Downgrade, sell-off zap Red Hat shares

The Linux seller's shares drop 16 percent in the wake of an analyst downgrade and a stock sell-off, one day after it edged past analysts' earnings estimates.

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Stephen Shankland
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Red Hat shares dropped 16 percent today in the wake of an analyst downgrade and a stock sell-off, one day after the Linux seller edged past analysts' earnings estimates.

ABN Amro analyst Keith Bachman downgraded Red Hat from "buy" to "market outperform" today. "Revenue growth was 15 percent, and while it was essentially in line with our projections, we were hoping for more," Bachman said in a report today. In addition, he said, Red Hat revenues are shifting to services, which have a lower profit margin.

At the close of regular trading today, Red Hat's stock had slipped $4.06, or 16 percent, to $21.19.

However, other analysts had a rosier outlook on Red Hat's revenue. Merrill Lynch analyst William Crawford, who left his "accumulate" ranking unchanged, said "Red Hat's version 7.0, due later this month, should help...revenue" in the current quarter. And Chase Hambrecht & Quist's Christopher Galvin, who rates Red Hat a "buy," said, "The company asserted that they are in front of some key product releases, which should help bump up the growth rate in subsequent periods."

Meanwhile, Oracle sold off 800,000 Red Hat shares for $19.4 million, and Novell sold off 50,000 for $1.35 million, according to regulatory filings yesterday and today.

Red Hat yesterday reported an adjusted loss of 1 cent per share, beating analyst estimates by a penny and stepping closer to profitability than the adjusted 6-cents-per-share loss from a year ago. The leading Linux seller reported an adjusted net loss of $1.9 million on revenues of $18.5 million for its fiscal second quarter ended Aug. 31.

Not including the adjustments financial analysts factor in, Red Hat reported a net loss of $15.7 million, or 10 cents per share, compared with $4.8 million, or 7 cents per share, a year ago.

Embedded push
Red Hat announced several new customers in its push to spread its operating system into embedded devices--non-PC computing products that include everything from Palm handheld computers to car antilock-braking systems.

Companies that hired CNET's Linux CenterRed Hat in the past quarter to help push Linux into embedded devices include Samsung, Eastman Kodak, Hitachi, Ericsson, Cirrus Logic, Cradle Technologies and Intel, Red Hat chief operating officer Tim Buckley said during a conference call today. Such contracts typically have garnered Red Hat revenue from $100,000 to more than $1 million each, he said.

Red Hat's embedded Linux effort--which began with the company's acquisition of Cygnus Solutions in November and continued with its June acquisition of WireSpeed Communications--will get another boost in two weeks when Red Hat introduces its version of embedded Linux at the Embedded Systems Conference in San Jose, Calif., chief executive Matthew Szulik said in a conference call yesterday.

Red Hat is working on making money in the future by selling the open-source operating system, technical support, customization services and advertising on its Web site. The company, founded in 1994 and headquartered in Durham, N.C., was the first Linux company to go public when it launched its IPO in August 1999.

Demand for Red Hat software and services is increasing in three areas--large corporations, makers of embedded devices, and small and medium-sized businesses--Szulik said in the conference call.

In the embedded market, Red Hat will make money both through service contracts with device makers and, in the long term, by charging device users for services such as support and software updates, Buckley said in an interview. Ultimately, that could earn more money than the original contracts with manufacturers, he said.

Like most embedded Linux companies, but unlike traditional embedded software companies, Red Hat won't charge a per-unit royalty for its embedded software, vice president of global sales Don Langley said. Red Hat plans to detail its embedded software strategy in two weeks, Buckley added.

Early embedded Linux products will include networking hardware, with later plans for Internet-connected and wireless gadgets, Red Hat said.

Merrill Lynch's Crawford said embedded software is a solid business. "To me, one of the great things about Linux is the malleability of the operating system, the fact that you've got access to the source code," he said. "Red Hat, with its broad support (offerings), is a natural alternative for a company doing that." Crawford called Red Hat's list of embedded customers "impressive."

However, embedded software isn't as big a market as Red Hat's core business, which is selling products and services to businesses, Crawford said. "There are only so many customers that are going to create products in the embedded space, compared to the thousands of companies in the enterprise space," he said.

Red Hat added several new commercial support customers in the quarter, Buckley said, including Motorola, Fidelity Investments, the National Institutes of Health, TeraBeam Networks, Cisco Systems and WorldCom.

The company has been selling training services to Qwest Communications International, Oracle, Cisco, Intel, IBM and Symantec, Buckley said. Red Hat also has offered engineering support to Advanced Micro Devices, EMC and Conexant Systems.

Linux, though no longer an IPO darling, is still considered a strong contender in competition against Microsoft's Windows and various versions of Unix, such as Sun Microsystems' Solaris. Linux is created not by a single company but by an army of programmers worldwide who share code as part of the open-source community.

Hunting for a CFO
Red Hat is in the midst of several changes. In addition to its recent acquisitions of C2Net and WireSpeed, the company is searching for a new chief financial officer to replace Hal Covert. Covert left Red Hat in July to take over as SGI's chief financial officer.

"We will not let our haste to find a CFO interfere with our judgment to find and hire an exceptional leader," Szulik said.

Hiring a new CFO is Szulik's "No. 1 priority," Buckley said. The company has conducted interviews but is still "scouring the market," he said.

WR Hambrecht analyst Prakesh Patel said in a research note that hiring a CFO is crucial for the company. "We feel that it is very important to have someone accountable for the company's plan of revenue growth and movement toward profitability in the face of rapid projected revenue growth and numerous acquisitions," Patel said.

Though Red Hat was the first Linux company to hold an initial public offering, computer maker VA Linux Systems has more revenues. Last month, VA reported revenues of $50.7 million and a net loss of $4.1 million.

Neither company expects profitability until 2001.

Crawford said he was pleased with Red Hat's gross margin, a measure of profitability. "They had in-line revenue, and I found upside on the gross margin relative to what I was expecting," he said.

The company has a gross margin goal of 56.2 percent for its fiscal year, which ends February 2001. Crawford projects a gross margin of 56 percent.