Linux Reality Doesn't Match Hype

Almost every week, it seems, another government is jumping on the Linux bandwagon, badmouthing Microsoft (MSFT:Nasdaq - commentary - research) all the way. But for all the headlines, the open-source software movement remains very much a fringe business, raising troubling questions for investors who've plowed into publicly traded Linux providers in the past year.

And plowed they have: As of Tuesday's close, Red Hat (RHAT:Nasdaq - commentary - research) shares were up 110% in the past 12 months, while shares of Novell (NOVL:Nasdaq - commentary - research), which recently acquired Germany-based SUSE Linux, had soared nearly 150%. Those returns compare quite favorably with the 33.4% gain by the Nasdaq Composite and 26% rise by the Goldman Sachs Software Index in the past year.

Yet, "in spite of all the talk [about Linux] , there's still not a lot happening," said Robin Simpson, a Gartner research director in the Asia Pacific region.

Investors today risk making the same mistakes as those who wholeheartedly embraced the IPOs of Red Hat and VA Linux (now named VA Software (LNUX:Nasdaq - commentary - research)) in 1999. Shares of both soared initially, setting all-time intraday highs of more than $150 and $300, respectively, before suffering precipitous declines in the 2000-2003 bear market.

Brazil's recent support for open-source software and Sun Microsystems' (SUNW:Nasdaq - commentary - research) recent agreement with a government-sponsored consortium in China suggest Linux has evolved from its early concept phase. But the reality is that Linux is still being used only under very limited circumstances, while the revenue growth of publicly traded Linux providers has not nearly matched their stock price appreciation.

Of course, low Linux sales should not be a huge surprise given the unique open-source model, which distributes software free over the Internet and draws on volunteers around the world who offer free technical advice online.

A "weirdo competitor" is how Microsoft CEO Steve Ballmer described Linux in a recent Business Week interview. "There's no company behind it. You don't know exactly who builds it. It's free," Ballmer said. "I prefer to say: 'Look, what we have here is a small price disadvantage.' "

That statement might represent a rare case of understatement from the normally bombastic Ballmer. The reality is Microsoft is hardly disadvantaged in its competition vs. Linux.

"The reality of business is that it is a Microsoft world, and if you want to do business in that world the simplest and 'safest' path currently is to use Microsoft software," Simpson said.

Owing to Microsoft's dominant position on the desktop, Linux vendors such as Red Hat have cast their sights on the more lucrative server operating system market, where Linux boasts a nearly 25% market share. Yet Linux's double-digit growth there to date has primarily come at the expense of Unix systems, not Microsoft.

Indeed, in contrast to the ubiquitous Microsoft vs. Linux chatter, "typically, we are not seeing competitive situations where Linux and Windows are considered for the same task," said Dan Kusnetzky, vice president of systems software research for market research firm IDC. "I think right now Linux is a threat to the Unix suppliers, not directly to Microsoft."

Linux proponents, including Red Hat, point to the huge growth in Linux server shipments, which doubled from 2001 to 2002 to 424,898, according to Gartner Dataquest. Linux shipments are expected to cross the million units mark in 2005, Gartner Dataquest predicts.

But dig deeper and you'll see Linux numbers are still minuscule compared with Microsoft, not to mention the market caps of Red Hat and Novell. IDC estimated the combined market for Linux on the client and the server levels at a tiny $170 million by 2007. Yes, that's million with an "m." By comparison, Microsoft reported revenue from its client and server and tools business totaled a whopping $4.7 billion in just its latest quarter, which ended in September.

One reason IDC's Linux number is so low, of course, is that it includes only licenses sold by companies such as Red Hat and SUSE Linux as part of a package that includes technical support and service guarantees. IDC does not count Linux running on servers that companies downloaded at no cost over the Internet.

Last month, Credit Suisse First Boston analyst Michele Laverty estimated only one out of every 10 Linux servers ships with a paid subscription of Linux software. That means nine out of 10 servers currently shipped are operating with a free Linux operating system.

In her note initiating coverage of Red Hat with a neutral rating, Laverty said she believes companies will increasingly start paying for Linux, so that a quarter of all Linux servers in 2006 are shipped with a paid version of Linux software. But even then, that brings her estimate for the Linux software market to a still tiny $335 million in 2006. (Her firm has done banking business with Red Hat but not Microsoft, and has a neutral rating on Microsoft.)

How, then, to justify Red Hat's current market cap of $2.26 billion -- almost seven times Laverty's estimate for entire market in 2006 -- and price-to-earnings ratio of 163 times expected fiscal year 2004 earnings? Or why Novell deserves a market cap of $3.6 billion despite posting losses in nine of the past 12 quarters on a generally accepted accounting principles basis?

Red Hat CFO Kevin Thompson defends the valuation, noting that Red Hat has generated 5 cents to 6 cents per share of cash flow in recent quarters. The company posted its first operating profit last quarter on revenue of $28.8 million. Plus, Red Hat has moved to a subscription sales model with revenue recognized over the life of a one-year contract, offering more visibility than other software companies who recognize new sales upfront, Thompson said.

But Transamerica Funds portfolio manager Chris Bonavico isn't buying the hype and has stayed clear of Linux altogether. Linux "is in its honeymoon stage of everyone chipping in and saying, 'Isn't this neat. We're working on this cool thing,'" he says. But "in the very long run it is not much of a threat because there will come a day when Linux will break down."

Bonavico believes Linux could succumb to security bugs that have plagued Microsoft and eventually will splinter into different varieties like Unix. That may be inevitable as companies and individuals throw aside their altruistic ways and seek to make money off of their work.

For investors who still want to get into the Linux game, one buy-side source notes Novell is a cheaper play on Linux than Red Hat, trading at 42 times forward earnings. The source, who requested anonymity, bought shares of Novell after it announced its SUSE Linux acquisition. Shares of Novell have climbed 31% since that announcement.

"If you believe in Linux and Red Hat, you have to believe in Novell," the portfolio manager said. While execution is a risk to Novell's success with Linux, he said, IBM's decision to invest $50 million in the company is a good insurance policy.

Whether that "insurance" is sufficient to compensate investors for the risks in richly valued Linux-related stocks remains to be seen.

Rockin' on without Microsoft

Last modified:August 20, 2003, 4:00 AM PDT
By David Becker
Staff Writer, CNET News.com

Sterling Ball, a jovial, plain-talking businessman, is CEO of Ernie Ball, the world's leading maker of premium guitar strings endorsed by generations of artists ranging from the likes of Eric Clapton to the dudes from Metallica. But since jettisoning all of Microsoft products three years ago, Ernie Ball has also gained notoriety as a company that dumped most of its proprietary software--and still lived to tell the tale.

In 2000, the Business Software Alliance conducted a raid and subsequent audit at the San Luis Obispo, Calif.-based company that turned up a few dozen unlicensed copies of programs. Ball settled for $65,000, plus $35,000 in legal fees. But by then, the BSA, a trade group that helps enforce copyrights and licensing provisions for major business software makers, had put the company on the evening news and featured it in regional ads warning other businesses to monitor their software licenses.

Humiliated by the experience, Ball told his IT department he wanted Microsoft products out of his business within six months. "I said, 'I don't care if we have to buy 10,000 abacuses,'" recalled Ball, who recently addressed the LinuxWorld trade show. "We won't do business with someone who treats us poorly."

Ball's IT crew settled on a potpourri of open-source software--Red Hat's version of Linux, the OpenOffice office suite, Mozilla's Web browser--plus a few proprietary applications that couldn't be duplicated by open source. Ball, whose father, Ernie, founded the company, says the transition was a breeze, and since then he's been happy to extol the virtues of open-source software to anyone who asks. He spoke with CNET News.com about his experience.

Q: Can you start by giving us a brief rundown of how you became an open-source advocate?
A: I became an open-source guy because we're a privately owned company, a family business that's been around for 30 years, making products and being a good member of society. We've never been sued, never had any problems paying our bills. And one day I got a call that there were armed marshals at my door talking about software license compliance...I thought I was OK; I buy computers with licensed software. But my lawyer told me it could be pretty bad.

The BSA had a program back then called "Nail Your Boss," where they encouraged disgruntled employees to report on their company...and that's what happened to us. Anyways, they basically shut us down...We were out of compliance I figure by about 8 percent (out of 72 desktops).

How did that happen?
We pass our old computers down. The guys in engineering need a new PC, so they get one and we pass theirs on to somebody doing clerical work. Well, if you don't wipe the hard drive on that PC, that's a violation. Even if they can tell a piece of software isn't being used, it's still a violation if it's on that hard drive. What I really thought is that you ought to treat people the way you want to be treated. I couldn't treat a customer the way Microsoft dealt with me...I went from being a pro-Microsoft guy to instantly being an anti-Microsoft guy.

Did you want to settle?
Never, never. That's the difference between the way an employee and an owner thinks. They attacked my family's name and came into my community and made us look bad. There was never an instance of me wanting to give in. I would have loved to have fought it. But when (the BSA) went to Congress to get their powers, part of what they got is that I automatically have to pay their legal fees from day one. That's why nobody's ever challenged them--they can't afford it. My attorney said it was going to cost our side a quarter million dollars to fight them, and since you're paying their side, too, figure at least half a million. It's not worth it. You pay the fine and get on with your business. What most people do is get terrified and pay their license and continue to pay their licenses. And they do that no matter what the license program turns into.

What happened after the auditors showed up?
It was just negotiation between lawyers back and forth. And while that was going on, that's when I vowed I was never going to use another one of their products. But I've got to tell you, I couldn't have built my business without Microsoft, so I thank them. Now that I'm not so bitter, I'm glad I'm in the position I'm in. They made that possible, and I thank them.

So it was the publicity more than the audit itself that got you riled?
Nobody likes to be made an example of, but especially in the name of commerce. They were using me to sell software, and I just didn't think that was right. Call me first if you think we have a compliance issue. Let's do a voluntary audit and see what's there. They went right for the gut...I think it was because it was a new (geographical) area for them, and we're the No. 1 manufacturer in the county, so why not go after us?

So what did swearing off Microsoft entail?
We looked at all the alternatives. We looked at Apple, but that's owned in part by Microsoft. (Editor's note: Microsoft invested $150 million in Apple in 1997.) We just looked around. We looked at Sun's Sun Ray systems. We looked at a lot of things. And it just came back to Linux, and Red Hat in particular, was a good solution.

So what kind of Linux setup do you have?
You know what, I'm not the IT guy. I make the business decisions. All I know is we're running Red Hat with Open Office and Mozilla and Evolution and the basic stuff.

I know I saved $80,000 right away by going to open source.

We were creating the cocktail that people are guzzling down today, but we had to find it and put it together on our own. It's so funny--in three and half years, we went from being these idiots that were thinking emotionally rather than businesslike...to now we're smart and talking to tech guys. I know I saved $80,000 right away by going to open source, and each time something like (Windows) XP comes along, I save even more money because I don't have to buy new equipment to run the software. One of the great things is that we're able to run a poor man's thin client by using old computers we weren't using before because it couldn't handle Windows 2000. They work fine with the software we have now.

How has the transition gone?
It's the funniest thing--we're using it for e-mail client/server, spreadsheets and word processing. It's like working in Windows. One of the analysts said it costs $1,250 per person to change over to open source. It wasn't anywhere near that for us. I'm reluctant to give actual numbers. I can give any number I want to support my position, and so can the other guy. But I'll tell you, I'm not paying any per-seat license. I'm not buying any new computers. When we need something, we have white box systems we put together ourselves. It doesn't need to be much of a system for most of what we do.

But there's a real argument now about total cost of ownership, once you start adding up service, support, etc.
What support? I'm not making calls to Red Hat; I don't need to. I think that's propaganda...What about the cost of dealing with a virus? We don't have 'em. How about when we do have a problem, you don't have to send some guy to a corner of the building to find out what's going on--he never leaves his desk, because everything's server-based. There's no doubt that what I'm doing is cheaper to operate. The analyst guys can say whatever they want.

The other thing is that if you look at productivity. If you put a bunch of stuff on people's desktops they don't need to do their job, chances are they're going to use it. I don't have that problem. If all you need is word processing, that's all you're going to have on your desktop, a word processor. It's not going to have Paint or PowerPoint. I tell you what, our hits to eBay went down greatly when not everybody had a Web browser. For somebody whose job is filling out forms all day, invoicing and exporting, why do they need a Web browser? The idea that if you have 2,000 terminals they all have to have a Web browser, that's crazy. It just creates distractions.

Have you heard anything from Microsoft since you started speaking out about them?
I got an apology today from a wants-to-be-anonymous Microsoft employee who heard me talk. He asked me if anyone ever apologized, because what happened to me sounded pretty rough to him, and I told him no. He said, "Well, I am. But we're nice guys." I'm sure they are. When a machine gets too big, it doesn't know when it's stepping on ants. But every once in a while, you step on a red ant.

Ernie Ball is pretty much known as a musician's buddy. How does it feel to be a technology guru, as well?

The myth has been built so big that you can't survive without Microsoft.

I think it's great for me to be a technology influence. It shows how ridiculous it is that I can get press because I switched to OpenOffice. And the reason why is because the myth has been built so big that you can't survive without Microsoft, so that somebody who does get by without Microsoft is a story.

It's just software. You have to figure out what you need to do within your organization and then get the right stuff for that. And we're not a backwards organization. We're progressive; we've won communications and design awards...The fact that I'm not sending my e-mail through Outlook doesn't hinder us. It's just kind of funny. I'm speaking to a standing-room-only audience at a major technology show because I use a different piece of software--that's hysterical.

You've pretty much gotten by with off-the-shelf software. Was it tough to find everything you needed in the open-source world?
Yeah, there are some things that are tough to find, like payroll software. We found something, and it works well. But the developers need to start writing the real-world applications people need to run a business...engineering, art and design tools, that kind of stuff...They're all trying to build servers that already exist and do a whole bunch of stuff that's already out there...I think there's a lot of room to not just create an alternative to Microsoft but really take the next step and do something new.

Any thoughts on SCO's claims on Linux?
I don't know the merits of the lawsuit, but I run their Unix and I'm taking it off that system. I just don't like the way it's being handled. I feel like I'm being threatened again.

They never said anything to me, and if I was smart, I probably wouldn't mention it. But I don't like how they're doing it. What they're doing is casting a shadow over the whole Linux community. Look, when you've got Windows 98 not being supported, NT not being supported, OS/2 not being supported--if you're a decision maker in the IT field, you need to be able to look at Linux as something that's going to continue to be supported. It's a major consideration when you're making those decisions.

What if SCO wins?
There are too many what-ifs. What if they lose? What if IBM buys them? I really don't know, and I'll cross that bridge when I come to it. But I can't believe somebody really wants to claim ownership of Linux...it's not going to make me think twice.

You see, I'm not in this just to get free software. No. 1, I don't think there's any such thing as free software. I think there's a cost in implementing all of it. How much of a cost depends on whom you talk to. Microsoft and some analysts will tell you about all the support calls and service problems. That's hysterical. Have they worked in my office? I can find out how many calls my guys have made to Red Hat, but I'm pretty sure the answer is none or close to it...It just doesn't crash as much as Windows. And I don't have to buy new computers every time they come out with a new release and abandon the old one.

Has Microsoft tried to win you back?
Microsoft is a growing business with $49 billion in the bank. What do they care about me? If they cared about me, they wouldn't have approached me the way they did in the first place...And I'm glad they didn't try to get me back. I thank them for opening my eyes, because I'm definitely money ahead now and I'm definitely just as productive, and I don't have any problems communicating with my customers. So thank you, Microsoft.

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