NEW YORK (CNN/Money) -
Stop me if you've heard this one before. The Linux operating system is starting to emerge as a formidable threat to Microsoft's Windows.
Well, it's true. Linux is finally moving from the hype stage to reality. Software companies like Novell and Red Hat are reaping the benefits of the increased popularity of the open source operating system, particularly with corporations.
It's helped that hardware giants IBM, Hewlett-Packard, Dell and Sun have all started to sell servers that run on Linux. So even though Linux's unofficial mascot, the penguin, may not be able to fly, it certainly has wings.
But, as is often the case with a technology that's getting a lot of mainstream attention, you have to wonder if investors aren't getting a tad too excited. Shares of Novell (NOVL: Research, Estimates) and Red Hat (RHAT: Research, Estimates) have both surged more than 200 percent in the past 12 months.
As a result, expectations for these two stocks are extremely high and that makes these stocks vulnerable for pullbacks. That's exactly what happened to Novell Tuesday.
Novell, which entered the open source market in a big way last year through its acquisition of software developer SuSE Linux, said its fiscal second quarter earnings, excluding charges, came in at 3 cents a share, in line with analysts' estimates. Sales came in at $294 million, up 6.5 percent from a year ago and ahead of the Wall Street consensus estimate of $287 million.
Still, the stock plunged nearly 10 percent Tuesday morning. And Red Hat fell more than 1 percent on a day when the Nasdaq was trading higher.
"I'm not surprised by the sell-off," said Dion Cornett, an analyst with Decatur Jones Equity Partners. "Other tech companies have beat or met expectations and fell the next day."
Priced for perfection
Investors need to be even more wary of Novell and Red Hat than many other tech stocks since both continue to trade at extremely high valuations. Novell, even after its price haircut Tuesday, trades at 58 times earnings estimates for this fiscal year, which ends in October, and 33 times fiscal 2005 profit projections.
And Red Hat's P/E, based on earnings estimates for this fiscal year (ending in February 2005) is an astronomical 111.
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To be sure, both companies are expected to post healthy levels of growth over the next few years. Analysts are forecasting a 12 percent increase in sales for Novell next year and more than 50 percent jump for Red Hat.
What's more, analysts are predicting a long-term earnings growth rate of 14 percent annually for Novell and 35 percent a year for Red Hat.
But even when factoring that in, Red Hat trades at a PEG ratio, calculated by dividing the P/E by the long-term growth rate, of about 3.3 times while Novell trades at a PEG of 4. By way of comparison, the S&P Technology sector is trading at just 1.6 times long-term earnings estimates.
"Novell and Red Hat are very expensive stocks, even with their strong growth," said Richard Williams, director of research and software analyst with Garban Institutional Equities.
In the case of Novell, investors also need to take into account that it is still a relative small fry in the Linux world, compared to Red Hat, since Novell entered the market later.
To that end, Novell said Monday that it sold 3,800 SuSE Linux software licenses in the second quarter. Red Hat added 87,000 new Linux software subscriptions in its last quarter.
"Novell is approximately 12 months behind Red Hat," said Amy Feng, an analyst with JMP Securities.
Feng adds that investors probably need to be a bit concerned because favorable currency exchange rates helped boost Novell's latest results. Without the benefits of the weak dollar, Novell would have missed consensus sales estimates, she said.
All in all, Linux certainly is making an impact. This is not an indictment of the technology. Linux is for real and it's here to stay, to the consternation of Microsoft, I'm sure.
"Investors should have Linux exposure. It is one of the biggest trends in technology," said Cornett.
I agree. But rather than invest in the pure plays, it's probably safer for investors to bet on Linux by way of the large cap hardware companies like IBM, HP and Dell. They should also benefit from increased adoption of open source software on servers but are more diverse...and far less expensive.
Analysts quoted in this piece do not own shares of the companies mentioned and their firms have no investment banking relationships with the companies.
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