Is Linux Enough for Novell and Red Hat to Thrive?

While Novell's report yesterday that its quarterly Linux revenue soared 22 percent year-over-year was a positive note, and one that was expected, the real upshot of the company's earnings report was that every other part of its business sank. Overall, its revenues slipped to $216 million for the quarter, compared to $245 million for the comparable quarter last year. Despite the company's drum pounding about the promise and growth of its Linux business, Novell is a public company that needs revenues to come from more than one aspect of its business.

As Matt Asay notes, Red Hat's financial performance has been much rosier during the recession, but there are also questions arising about why Red Hat's revenue growth is slowing. Both companies need more than just Linux business to grow over the long run, and there are good reasons to believe that Red Hat may be the one of the two that pulls a rabbit--or a series of them--out of its red hat.

Novell's report yesterday was preceded by a drop in its stock price, and as I write this, the stock is down another seven percent. It didn't meet revenue expectations despite strength in its Linux business. Meanwhile, Matt Aslett has some interesting charts here showing how Red Hat's rate of revenue growth has been declining. Despite that worrisome note, he points out that Red Hat's two major acquisitions in recent years (JBoss and Qumranet) both provide opportunities for the company to drive organic growth. Acquisitions are important for long-term growth, and Red Hat has made good ones.

Red Hat's middleware business, led by JBoss, is actually growing faster than its Linux business. Novell can't point to anything growing faster than its Linux business. To really understand Red Hat's consistency, though, it's wise to look at how the company focuses on investing. In this post, based on some good analysis from Savio Rodrigues, we discussed how over the past two years, Red Hat has derived a whopping 48 percent of its income before taxes from what it classifies as "Other Income." A close analysis of what "Other Income" means reveals that Red Hat steadily earns interest income from, and gets capital gains on investments made with its nearly $800 million in cash. Think about that percentage of its steadily growing earnings for a minute: 48 percent--almost half.

Novell has $1 billion in cash, but its pattern of investment of that cash is more in line with how other software companies operate, and it's atypical for software companies to derive more than 10 percent of their earnings from "Other Income." In short, Red Hat can be characterized as a financial institution that is also a successful software and services company. With JBoss and Qumranet, it can also grow its business in ways that Novell currently can't.

Novell's challenge going forward is going to be finding some successful path to follow outside of its Linux business. If that path is going to be found through acquisitions, then the company needs to find some good ones soon.

Novell and Red Hat will be the only two remaining public companies focused primarily on open source now that Oracle has the green light to acquire Sun Microsystems. I'm rooting for both of them, but it seems clear that Red Hat has pursued shrewder types of diversification than Novell has, and any good investor will tell you that diversification is a proven way to mitigate risk.