Linux Firms Still Searching for Success
The scattered boxes and extension cords snaking through the spacious new VA Linux Systems offices show that the company is riding a wild growth curve.
Last week, VA Linux moved into buildings four times bigger than its old offices, giving the past year’s 400 new hires a place to stretch their legs. “We’ve been very pleased with the way it’s gone,” said Chief Executive Larry Augustin of sales that have tripled in the last three quarters.
VA Linux is on the upswing, selling thousands of specialized computers handling data storage, World Wide Web pages and other functions, all running the free operating system known as Linux.
Only a year ago many analysts expected there would be dozens of similar companies, all closing in on sizable profits by providing Linux products or services. Instead, VA Linux is one of only four Linux companies that had initial public stock offerings before the technology slump this spring, and all four are trading at fractions of their giddy highs.
Although VA Linux is nearing break-even, none of those four firms make any money yet. And for all Linux firms, public or private, tougher times may lie ahead as IBM, Compaq and other major computer makers embrace Linux and step up the level of competition.
The enthusiasm hasn’t helped Linux companies live up to the promise of their early stock prices. “People thought that Linux was going to overthrow Microsoft, and that was misplaced,” said analyst Prakesh Patel of WR Hambrecht & Co. in San Francisco.
Created in 1991 by Finnish student Linus Torvalds, Linux is an operating system like Microsoft’s Windows, a major piece of software that runs an entire computer. Smaller programs, such as e-mail, Web browsing and word processing, work within this operating system. But Linux is an “open source” system, one with the blueprints available to all, so that Linux is not under the control of a single corporate owner.
Although the basic Linux system can be downloaded for free, it isn’t easy to use. Investors believed that many companies would prosper by writing Linux software applications, helping customers integrate Linux with their other systems, and selling Linux pre-installed on computer equipment.
Linux has generated wide support among programmers, and that enthusiasm spread to Wall Street last year. VA Linux’s initial public offering in December set a record for first-day performance when the stock soared from $30 to as high as $320. On Friday, VA Linux closed at $46.25.
Yet corporate demand for Linux systems keeps rising. Last year Linux accounted for 24% of new operating systems shipped for computer servers (which run tasks such as e-mail or printing), second only to Windows NT’s 38%, according to International Data Corp. By the end of this year, IDC projects that paid Linux installations will top 3 million. And the proportion of Fortune 500 companies using Linux has surged from 14% to 22% in six months, according to Salomon Smith Barney.
For these customers, the attraction is that Linux is free, or nearly free, and can be adapted to various network systems and handle a wide range of heavy-duty functions without crashing.
All told, more than a hundred companies now sell various Linux products. And although the business of Linux is still in the chaotic early stages, industry experts say some lessons are emerging.
First, selling material that can be downloaded for free isn’t much of a long-term strategy.
Red Hat Inc. sells packages of Linux on compact discs, together with technical documentation and a promise of technical support, for as little as $30. The first out of the Linux IPO gate last year, Red Hat’s stock soared from its IPO price of $14 and rose as high as $151.31 before skidding.
That slide has accelerated since Sept. 15, when the Durham, N.C., company reported that its sales rose a less-than-spectacular 15% from the previous quarter. Red Hat is now trying to sell more technical help for corporate customers that have already installed the Linux system. But in the most recent quarter, Red Hat’s loss widened to $16 million on just $18.5 million in sales, and the stock closed Friday at $17.06.
“People don’t understand how Red Hat is going to make money,” Patel said.
One basic problem is that packaging Linux software for sale isn’t worth much. “There’s no barrier to entry,” said IDC analyst Dan Kusnetzky. “A college student could configure Linux software and buy a CD burner and sell it on campus. At best, you can charge enough for the production, packaging and advertising.”
Caldera Systems, another Linux distributor, based in Orem, Utah, has seen its stock plunge from $33 after its March IPO to $4.09 on Friday. Caldera sells Linux packages and also develops Linux-oriented training material.
Another rival is TurboLinux based in Brisbane, Calif., and sells most of its Linux sets in Asia. On the verge of filing for an IPO, the company is now shifting toward creating software applications for big businesses already using Linux.
But TurboLinux Chief Executive Paul Thomas concedes that with little difference among Linux rivals, mergers might leave only two major distributors standing by year’s end. “The operating system is a commodity,” he said. “All of us try to tie bells and whistles on it.”
Already, the pressure to do more than peddle Linux has driven Red Hat to acquire Cygnus Solutions, which makes development tools for Linux programs. And Caldera recently agreed to buy units of a company called Santa Cruz Operation that makes software and offer professional services.
Another Linux lesson is that consulting services are hard to manage.
San Francisco’s 2-year-old Linuxcare was created to help corporations install Linux, train their in-house technical staff and integrate Linux with their existing systems. Linuxcare’s early customers included Motorola and Sun Microsystems.
But Linuxcare’s 1999 revenue was less than $2 million, with losses topping $20 million. The firm canceled its IPO when the markets turned south. The company trimmed its staff by 25%, but things are starting to pick up, with its revenue doubling each of the last three quarters as it gets more calls from IBM and others needing expert help for their customers.
Profitability is in sight by the end of next year, said Linuxcare’s co-founder, Arthur Tyde III. But without a strong brand like Red Hat or even VA Linux, establishing itself as an advisor “is not the easiest road to tread,” Tyde said.
The brightest spot in the industry so far has been VA Linux, which bundles Linux software and support with hardware it sells to such customers as Akamai and EToys. Those companies prefer Linux systems because they are less expensive, more stable and adaptable than those running Microsoft, and work more easily with other programs.
VA Linux posted $51 million in sales last quarter and a loss from operations of $4 million, compared with sales of $35 million and an operating loss of $21 million in the previous quarter.
“Their business model is one where it seems to make a lot of sense,” said analyst Walter Winnitski of Chase H&Q.; “They’re selling to the [Linux] converted.”
Cobalt Networks, which also went public last year, had a similar approach, bundling Linux operating systems with servers for Web pages and the like. It paid off when Sun Microsystems agreed in September to buy the Mountain View, Calif., company for $2 billion in stock.
But all these strategies may run into problems as Dell, Compaq and other computer manufacturers get better at selling and supporting Linux machines. Those companies already offer Linux as an alternative to Windows on many of their computers. And for subsequent technical support, they have deals with some of the Linux start-ups. Compaq is now the leading U.S. seller of Linux servers, followed by VA Linux, Dell and IBM.
For the Linux start-ups, this growing acceptance is a double-edged sword. For Linux to move into the mainstream of corporate America, it needs the support of the large organizations such as IBM and Compaq.
But if a customer can buy the same hardware or services from an established computer maker, why take a risk on a Linux company in its infancy?
“It isn’t going to be very long before the person they call is IBM or EDS . . . not Linuxcare,” said Andrew Rappaport of Menlo Park, Calif.’s August Capital, which has invested in TurboLinux, Cobalt and Cygnus.
IBM has configured Linux for some of its mainframe computers and is devoting 100 software experts to work on the Linux operating system full time.
“Linux is one of the top areas identified for growth across the entire company,” said IBM Linux Program Director Dan Frye.
Big Blue’s initiatives are leading an industrywide lab to test and tweak programs to run on Linux.
The unqualified endorsement of Linux “will reinstate IBM as the infrastructure gorilla,” predicted Forrester Research analyst Carl Howe.
So in the end, the Linux companies that fare the best may be the ones with the very familiar names.
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The Linux Movement
The Linux operating system was developed by a community of volunteers, so it is not controlled by one company. Scores of Linux firms have begun offering various software, hardware and services, and Linux is now a serious competitor to Microsoft’s Windows NT. But stocks in all the major Linux companies have dropped this year, and none of them are yet profitable.
