Linux may someday rule, but
can it make money?
By Tom Davey
Redherring.com
January 5, 2000
Mounting interest by institutional investors in Linux is
proving the operating system is more than a fad. But a
nagging question remains: how do Linux companies
make money when the core product is free?
Larry Augustin, CEO of VA
Linux Systems (Nasdaq: LNUX),
last month watched his company's
initial public offering rocket nearly
700 percent on Nasdaq, setting a
new record for a first-day gain.
Other companies associated with
the Linux craze, such as Red Hat
(Nasdaq: RHAT) and Cobalt
Networks (Nasdaq: COBT), enjoyed similar
humongous run-ups in the second half of 1999.
Those three Linux companies lost a total of $33.7
million in their recent quarter and aren't expected to
show a profit until at least 2002. Yet their combined
market capitalization is nearly $25 billion. And that's
after nervous investors began selling stocks Monday
due to interest-rate concerns. In the world of
pre-Linux and pre-Internet stock values, the trio needs
combined net profits of at least $1 billion to justify their
hefty valuation.
NO FLUKE
Linux certainly is more than a
fluke. Nearly a third of all Internet
servers are powered by the open
source software. The rapidly
evolving and freely distributed
operating system, developed
largely by a loose confederacy of
freelance programmers, is
expected to continue taking a
bigger bite out of the market. But
it'll take many years, if ever, for
Linux to displace Sun Microsystems (Nasdaq:
SUNW) for use with corporate databases, or to
displace Microsoft (Nasdaq: MSFT) for running
desktop applications.
For VA Linux, opportunities lie in building hardware,
rack-mounted servers which are used increasingly by
companies who provide outsourcing of Internet
services and software. In some respects, the
company's business model is promising.
But VA builds its servers around chips and standard
engineering designs from Intel (Nasdaq: INTC) that
are used by most large server vendors, such as IBM
(NYSE: IBM), Dell (Nasdaq: DELL), Compaq
(NYSE: CPQ), and Hewlett-Packard (NYSE: HWP).
Such competition constrains profit margins and makes
product differentiation a challenge.
Mr. Augustin's big challenge is not only selling the
company's products and stock, but convincing people
that VA Linux isn't just a hardware vendor. "Because
we sell systems, many people view us as a hardware
company," he says. "That's a misnomer. We offer
expertise in getting customers to open code."
The fledgling company, which has a market
capitalization of $7.3 billion, is showing fast revenue
growth, at least on a percentage basis. Revenues from
the quarter ending October 29 jumped to $14.8
million, up 517 percent from $2.4 million a year ago.
The latest quarterly loss of $15 million even exceeded
revenue. But for a company flush with cash after an
IPO, that's a minor annoyance.
NERDY BY NATURE
Mr. Augustin is a far cry from a typical hired-gun CEO
brought in to hype a company prior to an IPO. Mr.
Augustin, who holds a PhD in electrical engineering
from Stanford University, began building his own
machines from scratch before founding the company in
1995.
"I believe I have a tremendous responsibility to the
people who bought our stock," he says. "It's as though
they've personally loaned me money." Of course a
CEO has no direct control over his company's stock
price, which in this case shot like a missile to $320 a
share on its first trading day and hasn't been north of
$250 since December 10, its second trading day. VA
Linux closed Monday at $180.
Mr. Augustin says he won't bend over backward to
please Wall Street. Regarding quarter-to-quarter
analyst expectations, he says, "Some of it is good
because the deadlines give you focus, but we'll never
trade off long-term for short-term performance."
SOCIALISTIC CAPITALISM?
When he says "long-term," he's talking about turning
the business model of the entire software industry on
its head. He envisions legions of independent software
developers cranking out open source code that's free
to all. "For every dollar that goes into Microsoft,
maybe ten cents goes to software development," he
says.
Aside from selling hardware, Mr. Augustin believes he
can build a sustainable business by aiding application
development, providing drivers, and fixing bugs. VA
launched a Web site, called Sourceforge, which
encourages people on the Internet to freely write Linux
code and other open source-development projects.
For example, VA currently is building a "highly secure
version" of Linux for corporate customers. People who
help write code don't receive royalties, but get first
crack at using it for their own businesses. For
orchestrating the project, VA receives payment from
initial customers, after which the code becomes freely
available. Future revenues from such projects help
fund software support, such as writing drivers.
WEB FARMING
Linux also is a growing force in Web server "farms"
that house hundreds or thousands of computers. That's
because the core operating system is free while Sun's
Solaris is expensive. Although Microsoft's NT is
cheaper than Solaris, it's proven to be more prone to
crashing.
VA sees a revenue stream in building management
software tools that let people control machines from
remote locations. "Our real value is providing these
services around a system," says Mr. Augustin. He says
his goal is making VA a one-stop shop for anything
Linux.
Even on the hardware side, Mr. Augustin thinks he can
stay ahead of big players. For instance, he notes that
memory chips, which Intel approves to run machines
that use its chips, can cause problems when running
Linux. He says VA is using other memory chips that
have been more rigorously tested for Linux
specialization.
LINUX ON IA-64
Other industry sources note that VA hired Intel
employees with expertise in IA-64, the 64-bit chip
technology developed by Intel and Hewlett-Packard
that's slated for release in products this summer. The
workers, hired to ensure that Linux runs on the new
chip architecture, will indirectly help Intel and other
hardware vendors who will use Intel 64-bit chips. But
because VA knows the nuts and bolts of how Linux is
ported to IA-64, it should have an edge on providing
ancillary services and support. (Intel owns 9 percent of
VA Linux.)
Linux supporters say making the operating system free
hastens overall software development, which in turn
creates wealth for developers and the businesses
involved. "Linux sucks the value out at the operating
system level," says Adam Goodman, publisher of
Linux Magazine. "It's about rearranging the value
chain."
Exactly how this will work, however, remains to be
seen.
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