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Tickers in this Article: RHAT, NOVL, ORCL, MSFT, HPQ, DELL, IBM, INTC, BEAS, CRM
As any good contrarian knows, the biggest profits come from buying stocks that are out of favor and holding them until the herd falls in love with them again. With that in mind, take a look at Red Hat (RHAT).

For years, Red Hat could do no wrong. The company rode the riding popularity of open-source software to claim 80% of the market for Linux-based corporate server software. Market buzz lifted the stock as high as $32.30 this year.

In the past few months, however, the company has suffered some serious blows. First, disruptions arising from Red Hat's $450 million acquisition of JBoss resulted in a dismal set of Q2 earnings. Then, two of the software industry's biggest players, Oracle (ORCL) and Microsoft (MSFT) (through a partnership with Novell (NOVL)), announced their intentions to step into the Red Hat-dominated Linux market.

Worried investors dumped Red Hat. Now priced at $16.88, it's down 48% from its May high. The way I see it, the stock is descending into buying territory.

Red Hat's merger headaches may be temporary ones. It's been six months since the completion of the JBoss acquisition and, by now, most of the R&D and sales force personnel integration challenges should be ironed out.

Gains from adding JBoss' open source middleware to Red Hat's product stack should start to show up in the numbers over the coming quarters.

Of course, when big companies like Oracle and Microsoft choose to move into a market, it is cause for concern. Their entry is sure to shake things up a bit, but by no means does it sound the death knell for Red Hat.

If anything, Oracle and Microsoft confirm that the open source Linux movement is simply getting too big to be ignored. Market researcher International Data Corp. says the overall Linux market is going to grow by a whopping 25.9 percent annually to reach $35.7 billion in 2008. Greater support for Linux by Oracle and Microsoft's entrance could drive Linux adoption rates even higher, which is bound to benefit a pure-play vendor like Red Hat.

To give the benefit of the doubt to the bull's case for Red Hat, even in the face of new competition, Red Hat maintains a solid, leading position in a fast-growing market. Deep relationships with giants Hewlett Packard (HPQ), Dell (DELL), IBM (IBM) and Intel (INTC) cannot be dismissed. Its software, tried and true, is now deeply embedded in corporate customers' IT departments. Lengthy software service contracts mean that Red Hat's cash flows will remain strong. This company is not going away anytime soon.


Admittedly, this is a bit of a stretch, but recent events could be a prelude to a buyout. Oracle's move could be aimed at driving down Red Hat's shares ahead of a takeover bid. Oracle did the same thing before acquiring Siebel Systems and PeopleSoft.

Accounting for stock its stock option expenses, RHAT trades on a multiple of 35 times 2006 earnings and 26 times 2007 earnings. Compared to other software/technology stocks with fast growth outlooks (~25+%), Red Hat looks inexpensive. Seen against Novell, a close, but slower-growing competitor, Red Hat is a bargain.


Besides, we've seen that investing in solid software stocks after major disappointments can pay off handsomely. Coming off setbacks in 2005, Oracle, BEA Systems (BEAS) and Salesforce.com (CRM) each bounced back with sizable share gains in 2006. Red Hat could follow a similar path in 2007.

Of course, Red Hat may well face an unpleasant quarter or two as some customers try their hand at Oracle and Microsoft's Linux offerings. That could weigh on the stock in the near term.

But here's how I see it: Investors can snap up Red Hat stock now or wait until next quarter's results for a lower price to come along before buying in. Either way, I reckon it's a pretty good bet for those willing to wear the Red Hat for the long haul.

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