December 10, 1999

A Tiny Company With Dim Prospects Goes Public With a Bang

By LAWRENCE M. FISHER

AN FRANCISCO -- Internet mania reached new levels of frenzy Thursday as investors paid huge multiples on an initial public offering, giving a market value of almost $10 billion to a tiny company with powerful competitors, little revenue and no expectation of earnings in the foreseeable future.

Related Articles Red Hat Soars After Inking Deal With AutoZone (November 29, 1999) Supporters of Linux Worry That Commercialization Could Bring Chaos (October 18, 1999) Share Price More Than Triples in Red Hat's Public Offering (August 12, 1999)

The company, VA Linux Systems of Sunnyvale, Calif., sells computers powered by standard Intel Pentium processors that run on Linux, the free Unix-based operating system created by a Finnish graduate student and now marketed by more than a dozen companies worldwide. The computers are designed as servers, computers that deliver Internet products, like Web pages and e-mail, or other network services.

Though giants like Dell Computer and I.B.M. already market Linux servers of similar power, shares of VA Linux Systems surged more than eightfold today, setting a record for an initial public offering.

The company sold 4.4 million shares, an 11 percent stake, priced at $30 a share, raising $132 million. The shares opened at $300, and closed at $242.375 in Nasdaq trading.

The appetite for shares of companies that deal in Linux products and services has been enormous this year, and those stocks shared in today's largess. Shares in Red Hat, a Linux distributor, have soared 20-fold since the company went public Aug. 11 and rose $16.50, to $287, today. Andover.Net, which runs a network of Web sites devoted to Linux, has more than quadrupled since its initial offering on Wednesday, gaining $14.8125, to close at $78.8125. The Corel Corporation, which sells software that runs on the Linux system, most notably a Linux version of its WordPerfect document creation software, rose $11.25, to $39.375, after trading as low as $2 in the last year.

VA Linux has never made money and does not expect to for some time.

As the company's prospectus points out: "We do not expect to generate sufficient revenues to achieve profitability and, therefore, we expect to continue to incur net losses for at least the foreseeable future. If we do achieve profitability, we may not be able to sustain it."

No problem, said the stampeding market.

"A stock like this is an obvious example of something going through the roof with absolutely no underlying fundamentals," said Michael C. Perkins, co-author of "The Internet Bubble" (Harper Business, 1999). "It starts with the institutions flipping the stock, and then the momentum players and the day traders take over. Just when you think you've seen the peak of the insanity, this is a perfect bubble stock."

Linux, created by Linus Torvalds in 1991, has become a cause célèbre within an industry wary of Microsoft's domination of both operating systems, with Windows, and the business application programs that run on it.

It is also the darling of "open source" advocates. Open Source is based on the concept that making a program's underlying code freely available, and allowing it to be modified by anyone, will result in a more powerful and secure system and will free consumers from the tyranny of proprietary operating systems, especially Windows. Linux grew out of the GNU Project, an effort to build a free operating system similar to Unix.

Although the Linux kernel and associated GNU (pronounced NEW) components can be downloaded for free by anybody, more than 22 companies now sell GNU/Linux software. The best known are Red Hat, Suse, Turbo Linux, Caldera Systems and Mandrake Soft.

As the notion that Linux could be a viable alternative to Windows has gained currency, these companies have captured the imagination of investors.

In part, that notion was fed by Microsoft itself, which insisted earlier this year in its antitrust battle with the government that Linux threatened its Windows monopoly.

So much for making money the old- fashioned way.

"People who were not there for the great I.P.O. of the 80's see this as an opportunity to ride the crest again, as Microsoft II," said Maureen O'Gara, publisher of Client Server News, a trade publication. "This is not based on fundamentals. They don't read beyond the first page of the prospectus."

In the case of VA Linux, she said, "The fact that they could be crushed by one finger of Dell's hand has not slowed their flight."

Shipments of Linux-based computers are expected to grow by 25 percent from 1999 through 2003, more than twice the 10 percent to 12 percent pace for other workstation and server systems, according to the International Data Corporation, a market research firm based in Framingham, Mass.

But that kind of increase is possible only because the market today is so minuscule. Lost in the excitement about Linux is the fact that the actual user base today is tiny compared with Windows, commercial versions of the Unix operating system or Apple Computer's Mac OS. Although Linux proponents often say that the operating system is more reliable and secure than Windows NT, major corporations have not been eager to run mission-critical applications on Linux.

Those that have embraced Unix are more likely to purchase Solaris from Sun Microsystems, HP/ UX from Hewlett-Packard or other name brands.

VA Linux's biggest sales have been to Internet companies, including Akamai Technologies, eToys, StarMedia Network and 24/7 Media. Sales to these four customers accounted for 14.5 percent of the company's total revenue of $17.7 million in fiscal 1999 and 23.3 percent in the first quarter of fiscal 2000.

"People say Linux is going to kill Microsoft, but I say, 'How do you do that without killing Sun first?' " said Michael Murphy, editor of the California Technology Stock Letter. "I don't think they have any understanding of what Linux is, what it means, the fact that it's free."

Nevertheless, VA Linux was represented by leading investment banks, and had previously attracted savvy venture investors. Credit Suisse First Boston was the lead underwriter, with Deutsche Banc Alex. Brown, Hambrecht & Quist and Lehman Brothers as the co-managers of the offering. The company's backers include the Silicon Valley venture capital firm Sequoia Capital, which holds a 23 percent stake, and Intel, which holds an 8.9 percent stake.