THE DAY AHEAD: Red Hat faces turbulent IPO aftermarket

Despite a choppy IPO market, Red Hat Inc. should make an impressive debut. But considering few will get in on the original IPO price, investors need to focus on the aftermarket prospects.

Enter the questions. Can Red Hat, which sells services for the upstart Linux operating system, balance open source software advocacy with shareholder interest? Can a company without proprietary products win? Can the company transform to a Web community player as increased bandwidth hurts its software revenue?

Red Hat: Potential powerhouse?

Yes Red Hat (RHAT) is one of the premier companies behind the Linux movement, which revolves around a free, open source, highly scalable operating system created by programming guru Linus Torvalds, who outlined the latest Linux version last night.

And Red Hat has the cute logo, strategic partners, big-time underwriter with Goldman Sachs and a stage known as LinuxWorld (full coverage) to make a splash.

Even the financials aren't bad considering Red Hat sells free software. Red Hat generated $10.8 million in revenue for the fiscal year ended February 28 and sales of $2.8 million in the first quarter.

But the company, which is offering 6 million shares priced at $14, is clearly in transition. Information technology professionals and analysts believe there's a business model for Linux, but Red Hat is still tweaking it.

To see where Red Hat is heading, look no farther than its name change two months ago. In June the company changed its name from Red Hat Software Inc. to Red Hat Inc.

It's a subtle, but telling difference. The name change indicates how Red Hat isn't likely to derive the majority of its future revenue from Red Hat Linux, its version of Linux complete with technical support. Instead, Red Hat plans to grow by tacking on services to Linux and turning its Web site into a community for the open source movement (Think EarthWeb (EWBX). Unfortunately, the growth path is also untested.

Here are a few issues that are likely to affect aftermarket performance:

Shareholder interest vs. open source religion: Investors may not know what they are getting into when it comes to Linux companies. Where does Red Hat the advocate and Red Hat the business begin? Look for the two to clash.

As reported by PCWeek, Red Hat's site ditched some of its community features for an online store. Red Hat's installation wizards for Linux will be proprietary. Good for shareholders, but bad for the open source community.

It's no wonder that some in the Linux crowd are accusing Red Hat of being a bit Microsoft-ish. "Some members of the open source software community have criticized the expansion of our strategic focus," said the company in filings. "These critics argue that our strategy could fragment the Linux community."

Red Hat doesn't own anything: Consider this: Red Hat Linux, in compressed form, consists of approximately 573 megabytes of code. Of that total, approximately 500 megabytes have been developed by independent third parties.

In filings the company admitted that it might not be able to deliver major upgrades of Red Hat Linux, its primary revenue source, because it doesn't own any code. Torvalds and a small group of engineers control development.

If Red Hat is hindered by the third parties, it will have to develop its own versions, which will increase expenses.

Bandwidth is bad: Ever wonder how Red Hat can sell free software? It takes about 36 hours to download Linux over standard phone lines. Shrink-wrap looks pretty good in that environment. More bandwidth could be bad news.

"If increased bandwidth allows users to more quickly download our products from the internet, users may no longer choose to purchase Official Red Hat Linux," the company said. "This could lead to a significant loss of product revenue."

Red Hat ... the community: Because Red Hat sees its version of Linux as a potentially dwindling revenue stream, the company now sees itself as a community play. Given the track record of communities as a stand-alone businesses, this fact could be a little disconcerting.

Red Hat said its Web site had 265,000 unique visitors and approximately 2.5 million page views in March. Red Hat wants to gain e-commerce and advertising partners, but there's a catch. In 1998, the company reported no Internet advertising revenue. In the first quarter ad revenue was $80,000.

And those issues are just a sample. The company is likely to see competition from Microsoft, Novell, IBM, Sun Microsystems, The Santa Cruz Operation, AT&T, Compaq, Hewlett-Packard, Olivetti and Unisys. Linux distributors such as Caldera and Corel are also eyeing Red Hat.

Take all those issues and dare question whether Linux will take off in the corporate world and you have some interesting developments in the aftermarket.