I'll give credit where it's due - Red Hat (NYSE:RHT) did a great job with its Linux business, and management has shown prudent aggression when it comes to building next acts in middleware, storage, virtualization and cloud. The question, though, is whether the company can deliver the sort of growth and margin leverage that the valuation assumes. So far, it's not looking like a sure thing.
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Familiar Themes in Fiscal Q2
As has generally been the case, there's not much for me to gripe about when it comes to Red Hat's revenue growth. Revenue was up about 15% from last year (and 2.5% sequentially), with billings up 19% on a constant currency basis. Even though that billings figure represents ongoing growth deceleration, the overall numbers are not bad at all when compared to the likes of large enterprise IT players like IBM (NYSE:IBM) and Oracle (Nasdaq:ORCL) and Red Hat continues to announce growing high-value deals.
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For all of that top-line growth, though, I'm still going to harp on the fundamental profitability of the business. GAAP and non-GAAP gross profit both grew about 17%, but operating income was not so strong. GAAP operating income fell 5%, while non-GAAP operating income rose only 4%. As has been the case for Red Hat for some time, marketing leverage has yet to materialize, as sales and marketing rose to more than 38% of sales (from over 35% a year ago).
Middleware Seems to Be Coming Along
Part of the bear thesis on Red Hat has been that the company won't be able to match its success in Linux support with similar performance in middleware or other offerings like storage and virtualization. Given the higher value-add of offerings like middleware and storage, that's no trivial question when it comes to Red Hat's ongoing value. So far, I'd say Red Hat is doing well in middleware. Maybe the company hasn't replicated the success of its Linux business (yet), but JBoss looks increasingly competitive to Oracle's WebLogic and IBM's WebSphere.
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But What About the Other Business?
I'm not quite as certain about the virtualization and storage businesses. The risk in virtualization is that customers elect to stick with technologies from VMware (NYSE:VMW), Microsoft (Nasdaq:MSFT) or Citrix (Nasdaq:CTXS) instead of Red Hat's hypervisor, and IBM seems to be emerging as more of a threat. On the storage side, I get the appeal. Through the acquisition of Gluster and subsequent developments, it looks like Red Hat can be a player in unstructured data and may be able to offer some storage technologies at maybe 10% to 20% the cost of rival offerings from EMC (NYSE:EMC), IBM or NetApp (Nasdaq:NTAP).
The question, though, is functionality. The people I've spoken to say that Red Hat's offerings are indeed cheaper but with more limited functionality - just how limited seems to depend on the particular customer's demands. This makes me wonder whether Red Hat is more of a threat to the likes of NetApp, IBM or Hewlett-Packard (NYSE:HPQ) on the lower ends of the market, as EMC doesn't usually worry about losing business on the low-price/lower-functionality side of the business.
The Bottom Line
I like Red Hat as a company, and I think there's a bright future for the company's open source, service-oriented model across categories like middleware, virtualization, cloud and maybe storage. I still don't like the lack of margin leverage, even as the company posts quite solid free cash flow margins.
Even if the company can continue to grow revenue at a low-to-mid teens rate over the next decade and improve its free cash flow conversion into the mid-30%'s, it looks like the fair value should fall somewhere in the $50s. If you bump up that 10-year revenue growth rate to 15%, that puts revenue near $5 billion in 2022 and points to a fair value in the high $60s. That's still not an especially compelling target for a company in such a competitive market, so I'd be inclined to wait on Red Hat in the hopes of seeing some improved margin leverage and a better entry price.
Disclosure: The author has owned shares of EMC since September 2012