Red Hat breaks out of Linux niche

With its open-source cloud computing platform gaining traction, and revenue and earnings trending in the right direction, green is the only color Red Hat is looking at.

By TheStreet Staff Sep 20, 2013 11:08PM

Hands in circle, palms upward, close-up © Sami Sarkis, PhotographerBy Richard Saintvilus, TheStreet

 

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From a valuation viewpoint, I haven't been the biggest fan of Red Hat, which reports its fiscal-second-quarter financial results Monday after the market's close. Shares of the open-source software developer carry a price-to-earnings ratio of 67, five times more than both Oracle (ORCL) and Microsoft (MSFT). (Microsoft owns and publishes MSN Money.)

 

I don't mind disclosing that, as a value investor, I've always resented Red Hat for its costly premium. You can save your "keep emotions out of investing" emails -- I'm over it now.


I've come to accept there's not much a company can do when the Street has already made up its mind that it's going to love the stock no matter what, especially when it comes to companies having anything to do with cloud computing or virtualization software.

 

While I wouldn't make an all-out plea for investors to jump into the stock ahead of earnings, I would point out that -- after a solid June quarter by that included new strategic growth initiatives such as Open Shift and Open Stack -- Red Hat may have uncovered new ways to justify investors' trust.


As with "big data" and other IT buzzwords, Open Stack -- which has attracted interest from Microsoft, Hewlett-Packard (HPQ) and VMware (VMW) -- has begun to generate considerable momentum.


Growth has never been a concern


What's more, unlike at Oracle, which had an absolutely brutal June quarter, management at Red Hat continues to do an excellent job of balancing expectations with performance. So, as with IBM (IBM) and Oracle, which have shown eroding growth trends, growth has never been an issue for Red Hat.


With revenue climbing more than 15% in the June quarter, I've had no choice but to tip my cap to the company's management, especially since Oracle produced growth of less than 1% in the period.


Unlike Oracle and, to some extent, IBM, Red Hat continues to outperform in its subscription business, which grew 16% year over year and 4% sequentially. Not to mention, the company beat earnings-per-share estimates by 1 cent.


Now, Red Hat bears and perhaps Oracle bulls might suggest that I'm "exaggerating" the June performance. But in the context of a weak enterprise spending environment, which (pretty much) killed hope for any growth in software sector, I can counter that argument and suggest that it's "sour grapes."


Stealing some meaningful market share


Along those lines, while I'm not willing to go "tit-for-tat" as to which software companies are better managed than others, it certainly appears as if Red Hat has begun to steal some meaningful share from its rivals. Before you disagree, consider that the company posted a 3% miss in its "billings" or deferred revenue target in the March quarter, which (then) prompted management to guide down.


However, in the June quarter, Red Hat's billings, which is the metric that indicates the strength of future sales, increased 12% year over year. I don't believe that level of improvement was manufactured out of thin air. The question is if this can continue. On Monday, we are certain to find out. The Street is looking for 33 cents in earnings per share on revenue of $372 million, which represents year-over-year revenue growth of 15.3%.


Although management did issue both revenue and profit outlook that were in line with analysts' expectations, on the basis of Red Hat's sequential improvement I'm expecting the company to beat both estimates. As is often the case, how the stock reacts will be based on how the company guides. With still no clear signs that enterprise spending will be back to robust levels, I expect that management will play it conservatively and not divert too much from consensus estimates.


The good news is Red Hat is no longer just a niche Linux operator. Investors have long feared that despite the company's strong Linux business, Red Hat lacked differentiation in areas such as middleware, which is the software that lies between an operating system and specific software applications. With Open Stack gaining traction and both revenue and earnings trending in the right direction, expensive stock or not, "green" is the only color Red Hat sees.


These realities have prompted investors to sell off the stock this year by as much as 13%. The stock still hasn't entered my value threshold yet, however.


At the time of publication, the author held no position in any of the stocks mentioned in the post.

 

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2Comments
Sep 21, 2013 10:11AM
avatar
yay this is better then jesus good news !   and i dont understand  this: REDHAT CAN BE FREE  check it out guys  Scientific linux and centOS both try to be 100% compatible with red hat code.
but for free. where microsoft has nothing like that.  and even RHEL GIVES SCIENTIFIC LINUX (CERN) the thumbs up to copy there software...  becuz rhel is based off FEDORA (free)

grats rhel

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