THE DAY AHEAD: Cobalt Networks will be hot, but commodity clouds loom

Larry Dignan
3 min read

Cobalt Networks (Nasdaq: COBT) could be the best-performing IPO on tap Friday with most observers expecting a scorching debut. But concerns about future pricing pressure cloud the long-term view.

Cobalt, which priced its IPO at $22, is the other half of Goldman Sach's IPO double header. Goldman is the lead underwriter for Cobalt's 5 million share offering and the Webvan Group's (Nasdaq: WEBV) IPO (analysis).

While Webvan, priced at $15, is stealing most of the press, Cobalt should more than hold its own with its market debut. Cobalt upped its price range to $20 to $22 from $14 to $16. The company, which makes "server appliances," has two things going for it -- its products use the Linux operating system and its focused on a small, but growing market.

Cobalt: Future star?

Dataquest predicts the server appliance market to grow from $2.2 billion in 1999 to $15.8 billion in 2003 with Linux-based servers representing 24 percent of that sum, or $3.8 billion, in 2003.

Since Cobalt's servers use a version of Red Hat Linux, look for every fleet-footed day trader to hop all over this IPO looking for the next Red Hat (Nasdaq: RHAT). Of course, if folks read the prospectus they would realize Cobalt is a hardware company.

For now, Cobalt is nearly alone with its new category of servers aimed at the small- to mid-sized businesses and educational and government organizations.

The company's server appliances are specifically designed to handle one or a few network-based applications such as e-mail or e-commerce well. Since Cobalt doesn't try to do too much with one box and runs on Linux, the company's products may be more stable.

"Our server appliances enable small- to medium-sized organizations that could not previously establish a presence on the Internet to do so easily, cost-effectively and reliably," the company said.

So what's not to like?

If Cobalt's niche is so great -- and analysts say it is -- other hardware companies with vast resources will enter the server appliance market. More players mean more price competition. If that happens, Cobalt will look like another commodity box maker struggling with declining prices and profits.

And the commodity clouds are already forming.

The company reported revenue of $3.5 million for 1998 and $13.8 million for the nine months ended Oct. 1. Net losses were $10.5 million and $13.7 million for the same periods. Those results came mostly from sales of the company's Cobalt Qube and Cobalt RaQ products.

Cobalt is reporting losses and hasn't experienced a decline in average selling prices for its servers. But the prices will fall. "We anticipate that as products in the server appliance market become more commoditized, the average unit price of our products may decrease in the future," the company said.

Indeed, IBM Corp. (NYSE: IBM) is already moving into the market. Whistle Communications, a server appliance company the competes with Cobalt, was recently acquired by IBM.

According to Cobalt's regulatory filings, the company sees Compaq (NYSE: CPQ), Dell Computer (Nasdaq: DELL), Hewlett-Packard (NYSE: HWP), IBM, Sun Microsystems (Nasdaq: SUNW) as future competition.

"Server manufacturers may not only develop their own server appliance solutions, but they may also acquire or establish cooperative relationships with our other current competitors, including smaller private companies," said Cobalt. "It is possible that new competitors or alliances among competitors may emerge and rapidly acquire significant market share."

Cobalt, however, is trying to keep ahead of the big guys. It has sold more than 17,000 server appliances to about 1,300 customers through Oct 1. The company also inked a September deal to manufacture boxes under the Gateway Inc. (NYSE: GTW) brand. Under the pact, Cobalt will jointly design and manufacture server appliances for Gateway.

Cobalt's five-year agreement with Gateway provides some protection from larger foes, but Gateway can opt out and may not boost Cobalt's revenue.

Should investors be worried about Cobalt's future? Yes and no. Commodity pricing will be an issue and Cobalt could lose its luster, but the Linux-server focus gives it the opportunity to grab a nice chunk of the market. And if all else fails, Cobalt will be a nice acquisition for Sun, Dell, H-P or any number of the larger players.