This Tech Stock Disappointed but its Prospects Look Good

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The market didn’t like everything it heard from Red Hat (NYSE: RHT) about its latest results and the usual knee jerk reaction saw the stock open lower. Anytime a company misses estimates and lowers guidance the same response can be expected. However, I think the results were pretty good and read across quite well for the technology market. Stocks are being rewarded now for merely not reporting Armageddon and don’t be surprised if Red Hat recovers within a few days.


Red Hat’s Results

A brief summary of the results and guidance

  • Q2 Revenues of $322.6 million vs. analyst estimates of $321.7 million
  • Q2 EPS 28c vs. estimates of 29c
  • Q3 Revenue guidance of $336-339 million vs. estimates of $339.7 million
  • Q3 EPS guidance of 28-29c vs. estimates of 30c
  • Full Year Forecast lowered from $1.32-1.33 billion vs. previous guidance of $1.32-1.34 billion

Red Hat lowered the top end of full year guidance mainly because services revenue is seeing some weakness as the economy slows. The more important subscriptions revenue shows little sign of slowing which suggests its growth prospects are relatively secular. The earnings miss in Q2 was largely put down to a hit from acquisition integration costs. These costs aren’t recurring and Red Hat beat on the top line so perhaps the market is being harsh in its reaction?

A long term look at how revenues are trending illustrates these points well.

<img src="/media/images/user_12882/red-hat-1_large.png" />


Revenue growth is slowing but we are still talking about mid teens top line growth. As for the services weakness, part of it is due to training revenues slowing because of the economy. However part of it was deliberate. Red Hat has been encouraging its partners to sell services themselves in order to drive Red Hat’s subscription sales and in particular in middleware. Indeed, the recent acquisitions have been in order to expand Red Hats middleware offerings and it is reporting good growth here. So the service weakness is not as bad as first may be assumed.


A Good Few Years

Red Hat has been doing well in recent years from the ongoing shift to Linux from Microsoft’s (NASDAQ: MSFT) Unix based operating system. The good news for Red Hat is that there are still parts of the world like Korea, Russia or parts of Latin America that still have lots of Unix so Red Hat still has new territories to take.  Microsoft is also challenged by Linux within the cloud. Of the cloud providers the main user of Unix is (predictably) Microsoft while the others tend to use Linux based systems.  For example Rackspace and Amazon are both customers of Red Hat.

Another area where Red Hat has benefited has been from Oracle’s (NYSE: ORCL) purchase of Sun. As part of the strategy to integrate Sun, Oracle decided to move away from selling low-end servers. This strategy saw the likes of HP, Dell and IBM grab some easy market share. The good news is that they are all Red Hat partners.

As a result of these favorable opportunities, revenues and profits have increased dramatically.

<img src="/media/images/user_12882/redhat2_large.png" />


The question is can they continue?

 Much of the answer to that will depend on expanding its middleware sales.


Middleware Growth Prospects

Frankly I think this is a very attractive market to be in and Red Hat is doing well to enter it. The explosion of data from things like social networking and mobile internet usage is creating a need for the integration of data analytics and processing. The last leading player to report was Tibco (NASDAQ: TIBX) and despite lowering guidance the company forecast mid-teens growth in license revenues for the next quarter. Tibco is interesting because it provides highly specialized needs but the leading players are still IBM with Oracle following behind them. This is tough competition to beat and Red Hat has needed to make acquisitions in order to get traction, but things appear to be moving on the right track now.


Where Next For Red Hat?

It’s hard to argue that the stock is cheap but it’s also hard not to like its growth prospects. Longer term it has to continue to grab market share in operating systems by taking share from Microsoft’s Unix.  Moreover, in middleware it needs to accelerate deal flow to break the dominance of IBM and Oracle in the general middleware market. This is a tough call because these companies are formidable competitors with huge resources behind them, but so far so good.

 My view is that this stock is going to need a dip before its gets attractive on a risk/reward basis. I think there are better value stocks in the tech universe than Red Hat.

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