Tickers in this Article: RHT, ORCL, MSFT, SAP, IBM, HPQ, CRM, SFSF
Sometimes it seems that Wall Street drives the news more than the news drives Wall Street. In other words, investors interpret events and information in ways that are consistent with how they already want to view the world. Maybe that explains why stocks often sell off on good news or rise on bad news. In the case of Red Hat (NYSE:RHT), for instance, this software and service provider showed a fair bit of financial progress in the fiscal third quarter, but Wall Street seems hung up on a minor guidance revision and appears to be looking for an excuse to sell.

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Solid Third Quarter Performance
Red Hat announced that revenue rose 23% for the Q3, with subscription revenue up about 24%. Billings growth (which is revenue plus the change in deferred revenue) was up 23% for the period. For the quarter, Red Hat did well with large deals - signing 27 deals worth more than $1 million and 5 deals in excess of $5 million.

Margins are often a talking point with this story, but Red Hat showed some progress. Gross margin improved nicely on both an annual (130 basis points) and sequential (100 basis points) basis, and operating income rose 41%. With that rise, operating margin rose more than two points from last year, but it did slip about 20 basis points from the prior quarter. (For related reading, see What Is A Basis Point?)

Unfortunately, the sales and marketing leverage still isn't showing up. Sales and marketing expense growth (up 26%) exceeded revenue growth, and the company's operating margin leverage came from flat internal spending (G&A). It's worth noting that Red Hat's margins are better than those of Oracle (Nasdaq:ORCL) or Salesforce.com (NYSE:CRM) when they were at this size (in revenue), but this is still a key issue with the story.

Guidance Wasn't 'That' Bad
What seems to really be bothering the Street (and pushing the stock down before the market open on Tuesday) is the guidance that management gave for the fiscal Q4. Earnings guidance was fine - 26 to 27 cents versus a prior expectation of 26 cents. On the revenue line, though, management revised the range to $289M to $292M, versus a current average of $292.5M and a range of $278M to $301M.

That is the basis of the speculation with which I opened this article. A revision of that scale (coupled with this quarter's performance) just does not seem to mesh with the market response. That suggests, then, that the Street was already looking to take profits, as Red Hat has had a bit of a run on the backs of the acquisitions of RightNow and SuccessFactors (Nadsaq:SFSF) by Oracle and SAP (NYSE:SAP).

Otherwise, the Story Remains the Same
Not a lot has changed about the Red Hat story in the last quarter. The company continues to do well with Jboss middleware products, and service-oriented architecture seems to be making a real difference.

Likewise, the company is still vulnerable to competition from Oracle (Unbreakable Linux) and the Linux partnership between Novel and Microsoft (Nasdaq:MSFT). There is also still a potential buyout story here, as companies like SAP, IBM (NYSE:IBM) and Hewlett-Packard (NYSE:HPQ) could use Red Hat to plug various holes in the offerings.

The Bottom Line
Another part of the Red Hat story that hasn't changed much is the valuation issue. Red Hat's current valuation already assumes a great deal of growth. Could Red Hat use its ample cash flow and equity currency to launch more potentially transformative acquisitions? Absolutely. The problem is that today's valuation already seems to assume that some of that will happen, and it doesn't leave much wiggle room.

The reality is that Red Hat is a quality growth software name, and that will always appeal to a segment of the investing audience. Moreover, with M&A activity percolating in the software space, it's not hard to imagine that investors are projecting where the pieces will move on the board and what that could mean for Red Hat. Value investors aren't going to find much here, but that's not an uncommon situation in technology. (For related reading, see Biggest Merger And Acquisition Disasters.)

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At the time of writing, Stephen Simpson did not own shares in any of the companies mentioned in this article.

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