What to Do With This Cloud Stock?

Shas is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Red Hat (NYSE: RHT) is an American multinational software company and the world’s leading provider of open source solutions. Founded in 1993 and headquartered in Raleigh, North Carolina, it is engaged in providing such solutions to different enterprises. The offerings include its core enterprise operating system platform, Red Hat Enterprise Linux, Red Hat JBoss Middleware, virtualization, cloud, and other storage offerings.

The company is facing tough competition from its peers across all businesses. Cloud stocks have been a big catch for investors for many years now, but what about this stock?

Red Hat’s core business

Open source software is an alternative to proprietary software, and since it's free, there are no customary licensing fees for using it. The revenue of Red Hat mainly comes from the annual or multi-year subscriptions of its enterprise technologies from large corporate houses, government institutions, and small and medium sized businesses.

One more source of revenue is the channel partner relationships, including original equipment manufacturers (OEM’s), cloud computing providers, value added resellers, and system integrators. Although Red Hat has a strong Linux (open source OS) business, its core focus is on the virtualization market, where it insists on becoming a dominant player. In the middleware market, Red Hat still lags behind competitors like Oracle (NYSE: ORCL), IBM, and Salesforce.com.

Q4 results

Operating primarily in three geographic regions, the Americas, EMEA, and the Asia Pacific, 44% of Red Hat’s revenue come from outside U.S., which is a testimony to its increasing international focus. Net income in Q4 for Red Hat was up from $35 million to $43 million, or $0.18 per diluted share.

It reported fourth-quarter revenue of $348 million and fiscal 2012 revenue of $1.33 billion, both up by 17% from a year ago. Subscription revenue for the quarter increased 19%. Annual cumulative and subscription revenue crossed the $1 billion mark for the first time on account of increased customer additions and renewal of the existing customer base.

Inorganic growth through acquisitions

Red Hat has been aggressively investing in new product areas such as storage, cloud computing, management, and big data organically and inorganically. It achieved inorganic growth with the help of a number of acquisitions executed last year.

One such acquisition was ManageIQ, a Delaware corporation, for $104 million in cash. ManagelQ is a virtualization and cloud management company which develops, distributes, and provides support for automation software and enterprise cloud management.

In the middleware space too, Red Hat made some acquisitions. Some of them include technologies which are complementary to its JBoss middleware technology. The first one, which included certain assets and related operations acquired from Polymita Technologies closed in August 2012.

The second one was FuseSource, a division of Progress Software Corporation, which closed in September 2012. Despite all these acquisitions, Red Hat still managed to generate 9% year-on-year growth in non-GAAP operating income, which is quite impressive.

Tough competition in all businesses

Red Hat has some of the world’s biggest names as its competitors. In its core business, which is the virtualization market, there are players like Citrix Systems (NASDAQ: CTXS) and VMware.

Texas-based Citrix provides server and desktop virtualization, networking, software-as-a-service (SaaS), and cloud computing technologies. It has been growing its revenue and margins each quarter. Revenue from license updates grew 22%, showing the strength of its recurring business.

It has an efficient management in place, and is on the way to capture more market share through acquisitions such as Zenprise, which will also allow the company to develop a complete mobile suite including GoToMeeting, Podio, and Sharefile.

Oracle is the world’s largest enterprise software company and a dominant player in the database application space. The company has a lot of cash and believes in acquisition-driven growth. It made an entry in the cloud market and internet services last year. Also, in the growing middle ware space, it enjoys a market share of 25%, making it the second biggest player after IBM. Oracle did not perform as expected in the previous quarter, due to inefficient sales execution and its hardware business, which declined 23%.

The takeaway

Red Hat is trading at 9-times trailing revenue and 40-times trailing EBITDA. All said and done, in spite of all the acquisitions and aggressive investments being made, does Red Hat really deserve to trade at this level?

With a price to equity (P/E) ratio of 63, it needs some spectacular growth to sustain that kind of valuation. My safest bet is to hold the stock till the next quarterly results and see how Red Hat deals with competition, especially in the virtualization market. Not that the stock cannot rise to much higher levels, but I don’t see that happening right now.

This article is written by Sourav Dutta (B.Tech, Information Technology, MM, Paris, MBA in Finance, IIFT) and edited by Shas Dey, StockRiters' Editor-in-Chief. Neither StockRiters nor any of its Directors or employees have any position in any stock mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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