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.)

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