Does Red Hat Still Deserve a Tip of the Cap?
Richard is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
As the prospects of “the cloud” start to take shape, investors have started to place huge bets on certain companies that they think not only will become leaders, but also will produce market-beating performances. As evident by the inflated multiples within the sector – which includes names such as EMC (NYSE: EMC), Citrix (NASDAQ: CTXS) and Salesforce.com (NYSE: CRM) -- it seems investors care very little about valuation, so long as the growth potential is high.
One name that continues to get tossed into the mix is that of software and desktop virtualization giant Red Hat (NYSE: RHT). The stock continues to enjoy the market’s favor. But is it deserved? While there is nothing to suggest that its potential should not be as high as its peers, investors should wonder whether the company has shown enough that it can continue to leverage its business model as its valuation presumes.
Its P/E of 72 implies that investors don't care much about this question. That may be fine for now, because the company has performed as well as can be expected. However, there will come a time when investors have to offer justification for Red Hat's stock price -- and the failure of its margin and market share to grow commensurately. What do you suppose happens then?
Furthermore, the company’s second-quarter earnings results yielded several signs that now might be a good time to re-evaluate Red Hat's prospects.
The quarter that was
For the period ending Aug. 31, Red Hat earned $0.28 per share on revenues of $322.6 million. Though it exceeded sales expectations of $321.7 million, the company missed bottom-line estimates by a penny. Red Hat cited weak services demand for its miss. And as much credit it deserves for what it has done over the past couple of years in terms of revenue growth, my biggest concern when looking at its valuation is with its bottom-line performance. On that note, with so much competition gunning for its business, growth in earnings will continue to be secondary, as Red Hat will be forced to spend to grow its revenues.
For the third quarter, the company expects profit to arrive at $0.28 to $0.29 per share, with revenue ranging from $336 million to $339 million. Analysts had expected $0.30 per share in net income on sales of $339.7 million. For the fiscal year, the company also reduced its sales expectations to $1.32 billion from a previously expected top range of the $1.34 billion that it offered earlier this year. Investors were not pleased, sending the stock lower by 4.3% to $55.08.
Moving forward
While the driving force of its valuation has been its strong revenue growth, which increased 15% from the previous year, are investors now growing impatient? Valuation has rarely mattered for this sector, where Red Hat rivals such as Citrix, VMware (NYSE: VMW), and EMC all enjoy high multiples. But is this now a sign of things to come? I appreciate sales growth as much as anyone, but now wonder whether if investors will ever get the sort of margin leverage and profitability that they are paying for.
What’s more, not only is there the threat of competition from the likes of Microsoft (NASDAQ: MSFT) and Oracle (NASDAQ: ORCL), but the company also has a hard time proving that other areas of its business will have a challenging time matching the success of its Linux support. Can it steal market share from VMware or EMC in areas such as virtualization and storage? Currently, it seems that Oracle and IBM (NYSE: IBM) has superior services in WebLogic and WebSphere (respectively).
To its credit, Red Hat’s JBoss platform appears to be making meaningful strides, but for how long? Though it is performing now as well as can be expected, I think Red Hat will find it increasingly difficult to differentiate itself from rivals in specialized areas. Customers tend to stick with technologies they know and trust. And Red Hat may have to consider competing on cost to grow revenues in its “non-core” businesses. But being cheaper comes at a cost.
Will Red Hat risk hurting its margins and prolonging its weakness on its bottom line? It’s a delicate balance. But the company has the management structure in place to make these tough decisions. In the company’s favor, its days of being considered only a Linux niche business are over. The company is now highly regarded as a dominant force within the enterprise sector, and in all that the cloud has to offer. It only needs to prove that the high bets placed on it were correct.
Bottom line
Without question, the company is here to stay, and it's proven that its business is fundamentally sound. Nonetheless, it’s hard to fall in love with its valuation when margins don’t grow in tandem with to its strong revenue performances. Making a play for the stock at this level is a tough call to make. As much as I like its business, I just don’t see meaningful premiums on the horizon.
rsaintvilus has no positions in the stocks mentioned above. The Motley Fool owns shares of EMC, International Business Machines, 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.If you have questions about this post or the Fool’s blog network, click here for information.
