Red Hat proves free can pay off big

It's the first open-source software company to hit $1 billion in sales.

By InvestorPlace Mar 30, 2012 9:50AM

By Kevin Kelleher

 

It's taken more than 12 years, but business-software company Red Hat (RHT) has finally turned its open-source software model into a billion-dollar business. The Raleigh, N.C., company announced earnings after the bell on Wednesday, and it posted $1.1 billion in revenue in its fiscal year 2012, the first time a pure-play open-source software company has hit that milestone.

 

Red Hat's business centers on Linux, the open-source operating system software developed by a community of volunteer developers. Red Hat's job is to help ensure Linux runs smoothly on its customers' data centers as well as software from other companies.

 

Although Linux is free, some companies have shied away from it because it's a constant work in progress for its devoted developers. Red Hat's service is to combine the usefulness of Linux with the stability that companies require from enterprise software. And as data centers become a bigger part of a cloud-based software industry, Red Hat is increasingly in demand.

 

CEO James Whitehurst said the period ended Feb. 28 marked the 40th straight quarter of sequential revenue growth. Revenue grew by 25% last quarter from the year-ago period. Operating profit grew even faster, by 33%, and operating cash flow, a measure of the company's ability to finance itself through its business operations, expanded by 35%.

 

At $12 billion, Red Hat's market cap is tiny compared to those of enterprise-software giants like Oracle (ORCL) -- valued at $146 billion -- and IBM (IBM) -- valued at $241 billion. But its stock has performed much better than either of those giants. Red Hat shares have gained 262% over the past three years, beating Oracle's 63% gain, and even surpassing IBM's impressive 121% rise.

 

And while Red Hat has yet to recapture its record high of $130, reached a few months after it went public in 1999, the impressive earnings this week did cause the stock to rally to a 12-year high. Red Hat surged 20% Thursday to $61.43, putting it among the illustrious group of dot-com crash survivors that have recovered to levels near where they traded 12 years ago.

 

Many of Red Hat's clients are in the financial and telecom industries, but increasingly companies in other industries are signing up for its services. Whitehurst told Barron's that while the company has a good deal of business handling the enterprise operating systems of investment banks, it has "just a tiny share of retail banking core systems."

 

He also said Red Hat's cloud business is expanding, and should grow this year as it rolls out a storage program that will help companies scale up their storage capabilities in the cloud.

 

Analysts were encouraged by Red Hat's better-than-expected revenue and profit, as well as its new guidance of $1.34 billion in revenue and earnings per share of $1.18 in the current year, well above Wall Street's previous consensus.

 

Bank of America (BAC) raised its rating on Red Hat shares to "buy" from "neutral," citing a "broadening customer base and expansion into additional verticals." Goldman Sachs (GS) praised the company's ability to top what it considered to be high earnings expectations. In addition, Lazard Capital (LAZ) also raised its price target on the stock to $64 from $57, and Raymond James (RJF) boosted its target on RHT to $63 from $52.

 

Now that the stock is close to those new target prices, the expectations facing Red Hat may be even higher. The stock is trading at 52 times the $1.18 earnings per share that the company is projecting for this year, and at 44 times its fiscal 2014 earnings expected by analysts. That sets a lofty bar for Red Hat to jump over.

 

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