Think of Red Hat (RHT) as a technology company that has reinvented itself not just once, but twice in 15 years.
There aren’t too many of those around — Netflix (NFLX) comes to mind. And the payoff can be huge for companies that manage to pull it off.
While Netflix morphed from DVD renter to movie streamer to new-age Hollywood powerhouse, Red Hat’s reinvention is tied to the rise of cloud computing. Like many traditional suppliers of information technology, it has been pressured to adapt.
“Red Hat has gambled on a couple of significant cloud technologies or trends,” said Dennis Smith, an analyst at Gartner Group. “One of them has come up aces. That’s container technology and container adoption. The other bet is on a multicloud strategy. The jury is still out on that.”
The software maker’s original claim to fame: It led the commercialization of Linux open-source software. Its Linux operating system runs servers in data centers operated by most large U.S. companies.
Two years ago, bearish analysts said Red Hat faced a day of reckoning as Corporate America shifted more business workloads to cloud-computing specialists like Amazon Web Services, part of Amazon.com (AMZN).
“Public” cloud service providers rent customers shared computing infrastructure, including servers and data storage systems. Aside from AWS, the biggest cloud players are Microsoft‘s (MSFT) Azure, Alphabet‘s (GOOGL) Google and IBM (IBM).
Concerns Of Being Shut Out
Bearish analysts warned that companies would buy less of Red Hat’s software for their private data centers and that it could be shut out from the cloud. One worry was that Amazon Web Services offered customers its own version of open-source Linux for free.
But Red Hat already pivoted from its core Linux business. The company aimed to build a cloud-friendly app development platform.
It also charged into a new cloud technology called containers. By using Red Hat’s software containers, corporate developers build custom apps in private data centers and move workloads to public clouds.
Red Hat’s OpenShift platform combines Linux, container technology, cloud automation tools and software-defined networking for data storage. The OpenShift cloud product is priced 10 times higher than Red Hat’s enterprise Linux software.
“Our software runs everywhere, (in) on-premise and multiple public clouds. That’s part of the story,” Chief Executive James Whitehurst told Investor’s Business Daily in an interview.
“The other piece of the story is that, oh, Red Hat isn’t dead. It has a much larger addressable market opportunity because Linux is only so big but this next thing is potentially 10 times larger,” Whitehurst added. “That combination — Red Hat is not dead and its addressable market — is why you’re seeing so much interest in Red Hat and the stock.”
Cloud computing marks the latest evolution in Red Hat’s business model. In the early 1990s, Red Hat developed its own version of Linux, open-source software. The company gave the software away for free, then sold shrink-wrapped boxed versions in hopes of making money from technical support.
A decade later, the Raleigh, N.C.-based company released Red Hat Enterprise Linux for corporate customers. With additional features, RHEL targeted computer servers in on-premise data centers.
RHEL enabled the software maker to shift to a subscription-based business model. The company provided customers with software updates via the web.
Red Hat next moved into virtualization, or software that enables servers to share business workloads. In that market, it took on powerhouses VMware (VMW) and Microsoft.
As the tech industry slowly bounced back from the 2008-09 global recession, Red Hat stock did OK. But it never caught on fire like that of Salesforce.com (CRM), the leader in software-as-a-service. One investor concern was that Red Hat’s Linux-related growth might be limited as new rivals leveraged open-source software.
In 2017, Red Hat showed signs of gaining traction in cloud computing. Analysts focused on its early lead in container technology. Shares shot up 71% in 2017 and have gained 40% this year.
Revenue rose 21% to $2.98 billion in the year ended Feb. 28. Adjusted profit increased 31% to $2.98 a share.
Red Hat’s Cloud-Computing Push
At its analyst day in May, the company said its emerging technology segment now has an annual $200 million run rate. Most of that comes from cloud revenue, such as OpenShift.
“While RHEL still stands at Red Hat’s core, it is clear that OpenShift is its future,” Oppenheimer analyst Ittai Kidron said in a report to clients.
Gartner’s Smith says that large RHEL customers have given OpenShift a boost. He says it’s unclear if OpenShift will keep its momentum with smaller RHEL users.
Red Hat isn’t alone in aiming to make it easier for companies to develop apps that can run on multiple public clouds. It competes with Pivotal Software (PVTL), spun off by VMware, Docker and Rancher Labs.
Red Hat has an edge, Smith says, as companies steer away from proprietary technologies that could lock them into one vendor for years. The Linux leader’s tools enable companies to develop applications that run on cloud infrastructure, a market called platform-as-a-service, or PaaS.
“Red Hat provides the most flexible PaaS environment from an infrastructure standpoint, allowing users to runs its solution on private data centers or in any public cloud,” MoffettNathanson analyst Adam Holt said in his note to clients. “Pivotal has a similar offering to Red Hat, but not as broad or deep.”
Red Hat partnered with AWS, by far the biggest cloud service provider, in 2017. They aimed to make it easier for OpenShift customers to move workloads to the AWS cloud platform.
At its investor day in May, Red Hat and Microsoft announced they will jointly offer OpenShift as a managed service on the Azure cloud platform.
“While not a needle-mover short term, the Microsoft partnership represents a sizable call option for future growth,” Matthew Hedberg, a RBC Capital analyst said in a report.
Reports surfaced in March that Google’s cloud-computing unit was eyeing an acquisition of the Linux leader to boost its presence in the corporate market.
“I could see why any cloud provider might say owning Red Hat has value because it would give them more ability to move workloads to their cloud,” Redhat’s Whitehurst said. “But any cloud provider would also have to recognize that we are neutral and weigh the benefits of having an edge moving workloads with the dis-synergy associated with us losing our Switzerland status.”
Going After Startups
The company also has been a steady acquirer of startups.
In 2006, it bought JBoss for $350 million. With the purchase, Red Hat gained popular enterprise application development tools. In 2015, the company bought cloud automation specialist Ansible for a reported $150 million.
In January, Red Hat acquired container platform developer CoreOS for $250 million, marking its largest deal since buying JBoss.
“OpenShift will be more formidable once it integrates the recently acquired CoreOS,” said a Cowen & Co. report on container technology. “Although we estimate that OpenShift was only 3% of total Red Hat billings (a sales growth metric) in fiscal 2018, we forecast that it will eclipse $300 million in 2020 billings, equating to 7% of total.”
The report went on to say: “Given its financial resources, container focus, and strong recent track record with (mergers), we believe that Red Hat will perhaps uniquely, continue to act as a consolidator of some of the very best innovation in the container market.”
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