Red Hat: Bringing Open Source to Enterprise IT
Red Hat is leveraging its open source expertise to grow in a rapidly changing Enterprise IT market.
Introducing Red Hat
For the incumbents in the big budget land of Enterprise Information Technology, the outlook is grim. The high end hardware vendors like IBM, Cisco, and EMC are on the ropes, struggling to maintain growth and retain their value proposition. The current buzz word is “cloud,” but cloud is simply part of a larger story, in which the value in IT is migrating from custom hardware solutions to cheaper, more flexible software running on commodity hardware. And in the chaos, Red Hat is one of the few vendors with the experience to capitalize on this shift.
So what does Red Hat do?
Simply put, Red Hat sells software licenses on a subscription basis. This isn’t unique; many of their competitors do the same. What makes Red Hat so different, however, is that the software they sell is open source. Instead of developing proprietary IP and strictly controlling the software, Red Hat follows a very different model. They outsource a large amount of their development to an open source community with contributors from a wide range of backgrounds. They then package this into software with Enterprise-grade SLAs, and sell a license that includes very broad rights, allowing the customer to improve and distribute the software. In short, Red Hat creates value not by being the best, but by bringing the best together to produce a compelling product.
How do they do it?
The central piece of Red Hat’s operating model is the way it develops software. While Red Hat does have an R&D department that packages their offerings and works on development, they also heavily leverage two additional sources:
Open Source communities: Red Hat maintains very close relationships with a number of communities for which they offer products. These include their central product, the server OS Linux, as well as some new emerging trends such as Ceph (object storage), OpenStack (cloud software), and Project Kubernetes (containerization). Red Hat’s relationship with these communities allows it to be cutting edge with a good finger on the pulse of future trends at comparatively low risk, and unlikely to be disrupted by these trends. This is especially critical now, as vendors like VMware find their premium offerings at risk due to new products like containerization. Red Hat, on the other hand, has relationships with the open source Project Kubernetes, allowing it a much smoother transition to an eventual product, while placing the rest of its business at much less risk.
Legacy IT companies: Red Hat also maintains close relationships with many enterprise hardware and software companies with whom they ostensibly compete. These companies have found it necessary to maintain relationships with Red Hat in order to drive sales and maintain good relationships with open source communities. In return, Red Hat benefits from broad ease of integration and development in part funded by these companies.
Additionally, there are a few elements that Red Hat is able to provide that also reinforce their software offerings. Red Hat’s paid subscriptions allow customers access to legacy support, maintenance, and service/consulting contracts, all of which are necessary for an Enterprise IT environment but are a notable gap in a typical open source product. These elements, while not very glamorous, are central to enabling Red Hat’s success in the market.
Conclusion
Red Hat’s business model centers on being able to reliably support the IT infrastructure and management/orchestration trends, and doing so in a way that promotes flexibility and transparency. Their lower cost development model, enabled by their ties to the open source communities they leverage, allows them to do this without the need to zealously defend and develop their proprietary IP. They also are able to reliably remain on the forefront of cutting edge computing trends without significant fear of disruption. Instead, their primary risk lies in their ability to make open source software reliable enough and user-friendly enough for an Enterprise IT environment.
As evidenced by their solid, double-digit revenue growth and stock performance (~30% y/y growth), Red Hat is executing well and is well poised for continued strength in the cloud era, where software will increasingly dominate the IT “stack” and flexibility will be of increasing importance.
Sources
(1) 10K Filing: Red Hat (4/28/2015)
(2) Report: “Red Hat Inc.: Cloud Redraws the Competitive Map,” Morgan Stanley (11/4/2015)
(3) Report: “Q2 Results Show Doors Opening For Open Source,” Morgan Stanley (9/22/2015)
(4) Report: Initiation of Coverage, BTIG (9/10/2015)
(5) Wikipedia: https://en.wikipedia.org/wiki/Red_Hat
(6) The Register: http://www.theregister.co.uk/2015/06/19/red_hat_q1_fy2016_everythings_great/
(8) InfoWorld: http://www.infoworld.com/article/2998810/open-source-tools/red-hat-is-boring-and-more-open-source-companies-should-emulate-it.html
Red Hat is a truly amazing story. What surprises me the most (and always has) is the amazing valuation. How do they get software multiples in a relatively low growth and relatively traditional services model? It’s an example of an organization with MAJOR value created, but a definite value capture challenge. One thought is that the valuation is kept high by its potential acquisition by some of the larger firms…
I’ve thought about this – it seems in some ways that Red Hat creates value in a way that is basically taking a lot of the margin out of the equation that more differentiated software providers require to survive. But I think you could make an argument that in the future, these open source models may move continually towards the norm to the point where more companies need to embrace them. And then, Red Hat is really the only one with the expertise to do it right. What if Oracle bought Red Hat, and then turned around an open sourced everything and used Red Hat to monetize it? It may make no sense today, but it would certainly rock the industry, and is an interesting thought experiment!
Really interesting post and I’m impressed by your succinct summary of their operating model! Red Hat was one of the software/Enterprise IT companies we covered when I worked at Deutsche Bank in Equity Research sales. Our research analyst found this company to be one of the harder ones to fully explain to investors. Many investors simply focused on Red Hat’s connection with the “cloud” buzzword you mentioned and they jumped on board, but as you clearly lay out above, there are a lot more nuances to their business model that demonstrate the immense value the company creates. I hadn’t realized the extent to which Red Hat maintains a relationship with the legacy IT companies and is able to capitalize on their connection to the open source community.
To Professor Iansiti’s point above, our investors were also most interested in hearing about any acquisition talks Red Hat was engaged in, and became noticeably more engaged with our research on Red Hat after larger companies bought other smaller software firms that had some similarities to Red Hat’s business proposition. I agree that this is one explanation for the higher multiples!