Economic Characteristics of the IT Industry


Company Background

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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 (, 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 annual report of how it values inventory. Inventory valuation is not material to Red Hat. As of FY 2011, inventory was valued at $265,000, compared with current assets of $1 billion.

Profitability and Risk

Red Hat’s service/subscription model yields high gross margins. The current gross margin for the company is 83.4%, the operating margin is 16% and the net margin is 11.7%. Gross margins are typically high in this industry, and the major expense is the selling, general and administrative expensive. Containing this expense is key to profitability for Red Hat. Over the past five years, Red Hat has shown the ability to control this cost. SGA expenses were 48.6% of gross revenue in FY2011, compared with 53.5% in FY2007.

Another method of examining profitability is to analyze the cash flow statements to see where the company makes its cash. Cash flows from operations were $255 million in FY 2011, compared with $236 million in FY 2010, an increase of 8%. The company also invests in debt securities for sale with some of its free cash flow, and these net investments were $276 million FY2011. These investments provided positive cash flow in FY2010. The company embarked on a purchase of treasury stock in FY2011, increasing such purchases substantially. These figures show that the cash flow is healthy, and cash flow from operations is both stable and increasing slightly.

Red Hat has a high degree of liquidity and solvency. The company’s current ratio is 1.77, and its cash ratio is 0.68. Last year, the company’s current ratio was 1.99 and the cash ratio was 1.15. These figures point to a slight decline in liquidity, although the company remains liquid. Red Hat has no long-term debt. The capital structure of the firm in total is 59% equity and 41% liabilities, most of which come in the form of deferred revenue. This analysis shows that Red Hat has healthy cash flow and this cash flow is not going to be compromised by debt obligations any time soon.

Red Hat’s performance is strong, but it is also important to compare the firm’s performance to that of its industry peers. This is because it is important to ascertain whether the firm’s performance is a reflection of its own inherent strength or just a function of operating in a generally favorable industry. It is important to consider that the Five Forces analysis determined that the industry was a generally favorable one in which to operate. Red Hat’s comparisons with the industry (MSN Moneycentral, 2011) are generally substandard:


Red Hat


5-year gross margin avg



5-year net margin avg



Current ratio



Receivables turnover



Asset turnover



5-year ROE avg



5-year ROA avg



5-year ROC avg



These figures show that while the company has a slightly better gross margin it generally underperforms the industry. This could be a reflection of the company lacking economies of scale relatively to competitors. Red Hat operates in 65 countries, but earns less than $1 billion in revenue. Some of its competitors make tens of billions in revenue, so there are definitely scale disadvantages for Red Hat. Of particular note in these figures is the return on equity. The company’s lack of debt in its capital structure means that it is financed predominantly with equity. As a result, its ROE is lower than that of its competitors, many of whom use leverage to improve their return on equity.

In the long-run, however, there is reason for optimism with respect to Red Hat’s financial position. The company’s profitability should increase it is gains size, as this size will help improve economies of scale. It is more cost effective to add incremental size to existing sales offices than it is to build out new offices in order to expand the company’s business. This cost issue derives from Red Hat’s strategy of being a differentiated niche player, but still attempting to compete globally. Inherently, such as a strategy will put the firm at a disadvantage with respect to economies of scale in marketing — it needs to cultivate a more mainstream customer base in order to build out scale and that means competing more directly with larger competitors, some of whom are also distributors of Red Hat products.


Red Hat’s business is in the growth stage of the company life cycle, but is growing at a steady rather than exponential rate. There is no indication that the company is expanding into other businesses, engaging in major merger and acquisition activity or anything else that might impact on the trends in the company’s business. This means that future projections for Red Hat can be expected to mirror past performance. Using these trends, future statements can be constructed.

Red Hat Forecast Income Statement






Cost of Sales

Gross Profit

SGA Expense

R&D Expense

Operating Income

Tax Expense





Net Income

Red Hat Forecast Balance Sheet





Current Assets


LT Assets

Total Assets

Current Liabilities

LT Liabilities

Total Liabilities


Shareholder’s Equity

Total Liabilities and Equity


The valuation of the firm can be determined by using the capital asset pricing model. The risk-free rate (1 year Treasury) is 0.446%. The market premium has historically been around 7%. The beta for Red Hat is 1.26. Therefore the company’s cost of equity is as follows:

.446 + (1.26)(7) = 9.27%

Red Hat does not pay dividends, but it can be valued on the basis of its free cash flow per share. The firm’s free cash flow per share is $1.17. This implies a stock price of 1.17/.0927 = $12.65. The current value of Red Hat shares is $44.93. The market is pricing in significant growth, as evidenced by the price/earnings ratio of 67. Yet, Red Hat has been growing steadily, not rapidly. This points to a conclusion that Red Hat is currently overvalued in the market.


Red Hat has experienced slow but steady growth of its business. It underperforms its key rivals, in part because it operates globally using a niche model, which results in a high selling expense for the company relative to its earnings. Thus, despite steady earnings growth and a healthy gross margin, Red Hat is less profitable than its industry peers. That said, the company’s financial condition is generally healthy. Red Hat is debt-free and is growing its revenues and profits. The market has priced in strong growth that is perhaps not reasonable given the company’s current growth rates, making Red Hat overvalued on the market.

Works Cited:

MSN Moneycentral. (2011). Red Hat. Retrieved November 26, 2011 from

Red Hat 2010 Annual Report. In possession of the author. (2011). Various pages. Retrieved November 26, 2011 from

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