Insiders Are Selling This Expensive Software Provider

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

As insiders have a lot of advantages over average financial investors in terms of the company’s operations and industry backgrounds, insider trading should be closely monitored. Thus, we need to be aware of insiders’ actions, especially when insiders are selling out, as it might indicate the bearish outlook on the company. Recently, both the CEO and the CFO of Red Hat (NYSE: RHT), an open-source software provider, sold more than $950,000 of their personal stakes in the open market. Should investors follow their personal insider sales? Let’s find out.

The Business is Growing Fast and Generate Lots of Cash

Red Hat is considered to be the global provider of open source enterprise operating system platform, middleware platform, and virtualization as well as storage offerings for enterprise customers.  The Red Hat enterprise technologies were given to customers with annual or multi-year subscriptions, including the delivery, support services, enhancements and software application. The majority of Red Hat’s revenue came from Subscriptions, more than $965.5 million, accounting for 85% of the total revenue in 2012, whereas Training and Services contributed 15% of the total revenue. In the past 5 years, Red Hat has delivered significant growth in both topline and bottom line. The revenue has grown from $523 million in 2008 to $1.13 billion in 2012. Following the same trend, its EPS has increased from $0.36 in 2008 to $0.75 in 2012. The annualized compounded growth of revenue and EPS were 16.7% and 15.8% respectively. During the same period, its free cash flow has also increased significantly, from $156 million to $340 million.

On a Strong Balance Sheet

The high growth has been generated with a strong and debt-free balance sheet. As of August 2012, Red Hat had more than $1.48 billion in total stockholders’ equity, $869 million in cash and short-term investments, and no debt. Its goodwill and intangible level were high, of $718 million. The big items in the liabilities were current and non- current deferred revenue, which were $945 million combined. 

But CEO and CFO are Selling  

On December 26, James Whitehurst, the President and CEO sold 12,738 shares at an average price of $53.37 per share, with the total transaction value of nearly $670,000. On the same day, Charles Peters, Executive VP and CFO, sold 5,000 shares at $54.04 per share, with the total transaction value of more than $270,000. Last month, the CEO has also exercised his stock options at $19.95 per share and automatic sold 100,000 shares in the stock market for nearly $5 million.

Expensively Valued 

Compared to its peers including Microsoft (NASDAQ: MSFT) and Oracle (NYSE: ORCL), the fast-growing Red Hat is expensively valued in the market. 

<table> <tbody> <tr> <td> <p> </p> </td> <td> <p><strong>RHT</strong></p> </td> <td> <p><strong>MSFT</strong></p> </td> <td> <p><strong>ORCL</strong></p> </td> </tr> <tr> <td> <p><strong>Net margin (%)</strong></p> </td> <td> <p>12</p> </td> <td> <p>21.27</p> </td> <td> <p>28.38</p> </td> </tr> <tr> <td> <p><strong>ROIC (%)</strong></p> </td> <td> <p>10.31</p> </td> <td> <p>20.35</p> </td> <td> <p>17.7</p> </td> </tr> <tr> <td> <p><strong>D/E</strong></p> </td> <td> <p>0</p> </td> <td> <p>0.1</p> </td> <td> <p>0.4</p> </td> </tr> <tr> <td> <p><strong>Forward P/E</strong></p> </td> <td> <p>40.7</p> </td> <td> <p>8.4</p> </td> <td> <p>11.2</p> </td> </tr> <tr> <td> <p><strong>Dividend yield (%)</strong></p> </td> <td> <p>N/A</p> </td> <td> <p>3.1</p> </td> <td> <p>0.7</p> </td> </tr> </tbody> </table>

Red Hat is currently valued at as much as 40.7x forward earnings, and it pays no dividend. Its net margin and return on invested capital are far below Microsoft’s and Oracle’s. Among the three, Microsoft stands out, with the highest profitability and return. It also had the cheapest valuation in the market. In addition, it pays the most juicy dividend yield.

Foolish Bottom Line

Red Hat has been growing fast and generating increasing free cash flow over time. However, it is expensively valued in the market. The return and profitability were less than both of its peers. It also hasn’t paid any dividends yet. In addition, both the CEO and CFO are selling out. With all those above-mentioned reasons, I would not touch Red Hat for now. 

hoangquocanh has no position in any stocks mentioned. The Motley Fool owns shares of Microsoft and Oracle.. 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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