Hold This Cloud Stock

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Red Hat Inc. (NYSE: RHT) is the world’s leading provider of open source solutions. It is an American multinational and is engaged in providing various solutions to enterprises. These include its core enterprise operating system platform, Red Hat Enterprise Linux, virtualization, Red Hat Middleware, cloud and other storage offerings. Nowadays cloud stocks are a hot topic for investors, but what about this stock?

Core business

Red Hat mainly deals in open source software which is free and an alternative to proprietary software. There are no customary licensing fees for using this kind of software. Red Hat’s revenues mainly come from the annual subscriptions of its enterprise technologies from government institutions, large corporate houses and small and medium sized businesses. Another source of revenue is the channel partner relationships, including original equipment manufacturers (OEM’s), value added resellers, cloud computing providers, and system integrators. Red Hat insists on becoming a dominant player in the virtualization market in the future. Red Hat is quite diversified in its choice of markets with 44% of its revenue coming from outside US. Recently both the annual subscription and cumulative revenue crossed the $1 billion mark for the first time due to increase in customer additions and renewal of the existing customer base.

Growing, and growing fast

Red Hat has been aggressively investing in new product areas such as storage, cloud computing and big data. It achieved inorganic growth by executing a number of acquisitions last year with deals worth around $5 million. One of them was ManageIQ, a Delaware corporation and a virtualization and cloud management company which develops, distributes and provides support for enterprise cloud management and automation software.

In the middleware space too, Red Hat acquired some companies whose business is similar to its JBoss middleware technology. One of them was the acquisition of certain assets and related operations of Polymita Technologies which was closed on August, 2012. The second one was FuseSource, a unit of Progress Software Corporation which ended on last September. In spite of all the acquisitions, Red Hat still managed to generate a 10% year-on-year growth which acts as a testimony to its strong balance sheet and cash flows.

The peer market

Red Hat competes with some of the world’s biggest names. In the virtualization market, which is its core business, there are players like Citrix (NASDAQ: CTXS) and VMWare (NYSE: VMW).

Citrix, a Texas based company provides server and desktop virtualization, software-as-a-service (SaaS), networking, and cloud computing technologies. It has been growing its revenues and margins at an impressive pace quarter by quarter. License updates grew by 20% proving the strength of the company’s recurring business. Citrix has a competent and efficient management in place and is set to capture more market share by acquisitions like Zenprise. That will also help the company to develop a complete mobile suite including Sharefile, GoToMeeting and Podio.

Oracle is the world’s largest enterprise software company and a strong player in the database application space. The company possesses huge cash in hand and its management believes in acquisition-driven growth. Oracle made an entry though a bit late in the cloud market and internet services only last year. In the middle ware space, it enjoys a healthy market share of 25% which makes it the second biggest player after IBM. The recent introduction of the Oracle services cloud will boost its cloud offerings and product support revenues.

Summary

Currently, Red Hat is trading at 9-times trailing revenue and 40-times trailing EBITDA. With a price to equity (P/E) ratio of 63, can it really maintain that kind of valuation? Even with a strong balance sheet, the stock looks a little overvalued to me and needs some spectacular growth to sustain it. I will suggest holding Red Hat till the next quarterly results and checking how the company deals with competition, especially in the virtualization market. The stock definitely can rise to higher levels; however I see a slim possibility of that happening at the moment.


Tanya Kanodia has no position in any stocks mentioned. The Motley Fool recommends VMware. The Motley Fool owns shares of 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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