Relief At Red Hat, But The Long-Term Growth Debate Will Rage On

By Stephen D. Simpson, CFA | June 20, 2013 AAA

I realize that Rule 36 of the internet says that you cannot challenge or question a stock in any fashion without being “secretly short”, but I think it's worth asking some questions about Red Hat (NYSE:RHT). On one hand, I do like the cash flow that this business produces, and I do believe that there are real opportunities for the company in middleware, data center, and cloud. On the other hand, the trend in billings and margins makes me wonder if this company is already transitioning out of its growth phase. Accordingly, while I wouldn't bet against this stock with my own money, it's hard for me to scoot this name up my watch list to a point where I'd seriously consider buying it with my own money.

Fiscal Q1 Results Rebound
I don't think investors can sound the “all clear” for tech on the basis of Red Hat's fiscal first quarter results, but they were a step in the right direction.

Revenue rose 15% as reported (or 17% in constant currency) and basically met the average Street estimate. Subscription revenue basically matched total revenue (up 16% and 4%), while billings were up 14% in constant currency, against a pretty easy year-ago comp.

Things usually get a little hairy when it's time to talk about the margins with this generation of software companies, and this was no exception. Gross margin fell slightly from last year, but did rebound from the prior year. Operating income rose only 7%, though, and this marked the fourth quarter in a row of lower margins.

Extending The Business In Logical Directions, But Will The Growth Measure Up?
I don't think there's much doubt that Red Hat did well for itself (and shareholders) on the basis of Linux support, and now the question is whether the company can replicate that success with its next act(s).

It would seem that the efforts in middleware are doing pretty well – middleware was included in 60% of the top deals this quarter, and Red Hat is a legitimate alternative (if not threat) to IBM (NYSE:IBM) and Oracle (Nasdaq:ORCL) in these markets. But while the attach rate is improving (it wasn't so long ago that middleware was included in only about 20% of the top deals), the margins very clearly are not – so the revenue base is expanding, but it's worth less now.

That makes me wonder what will happen as the company challenges rivals like EMC (NYSE:EMC), IBM, VMware (NYSE:VMW), and Microsoft (Nasdaq: MSFT) in markets like storage, virtualization, and cloud management. I don't dispute that Red Hat's offerings will appeal to enterprise customers, nor that they offer good savings relative to the entrenched competition. But if the recent trend in margins continues, it raises the question of “profitless prosperity”.

SEE: Technology Sector Funds

I'm also a little concerned about long-term sell-side expectations relative to recent trends in bookings. This is clearly a sluggish period for the tech sector, so I don't want to argue that this quarter is the “new normal”, but Red Hat's bookings deceleration started before this lull, and I'm concerned that the expectations of consistent mid-teens growth may be too aggressive now.

The Bottom Line
On a cash flow basis, I think Red Hat could still be undervalued. That said, cash flow-based valuation doesn't often drive tech stocks and worries about mid-term and long-term growth could lead to lower multiples and a harder road for the stock. Plenty of sell-side analysts applauded these earnings and continue to support the stock, and if companies like Oracle report better earnings and guidance the shares could certainly regain momentum. Even so, I'm not comfortable enough with the sentiment issue to buy these shares today, even if the cash flow-based valuation looks reasonable.

Disclosure – As of this writing, the author owns shares of EMC.

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