Surviving and Thriving in the Cloud

The change in computing model from client-server to cloud-device presents opportunities and pitfalls for  Red Hat . The undisputed king of the Linux operating system faces possible disruptions to its business model, since end users may be insulated from OS decision-making in the public cloud. However, we think the core Red Hat Enterprise Linux business combined with its growing middleware and virtualization distribution will give the firm an edge in the data center, private cloud, and hybrid environments while it develops its open-source cloud infrastructure projects, OpenStack and OpenShift. Our $50 fair value estimate assumes continued growth in the core RHEL business, adoption and strong growth of middleware and virtualization services, and little near- to medium-term revenue contribution from OpenStack and OpenShift.

Sunny Forecast for Clouds
Improvements in hardware, software, and networking have combined with the secular trend toward outsourcing to usher in the era of cloud computing. The economies of scale offered by remote data centers managed by third parties allow enterprises to offload or outsource some or all of their computing and storage workloads. Cloud adoption is particularly cost-effective for smaller and midsize users that lack the capital, manpower, or expertise to build and maintain their own data centers.

Startup costs for a data center include real estate, power, software licenses, servers, specialized infrastructure (racks, HVAC, raised floors, fire suppression, and so on), networking equipment, IT professionals, and recurring maintenance and upgrade costs that would start at tens of thousands of dollars for a small on-site data center to tens of millions and higher for a large facility. Users that periodically experience extremely high computing workloads also find it effective to use cloud services for those peak loads (retailers during holiday times, for example), rather than building and maintaining IT infrastructure that would lie dormant for long periods. Finally, the third parties that build and maintain cloud data centers have purchasing power, scale, and expertise that are unavailable to most users. As a result, these third parties can pass along some of the cost savings from their equipment and staffing spending to their customers. Increased competition among the third-party data center providers has resulted in price wars among the major vendors even as their services and offerings have expanded, as players jockey to gain market share.

We believe the cloud adoption cycle is still in its early stages and therefore expect spending on the cloud by both providers and customers to remain robust over the next few years. Research firm Gartner has forecast a 17% compound annual growth rate from 2013 through 2017 for worldwide spending on cloud-based business process services, software as a service (SaaS), platform as a service (PaaS), infrastructure as a service (IaaS), management and security, and advertising.

Different Clouds for Different End Users
The cloud is a generic term that typically means nonlocalized computing resources. There are several kinds of clouds for different types of end users. In our view, the distinctions between private and public clouds are blurring because public cloud providers now also offer virtual private clouds by allocating isolated resources for specific users in a public cloud environment.

Public cloud. A third party offers computing services such as database, operating system, storage, or Web servers, among others, over a network that is available for public use. Examples of public cloud providers are Amazon (AMZN) Web Services, Microsoft (MSFT) Azure, Google (GOOG) App Engine, and IBM (IBM) SmartCloud/SoftLayer.

Private cloud. Computing resources or data center infrastructure are operated solely for a single business or user that may be managed internally or by a third party. Private clouds typically do not offer the same magnitude of cost savings that come from the scale in a public cloud, but may be preferable or necessary because of security or regulatory concerns.

Community cloud. Cloud infrastructure and costs are shared by several organizations that can be managed internally or by a third party.

Hybrid cloud. This is a combination of any of the aforementioned types of clouds, from the end-user perspective. A hybrid cloud or different parts of the hybrid cloud can be hosted internally or by a third party.

Cloud providers offer IaaS and PaaS services to customers. IaaS is the allocation of machines, either physical or virtual, with which users can install their own software or development environments. In PaaS, the cloud provider offers machines, but also provides software, such as operating systems, database software, storage, and other extras, as an easy-to-use or turnkey computing solution.

For the purposes of this discussion, we consider SaaS, IaaS, and PaaS to be the main offerings in cloud services. In our view, these are the major spending categories that are comparable to what Red Hat offers in its product lineup. In aggregate, Gartner has forecast these three cloud-based services to grow at a five-year compound annual rate of 26%, higher than that of overall public cloud spending. The growth rate discrepancy is due to IaaS, PaaS, and SaaS being the services where end users can reap the most economic, technological, and usability benefits, and therefore are the highest categories of investment by third-party providers.

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Although Red Hat appears on the surface to be well positioned because of secular tailwinds, the differences between IaaS and PaaS help illustrate the pressures that the firm faces in the cloud. On the plus side, in an IaaS environment, users can install their own licensed software or operating systems, such as RHEL. However, in a PaaS environment, Red Hat's services may not be among the choices offered by the third-party cloud provider. Although there are a plethora of Linux service providers, including Ubuntu, Suse, and Oracle (ORCL), the Linux OS offered is the same (because of open-source community rules); the only point of differentiation is the service contract and pricing. In our view, the number of cloud providers should consolidate over time, since the current level of price competition (AWS, Microsoft, and Google have all matched one another's multiple price cuts over the past year) is probably unsustainable for all but the largest and best-capitalized providers. This means the status quo is largely positive for Red Hat; while public cloud adoption holds potential negatives for the firm, on-site and private cloud computing provide a nice counterweight. Over the longer term, cloud growth and adoption offer growth opportunities for Red Hat, predicated on the success of its cloud infrastructure projects.

Mixed Forecast for Red Hat as It Searches for Blue Sky
It's bound to be a long and perhaps choppy road, but we think Red Hat is still well positioned. We believe the lower initial investment for customers, lower long-term maintenance costs, and increased flexibility from using SaaS, IaaS, and PaaS will continue to drive cloud adoption and investment, which is a good thing, in general. However, in third-party PaaS and SaaS environments, customers may not have the ability to choose specific vendors. Although RHEL, JBoss, and KVM are offered through some public clouds, other open-source service providers are also offered, in addition to traditional proprietary software vendors.

We believe Red Hat remains the vendor of choice for server operating systems in on-site data centers and private cloud deployments, given its significant cost advantages and record of reliability. Because Linux was been engineered to replace Unix systems, its stability and reliability are a selling point: It is used by all major global stock exchanges and data and computing-intensive enterprises such as NASA, the National Security Agency, and telecommunications and financial services firms. We believe RHEL will continue to be the OS of choice to replace aging Unix systems over the long term, given the compatibility of the systems, the incredible price advantage for RHEL versus Unix (we estimate the list price for RHEL is approximately 2%-3% of a comparable Unix license), and Gartner's forecast for the continued slow decline of Unix.

Relative to the two most popular server operating systems, the position and decline of Unix appear even more grim. However, because the most comparable substitute for Unix-based workloads is Linux, we believe Red Hat will directly benefit as Unix licenses expire and systems are replaced or upgraded. We estimate that RHEL currently has 60%-75% market share of total Linux distributions.

Red Hat has experienced increasing adoption of its middleware product, JBoss, and its virtualization product, KVM, demonstrating that the firm has evolved from being a one-product company. Management said OpenStack has had proof-of-concept requests from customers, so we believe demand is building. Nevertheless, Gartner has cautioned that OpenStack remains a work in progress, with approximately 12-24 months of additional development needed before it is enterprise-ready.

Cloud Providers' Decisions Could Alter Infrastructure Software Landscape
Decisions by cloud providers will affect infrastructure software providers' market share and customer usage. As a result, open-source vendors are trying to increase their product offerings to expand their presence in the cloud as investment and adoption increases. To that end, Red Hat is helping to sponsor two open-source cloud products: OpenStack and OpenShift. OpenStack is the open-source community's equivalent to proprietary IaaS offerings. OpenShift is the open-source equivalent--and more specifically, Red Hat's answer--to PaaS offerings. Because OpenShift is a Red Hat-branded project, it requires RHEL, but offers other open-source options for the other PaaS functions such as storage, virtualization, and IT management.

The strategy behind OpenStack and OpenShift is not just to provide end users with open-source options, but also to provide cloud infrastructure providers with an open-source option as the foundation for their cloud infrastructure.

Although both of these projects are still relatively nascent, we believe they have great potential for the open-source community and cloud providers alike. In our opinion, as the ranks of public cloud providers thin out, we believe they will increasingly turn to open-source solutions for stability and cost savings should the development efforts be successful.

OpenShift and OpenStack Provide Potential Upside
Our base-case revenue growth forecasts do not assume significant adoption of either OpenShift or OpenStack over the near to medium term, although we do assume that it may help modestly accelerate revenue growth in fiscal 2016. Instead, our modeling assumptions for the firm are mainly predicated on the continued uptake of RHEL (through Unix license expirations and from on-premises and private cloud deployments) and JBoss and KVM continuing to gain adoption.

Current JBoss revenue growth rates are in the middouble digits, exceeding the broader middleware revenue growth rate of high single digits. Our model roughly mirrors Gartner's assumption that modest growth in annual IT budgets will force enterprises to accommodate the surge in computing and mobile devices by shifting spending to the cloud and reusing existing hardware and software resources. We believe this translates into faster uptake of public cloud services (which may not necessarily benefit Red Hat) and cost-cutting in the data center (which will probably benefit Red Hat). Any incremental adoption of OpenStack and OpenShift will result in further upside to our estimates.