Research Paper on "Complete Analysis and Valuation of a Business"

Research Paper 10 pages (2547 words) Sources: 1+

[EXCERPT] . . . .

RedHat

Company Background

Red Hat is an information technology company focusing on open source products. According to the 2010 Annual Report the company has a subscription-based business model, primarily working with corporate and enterprise customers. The company's 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, the company earned revenues of $909 million and profits of $107 million, both records for the company (MSN Moneycentral, 2011). The company's successes have not gone unnoticed, as it 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 to 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 substitutions, and intensity of rivalry. The industry can be defined a number of ways. The sub-industry is open source software but in a broader way Red Hat competes in the enterprise software industry. The bargaining power of suppliers is moderate. Labor is the biggest input, and quality programmers are in short supply. Red Hat improves its bargaining power on the basis of its open source philosophy, which is attracting to many IT people.

The bargaining power of buyers is moderate. The biggest driver of bargaining power is that there are few firms in open source that can handle the needs of large corporations. Red Hat's bargaining power is mitigated by the threat of substitutes, which include Windows or Apple infrastructure and especially Windows software solutions. The buyers, however, are diffused relative to enterprise software firms, giving firms in this industry high bargaining power in general.

The threat of substitutes is high, however. Red Hat's open source products have a low market share relative to the industry-leading solutions. For people in any given company's IT department, working with Red Hat solutions might be easy, but most end users are familiar with Windows and this provides a barrier that Red Hat must overcome in selling its products. The threat of new entrants is relatively low, given that there are considerable capital requirements for firms seeking to capture the enterprise market, in terms of both developers and sales staff. There are also reputation advantages for established firms in the industry, something that Red Hat benefits from, given its long track record and leadership position in open source.

The intensity of rivalry is high among firms in the enterprise solutions industry. The business is driven by a subscription revenue model, and these ongoing contract-based revenue streams encourage intense competition. There are high switching costs for customers, given the cost of implementing new software and architecture. This enhances the rivalry among enterprise solutions firms. Some of the major competitors for Red Hat are Hewlett Packard, IBM, Microsoft, Novell, Oracle/Sun Microsystems, and VMWare (2010 Annual Report). These firms are all much larger than Red Hat is, and are able to compete intensely both with each other and with Red Hat. For Red Hat in particular, there are high exit costs as the company relies on enterprise subscriptions for the bulk of its income, something that cannot be said of some of the other players in the business, who are more diversified.

The value chain for the enterprise solutions industry is focused on inbound logistics/operations, where developers are brought on board to create innovative products. Marketing and service are two other critical components of the value chain, given the high intensity of competition in the industry, which creates demand for high-end service and focused, effective marketing.

The economic attributes framework reiterates these points. Demand is high as just about every business needs some sort of enterprise solutions to guide the flow of data and provide a platform for critical software. Demand is subject to the business cycle, as firms will reduce spending during difficult economic times. There are many suppliers of enterprise solutions, but Red Hat is one of the only serious suppliers of open source solutions, so it has a dominant presence in its particular niche. There are high barriers to entry and a high degree of brand recognition. Marketing is a critical success factor in this industry. The company's strategy is based on diversification that comes from the open source model -- this model has many benefits but also faces significant barriers to adoption (2010 Annual Report).

Company Strategy

Red Hat operates with a differentiated strategy, based on the unique nature of its product. The company's open source platform is unique among major enterprise solutions players, most of which operate using Windows-bases platforms. Most competitors are much larger. The benefits of open source are that the customer has more control over the development of the software used by the organization, something that can lead to better proprietary software and competitive advantage in the long run.

According to the 2010 Annual Report, Red Hat operates primarily on a subscription-based model. The company licenses its enterprise solutions, often on long-term subscriptions. The general idea is that Red Hat "provides customers with an all-inclusive software solution" that includes "product delivery, problem resolution, ongoing corrections and enhancements" and other benefits. The company believes that the main attributes it provides are "value, flexibility and rapid innovation."

The degree of integration with the value chain is high. Red Hat is a specialist firm within the industry, and it has focused the development of its strategy in two respects. The key point of differentiation is the open source model. This is what provides the "flexibility and rapid innovation" to which the company alludes in its annual report. These attributes derive from the first two stages of the value chain -- inbound logistics and operations. The former is primarily focused on the human resources department in recruitment and selection, where the company attracts top developers and those developers then work together with customers to create the best possible products. The service and sales functions, which important to the value chain, are not differentiated to the same degree as the product. These dimensions are similar in structure and ability to those of Red Hat's main competitors, and are more easily replicable than is the product.

The marketing function is assisted by a large group of vendors with whom Red Hat works. The company actually works with many of its competitors for distribution, including HP, IBM, SAP, Symantec as well as a wide range of hardware providers (2010 Annual Report). The company markets its products globally, and reports based on three geographic segments. A total of 43.4% of the firm's revenues are generated outside of the United States and Red Hat has 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 more understood by IT departments, but those departments must convince key decision makers within the firm to adopt the concept, and this can be difficult. In order to grow its business, Red Hat needs to provide knowledge about its products and what they do better than the competition's solutions. The company also needs to provide a very high level of service. Despite these needs, the company must also provide tangible value to its customers, and this requires pricing at a competitive level. The combination could put the squeeze on margins unless the company's products are so good that they offer a much higher degree of value to customers.

Quality of Earnings

Revenues in FY 2011 were $909 million, an improvement from $748 million in FY 2010, or 21.5%. Net income increased 22.9% from $87 million to $107 million. In the past five years, Red Hat's revenues have increased 127% and its net income has increased 78.6%. The company improved revenues and net income steadily even through the economic downturn.

There are no unusual items on the income statement. Red Hat's business appears to be stable and growing. There are no discontinued operations of note. The company's earnings break down as roughly 85% subscription-based business and the remaining 15% in training and services. While the latter's revenues have experienced a more erratic growth trajectory, the subscription business has been growing steadily. This points to a predictable pattern of growth at Red Hat. Revenues have increased 21.5%, 14.7% and 24.6% in the past three years respectively (MSN Moneycentral, 2011). Net incomes have improved 22.9%, 10.8% and 2.6% in that period. This shows that revenue increases have outpaced profit increases, a function of increasing costs associated with doing business.

There have been no extraordinary items on Red Hat's income statement for the past five years.

Red Hat recognizes revenue in accordance with FASB's Accounting Standards Codification Section 985-605, which is the statement regarding software revenue recognition (2010 Annual Report). The company also notes in the Annual Report that there have been no material changes in accounting policy.

The company does not make mention in its… READ MORE

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