Red Hat Earnings: Two Months Later
Tim is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
It was about two months ago when the now $10 billion open source software provider Red Hat (NYSE: RHT) blew up – in a good way - for shareholders. The company had just released fiscal Q4 numbers and tech geeks everywhere were all aflutter. Revenue was up – again – and management guidance for the balance of 2012 and 2013 was unwavering.
After the run-up of about 16% following the late March earnings announcement someone – I’m legally bound to avoid naming names – had the unmitigated gall to suggest Red Hat was overvalued. Well, you can imagine the comments from rabid open source fans - none were positive, though thankfully cursing was kept to a minimum. That’s to be expected though since Red Hat – like many a tech-related firm – has formed an strong alliance with their users and shareholders, much like Apple, LinkedIn, Netflix and other companies of the ilk. The sometimes unfortunate result is making important investment decisions based on emotion instead of fundamentals.
Let’s take another look at the numbers that so enthralled investors two months ago. Revenues were up significantly vs. the year-ago period – as were gross profits, gross margins and operating income – which was all good. But there were a couple other items that were somehow swept under the rug during the shareholder lovefest. On a non-GAAP basis net income was essentially flat compared to Q4 of ’11, largely because operating expenses shot through the roof. On a sequential quarter vs. quarter basis operating income was down, profits were down and the aforementioned expenses – primarily selling and admin – skyrocketed. And more telling is each of these areas have been trending downward for several successive quarters.
Does this data suggest that Red Hat is somehow a bad investment for existing shareholders and they should run for the hills? No, not at all – in fact Red Hat is a sound company with solid products and services, making the stock a hold for current owners. But a buy today – even after the 12% drop since the article a couple of months ago - nope. Valuing a company like you would an internet growth firm new to the market – though Red Hat’s been public for nearly 13 years now - waiting for the company to catch up to its stock price isn't warranted.
Readers of the article a couple months ago made comments suggesting that P/E multiples don’t apply – or at least they shouldn’t – because Red Hat has strong cash flow. Okay, let’s forget the company has been publicly owned for 13 years and throw the 70 times current earnings and nearly 40 times future earnings multiples out the window.
As Red Hat continues emerging as a serious Cloud competitor – on top of their middleware prowess and a solid suite of other products and services – they’ll be competing with the likes of IBM (NYSE: IBM), Oracle (NASDAQ: ORCL) and Microsoft (NASDAQ: MSFT) even more than they already do.
Based on Red Hat’s current price to sales ratio the company is anywhere between three to four times more expensive than IBM, Microsoft or Oracle. Based on sales? Two to three times more costly than Oracle or Microsoft, though IBM takes the cake in that department. Return on equity isn’t really fair because – to Red Hat’s credit – they have no debt and the higher equity skews that result.
As a VP of two independent equity research firms, I learned – among other things – there are innumerable ways to value a company. And these don’t even count the gazillions of proprietary valuation methods that permeate the investing landscape. The two research firms I alluded to? Yeah, each have their own means of screening investment opportunities.
For the emotionally attached investor the myriad of valuation techniques and methodologies can pose a problem. Why? Because it’s virtually certain if you look hard enough you’ll find one – somewhere – that validates what is really an emotional decision. For an established firm with a track record, rely on fundamental data - you’ll be glad you did in the long run.
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