SourceForge: Undervalued Open-Source Stock

Aug. 3.08 | About: SourceForge, Inc. (LNUX)

SourceForge (LNUX) is a small internet company that had a wild beginning. At the height of the internet bubble, its stock, like fellow Linux stock Red Hat, soared to insanely high values, peaking at over 400 per share. But the company’s current price is too low, and opportunities abound.

The first thing you need to know about the company, now trading around $1.35, is that it is sitting on about a dollar a share in net cash and other hard assets, and has no long-term debt. The second thing is that it has turned a profit for 9 of the past 10 quarters. The third thing is that it owns a number of high-traffic websites, including Slashdot, Linux.com, Unix and Palm software site freshmeat.net, online retailer ThinkGeek.com, and SourceForge.Net, the home page for a large number of open source software projects.

Right now hundreds of millions of dollars are flowing into open source software development. Google subsidizes the Mozilla software suite, which includes the popular FireFox browser, to the tune of more than $50 million a year. Sun Microsystems, which has a huge market cap relative to LNUX and is a potential buyer of LNUX, also heavily subsidizes open-source software development, in particular Open Office, a completely free alternative to Microsoft’s Office suite.

The problem with open source/Linux companies has always been monetizing the popularity of their software, which of course is free. LNUX mainly does so by selling advertising on its group of sites, whose readers tend to be a high-income and hard-to-reach market of software industry professionals and individuals with decision-making authority on technology purchases for their company or organization.

LNUX has also recently unveiled a new revenue stream for Sourceorge.net by streamlining the process by which those who want to customize open-source applications can contract with the software developers.

I see three potential catalysts that can propel LNUX upward. First, LNUX could be purchased by a company looking to expand its open-source software business. The two most obvious buyers are Sun Microsystems (JAVA) and Red Hat (NYSE:RHT). A partial sale of one of LNUX’s discrete sites is also a possibility. Both JAVA and RHAT are vastly larger than LNUX, making the company a tiny snack to digest. At the current price of about $1.35, and subtracting out the company’s book value (consisting mostly of its cash horde) gives a forward P/E for LNUX of only 7 times 2009 estimates. Thus for these companies a purchase of LNUX would improve their profitability and earnings ratios.

Two, the company could improve its advertising, in particular by signing an exclusive deal with Google and eliminating the expenses it incurs from in-house ad sales. I believe the mere announcement of such a deal would be good for a 20% bump in the company’s shares.

Third, with the stock trading so cheap, especially given LNUX’s big cash pile, simple organic growth and a small increase in profit margins could allow the stock to recover to the price it fetched last year of around $4. The company’s fortunes are tied to those of open-source software, and that future looks bright. Windows Vista has had a very poor reception in the marketplace.

As a long term play, LNUX’s downside is limited by its big pile of cash and consistent if not amazing profitability. Its upside, however, is huge. When Apple was at its nadir five years ago, it traded for under $7 a share. Now it is at $170. Driving much of Apple’s incredible growth has been consumer apathy towards Microsoft products. Just ask any Apple fan what they think of Microsoft, and you will get an earful.

With Vista, we are starting to see this same apathy in enterprise computer buyers, many of which already are using Linux and other open-source software on their servers. I expect Linux’s server market share, already quite high, to increase. As the economy weakens, Linux consumer PC sales may also finally take off. Right now both Dell and on an experimental basis even Wal-Mart see enough potential in this market that they both sell consumer-oriented PCs with versions of Linux pre-installed. These computers are generally much cheaper than Windows PCs, with an especially notable difference at the low end, where MS software licenses can increase the cost of a PC by more than 30%. Linux-powered PCs benefit not only from not having to pay Microsoft licensing fees for Vista and Office, but also not needing the powerful hardware needed to run Microsoft’s clunky, resource-hogging software, which gets worse with each new generation. While the upper-end of the consumer PC market deserts Windows for Apple, the lower end I think will increasingly choose the sleek, easy to use consumer versions of Linux.

Here’s an example of how Vista apathy could benefit SourceForge. A company that has 1000 employees in its call-center might need to replace its computers. Switching to Linux would allow the company to save hundreds of thousands of dollars. First, by not paying for Windows licenses. Second, by being able to buy cheaper computers. Third, because those cheaper computers use less electricity. Fourth, rather than both paying for its call center software and then paying again for the software to be customized to its needs, the company could instead start with free software, and pay developers via SourceForge to provide the necessary customizations. Fifth, the computers will last longer since few viruses and e-mail worms affect Linux, but entire Windows networks can get wiped out without expensive, annoying, and frequently updated anti-virus software.

We are already seeing governments, especially in South America and the EU, make the switch to open-source for all their computers, not just servers. There is simply no other company positioned to capitalize on this trend that is selling at such a cheap ratio to earnings as LNUX.

Companies mentioned: Microsoft (NASDAQ:MSFT), Apple (NASDAQ:AAPL), SourceForge (LNUX), Sun Microsystems (JAVA), and Red Hat (RHAT).

Disclosure: Author is long LNUX and holds no position in other companies mentioned.