Red Hat and Oracle: Two PE’s in a Pod

Last week, a colleague forwarded me this article on the recent financial results of open source software provider Red Hat:

“Red Hat: Bad economy is good for open source”

I’ve never really examined the business model of the open source software providers, so I decided to take a peak. We track the largest software providers in the Service 50 and we know that license revenues have been under pressure.  Is the open source model a shining star in this grey and gloomy economy? After comparing and contrasting the most recent quarterly results of both Oracle and Red Hat, I would make three key observations:

  1. Despite Red Hat’s growth in revenue, Oracle’s business model remains substantially more lucrative.
  2. Surprisingly, Red Hat’s business model is R&D intensive.
  3. When all is said and done,  Oracle and Red Hat are actually executing the same service strategy profile.

These three observations have ramifications as the software industry continues to migrate from the traditional license model represented by Oracle to evolving software consumption models like open source, subscription, and advertising based (Google).

 

COMPARING BUSINESS MODELS

The most recent quarterly results from Red Hat and Oracle are shown below:

Oracle Results

Red Hat Results

Red Hat Results

What is amazing is when you put these business models side by side in a graph:

Business Models of Oracle and Red Hat

Business Models of Oracle and Red Hat

The bad economy may be good for open source, but Red Hat is generating less than half the operating income Oracle is with their business model. Part of this could be function of scale. Yet, look how much, as a percentage of revenue, Red Hat must invest in G&A, Sales and Marketing and R&D to secure revenues. Is this the new face of the software business model? Will open source software companies, by definition, generate less operating income than the previous generation of proprietary software vendors?

 R&D THAT WON’T GO AWAY

To be honest, I was surprised that Red Hat is forced to invest 20% of revenues back into research and development.  Read this excerpt from the home page of the Open Source Initiative

Open source is a development method for software that harnesses the power of distributed peer review and transparency of process. The promise of open source is better quality, higher reliability, more flexibility, lower cost, and an end to predatory vendor lock-in.

This vision is compelling. However, an open source provider like Red Hat clearly must invest intensely to deliver enterprise class solutions.

 A CLASSIC PRODUCT EXTENDER

We have done work over the past four years that helps technology product companies classify and align their services strategy to maximize product success. In this work, we have identified four classic services strategy profiles pursued by product companies like Cisco, HP, OBM, and Oracle.

Oracle executes a services strategy profile we call “the product extender.” Product extenders receive a majority of their revenue from annuity (or maintenance) service revenue streams. New product license revenues represent less than half of total company revenues. In addition, project based services like consulting, education, and integration represent 15% – 25% of total company revenues. The economic engine of a typical product extender is shown below:

 

The Product Extender Revenue Mix

The Product Extender Revenue Mix

Now, is Red Hat, as an open source provider, executing a new type of services strategy? The answer is a resounding no. Red Hat secures over 80% of its revenues from “subscriptions.” These subscriptions represent new “license” sales as well as “maintenance” renewals with existing customers. Just like the Oracle model. In addition, Red Hat secures roughly 15% of its revenues from project based education and consulting revenues. Just what we would expect from a classic product extender.

So, in conclusion, what have I learned by peaking into Red Hat’s numbers? Open source may by an attractive and revolutionary consumption model for customers, but it represents fundamentally the same service strategy being executed by traditional software providers. In addition, the operating income being generated by the open source business model is substantially less than the traditional software business model. If this is indeed the future of software, I would argue every margin dollar generated by those project based services will become more precious than ever.

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