Open source is still popular, and Red Hat (NYSE:RHT) is riding the wave. What remains to be seen, though, is whether Red Hat can prove that there is further leverage in its business model and/or when investors will start to care about this detail. Although Red Hat has as good a shot as any of being a force in server and desktop virtualization for years to come, ultimately there has to be a resolution to the tension between market share and margin.

Tutorial: The Industry Handbook

A Great Quarter ... Or Is It?
On first blush, it looks like Red Hat is primed destroy the bears. After all, the company did post an impressive 25% revenue growth number for its fiscal fourth quarter well ahead of even the high end of the analyst range (which, with 22 analysts, was surprisingly tight). Other numbers looked quite good as well. Subscriptions were up 24% from last year, and 5% from the last quarter. Billings were up 31%, and deferred revenue jumped almost 20%.

And now for the "yeah, but ..." Operating income (presented on an adjusted basis) grew 31% and the operating margin jumped about a full point from the year-ago level. The thing is, analysts were expecting better margins. Red Hat got a sizable boost from lower taxes and an R&D credit, and the company basically met its expectations without those factors.

So where is the operating leverage? Should it not stand to reason that a solid beat on the top line would translate into a solid beat on the bottom if there was good operating leverage within the model? Sure, some will say that "any beat is a good beat," but those stories do not tend to work over the long haul.

Leverage Needed: Apply Within
There is no question that the stocks of companies like VMware (NYSE:VMW), (NYSE:CRM), Citrix Systems (Nasdaq:CTXS), Concur (Nasdaq:CNQR) and Red Hat are red-hot right now. Moreover, pretty much across the board these companies seem to validate their rich multiples with exceptional top-line growth. The question, though, is whether these companies have the power to turn the dial any further on profitability and whether they can generate still more free cash flow from their revenue base.

In the case of Red Hat, there seems to be an issue with what the company has to pay internally on subscription renewals, hamstringing a lot of the benefit in a subscription-based model. After all, the way it is supposed to work is that a company spends money to generate an initial subscription but can then reap high-margin cash flow from that customer with subsequent renewals. If Red Hat cannot produce better margins on its subs, does that not give comfort to a rival like Oracle (Nasdaq:ORCL) that has the massive infrastructure to compete with Red Hat on a support-after-sale basis - allowing that there is no sale per se in the Red Hat model.

The Bottom Line
There is a lot to like about Red Hat, and I have no quarrel with the bulls who think that Red Hat could become a significant force in virtualization. Where I worry, though, is in the cash flow generation capabilities. More and more, it seems like companies in this space - speaking broadly about cloud computing and virtualization - have to increasingly explain why their business models are not producing the leverage that they originally projected. (For more, see Investing In Cloud Computing.)

Ultimately, then, these valuations are looking increasingly stretched. Red Hat, as a company, looks poised to succeed, as do rivals like VMware. The question for investors, though, also needs to include whether or not these stocks can do well from here on out. On that question, unfortunately, there are quite a few more doubts and points left to prove. (For more, see The Next Cloud Computing Takeovers.)

Use the Investopedia Stock Simulator to trade the stocks mentioned in this stock analysis, risk free!

Related Articles
  1. Stock Analysis

    3 Resilient Oil Stocks for a Down Market

    Stuck on oil? Take a look at these six stocks—three that present risk vs. three that offer some resiliency.
  2. Economics

    Keep an Eye on These Emerging Economies

    Emerging markets have been hammered lately, but these three countries (and their large and young populations) are worth monitoring.
  3. Stock Analysis

    Is Pepsi (PEP) Still a Safe Bet?

    PepsiCo has long been known as one of the most resilient stocks throughout the broader market. Is this still the case today?
  4. Investing

    The ABCs of Bond ETF Distributions

    How do bond exchange traded fund (ETF) distributions work? It’s a question I get a lot. First, let’s explain what we mean by distributions.
  5. Stock Analysis

    3 Stocks that Are Top Bets for Retirement

    These three stocks are resilient, fundamentally sound and also pay generous dividends.
  6. Investing News

    Are Stocks Cheap Now? Nope. And Here's Why

    Are stocks cheap right now? Be wary of those who are telling you what you want to hear. Here's why.
  7. Investing News

    4 Value Stocks Worth Your Immediate Attention

    Here are four stocks that offer good value and will likely outperform the majority of stocks throughout the broader market over the next several years.
  8. Investing News

    These 3 High-Quality Stocks Are Dividend Royalty

    Here are three resilient, dividend-paying companies that may mitigate some worry in an uncertain investing environment.
  9. Stock Analysis

    An Auto Stock Alternative to Ford and GM

    If you're not sure where Ford and General Motors are going, you might want to look at this auto investment option instead.
  10. Mutual Funds & ETFs

    The 4 Best Buy-and-Hold ETFs

    Explore detailed analyses of the top buy-and-hold exchange traded funds, and learn about their characteristics, statistics and suitability.
  1. Does working capital measure liquidity?

    Working capital is a commonly used metric, not only for a company’s liquidity but also for its operational efficiency and ... Read Full Answer >>
  2. How do I read and analyze an income statement?

    The income statement, also known as the profit and loss (P&L) statement, is the financial statement that depicts the ... Read Full Answer >>
  3. Can working capital be too high?

    A company's working capital ratio can be too high in the sense that an excessively high ratio is generally considered an ... Read Full Answer >>
  4. How do I use discounted cash flow (DCF) to value stock?

    Discounted cash flow (DCF) analysis can be a very helpful tool for analysts and investors in equity valuation. It provides ... Read Full Answer >>
  5. How do dividends affect retained earnings?

    When a company issues a cash dividend to its shareholders, the retained earnings listed on the balance sheet are reduced ... Read Full Answer >>
  6. What is the formula for calculating compound annual growth rate (CAGR) in Excel?

    The compound annual growth rate, or CAGR for short, measures the return on an investment over a certain period of time. Below ... Read Full Answer >>

You May Also Like

Trading Center
You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!