Red Hat Financial Analysis: Strategy, Earnings & Valuation

Company Background

Red Hat is an information technology company focusing on open-source products. According to its 2010 Annual Report, the company operates a subscription-based business model, working primarily with corporate and enterprise customers. Its products include systems management, infrastructure products, Linux, enterprise middleware, and consulting (RedHat.com, 2011). In recent years, the company has built its earnings and profits consistently. In FY2011, Red Hat earned revenues of $909 million and profits of $107 million—both records for the company (MSN Moneycentral, 2011). These successes have not gone unnoticed: Red Hat became the first open-source company to enter the S&P 500 in 2010.

Economic Characteristics of the Industry

Porter's Five Forces is an analytical tool that helps explain the pricing power of firms in an industry. The five forces are: bargaining power of buyers, bargaining power of suppliers, threat of new entrants, threat of substitutes, and intensity of rivalry. The industry can be defined in several ways—the sub-industry is open-source software, but more broadly, Red Hat competes in the enterprise software industry.

The bargaining power of suppliers is moderate. Labor is the largest input, and quality programmers are in short supply. Red Hat improves its bargaining position through its open-source philosophy, which is attractive to many IT professionals. The bargaining power of buyers is also moderate. The primary driver is that few firms in the open-source space can handle the needs of large corporations. Red Hat's bargaining power is partially offset by the threat of substitutes, which include Windows and Apple infrastructure solutions, as well as Windows-based enterprise software. Buyers are nonetheless diffused relative to enterprise software firms, which gives those firms generally strong bargaining power.

The threat of substitutes is high. Red Hat's open-source products hold a relatively small market share compared to industry-leading solutions. While IT departments may find Red Hat solutions straightforward to work with, most end users are familiar with Windows, creating an adoption barrier the company must continually overcome. The threat of new entrants is relatively low, given the considerable capital requirements—in both developers and sales staff—needed to capture the enterprise market. Established firms also benefit from strong reputations, something Red Hat enjoys thanks to its long track record and leadership in open-source software.

The intensity of rivalry is high among enterprise solutions firms. The subscription revenue model and ongoing contract-based revenue streams drive intense competition. High switching costs for customers—stemming from the expense of implementing new software and architecture—further intensify this rivalry. Red Hat's major competitors include Hewlett-Packard, IBM, Microsoft, Novell, Oracle/Sun Microsystems, and VMware (2010 Annual Report). All of these firms are substantially larger than Red Hat and compete aggressively with one another and with Red Hat. For Red Hat specifically, exit costs are high because the company relies on enterprise subscriptions for the bulk of its income—unlike some competitors, who are more diversified.

The value chain for the enterprise solutions industry centers on inbound logistics and operations, where developers are recruited to create innovative products. Marketing and service are also critical components, given the high competitive intensity, which creates demand for high-quality service and focused, effective marketing.

The economic attributes framework reinforces these points. Demand is strong, as nearly every business requires some form of enterprise solutions to manage data flows and support critical software. Demand is subject to the business cycle, however, as firms reduce spending during economic downturns. Although there are many enterprise solutions providers, Red Hat is one of the only serious suppliers of open-source solutions, giving it a dominant position in its niche. High barriers to entry and strong brand recognition are also notable features of this market. Marketing is a critical success factor, and Red Hat's strategy is built on the differentiation that the open-source model enables—a model with significant advantages but also meaningful barriers to mainstream adoption (2010 Annual Report).

Company Strategy

Red Hat pursues a differentiated strategy grounded in the unique nature of its product. Its open-source platform distinguishes it from virtually all other major enterprise solutions competitors, most of which operate on Windows-based platforms. Most competitors are also considerably larger. The core benefit of the open-source approach is that customers gain greater control over the development of software used within their organizations, which can yield proprietary advantages and long-term competitive benefits.

According to the 2010 Annual Report, Red Hat operates primarily on a subscription-based model, licensing its enterprise solutions—often through long-term subscriptions. The company's goal is to provide customers with "an all-inclusive software solution" encompassing "product delivery, problem resolution, ongoing corrections and enhancements," and additional benefits. The company believes its main value drivers are "value, flexibility and rapid innovation."

Red Hat is deeply integrated with the value chain. As a specialist firm, it has focused its strategy in two key respects. The primary point of differentiation is the open-source model, which is the source of the "flexibility and rapid innovation" cited in the annual report. These attributes stem from the first two stages of the value chain—inbound logistics and operations. Inbound logistics, in particular, involves human resources in the recruitment and selection of top developers, who then collaborate with customers to build the best possible products. The service and sales functions, while important, are not differentiated to the same degree as the product itself. These functions are similar in structure and capability to those of Red Hat's main competitors and are more easily replicated.

The marketing function is supported by a broad network of vendors. Red Hat works with many of its competitors for distribution, including HP, IBM, SAP, and Symantec, as well as a wide range of hardware providers (2010 Annual Report). The company markets its products globally, reporting results across three geographic segments. A total of 43.4% of revenues are generated outside the United States, and Red Hat maintains offices in 65 countries (Ibid).

As a differentiated niche provider in an intensely competitive industry, Red Hat must compete aggressively by demonstrating the value of its unique offerings. The open-source platform is well understood by IT departments, but those departments must persuade key decision-makers within their organizations to adopt the concept—a process that can be difficult. To grow its business, Red Hat must educate the market about its products' advantages over competing solutions and deliver an exceptionally high level of service. At the same time, the company must offer tangible value at competitive prices. This combination could compress margins unless Red Hat's products deliver a clearly superior value proposition to customers.

Works Cited

MSN Moneycentral. (2011). Red Hat. Retrieved November 26, 2011, from

Red Hat 2010 Annual Report. In possession of the author.

RedHat.com. (2011). Various pages. Retrieved November 26, 2011, from http://www.redhat.com