Competitive Positioning

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1 Markets, G. Weiss Research Note 4 March 2003 Red Hat: An Appraisal and Outlook Red Hat is the leading Linux distributor, with a wide lead over its next competitor. Although opportunities abound, Red Hat will be challenged to leverage market share into higher profitability and revenue growth. Core Topic Hardware Platforms: Server Platforms Key Issue How will centralized and distributed servers evolve during the next five years? Red Hat holds an enviable position as the leading Linux distributor, with a wide lead over its next competitor. However, market dominance in the Linux and open-source community has a different meaning, because the open-source paradigm operates by different principles than commercial software. Linux distribution is a tough business model from which to generate profits. Red Hat expends large resources in packaging and integration. In an effort to keep the operating system (OS) one step beyond a commodity, Red Hat must continually seek new ways to add value in and around the kernel. In addition, to sell an OS requires a critical mass of applications certified to run with the package and on vendors' hardware further consuming resources in independent software vendor (ISV) programs. Red Hat realized early that it had to change its business model from product-oriented to service-oriented revenue. The service pricing is the value delivered to users in resources to maintain and upgrade the software, apply bug fixes and security patches, and simplify deployment and provisioning. Competitive Positioning With Red Hat at $90 million in revenue and slightly profitable, no other Linux distributor is close to it in size. SuSE, next in size with about $40 million in revenue, still is not profitable and has had management turnover, with a new CEO in January However, SuSE has had a close relationship with IBM and has been more willing to dedicate resources to supporting IBM hardware and middleware products. Red Hat's strategic advantage is its knowledge base. Much of its engineering talent derived from the original brainpower developing Linux with Linus Torvalds and still retains connections with or has active involvement in the kernel community of maintainers. Gartner Reproduction of this publication in any form without prior written permission is forbidden. The information contained herein has been obtained from sources believed to be reliable. Gartner disclaims all warranties as to the accuracy, completeness or adequacy of such information. Gartner shall have no liability for errors, omissions or inadequacies in the information contained herein or for interpretations thereof. The reader assumes sole responsibility for the selection of these materials to achieve its intended results. The opinions expressed herein are subject to change without notice.

2 To better compete against Red Hat in the Linux server market, four Linux distributors SuSE, Conectiva, The SCO Group (formerly Caldera) and Turbolinux (acquired by a Japanese software firm) pooled their development and research resources to create UnitedLinux, which was introduced in November SuSE is also the most important member of UnitedLinux, a consortium aiming at broad ISV support and geographic distribution to counter Red Hat's dominance. However, the results of such a venture will take time and, without strong organizational skills at the helm, could easily fail to materialize. Vendor support from IBM, Advanced Micro Devices, Hewlett-Packard (HP), Intel, NEC and Oracle superficially appears encouraging. The obvious motivation is fear that UnitedLinux represents the best chance to create competition to Red Hat and avoid the appearance that Linux will succumb to single-vendor dominance. Once users are committed to the Red Hat Advanced Server strategy, they may face forced licensing and upgrade programs similar to those of Microsoft. At this stage, Gartner feels UnitedLinux will remain a second-class competitor, with limited market share through The following encapsulates the strengths, challenges, opportunities and threats for Red Hat: Strengths X86 architecture combined with Linux Strong community standing Investment backing and cash position Strong management Strong IT acceptance among leading-edge adopters Challenges User resistance to increasing license and service fees Fear of dependence on a single dominant vendor Maintaining total cost of ownership advantages in morecomplex deployments UnitedLinux rallying the ISV community Broader interest and support from ISVs of business applications Desktop Linux penetration at profitable volumes Limited above-the-os revenue opportunities 4 March

3 Opportunities Downturn in the economy that is creating CFO and other topmanagement pull to reduce costs and investigate the savings possible from Linux The perception that a "freely" available OS for basic network functions and infrastructure should be inexpensive (intranets, Domain Naming System, FTP, HTTP, file/print) Early implementations focusing mostly on additive deployment vs. replacement costs, with easy migrations for example, Unix applications on reduced instruction set computer (RISC) systems Backlash against Microsoft business practices Deployment of commodity servers, especially in horizontally scaled applications Maturity of the Linux kernel, boosted by help from Unix vendors Grid computing as an outgrowth of clusters Threats Kernel fragmentation Revenue siphoning by hardware and middleware vendors Inability of Linux to graduate into the "big time" applications Intellectual property claims (such as The SCO Group's SCOsource) Revenue Opportunity Red Hat's biggest revenue opportunity comes from its Advanced Server. Before the Advanced Server, there was little likelihood that enterprises and ISVs would support and be able to synchronize applications on the chaotic four-to-six-month release cycles of the ".x" releases. In return for the improved features, longer and more stable life cycle, and longer support commitment, Red Hat came out with an enterprise pricing schedule based on per-server deployment and response coverage. Since the Advanced Server introduction, Red Hat claims sales of 20,000 Advanced Server licenses. Red Hat is diversifying and creating new annuity revenue streams from its initial basic start in the retail business. Sales to enterprise and government business will either be a result of its own lead generation and qualifying or by secondary activity through its partnerships with IBM, HP, Dell Computer, Sun Microsystems, Oracle, and European and Asia/Pacific vendors. 4 March

4 These partnerships have positive upside potential, but they present challenges as well. The upside is the worldwide sales and distribution coverage and name recognition of the vendors. The downside comes from the vendors' desire to steer service and support revenue from large end users and pressure to cater to specific vendor needs. IBM pressed for integration testing of Advanced Server for WebSphere, zseries and DB2, Oracle for 9i RAC, Veritas Software for its cluster file system, and so on. Moreover, Oracle announced its single "unbreakable Linux" marketing program that features total database and application support, based on the Red Hat Advanced Server but bypassing direct Red Hat engagement as a separate support requirement, judging users would be more comfortable without another party. IBM has been training IBM Global Services professional service consultants on Linux and now offers virtual hosting services for Linux applications on its mainframes. Red Hat, however, will not concede large accounts to IBM and Dell but will compete on the basis of its resources (about 300 engineers) two examples of success were Cisco Systems and Amazon. Red Hat's pricing model is aimed at value-based enhancements that can drive an annuity revenue stream. The key element is how to raise profit margins. The OS is labor-intensive, but plug-in modules can be leveraged over longer software cycles and generate higher profits. The key difficulty is to pick the gaps where Red Hat's expertise is a plus and avoid areas where large vendors such as IBM, HP, Sun, Oracle and Veritas are trusted and experienced. Red Hat also must cautiously assert market pressures against the use of the standard releases as substitutes in enterprise applications to ensure a strong service revenue stream. Red Hat can't be too abrupt in price escalation because of the sensitivity to, and misperceptions of, how much open source should cost. Red Hat's marketing must be vigilant and demanding to collect a fair share of support revenue. Most of the vendors have a revenue-sharing arrangement that compensates Red Hat for resources applied to OS support if enterprises choose to sign a single support contract. Red Hat's own consultative services will, of course, focus on the kernel configuration, application dependencies, security fixes and feature enhancements. However, it can also provide support for open-source applications, such as Samba and Apache. Red Hat has wisely chosen to avoid being a channel for IBM or other vendor packaged solutions, in keeping with its image as an open-source supplier. To broaden its reach, Red Hat recently announced Red Hat Academy, an offshoot of its professional certification program, 4 March

5 but extended to universities and high schools. Although probably marginal in revenue and profit contribution, the academy is a deft strategic ploy to generate more student interest and fertilize the next generation of IS organizations with Linux and open-source skills. Red Hat is also driving greater penetration into the government Department of Defense (DOD) applications. Advanced Server achieved DOD Defense Information Systems Agency (DISA) Common Operating Environment (COE) certification. (COE is a DOD software security and interoperability specification and recognized as a computing standard across the U.S. government.) Acronym Key COE DISA DOD HP ISV OS RISC Common Operating Environment Defense Information Systems Agency U.S. Department of Defense Hewlett-Packard Independent software vendor Operating system Reduced instruction set computer Bottom Line: Ever since the market bubble burst, Red Hat has been struggling to regain its initial glow of excitement. Although it claims prestigious accounts (Amazon, Morgan Stanley, Merrill Lynch, Cisco and others), enterprise IT loyalty to a specific Linux distribution and distributor is less locked in than with proprietary systems. Linux is displacing Unix on reduced instruction set computer (RISC) in selected applications, but the revenue opportunities are still coming from the "low-hanging fruit." The future of Linux as a pervasive enterprise market opportunity is still four to five years away. The greatest challenge to Red Hat comes from generating revenue growth. Currently, Red Hat does the labor-intensive work of making Linux robust and scalable for enterprise applications, while the platform and middleware vendors corner the largest share of revenue (for example, IBM is already at $1 billion in Linux business). So although we praise Red Hat for "commercializing" Linux, the open-source model and its "allowance" for commercial opportunities leave Red Hat the slimmer rewards of managing the edge of the kernel. It will, therefore, take Red Hat five years with aggressive growth (25 percent to 30 percent) to reach a revenue target of $400 million (0.8 probability). 4 March