Red Hat Shows Good Growth, But Still a Long Term Risk

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

My sell recommendation for enterprise giant Red Hat (NYSE: RHT) ahead of the company’s third quarter earnings report on Thursday didn’t win me many friends. The premise was simple: as evident by its P/E ratio of 70, the stock was too expensive relative to the growth the valuation presumes. I still feel this way. Nonetheless, on the heels of what was a solid earnings report, I feel the need to give credit where credit is due.

The Quarter That Was

For the period ending Nov. 30, Red Hat posted revenues of $343.6 million – representing a year-over-year increase of 18% and 21% in constant currency. Also impressive were subscription revenue, which registered at $294.2 million - surging 19% year-over-year. This was encouraging since Red Hat absorbed criticism for its weakness in this area. Things appear to have changed.

On the other hand, operating income was disappointing – registering at $49.9 million, down 7% year-over-year. Management said this was due to (among other things) costs related to acquisitions and stock-based compensation. On a non-GAAP basis, operating income arrived at $82.5 million – representing a 5% year-over-year increase.

Likewise, non-GAAP operating margin logged in at 24%, over 3 points lower year-over-year. This impacted the company’s bottom line. Net income arrived at $34.8 million, or $0.18 per share - 9% lower than the $38.2 million Red Hat earned last year. On a Non-GAAP basis, net income showed a slight year-over-year improvement - arriving at $56.9 million, or $0.29 per share.

This was enough to best last year’s mark of $55.7 million. Cash flow was also impressive – coming at $100.2 million, an improvement of 3.7% year-over-year with total deferred revenues increasing 21%.  To top it off, the company ended the quarter with $1.35 billion in cash equivalents and investments.

Moving Forward

It’s hard not to have been impressed by these numbers. Red Hat continues to show that it has a solid business. However, so too does the competition – particularly VMware (NYSE: VMW) and Citrix (NASDAQ: CTXS), which have both been gunning for Red Hat’s business. In many respects, they have been successful since their virtualization platforms compare favorably.

Red Hat’s 3% dip in operating margin suggests that the company is starting to experience some pricing pressure and may not have the sort of leverage that it needs to fight off the competition. Meanwhile both VMware and Citrix have been growing revenues and margins each quarter. 

To date, Red Hat is doing a decent job averting these threats. But for how long? Can it fend off others such as Oracle (NYSE: ORCL) and IBM. I think they're just biting their time and have Red Hat in their crosshairs. Although Red Hat's JBoss platform has gained traction, I just don't think (today) it is a match for Oracle's WebLogic or IBM's (NYSE: IBM) WebSphere.  

Also, Red Hat has been trying to enter the middleware market, which makes sense. The company sees a way to diversify its offerings while also being able to provide higher margin services such as storage and virtualization. But how well will this work? Storage giants such as NetApp and EMC are not just going to roll over and give up their business.

Likewise, although Red Hat seems fine now in the realm of virtualization, it often takes acts of god to get companies to end their relationships with existing vendors where rivals such as Microsoft and Citrix have already planted flags.

In other words, unless Red Hat can convince the market that it can offer equal to better solutions than what they already have, there’s only one thing that can motivate a loyal client to switch – and that’s price. But then we’ve circled back to the same issue that we started off with – margin pressure and profitability. So what’s next? Good quarter or not, this is the question Red Hat must answer today.

Bottom Line

When I issued my sell recommendation earlier this week, Red Hat’s P/E registered at 70. Today, it has jumped to almost 73. My opinion has not changed. With the current risk factors that I have highlighted above, the stock remains too expensive. The good news is that growth has not slowed. On the other hand, I just don’t believe the company will ever grow enough to support the premium investors are expecting. The competition won’t allow it.  

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