How Red Hat Routed the Recession

While the recession has battered many U.S. software companies, Red Hat (s RHT) — which has staked its future on open-source Linux software, virtualization and cloud computing — has flourished. The company has a number of secrets behind its success, some of them unique.

Throughout the recession, Red Hat delivered quarter after quarter of profit and revenue growth, including in the most recent three-month period; it has also built up $1 billion in cash and attracted large companies such as The Gap to standardize on its Linux-based enterprise platform. And the stock market has rewarded Red Hat steadily, as seen below:

So how has Red Hat consistently done so well during such punishing times? CEO Jim Whitehurst, the former Delta Airlines chief who joined the Raleigh, N.C.-based company in January of 2008, has kept it focused on a number of offbeat strategies, the most significant of which include:

Open Source Tackles the Cost Crunch. IT departments have had their budgets shaved to razor-thin levels, but Red Hat’s open-source enterprise Linux, middleware, virtualization and other solutions strip out many up-front costs from companies that want to transition to its platforms.

Red Hat Sells Support — Well. Instead of the traditional strategy of selling expensive proprietary software licenses, as practiced by the Microsofts and Oracles of the world, Red Hat gets the vast majority of its revenues from selling support contracts. In the third quarter of last year, support subscriptions accounted for $164 million of its $194 million in revenue, up 21 percent year-over-year. All 25 of the company’s largest support subscribers renewed subscriptions, even despite a higher price tag.

In the meantime, several startups have been following Red Hat’s lead (GigaOM Pro, subscription required), among them:

  • Cloudera, which sells subscription support for the open-source Hadoop platform, for querying large data sets.
  • Acquia, which sells subscription support for the increasingly popular open-source Drupal content management system (CMS). (Many newspapers and publishers are deploying Drupal for online publishing.)
  • Eucalyptus Systems, which provides support, training and services for the open-source Eucalyptus cloud computing platform. Eucalyptus is aiming to serve companies that want to customize private and public cloud offerings.

Other Income. IBMer and open-source software pundit Savio Rodrigues published a highly interesting report last year on Red Hat, titled “Is Red Hat a Software Firm or Financial Institution?”  In it, he noted that for two years running, nearly 50 percent of Red Hat’s income before taxes was classified in financial reports as “Other Income.” In other words, a substantial portion of Red Hat’s earnings comes from outside its core software-and-support business.

Upon closer inspection, Rodrigues determined that Red Hat generates the lion’s share of the “Other Income” from conservative fixed-income investments and some equity investments. He also provided a data set showing how Red Hat’s “Other Income” compares to that of other large U.S. software companies, a portion of which is shown below. Oddly, the fact that steady profits on fixed-income investments have kept Red Hat’s overall results consistent throughout the recession is rarely cited in analysis of its quarterly reports:

Linux On the Desktop? Fuggeddaboudit. Linux, which is at the core of Red Hat’s software strategy, has never been a huge success on the desktop, and especially not on the business desktop. Red Hat officials have shrewdly maintained that desktop Linux is not a core focus for the company, but that virtualization and the facilitation of desktop and cloud operating systems applications are.

While Red Hat has remained remarkably consistent and profitable, a rosy future isn’t guaranteed. It is frequently cited as an acquisition target, with VMware (s vmw) and Oracle (s orcl) noted as possible buyers, but its stock market success has caused it to trade at a very high multiple. As noted above, it also depends heavily on successful investments, returns for which may or may not stay consistent. And there are those who question whether heavy enterprise dependency on Linux makes long-term sense.

Yet so far the company’s unusual business approaches have made it a success. So while many in the open source community have noted that Oracle’s acquisition of Sun Microsystems (s java), which was approved by European regulators yesterday, will leave Novell (s novl) and Red Hat as the only independent, public U.S. software companies focused primarily on open source left standing, Red Hat has proven that open source doesn’t mean closed business opportunities.

Top image courtesy of Red Hat Press.