Another quarter has rolled by, and cloud is still a hot topic in the tech world. Recently, though, some of that chatter has turned more negative. With Amazon's (Nasdaq:AMZN) cloud servers apparently being used by the hackers that targeted Sony's (NYSE:SNE) PlayStation network, there's a fresh reminder of some of the potential vulnerabilities to cloud architecture.

TUTORIAL: Stock Basics

How much that matters to Red Hat (NYSE:RHT) right now is not so clear. Red Hat is still in the early days of its evolution into a cloud provider (middleware and virtualization, alongside its enterprise Linux) and even if cloud adoption slows a bit in the short term, it likely does not impact the long-term picture at Red Hat for a while. That said, Red Hat still has some of its own issues to address.

Yet Another Strong Performance at Red Hat
Pardon the pun, but good quarterly reports are becoming a little old hat for this name. Red Hat posted revenue growth of nearly 27% (and up about 8% sequentially), as subscription revenue rose almost 26% and training/service revenue rose more than 30%. Backing up the solid revenue number was 28% growth in billings - suggesting that momentum is still pretty solid. (For more, see Introduction To Momentum Trading.)

The "yeah, but" comes once again from the profit leverage at Red Hat. Gross margin was basically flat (at a solid 84%) and operating income rose nearly 33%. While a nearly one-point increase in operating margin would sound like a good thing, the concerning detail is that leverage is coming from R&D and general and administrative expenses. Sales and marketing expenses were up a little over 30% and that still concerns me - if Red Hat cannot find a way to deliver better marketing leverage, it is basically racing itself on a hamster wheel.

Scarcity Value Picking Up?
To some extent, the question of whether Red Hat can build a leverage sales model may be moot. Alongside Tibco (Nasdaq:TIBX), Red Hat stands as one of the few attractive freestanding middleware targets and that's an area where a company like Hewlett-Packard (NYSE:HPQ) is still weak.

Likewise, Red Hat could be an attractive fill-in deal for a much larger software company like SAP (NYSE:SAP) or IBM (NYSE:IBM). Whether tech spending stays strong or not, it does not seem unreasonable to think that a bigger software company is considering its "buy versus build" options and M&A has always been pretty common in the software space. (For related reading, see 8 Reasons M&A Deals Fall Through.)

No Deal, No Problem
Leaving aside the sales leverage problem, there is plenty of revenue opportunity for Red Hat if it stays independent. If the company continues targeting the cloud market, Red Hat is going to start bumping into companies like VMware (NYSE:VMW), Salesforce.com (NYSE:CRM) and Concur (Nasdaq:CNQR) more often. Thus far, Red Hat has done well as one of the largest companies in the Linux space, so that degree of competition is a concern. On the flip side, there is ample business to go around and Red Hat has a few attractive tricks up its sleeve in terms of features and cost that should help it compete.

The Bottom Line
Red Hat is not cheap, but that seldom matters to tech investors. So long as Red Hat delivers 20% sales growth and maintains momentum in non-GAAP operating income and operating cash flow, the company's stretched valuation multiples are not going to be an obstacle to further price appreciation. Even with torrid growth, however, shareholders should keep an eye on the sales and marketing line. Absent some signs of leverage here, it is only a matter of time before the buzz around Red Hat turns from "good growth" to "can they grow profitably"? (For related reading, see Steady Growth Stocks Win The Race.)

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