Public Open Source Companies: Much Ado About Nothing?

The other day, in the post How Low Can Public Open Source Companies Go? I mentioned that Red Hat, Novell and Sun Microsystems now have such incredibly low market capitalizations that the independent existence of these open source leaders is threatened. The situation is substantially worse a few days later, with Red Hat's share price more than 20 percent lower than it was when I wrote the original post, starting to look like a penny stock. Some readers have suggested that Red Hat, in particular, is a nebulous entity that represents "nothing in the end." Really?

All the way back in March, we did a post on The New York Times' portrait of Red Hat as an up and coming open source company with an unusual business model and a brand new CEO: Jim Whitehurst. In that Times article, the author noted that Red Hat employees viewed the rosy quarterly earnings and financial performance of the company as "a present" for the incoming Whitehurst.

Since then, Red Hat's stock has been broken and scarred far worse than the overall stock market. In my post the other day, I suggested that it, Novell, and Sun Microsystems could be easy acquisition targets at the prices they sell at, even if a competitor just wants to buy them to shut them down.

Here are a couple of the responses this drew from OStatic readers, which were well argued, but which I politely disagree with:

"Didn't Oracle do an analysis in 2006 that concluded that any price was too much for Red Hat, because they could just take any technology for free?"

"All Red Hat is, is a legal entity - a corporate shell. This shell houses a set of projects and a set of people behind said projects. All of the projects do not actually belong to this shell - they are Free Software projects. All of the people employed by this shell are actually just people behind those projects. Therefore, what another legal entity/corporate acquires is just an empty shell. No matter how much (or how little) they pay, they're still paying too much because they are getting nothing in the end."

Let's dig into what Red Hat is, aside from its Linux product leadership. Red Hat derives most of its revenues from support and services surrounding Linux software that is, yes, free and open. Nevertheless, people, expertise, trust from customers, branding, goodwill, and many other non-financial valuable assets are under Red Hat's wing.

Coca-Cola carries more than $4 billion under the Assets portion of its balance sheet for goodwill alone--representing the fact that remote tribesmen in Brazil will give you a thumbs-up if you hold up a red Coke can. Brands matter. Quality support is viewed as an Achilles' heel for open source in general, and Red Hat has done an ingenious job of putting skilled people behind their Linux support efforts.

Red Hat's top 25 customers tend to retain their subscriptions. Matt Asay noted this after the company's second quarter earnings call: "Each of Red Hat's top-25 accounts due to renew in its second quarter did so, and at roughly 120 percent of subscription value." He has a number of other surprisingly strong aspects of the company's business noted in this post. Among the points, "subscription revenue was 83 percent of Red Hat's revenue for the quarter, and came in at a 93 percent margin (consistent with past quarters)."

So let's talk about the money. Red Hat has been consistently growing its revenues at 20 and 30 percent versus previous-year revenues. Profits have grown in the same range. This is a company that has a fiscal year-end estimate for revenues pegged at $675 million. And let's definitely not forget this: It sits on more than a billion dollars in cash, with a market capitalization currently barely above that at $1.5 billion. 

Two things I didn't check on in my previous post, which I should have, were the cash positions of Novell and Sun. As Matt notes here, Sun and Novell--two other open source leaders on the public market--have cash positions above their current market caps. (Sun has $2.63 billion in cash and a $2.18 billion market cap, while Novell has $1.36 billion in cash and a $1.29 billion market cap.) That's a rarity in public markets, and has been ever since Warren Buffett's hero and teacher Ben Graham wrote the value investing bible  The Intelligent Investor.

No, these companies do not amount to nothing. They are valuable, and I remain concerned that large suitors may threaten their independence.