Red Flags At Red Hat

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The open source computer software company, Red Hat (NYSE: RHT), has long been a favorite of tech investors and momentum traders.

There's certainly a lot to like about the company. Red Hat looks to be a leader in its field and has shown excellent growth over the last few years. In fiscal year 2010 revenues were $748 million, grew to $909 million in FY 2011, and increased to $1.13 billion in FY 2012. The company also has a pristine balance sheet with no debt and net current assets of almost $400 million.

Red Hat also recently reported its fiscal year 2013 third quarter with revenues at a record $344 million that beat analyst expectations.

So what's not to like?

Well, there are a few warning signs that investors might want to keep in mind.

1. The Law Of Large Numbers May Hurt Red Hat's Growth Rate

High growth companies like Red Hat eventually face a "Law of Large Numbers" problem. The issue is that as a company gets a larger revenue base it needs a higher and higher sales figure to keep its growth rate stable. For example, if company ABC has $100 million in sales it only needs another $10 million in sales to achieve 10% growth. But when that same company has sales of $500 million it needs $50 million to achieve the same 10% growth rate.

For eight straight reporting periods, since its first quarter of fiscal 2011 to its fourth quarter fiscal 2012, Red Hat had shown quarter-over-quarter revenue growth of between 20% and 28%. However, in the first three quarters of this fiscal 2013, the company posted revenue growth of 19%, 15%, and 18%.

While the dollar amount of sales has increased in every quarter much the same as in previous years, the relative slowdown in growth rate on a percentage basis was hurt by the numerical necessity to increase sales more than in the past.

Investors may want to watch closely to see if this slowing growth trend continues. If it does Red Hat could be starting to face a "Law of Large Numbers" headwind. Here's a couple examples of how slowing revenue growth can have a significant effect on a company’s valuation.

Oracle (NYSE: ORCL), the database software giant, showed 2003 to 2005 revenue growth of close to 30%, supporting an average Price-to-Earnings (PE) ratio of between 19x and 25x. But now the company is currently priced with a lower 15x PE ratio mainly due to its recent three-year revenue growth of less than 9%.

Symantec (NASDAQ: SYMC), a security software company, has demonstrated a similar tendency. Its average annual PE ratio was between 30x and 50x in the period 2003 to 2005, helped by sales that more than doubled. As its three-year sales growth dropped to a still respectable 12%, its PE ratio was cut roughly in half. 

2. Red Hat's Looking For Growth Through Acquisitions

Red Hat has really stepped up its acquisition program over the last couple of years. The company spent roughly $135 million to purchase other firms in fiscal year 2012. This equaled a relatively sizable 64% of the company's adjusted net income for that year. In the current fiscal year the company has expended, including the recently announced ManageIQ purchase, roughly the same $135 million on acquisitions or about 59% of analyst's expected net income.

Though building a business through acquisition is not necessarily a bad thing, it does raise some questions. As an investor, I'd wonder if the acquisition strategy indicates less confidence in the legacy product line's growth potential. I'd also be looking to see how much these acquisitions actually end up contributing to the top and bottom line. Red Hat is spending a good deal of money on acquisitions and investors should rightfully expect a good return on these purchases both in future sales growth and increased profit.

3. Red Hat's Valuation Is Very Optimistic

As much as the law of large numbers and acquisition strategy could be troubling issues, what really magnifies the potential downside for the Red Hat stock price is the company's extremely generous valuation.

Using an analyst adjusted earnings estimate of $1.25 per share, I get an average adjusted cash earnings amount of around $263 million. After putting a significantly optimistic 30x market capitalization ratio on those earnings, a Red Hat fair value estimate looks to come in around $41 a share.

Supporting a share price much higher than an optimistic fair value estimate over the long term is very tough to do. The current market price seems to indicate an expectation that Red Hat will continue to report growth equal to or better than that shown in the past. It is now up to the company to meet the market's expectation.

Red Hat has shown itself to be an outstanding company and the market has rewarded its performance so far. But, given its current market premium, investors may want to keep in mind that any meaningful slowdown in growth would likely reduce the stock market’s admiration for the company and its willingness to maintain the relatively high stock price.


grahamsway (Bob Chandler) has a short position in Red Hat. The Motley Fool has no positions in the stocks mentioned above. 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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