Red Hat: Free Has Never Been So Lucrative
Soroush is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
In its 2012 fiscal year ended February 2012, Red Hat (NYSE: RHT) became the first open-source software company to report over $1 billion in revenue. The milestone caps years of consistent revenue and income growth and is both a strong indication that an open-source software business model can be lucrative and that Linux products can be serious competitors of proprietary offerings. If the company can maintain the business formula that underpinned its revenue and income growth for the past 40 consecutive quarters, the company may be an excellent and novel investment opportunity. Heck, it may even make a bigger splash than this tech stock.
The Open Source Model
Unlike competitors such as Microsoft (NASDAQ: MSFT) or Oracle (NASDAQ: ORCL), Red Hat’s source code is open to the public. Jealously guarded proprietary technology does not underpin corporate profits. Rather, Red Hat sells annual or multiyear subscriptions that entitle customers to support, training, and periodic software updates. Red Hat’s principal offerings are enterprise-class technologies. Some key differences between the proprietary model and Red Hat’s open-source model are:
- Developers: Proprietary software giants rely on in-house developers to improve product offerings while Red Hat supplements in-house development with a decentralized developer network. Independent developers can modify the source code, report bugs in the software, and suggest changes to improve product offerings over time. Red Hat’s crowd sourced development process creates an incentive for customers and independent distributors to improve the company’s offerings over time.
- Revenue Model: While many customers of proprietary software giants complain about paying for major updates and then may be underwhelmed by the overhauled product, Red Hat subscribers receive updates automatically as they are released over the life of a subscription.
The company relies fairly heavily on independent distributors and vendors as primary sales channels. Although this circumstance forces Red Hat to surrender some control of its distribution network, it is consistent with the open-source model in that vendors and distributors are free to create custom additions to Red Hat’s platforms for their individual customers or otherwise inject their own value-add propositions into Red Hat products. This arrangement also expands the Red Hat developer network by incentivizing improvement in the underlying platform. The scalability of the model is underpinned by the direct relationship between the size Red Hat’s customer base and its developer network – more customers; more developers; better products. Of course, it isn’t quite so simple, although one may be forgiven for thinking as much upon a cursory examination of Red Hat’s sustained financial successes.
A few quick facts:
- Annual revenue more than doubled from $523 million in fiscal 2008 to $1.3 billion in fiscal 2012
- Annual revenue increased at least 15% in every fiscal year between 2008 and 2012, inclusive, and the company has logged revenue growth for the past 10 years.
- Operating margins increased from 13% in 2010 to 18% in 2012
Despite revenue growth of only 16% – below analyst expectations – in the most recent quarter, Red Hat has delivered solid growth numbers time and again, even in the immediate post-crisis period of economic malaise. Net income and gross margins have been fairly stagnant, but since the company is consistently growing its customer base and logging increases in market share at such a rapid clip, margin expansion can safely take a back seat to customer growth.
International sales made up about 45% of Red Hat’s revenues in fiscal 2012, although the company’s North American segment contributed an outsized portion of total revenues. The company cites international expansion through greater acceptance of Linux products and maturing overseas distribution networks to be essential to future revenue growth. Overseas markets also offer more fertile ground for expansion in countries where intellectual property rights are not strongly protected (such as China), since Red Hat’s business model is not underpinned by proprietary technology, and in countries where anti-trust regulation, especially in the tech sphere, is more cumbersome than that in the United State (such as the EU), since Red Hat’s freely distributed product is more difficult – if not impossible – to ensnare in trade regulations. Meanwhile, growth in market share through greater adoption of Linux and growing preference for the subscription model are the primary factors underpinning revenue growth in the United States.
For individual investors, rapid and consistent growth within a revolutionary business model is very attractive. However, the company has the astronomical valuation metrics befitting a rapid growth. It’s current P/E ratio is about 73; Forward P/E: 48; PEG: 4.05. Strong growth in future periods is clearly priced in by the market already, which may be a reason to pause before investing. Assuming revenue growth continues at 15%, using 2012 shares outstanding (diluted), and the company’s net income margin remains stagnant at 13%, here’s a snapshot of Red Hat’s future financial position:
Notes: (1) Revenues and net income numbers are in thousands of U.S. dollars, and (2) share prices are expressed for a given P/E ratio and the projected net income number.
Now assuming all previous conditions but with 20% annual revenue growth:
The main takeaway here is that Red Hat will need to sustain incredibly rapid growth to justify its current valuation.
Among the risks to the Red Hat’s future success are:
- Poor economic growth: Strong investment in enterprise IT solutions is vital to continued growth. Red Hat is gaining market share, but a healthy overall market is essential.
- Growing a decentralized distribution network: Expansion of distribution channels is a fundamental component of Red Hat’s growth strategy. However, growth must be managed effectively so as not to impair the quality of support and training delivered to users.
- Developers and customers: The Red Hat model creates intricate links between the company, developers, and customers. Red Hat’s developer network is beneficial for crowd-sourcing development and allows the company to tailor its offerings in a more efficient manner than proprietary firms. However, should the company fail to cultivate and sustain its developer network, quality could suffer.
- Failure to maintain the benefits of the subscription model and/or failure to accurately convey the benefits of the subscription model to customers: Basically, can Red Hat improve product quality and make a successful sales pitch to those who are still unconvinced by the benefits of open-source?
Hold or Buy?
One who tends to be skeptical of innovative and novel business models may be unconvinced that intellectual property possession is not a necessary condition for value creation at a software company. However, Red Hat now boasts over $1 billion in annual sales and is looking forward to $2 billion contingent on a few of more years of sustained revenue growth. Its business model is no longer untested. Linux is becoming a real competitor in the software space and Red Hat is at the vanguard of this trend. In fact, this author runs a Linux distribution on his PC rather than Windows and is very satisfied with its capabilities and ease of use. The open source model …works.
As Red Hat grows, its offerings improve. And as its offerings improve, Red Hat grows. Despite sky-high valuation metrics and limited brand-recognition compared to Microsoft or Apple, Red Hat has long-term potential to create extraordinary value for shareholders. However, its present valuation is very high. An investment in outperformance is a risky bet, implying the expectation of even more rapid revenue growth than most analysts. My recommendation: For investors with a long time frame, a fairly good understanding of enterprise software and what Linux and the subscription model have to offer, and a palate for somewhat risky long-term investments, this could be an excellent play. For the more risk-averse and income stock-oriented, best take a pass on Red Hat.
WealthLift's Sentiment Index rates RHT as a moderate buy, with 77.78% of the community's users placing an "overperform" rating on the stock. For more trading ideas in today's uncertain market environment, visit WealthLift INSIDER.
This article is written by Denis Hurley and edited by Jake Mann. They don't own shares in any of the companies mentioned above. The Motley Fool owns shares of Apple, Microsoft, and Oracle. Motley Fool newsletter services recommend Apple. 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.If you have questions about this post or the Fool’s blog network, click here for information.