VA Linux Crashes to Earth
Lessons from a once-soaring IPO
BY SCOTT HERHOLD
F YOU need a poster child for the volatility of the market this year, you might choose VA Linux Systems Inc. (LNUX), the Sunnyvale company that produces workstations and servers embedded with the open-source code first developed by Linus Torvalds.
VA Linux Systems' great success might have been its greatest curse. Four months ago, it was labeled the most successful IPO in history, soaring 700 percent above its offering price of $30. Its first-day close was $239.25.
The stock has slipped relentlessly since, finishing at $38 Wednesday after dipping below its IPO price Friday. A child prodigy has become an ordinary teenager. A Mozart suddenly is churning out Muzak.
What happened? Well, it's useful to begin by pointing out what didn't happen: There were no debilitating changes at VA Linux Systems. The company reported encouraging revenue numbers in its last quarter, $20 million, a huge increase over the $3 million in the quarter a year before. And it made the kind of acquisitions that analysts stand to applaud.
For that matter, VA Linux Systems, which also offers services and consulting, can boast of great lineage. Its CEO, Larry Augustin, was once a partner with Jerry Yang and David Filo in organizing a Web site list that became Yahoo (YHOO). And he's assembled a first-class team, including vice president of engineering Gregg Zehr, an Apple veteran, and chief technology officer Leonard Zubkoff, a former member of the inner circle at Oracle Corp.
None of those credentials could stop it from becoming the most prominent victim of the flavor-of-the month mentality that now rules the market. Like three other Linux companies that recently went public, Red Hat Inc. (RHAT) of Durham, N.C.; Caldera Systems Inc. (CALD) of Orem, Utah; and Andover.net (ANDN) of Acton, Mass., it has fallen faster than gravity would dictate.
``The reason they were valued so highly was, in part, speculation,' says Andy Rappaport, a general partner with August Capital, a venture firm in Menlo Park. ``I think the investment thesis was that if Microsoft is worth $500 billion, then Linux should be worth 10 percent of that.'
Now I'm tempted to pour scorn on investors who thought VA Linux Systems was a good buy at $240, or that Red Hat made sense at a split-adjusted $143. After all, last quarter, VA Linux lost $11.5 million. And lest anyone forget, the Linux companies face a wounded but still fearsome competitor in Microsoft.
But my scorn is tempered by the nagging feeling that something less appetizing is at work. In an era when an IPO has become an essential marketing event, a whole cadre of forces -- investment bankers, VCs, entrepreneurs and yes, the press -- is fanning that speculation. Those forces find an eager audience in a public that is turning away from mutual funds in droves to invest by themselves online.
Consider this whole drama from the standpoint of the established players. What looks like something supremely irrational -- how can VA Linux Systems be worth $10 billion in December and $1.6 billion in April? -- suddenly begins to assume a vulgar rationality.
Remember, the fund managers and institutional buyers who participated in the IPO got the stock at $30. And they were able to ``flip' it for a big profit on the first day. Because supply was kept low -- only 4.4 million shares were allowed to float initially -- the demand insured a steep opening price. The stock cost $299 per share the first time the public could buy it. And many did, simply on the belief that it would go higher.
For that matter, at least some of the institutional players and investment bankers were in a position to sell the stock short, which means they could make money as the shares declined in value. With more information about who was buying and who intended to flip, they could make better judgments than the average investor. The identity of short-sellers isn't public, but the latest reports show that 1.6 million shares of LNUX are being held in a short position.
Given the market's short attention span and sales from the flippers, it was almost inevitable that the money-losing Linux companies would come back to earth. The essential thesis that the Linux companies were worth a percentage of Microsoft was flawed. And even superb marketeers like Red Hat's chairman, Robert Young, faded into the noise.
``They (the Linux companies) may end up being a viable alternative to MS-DOS,' says author Michael Perkins, who co-wrote the ``Internet Bubble,' a book that forecast the deflation of many Internet stocks. ``But it was another one of those momentum vehicles that people jumped on.'
Naturally, the decline in stock price has an impact on employee morale. And it may make acquisitions, like VA Linux's announced plan to acquire Andover.net, a bit thornier. But fundamentally, most of the VA Linux people aren't hurting. CEO Augustin is worth $250 million on paper instead of $2 billion. OK, maybe he can't afford a pro basketball team. But he's hardly in a bread line.
For that matter, VA Linux has taken a smart approach toward keeping morale on an even keel. ``The things we focus on internally are really on helping our employees understand what the company's about, educating them and focusing on our execution as a company,' VA Linux's CFO, Todd Schull, told me. ``Those are the things we can control.'
Even the company's investors, which in this case include Sequoia Capital (9 million shares) and Intel Corp. (3.2 million shares), can't be called damaged. Remember, they bought their shares cheap (in Sequoia's case, for 46 cents apiece initially). By my math, Sequoia has still made nearly a 100-fold return on its initial investment.
As for the press, well, we've had a very good story to cover. Few things are better than a David and Goliath tale, particularly when much of Silicon Valley roots for David to slay Goliath. So David isn't quite as fearsome as advertised. So he left his slingshot at home. All the better. The story might have a sequel.
In fact, the only people who don't benefit from this cozy arrangement were the investors who bought VA Linux during its first four months on the market. And as I say, it's hard ordinarily to feel that sorry for people who swallow the hype. I just wish there wasn't such a cottage industry producing it.
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