Why Red Hat Is a Sell Ahead of Earnings

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

As much as I’ve liked the business of virtualization giant Red Hat (NYSE: RHT), making an investment case for the stock has never been easy. For one, I have always found the stock to be too expensive. But secondly, with the presumed death of PCs, I wonder if the PC virtualization business is a prudent area to invest in for the long term.

However, as evident by Red Hat’s price-to-earnings ratio of 70, it is clear that the market has another point of view. Although it is not uncommon to find tech companies that are trading at absurd valuations, not many of them are missing profit estimates as Red Hat did in its second quarter.

On Thursday, when the company report on its third-quarter earnings, Red Hat will have an opportunity to prove whether or not its recent bottom line miss was an aberration or a sign of bigger troubles ahead. But before we jump into expectations, let’s reflect on what the company did to fall out of favor with me.

Quarterly Review and reflect

As much as Red Hat deserves the benefit of the doubt in terms of Q3 expectations, reviewing Q2 numbers makes this difficult. The company earned 28 cents per share on revenues of $322.6 million for the period ending August 31. Top line growth was good, but the bottom line is what substantiates such high valuations. The company missed – citing weak services demand. But was it?

The earnings reports from several rival companies told a different story. For instance, Citrix (NASDAQ: CTXS) seems to have no such struggles. In its comparable quarter, Citrix generated revenues of $615 million – representing year-over-year growth of 16% with net income reaching $92 million.

Similarly, in VMWare’s (NYSE: VMW) most recent quarter, the company reported net income of $156.8 million, or 36 cents per share on revenues of $1.13 billion – meeting revenue targets while beating analysts’ EPS estimates. This was particularly glaring since VMware competes directly for the same clients as Red Hat.

What’s more, VMware’s revenue growth of 20% was helped by a 29% surge of services revenue, which registered at $642.6 million. Likewise, in Oracle’s (NYSE: ORCL) most recent quarter, the company’s software and services revenue jumped 17%. This while also reporting an 18% year-over-year increase in net income, reaching $2.6 billion.

Moving Forward to Q3

Red Hat is struggling and the company is citing “weak services demand”- remarkably in the areas where the competition is showing strength. How could this be? So who’s really winning the race for market share? It doesn’t appear to be Red Hat. Although it’s a discouraging sign, as we know, momentum in the stock market is assessed on a quarter-over-quarter basis. What will Q3 prove?

For the third quarter, the company expects profit to arrive at $0.28 to $0.29 per share, with revenue ranging from $336 to $339 million. Analysts had expected $0.30 cents 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.

Bottom Line

These are not the numbers that I would expect from a stock that trades at a P/E of 70. I think investors need to re-evaluate their position and take a more realistic view of what Red Hat is able to produce now and in the future. These numbers just aren’t going to cut it – not over the long term. Speaking of long term, as I said in the intro, here we have a PC virtualization company and the market is screaming "PC death" at every turn. Something doesn't seem right.

In the meantime, although investors are willing to sacrifice near term profits today in favor of top line growth, eventually the bottom line will matter. In my opinion, at $52 per share the stock remains expensive and I would be a seller here ahead of earnings. However, if shares fall to the $45 range things might get interesting. 

rsaintvilus has no positions in the stocks mentioned above. The Motley Fool owns shares of Oracle and VMware. Motley Fool newsletter services recommend VMware. 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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