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.

Discount Brokers Comparison: Your one-stop shop for finding the perfect broker for your investments.

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.

SEE: Is Cloud Computing An Investible Trend?

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.

SEE: Great Expectations: Forecasting Sales Growth

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

Related Articles
  1. Mutual Funds & ETFs

    ETF Analysis: PowerShares S&P 500 Downside Hedged

    Find out about the PowerShares S&P 500 Downside Hedged ETF, and learn detailed information about characteristics, suitability and recommendations of it.
  2. Mutual Funds & ETFs

    ETF Analysis: iShares Morningstar Small-Cap Value

    Find out about the Shares Morningstar Small-Cap Value ETF, and learn detailed information about this exchange-traded fund that focuses on small-cap equities.
  3. Mutual Funds & ETFs

    ETF Analysis: ProShares Large Cap Core Plus

    Learn information about the ProShares Large Cap Core Plus ETF, and explore detailed analysis of its characteristics, suitability and recommendations.
  4. Mutual Funds & ETFs

    ETF Analysis: iShares Core Growth Allocation

    Find out about the iShares Core Growth Allocation Fund, and learn detailed information about its characteristics, suitability and recommendations.
  5. Mutual Funds & ETFs

    ETF Analysis: iShares MSCI USA Minimum Volatility

    Learn about the iShares MSCI USA Minimum Volatility exchange-traded fund, which invests in low-volatility equities traded on the U.S. stock market.
  6. Stock Analysis

    Should You Follow Millionaires into This Sector?

    Millionaire investors—and those who follow them—should take another look at the current economic situation before making any more investment decisions.
  7. Professionals

    What to do During a Market Correction

    The market has corrected...now what? Here's what you should consider rather than panicking.
  8. Mutual Funds & ETFs

    ETF Analysis: WisdomTree SmallCap Earnings

    Discover the WisdomTree Small Cap Earnings ETF, a fund with a special focus on small-cap and micro-cap stocks with positive earnings.
  9. Mutual Funds & ETFs

    ETF Analysis: iShares US Regional Banks

    Obtain information and analysis of the iShares US Regional Banks ETF for investors seeking particular exposure to regional bank stocks.
  10. Mutual Funds & ETFs

    ETF Analysis: Vanguard Mid-Cap Value

    Take an in-depth look at the Vanguard Mid-Cap Value ETF, one of the largest and most popular mid-cap funds in the U.S. equity space.
RELATED TERMS
  1. Profit Margin

    A category of ratios measuring profitability calculated as net ...
  2. Quarter - Q1, Q2, Q3, Q4

    A three-month period on a financial calendar that acts as a basis ...
  3. Debt Ratio

    A financial ratio that measures the extent of a company’s or ...
  4. Price-Earnings Ratio - P/E Ratio

    The Price-to-Earnings Ratio or P/E ratio is a ratio for valuing ...
  5. Net Present Value - NPV

    The difference between the present values of cash inflows and ...
  6. Long-Term Debt

    Long-term debt consists of loans and financial obligations lasting ...
RELATED FAQS
  1. 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 >>
  2. What is the difference between called-up share capital and paid-up share capital?

    The difference between called-up share capital and paid-up share capital is investors have already paid in full for paid-up ... Read Full Answer >>
  3. When does the fixed charge coverage ratio suggest that a company should stop borrowing ...

    Since the fixed charge coverage ratio indicates the number of times a company is capable of making its fixed charge payments ... Read Full Answer >>
  4. Why would a corporation issue convertible bonds?

    A convertible bond represents a hybrid security that has bond and equity features; this type of bond allows the conversion ... Read Full Answer >>
  5. What is the difference between the return on total assets and an interest rate?

    Return on total assets (ROTA) represents one of the profitability metrics. It is calculated by taking a company's earnings ... Read Full Answer >>
  6. How does additional paid in capital affect retained earnings?

    Both additional paid-in capital and retained earnings are entries under the shareholders' equity section of a company's balance ... Read Full Answer >>

You May Also Like

COMPANIES IN THIS ARTICLE
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!