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STREET WISE by Sam Jaffe	June 9, 1999

How do you earn a living from a product that's free? That dilemma faces each of the dozens of startups that are trying to profit from the open-source operating system called Linux. The first of them to announce plans to go public, Red Hat, says it expects to establish market dominance -- and then morph into an Internet portal.

Red Hat's initial public offering may become one of the stock market's biggest events of the year, thanks mainly to enormous interest from the press and public about Linux. As the first Linux-only company to go public -- probably by the end of the summer -- and as the leading distributor of Linux, Red Hat will be closely watched by investors.

Anyone who carefully reads Red Hat's IPO prospectus, also known as its S-1 filing, will discover how difficult a business Red Hat is in. Even though it's the leading distributor of Linux, which according to the International Data Corp. has 17% of the server operating system market, Red Hat had only $10 million in revenues for its 1999 fiscal year, which ended in February. On the positive side, that's more than double its revenues from the year before, and it's enough to get Red Hat within $40,000 of operating profitability. But it isn't much money for a company that leads the market in Linux distribution.

FREE FOR ALL. The reason there's such a tiny pot of gold at the end of Red Hat's rainbow is obvious. Linux is a free, open-source operating system, meaning that anyone with a Web server and the inclination can start distributing it, as long as any changes they make to the code remain publicly available. Already, there are a slew of such distributors. Most of them are private companies such as Caldera Systems and Germany's Suse. But even nonprofit organizations have gotten into the fray, including one that distributes a popular version of Linux called Debian. How can a company make money by distributing the exact same product that's distributed for free by a nonprofit?

Red Hat's answer, according to its S-1, is that it doesn't plan to. In the near term, of course, it can pull in revenues from people who buy its shrink-wrapped version of Linux in computer stores. But such a market is limited because Linux is available from many sources, including from Red Hat, as a free download over the Web. Fortunately for Red Hat, such a download takes up to 36 hours, prompting many inexperienced computer users to give up and run to their local CompUSA and pay $39.99 for Red Hat's boxed version.

Unfortunately for Red Hat, the days of 14.4 modems are nearing their end. As broadband Internet access becomes more ubiquitous, even an operating system download will become a simple, short task. That's why Red Hat is betting its future on becoming the chief portal for the Linux community. It then hopes to collect the bulk of its revenue from advertising on that site.

MINI-PORTAL. Can such a strategy work? Red Hat has a good start. Its Web site attracted 265,000 unique visitors and recorded more than 2.5 million page views in March, its first month of existence. As Linux becomes more popular and as more people use Red Hat's site to download it, those numbers should climb significantly. The average visitor will be a highly paid, technologically savvy computer user who is to advertisers what a prized bull is to a cattle rancher.

The bad news is that Red Hat's unique visitors represent only 0.8% of portal leader Yahoo!'s (YHOO) 30 million visitors in April, according to Web ranking firm Media Metrix (MMXI). Of course, Red Hat is aiming only for the Linux portal market, but even that's pretty crowded already. Hardware manufacturer VA Research, which is expected to announce an IPO before the end of the year, has launched its own attempt at a Linux portal (www.linux.com) which promises to be a tough competitor. In addition, a number of Web sites that are popular with Linux devotees could quickly transform themselves into alternative Linux portals, including Slashdot (www.slashdot.org) and Freshmeat.net (www.freshmeat.net).

Even if Red Hat is able to become the preeminent Linux portal, it won't enjoy the same profit margins that a proprietary software company does. Microsoft (MSFT), for instance, has operating profits of 51.6%. So if Red Hat keeps its Microsoft-style market share of Linux, don't count on it becoming the next Microsoft-style stock.

Jaffe writes about the markets for Business Week Online

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