The Linux Populist: An Interview With Red Hat CEO Matthew Szulik

Although his company's stock trades for just 10 percent of what it did a year ago, Red Hat CEO and president Matthew Szulik sees no reason to sing the blues. After all, he's met or exceeded Wall Street expectations for six consecutive quarters, built one of the fastest-growing software empires in history and created what is arguably the best brand name in open-source computing today.

"I think the best of times are ahead of us," says the 44-year-old Linux executive.

Since joining Durham, N.C.-based Red Hat two-and-a-half years ago, Szulik has made an indelible impression on the company. Among other things, he's reduced the nerdy feel of Red Hat without mitigating its techie appeal. A veteran of Interleaf and MapInfo--two companies he helped take public--he has expanded revenue sources from one to 14, jump-started alliances with Dell, Hewlett-Packard and IBM, and delivered soaring sales growth. For the nine months ended Nov. 30, 2000, for example, revenue at Red Hat rose 94 percent to $56.9

million (fiscal year 2001 ends Feb. 28). On top of that, Szulik has moved up Red Hat's timetable for turning a profit; he now thinks that can be accomplished this year instead of next.

To stem its losses and achieve profitability, Szulik says he must create new alliances. To that end, he's embarking on a mission to increase the percentage of sales the company generates through partners, specifically solution providers and other integration specialists. At present, third parties account for less than 25 percent of Red Hat sales--too low, according to Szulik. He'd like to see the figure up around 50 percent to 60 percent. To get that effort moving forward, Szulik has appointed James Neiser to the position of chief marketing officer. Among other things, Szulik expects Neiser, a former IBM channels executive, to better communicate with Certified Service Providers and Certified Channel Partners.

Critics say that will be a tall order given how expensive Red Hat's programs are compared with competing programs (see "The Cost of Partnerships," page 38). Undaunted, Szulik says his company has as good a value proposition as anyone in the open-source movement. In an exclusive interview with VARBusiness senior executive editor T.C. Doyle, he explains why.

VARBusiness: Where is the open-source movement heading now?

Szulik: Having completed our sixth quarter as a major, publicly traded company, it seems that the question or debate of open source being a technical sideshow is giving way to seeing users around the world using open-source technologies practically, deriving both the functional benefit and the technical benefit from their use.

VB: Looking back, what do you consider to be your biggest accomplishment in 2000?
Szulik: I think there are three of them. We continue to validate that you can build a successful business with an open-source model. We were the first open-source company that went public. We had a successful follow-on and continued financial growth in our business. That was a very important element because some of the other open-source companies have had financial challenges. I believe our ability to sustain this has given investors enthusiasm that, with the right model, open source can succeed. I think that's been important to customers.

Second is the expansion of our product line. On Aug. 11, 1999, we went public with a boxed product sold at retail. The company now has more than 14 sources of revenue and has been able to scale the product line to include the handheld for the device market with the Cygnus acquisition. We now offer an expanding breadth of solutions based on open-source technologies in the e-commerce space.

Third, we have been able to deal with massive growth internally. We went from roughly 150 employees to more than 500 employees. And we have been able to do this globally. It's a tribute to a lot of the young people at our company to be able to manage all this growth.

VB: Looking ahead, what's the biggest challenge you face this year?
Szulik: To improve and increase the value of open-source solutions to customers beyond what was a core OS. We've announced that we are jointly developing a mainframe version of Linux for the IBM System 390 product, so that now we can offer customers a complete, scalable, top-to-bottom OS, from an embedded device all the way to a mainframe. The challenge for us is how do we build a new economy, not just for Red Hat, but for all open-source [business], to deliver more improved quality solutions at a better price?

VB: Can that be accomplished in 2001, or will it take a substantially longer time?
Szulik: I think it will take a longer period of time, but our hope is that you'll start to see more Red Hats around the world, bringing new ideas and improved solutions that can further challenge this historically proprietary industry.

VB: What's the smartest thing you guys have done in the past six months?
Szulik: Hire good people. C'mon, you know that as well as I do.

VB: Yes, but if you had to pin one down--and let's put the hiring down as a given--tell me an instance where you zigged and could have zagged but are glad you zigged. Any one come to mind?
Szulik: I would say the acquisition of Cygnus. That has to be right up there. I could give you the follow-on offering we did last January, but I think from a strategic standpoint, it has to be the acquisition of Cygnus. We were able to acquire a company that had just done over the past 12 years a great job of building great relationships and very demanding solutions for customers like Intel, Nortel and Sony in the embedded, handheld-device marketplace. That acquisition not only improved our technical capabilities, but brought a group of very skilled technical professionals to help our organization mature faster.

VB: In Q3 results released in December, you posted very strong gains revenue-wise, though losses continued. What is your timetable for unleashing Red Hat's profit potential?
Szulik: Calendar 2001. If I can put in a little bit of commercial sound bite into the message, it would be this: The piece [of our financials] I hope people take a look at is the gross margin improvement over the past 12 months%85

VB: %85It's paragraph two in your earnings release. Talk to me a little about why that's so important.
Szulik: A year ago, we were operating at 46 percent gross margin. Now we closed the quarter, Q3, at 60 percent. The team has really done a nice job, which is a great measure to investors and to the industry at large. It says the management team we have put together can responsibly run a business and operate efficiently. So we're very confident in our ability to become profitable in calendar 2001, which is up by an entire year. During the IPO, we told the Street 2002.

VB: What's the biggest drag on profitability now? Is it brand-building, technical infrastructure, support, filling out management--everything?
Szulik: It would be all of those activities. You know, on Sept. 1 last year, we had zero representation outside the United States. Now we have more than 165 people representing Red Hat across Asia, Europe and Japan. We want to make sure we're capable of responsibly building those very important markets. Everybody you speak to will want to talk about their companies being global, but until you have representation in those markets listening to customer demands, you have to make sure you build those relationships responsibly. We're starting to see very good customer uptick. Red Hat has become the dominant Linux distribution in the Japanese marketplace in the past 12 months. So, I think what we want to do is make sure we service those customers responsibly. If that forces me to push our profitability out by a quarter or two, I'm prepared to do that.

VB: Let's shift to a technical standpoint. Linux--at least your version--was upgraded in the most recent quarter. What's next for the Red Hat Linux platform?
Szulik: Well, you may have seen that we released online the beta version of the IA-64 work, which is important for us in combination with the 2.4 kernel because it will allow us to really scale our solution offering from just two- and four-way serving technologies to beyond that, which has historically been the sole domain of the high-end Unix offering. That will be an important element in giving application providers the confidence of having a completely open-sourced OS to move their applications over to this platform. We continue to push that functionality down so you have an embedded Linux product, one we want to continue to build on and pursue more aggressively. As I have mentioned, you'll now have a 31-bit and 64-bit version of Red Hat Linux for the mainframe. It's a pretty comprehensive offering.

VB: You keep mentioning, as do others, the potential of the embedded market. Tell me what your real opportunity is for this year.
Szulik: Well, if you look at some of our early success, you'll note that our strategy has been to allow customers to have a complete suite of open standards and APIs, from services to handhelds. They were telling us that this was very important in their computing environments. So far, our approach of going in with an open platform--not blocking them in and not having an onerous royalty model the way many proprietary vendors do--has been accepted positively. That's also happening at a time when some of the manufacturers of these [embedded] devices have now communicated to us the old notion of planned obsolescence is giving way to extending the life of the device by being able to upgrade it online. That's been a key element of our Red Hat Network strategy. As an example, you have the Ericsson web pad. Its goal is to have web pad customers be able to go to the Red Hat Network and get new functionality. As quality improvements become available, those customers could get updates in the field and online, which would extend the life of the device and certainly reduce what manufacturers understand is a high cost of customer acquisition. The more convenient we can make that through a set of open standards, a flexible, open license model and dynamic, technical base, the better.

VB: You and others make a lot of marketing headway with the fact that the Linux platform is the fastest-growing base in the server OS space, so let me ask you about that. In the third quarter, Compaq began shipping with Red Hat, and Dell previously made a substantial commitment to make Red Hat one of its three standards. What are you doing to further increase and jump-start the success you are having with OEMs?
Szulik: Well, I think application availability will continue to be a theme of ours. People don't buy OSs--they buy solutions to their problems. One of the activities we are starting to see that shows good progress for us is the consolidation and migration of the historic Unix variants over to Red Hat Linux. As it relates to your audience, I believe there's a strong opportunity for them to assist in that migration.

VB: Good segue. Has the value proposition changed much for service providers and channel companies in the past year?
Szulik: From my perspective, which is not objective, I think it has actually gotten better for third parties and channel partners. Historically, if you take a look at hardware vendors as an example, they have over the past 25 years always had their technology available. But they've had to wait for the software manufacturers. Now what we're seeing, through Linux and open source, is hardware vendors being able to expedite time to market for some of those platforms. This allows value-added services to truly be developed around that platform through the use of open-source technologies at a price point the channel can really build on. The Intel white box channel is a great illustration.

VB: How much of your sales are influenced or completed through a partner, such as a solution provider or consultant? What is that indirect percentage?
Szulik: I think right now it is probably around 20 percent to 25 percent. It's not where I'd like it to be.

VB: Where would you like it to be?
Szulik: Our business is totally based on leverage, so I'd like to see it as high as 50 percent to 60 percent.

VB: How are you committing and/or spending funds to make that happen?
Szulik: We are studying the needs of the channel. What we've tried to do is recognize that [Linux] is disruptive and you need to get a better understanding of what the channel partners are looking at. This is not a vendor that is issuing them a license and telling them how they will use that product.

VB: Can you be a little more specific about the types of investments you are making in training, recruiting and rewarding third parties to bring them into the Red Hat fold?
Szulik: Well, the program we are seeing really fantastic growth in is the Red Hat Certified Engineering program. This is consistent with the Cisco engineer, Novell engineer and Oracle programs. Because of the Internet, we're finding a lot of commercial accounts--and certainly a lot of governmental accounts--already have Red Hat Linux running. It's not like the old days where there was a huge cost-of-demand creation. What we're finding is spots where we don't have representation or plans to have representation. That creates an opportunity for a value-added partner to go in and sell the merit of their capabilities to provide support, installation or ongoing maintenance for that engagement. So the Red Hat Certified Engineering program is an important element. Training is another. Ongoing maintenance and other application development for that environment are just some of the things we are looking at to help partners.

VB: How are you guys engaging ASPs and other new types of channel companies?
Szulik: We think, through the Red Hat Network, those players will be very important. They are looking at ways to extend their capabilities and their relationships with customers. You have companies like RackSpace in Austin, Texas, which is one of the largest Linux-based hosting companies. We're looking to expand our relationship with those companies through the Red Hat Network where they could make margin and, at the same time, deliver to their customers and then sell more ongoing support services.

VB: Some broader market questions, if you will. Are you concerned about how the new administration will deal with the situation in Redmond, Wash.?
Szulik: Absolutely.

VB: A lot of people are wondering if Microsoft's acquisition of Great Plains Software suggests that Bill Gates is moving confidently back in business, meaning that whatever road bumps he hit with the past administration won't be there this time around. Let me ask you bluntly: Do you feel that way? Do you have concerns along those lines?
Szulik: No, I think it's a bit too early to tell. We are dealing with one of the most aggressive competitors in business history--and we recognize that. Microsoft will continue to do things to support its long-term business needs. What I'm certainly concerned about is how it will all be remedied. If it's business as usual, then I think we'll all be very disappointed. I will be very curious to see how this is all handled by the new administration.

VB: Your company has certainly felt the brunt of the Nasdaq situation. You were as high as $150 or $151, and now trade for around $8. Is the market reflecting your true, intrinsic value? What can you do to communicate that you are a long-term player and not just part of the short-term, dot-com-phenomenon era?
Szulik: Let me go back to your earlier question. I stated in our earnings call that, in light of the PC slowdown, I did not see that negatively impacting our business. I did that with great thought because, as I stated earlier, we are delivering a true economic benefit to an IT user and professional. This is not a dot-com play where it may have provided an incremental benefit to an everyday experience. Being able to save an organization 3-to-1 or 4-to-1 on its IT cost of operations is a financial benefit that, as IT organizations become squeezed to increase functionality and reduce costs, has a compelling value proposition.

I'm optimistic as to what our opportunity is in this supposed slowdown. Companies that have recognized the Internet can make their customer relationships much better and reduce the amount of financial exposure they have. I don't think they are going to slow down their investments in the Internet. I believe that provides a good forum and venue for Red Hat and open source. We've told the Street that we are going to grow 85 percent next year to $155 million, which would put us, at our current valuation, trading at nine times sales. To answer your question directly, I don't believe that reflects our true value. This is a company that has met or exceeded analysts' expectations for six straight quarters, has more than $300 million in the bank and has a worldwide brand. I think the best of times are ahead of us.