Headwinds Could Blow Red Hat from High Perch

Erik Kobayashi-Solomon: Hi, I'm Eric Kobayashi-Solomon, co-editor of Morningstar's Option Investor. And today, it's my great pleasure to welcome Mike Holt, who's a senior analyst on the tech team here at Morningstar. Mike, thanks for coming.

Michael Holt: Thanks for having me.

Kobayashi-Solomon: So, a little bit ago, I wrote an article talking about taking a bearish stance on Red Hat, a company that you cover, using options. And I just want to get a little more color about Red Hat.

As I was starting to write this article, I got worried. I said, these are guys who are selling refrigerators to Eskimos. They're taking free software and selling it to people. Can you explain how this business model works? Why would anyone want to pay for software that's open source that they can get free?

Holt: Sure. I mean, it's a great question. How does a company make money when they give away their product for free? The answer lies in the fact that with enterprise software, the total cost in ownership is a lot more than just the licenses you purchase. It also accounts for the support you need over the life cycle.

Kobayashi-Solomon: So like the maintenance and how to make everything secure and everything.

Holt: Exactly. So, they are giving away the software for free, but they're charging for the subscriptions that entitle you to all that support.

Kobayashi-Solomon: I see. So, one way to think of it, it's kind of like the razor company selling you a razor really cheaply, but then the actual replacement blades are expensive, right?

Holt: Yeah, there's certainly an element of the razor, razor blade model. I think another key part of it, though, is that with Linux, they're not doing all of the R&D themselves. So, if you look at the last report from the Linux Federation, Red Hat only accounted for about 12 percent of the code enhancements to the latest Linux kernel that was released.

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Kobayashi-Solomon: I see, so basically Red Hat is borrowing R&D from everybody else in the world.

Holt: Absolutely.

Kobayashi-Solomon: I see.

Holt: Now, the downside to that, though is, they're allowed to do that because everybody has to share the code. But, they have to, again, share their code and all their changes with everybody else. So, they benefit from the R&D of everybody else, but they also have to share back into it. They don't have exclusive right to that IP, and they can't charge a premium for that.

Kobayashi-Solomon: Sure. And so, I think their margins are much lower than let's say a Microsoft or some company like that, right?

Holt: Absolutely, so right now, they're in the low to mid-teens, and it's really difficult for me to envision a catalyst to get them up to the 30 percent margins of an Oracle or SAP or a Microsoft.

Kobayashi-Solomon: So, if they're basically providing support, can we think of Red Hat as kind of being like a consulting company?

Holt: There are certainly elements of it, and it's definitely a service that they're providing to help you maintain that system environment that you have.

Kobayashi-Solomon: So, if they've got this, let's say client link, this consultative link, let's say, how strong is that? Potentially that could be a bullish source of uncertainty. If they have good relationships with their clients, that'll be hard for a competitor to attack, right?

Holt: Absolutely. I think the million dollar question here is how strong are those customer ties? On the surface, they look pretty strong. They have two thirds of the Linux revenue share in the market. So, that looks pretty impressive.

But then, when you look at it, it's just the operating system that most of their contracts are around right now. And to me that is just not the stickiest tie that we have.

Kobayashi-Solomon: Because it doesn't involve so much of the hardware? It's not tied as deeply into the hardware?

Holt: Well, I think it's just a base of an operating system...

Kobayashi-Solomon: So superficial, in other words.

Holt: Yeah. It's important, but it's not something somebody else couldn't do for you. And it always ties back to the open-source model. So, somebody else could literally take Red Hat's source code. They have to release the source code. Somebody else could take that, recompile it, and provide that to you as a subscription from them.

So, I think they're going to keep growing. There's value in what they do. You definitely need support for these things. They're going to keep making money. The question is how much room is there? How much pricing power do they hold over their clients? How much room is there for margin expansion?

And that's where I don't think there's a lot. Because if you push prices up, if you try to squeeze the margins, somebody else steps in.

Kobayashi-Solomon: Somebody will come in and undercut you.

Holt: Absolutely.

Kobayashi-Solomon: So, it really does seem like there's some economic headwinds pushing against them. But, let's say you're an investor in this bearish idea. Luckily with options, we can kind of tailor our risks, so we don't have unlimited upside exposure.

But, at what point would an investor realize, well wait a second, maybe the market's not wrong about Red Hat. Maybe the stock price should go higher. What are some key determinants do you think?

Holt: Well, there are two that come front of mind for me. The first would be they're doing a lot of work to build up the stacks. Instead of just staying at the operating system level, they're working on the middle-ware. They have a product called JBoss.

Kobayashi-Solomon: So wait, you're saying stack. This means like the software that really makes the machines themselves work, is that right?

Holt: Right, so the operating system is handling the base level functions. And then the middle-ware is where you write your applications for.

Kobayashi-Solomon: I see.

Holt: And so, when they push up into that, they're doing a couple of things. They're solving more complexity for the client. They're providing an integrated stack. They don't have to get the operating system and then bring the middle-ware in from somebody else.

Kobayashi-Solomon: So, making it more sticky for the client.

Holt: Definitely more sticky. And the client might be building to the specific functionality of their middle-ware stack. And so I think that proposition is a lot stickier than just the operating system.

Kobayashi-Solomon: So, success in that kind of middle-ware area...

Holt: That could definitely be a catalyst for higher margins.

Kobayashi-Solomon: I see.

Holt: And not only does that solve more complexity, but this is I think an overlooked fact sometimes, their resellers stand to benefit a lot more from a more complex stack.

Kobayashi-Solomon: So, the resellers are going to sell their product a lot harder if they think they're going to make more money off of that.

Holt: Right, much more incentive to push the Red Hat package in that case.

Kobayashi-Solomon: And you mentioned one other kind of bullish uncertainty.

Holt: Yeah, this is one that comes up. Red Hat is always in the news as a potential acquisition target. Now, I think this is largely unfounded, because why would you pay to acquire a company whose product is available for free?

Then you're just buying the client relationships, and if we don't think those are very sticky, then it's not worth a huge premium to take that over.

Kobayashi-Solomon: So, a much larger company, let's say an IBM or an HP or something like that, they already have very sticky client relationships, so they probably wouldn't be so interested in it.

Holt: I think so. What IBM and HP, for example, don't have is a core operating system to build off of. So, if there was a reason for an acquisition, I would see it being one of those two companies as a competitive response to the tie up between Oracle and Sun.

Kobayashi-Solomon: I see.

Holt: But otherwise, I think it's still a stretch to push the acquisition angle.

Kobayashi-Solomon: Yeah, you know this is why I wrote the article. It really seems like the headwinds kind of outweigh the tailwinds in this case.

Holt: I sure think so.

Kobayashi-Solomon: Mike, thanks for coming in. I appreciate it.

Holt: Thanks a lot.

Kobayashi-Solomon: And thank you for joining us. Please stop by the OptionInvestor site, where you can find many more option ideas based on Morningstar's fundamental research.