Finally, Open-Source Model Paying Off For Red Hat

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O pen-source software has come a long way -- just ask Red Hat. The leading maker of the Linux operating system,Red Hat ( RHT ) announced a partnership last week with its once-bitter rival,Microsoft ( MSFT ). As part of the deal, Red Hat will provide the Windows creator with its enterprise version of Linux for use as the "preferred choice" on Microsoft's Azure cloud services.

Microsoft hasn't always been on the chummiest terms -- to say the least -- with Red Hat and the rest of the open-source community, given its history of patent litigation and licensing claims. But the tech heavyweight has come around on open-source software -- free software whose code can be legally changed and shared by anyone. Microsoft Chief Executive Satya Nadella even went so far as to proclaim "Microsoft loves Linux" last year.

Red Hat, which provides subscription-based support to accompany its cleaned-up version of Linux, has a ways to go before its stock returns to its all-time high, reached in the throes of the dot-com boom in 2000.

Watershed Moment?

But the Microsoft deal may have marked a watershed moment for the company, shares of which have struggled to regain past glory. The transaction sent Red Hat shares to a new high above 80 -- a level not seen since those halcyon days a decade and a half ago when it topped 150 -- and seemingly into a new era of prosperity.

"(Red Hat) is positioned to be one of the winners in this new era (of IT)," as open-source software and cloud computing transform the technology landscape, wrote William Blair analyst Jason Ader in a recent note to clients. He has an outperform rating on the stock.

Reputation is everything, and Red Hat's reputation for quality and reliability is a huge part of the company's success, Ader told Investor's Business Daily in an interview. Red Hat's approach to the market involves having a consistent operating system that works for both on-premises data centers and the cloud, and that promises both consistency and portability.

Among Red Hat's biggest competitors are Germany's Suse and privately held Canonical, the company behind open-source software platform Ubuntu, said Ader. There's alsoIBM ( IBM ),Oracle ( ORCL ) andHewlett Packard Enterprise ( HPE ) -- though open-source makes up only a "tiny" part of sales for both Oracle and HPE.

"(Red Hat is) by far the largest pure-play open-source company," he said.

Right Side Of Trends

In a note to clients last week, Deutsche Bank analyst Karl Keirstead called out the company for being "on the right side of the big public cloud and open-source trends," upgrading the stock to buy from hold and boosting his price target to 90.

"We are particularly impressed with the ramp of Red Hat's $100-million-plus cloud subscription revenue stream, with (Amazon (AMZN) Web Services) contributing almost half of this," he wrote.

So does the Microsoft deal really say that the open-source model has finally come of age? Plans for a co-located support center that will blend support teams -- a first for both Red Hat and Microsoft -- exemplify the depth of the companies' collaboration.

Red Hat Chief Financial Officer Frank Calderoni called the deal "significant" in a recent interview with IBD. He added: "(It) shows how open source over the last several years has grown."

Not Out Of Touch

Red Hat may be growing up, but analysts say that growing up doesn't mean that Red Hat is out of touch. The company has not only enterprise support, said analyst Ader, but also a lot of credibility with the developer community and young software coders who, as he puts it, are rebellious and have what he calls a "hacker" mentality.

"I think you have to have that if you're an open-source company," he added. But Ader points out that open-source providers need a more "grown-up version."

Calderoni wouldn't characterize the company's leadership that way, but he says that Chief Executive Jim Whitehurst has a management style that "fits in well with open technology" -- "very open, engaging and collaborative."

Whitehurst, a formerDelta Air Lines (DAL) executive who joined Red Hat in 2008, is the author of the recently published book "The Open Organization: Igniting Passion and Performance." It nixes the idea of a traditional, top-down hierarchy in favor of a collaborative meritocracy that rewards the best ideas.

That philosophy brings out the most creative ideas, gets employee buy-ins and generates enthusiasm, said Calderoni, who joined Red Hat in June after spending almost 11 years atCisco Systems (CSCO). Beyond Linux, Calderoni identified middleware as an area of great potential growth.

"That is a very successful and growing business for Red Hat," he said. "We're one of the key players in the middleware market."

Growth Areas

Other growth areas are cloud products OpenStack and OpenShift, as well as management and storage products, Calderoni said.

The company itself has been growing, sometimes by acquisition. In October, Red Hat announced the purchase of IT automation solutions provider Ansible for an undisclosed sum on the heels of a string of acquisitions.

A series of double-digit earnings and revenue gains have accompanied Red Hat's growth. In its most recently reported quarter, which ended August 2015, the company earned 47 cents per share, up 15% from the second quarter of 2015 and 3 cents above forecasts.

Revenue rose 13% to $504.2 million, well ahead of analyst estimates for $494.7 million. Subscription revenue for infrastructure-related offerings grew 9%, while application development-related subscription revenue climbed 37%, according to the company.

For fiscal 2015, per-share earnings grew 7% to $1.60 on 17% sales growth to $1.79 billion. Subscription revenue for the year rose 17%.

Red Hat has earned a 95 IBD Composite Rating, which means that it has outperformed 95% of all publicly traded companies in a mix of technical and fundamental factors. It is a member of IBD's Computer Software-Desktop industry group, which ranks 44 out of 197 groups and consists of fellow membersAdobe (ADBE) Systems, Microsoft andGlobalscape (GSB).

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

This article appears in: Investing , Investing Ideas
Referenced Symbols: RHT , MSFT , IBM , ORCL , HPE

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