as a maker of Linux servers but couldn't profitably grow in a field dominated by larger rivals such as Dell Computer. A couple of months ago, VA Linux announced plans to quit the hardware business and to focus on service and support.

Red Hat falloff
Stock price from August 1999 to present.  
Source: Prophet Finance
The company's shift came long after other competitors had staked their claim. Market studies generally have established Red Hat as the clear leader among Linux companies, largely because it was among the first to recognize that the real money in Linux comes with ancillary offerings. Red Hat didn't rely on commodity industries--unlike Caldera, which focused on the kernel itself, and VA Linux and Cobalt, which sold machines.

Although Red Hat tried other businesses, such as a Linux news network, the company was quick to back off from unprofitable ventures.

"These guys were not nailed to a particular business model...that was difficult to extricate themselves from," said Brent Williams, a McDonald Investments analyst who earlier this month began coverage of the operating system industry.

Red Hat's revenue engine isn't its OS distribution; after all, the Linux kernel can be had for free. The real money is in the company's Red Hat Network, used to provide patches, updates and other technical support to subscribers.

Other companies, such as Linuxcare, also revolved around support. But having a relatively easy-to-install kernel early on helped Red Hat build a brand name. And Red Hat honed its services in non-PC "embedded" devices, a smaller market, before aggressively pushing them to larger companies.

"If you're born in Indianapolis, get really good at selling in Indianapolis before selling nationwide," Williams said. "And that's what Red Hat did with embedded systems."

The big and small of it
Some analysts believe the biggest winners in Linux will be established corporate names, like IBM and Hewlett-Packard, both of which have announced Linux support. But the Big Blues of the world tend to concentrate on Fortune 500 companies; midmarket and smaller companies are largely left to Red Hat and its peers. And IBM itself has announced partnerships with Red Hat.

With its stock below $4, Red Hat hardly looks inspiring to investors. Red Hat and VA Linux also have been targeted for class-action lawsuits. Yet Red Hat remains the most highly valued member of its peer group, with a market capitalization worth more than four times as much as VA Linux and Caldera combined.

Red Hat in its latest quarter turned a profit for the first time, if amortization and one-time charges are excluded. Analysts don't expect much revenue growth from Red Hat--or almost any seller of business software--in the next couple of quarters because of the economic slowdown that has decimated technology spending. According to earnings-tracking firm First Call, three of five brokerages that follow Red Hat rate the stock the equivalent of a "hold."

But the company's future remains promising, analysts said.

"Near-term flat prospects for Red Hat appear to be diverging from the increasingly positive long-term potential of open source/Linux and Red Hat's leading position," Merrill Lynch analyst Peter von Schilling wrote recently. "Evidence continues to build supporting the fact that enterprises are adopting open-source/Linux solutions and that open-source/Linux will be a significant platform--but patience will be required."

The stock market's decline has weeded out or discouraged weak performers, analysts said. The disappearance of the technology-investing bubble lets rational investors find the strongest players, Williams added.

"We believe the 1999 Linux feeding frenzy is over," he said. "A valid investment case for quality Linux names can now emerge."

Where those quality names will come from is anyone's guess. One thing is certain: The time for succeeding based largely on a well-known name, as Red Hat did at first, has passed.

"The initial Linux wave was pure branding," Williams said. "Now you have to go back and...add features to your offering."