Is Red Hat Building A Business, Or Growing To Nowhere?

By Stephen D. Simpson, CFA | December 24, 2012 AAA

Of one of the biggest questions raised about this new generation of software companies (including, but not limited to, Red Hat (NYSE:RHT) and (NYSE:CRM)) is when (or if) they will start demonstrating the sort of margin leverage that investors used to expect from good tech stories. While Red Hat can certainly make the argument that the company is gaining share and assembling a potentially valuable collection of assets, it's harder to argue for paying huge premiums in the absence of signs of real profit leverage.

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Fiscal Third Quarter Results - Good to Some ...
In that same vein, I suppose the quality of Red Hat's third quarter earnings report depends on just how much that lack of operating leverage bothers you. The company is certainly continuing to post healthy-looking revenue and billings figures, but the margins and cash flow don't look so strong.

Revenue rose 18% from last year and 7% from the prior quarter, with subscription revenue up about 19% (or 22% in constant currency terms). Red Hat continues to report good renewal news, with its 25 largest deals renewing at more than 120% of the underlying value. Red Hat also continues to sign more large deals, and 20% of its largest deals included JBoss. Billings also continue to grow well, up 18% from last year (or 20% in constant currency).

And now we turn to the margins. Gross margin (GAAP) improved a tick from last year, but GAAP operating income fell 7%. While non-GAAP operating income performance was stronger (up 5%), margins still declined more than three points from last year (and more than a half-point from the second quarter).

SEE: A Look At Corporate Profit Margins

Committing More to Cloud Management and Virtualization?
Red Hat hasn't been shy about showing its intentions in virtualization and cloud management, and the company seems willing to go right at VMware (NYSE:VMW), Microsoft (Nasdaq:MSFT) and IBM (NYSE:IBM). Along those lines, management dropped over $100 million in cash for another acquisition - virtualization and cloud management company ManageIQ.

I would think that cloud management would be an important part of the next RHEL (RHEL7), and I can see why Red Hat is getting active here. Just as VMware's vCloud Suite could be a big part of that company's ongoing license growth, Red Hat likely sees a large addressable market. So too do Oracle (Nasdaq:ORCL), Microsoft and IBM, though, so it will be interesting to see how this plays out - and what consequences to margins Red Hat will have to bear from what I assume will be an intense sales effort.

SEE: Is Cloud Computing An Investible Trend?

Opportunities Remain in Middleware
With about 20% of large deals including JBoss, it would seem that there's still plenty of opportunity for Red Hat to grow its middleware franchise. While it's an apples-to-oranges comparison to some extent, it certainly looks as though Red Hat is going about it more aggressively than say CA (Nasdaq:CA) or Dell (Nasdaq:DELL). Here again, though, the company will run into IBM and Oracle and I'm curious to see if the company can deliver both market share gains and margin leverage at the same time.

The Bottom Line
I've harped on Red Hat's margin leverage issues more than enough, but I don't think it's a trivial point. While I'm sure growth investors will continue paying an EV/sales multiple of seven or higher so long as the company continues to deliver 20% plus growth, sooner or later the music stops and then details like profitability and valuation matter again.

Right now, I model Red Hat's revenue growth at over 12% for the next decade, but I have a hard time adding much on top of that for free cash flow (FCF) growth (yes, those margins again). FCF growth of 14 to 15% is good for a fair value around $50, but for Red Hat to look truly appealing today (at least as a GARP-type stock), it's going to take a higher level of profitability in the coming years.

At the time of writing, Stephen D. Simpson owned shares of EMC, a majority owner of VMware.

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