Red Hat Seems Ill-Fitting

By Stephen D. Simpson, CFA | June 26, 2012 AAA

Complaining about valuation with tech stocks is a little like complaining about diving in European soccer - none of the true fans really seem to care. That said, one of the ever-present lessons of the stock market is that valuation always matters eventually, and flagging growth tends to accelerate that day of reckoning. While Red Hat (NYSE:RHT) has had a volatile growth trajectory in its past and that means investors need to be careful about overreacting to any particular quarter, the results from Thursday night do nothing to ease worries about the company's growth.

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First Quarter Results Seem Lacking
Red Hat beat the consensus non-GAAP estimates this quarter, and many sell-side analysts seemed to go out of their way to defend the results. Nevertheless, I think they merit a closer examination.

Revenue rose 19% from last year's first quarter and 6% from the February quarter. Revenue growth was helped by stronger subscription growth (21% and 7%), while services growth was more sluggish.

SEE: How To Decode A Company's Earnings Reports

Red Hat management has claimed that billings are the more important/relevant metric to watch, and the company didn't do as well here. The company came in about $10 million shy of sell-side estimates here, as billings rose 16% or about 20% on a company-reported constant currency basis. This marked a definite deceleration from the February quarter (which was up 31%), and the weakest number in about two years.

I also wonder if these numbers point to weakening new business. I want to emphasize that Red Hat management does not provide this information and that it's a product of guesswork and estimates on my part, but new customer billing growth may be down into the mid or low single-digits. Management talked about how all of its "Top 25" deals that were up for renewal did so, and at 120% of the original value. Therefore, assuming that renewal rate percentages are in the mid to high 80s, that points to pretty low new billing growth (or weaker renewals, neither of which are good).

Margins remain a sore spot. Gross margin improved both annually and sequentially. The company continues to struggle to find sales & marketing leverage, though, and operating income (GAAP) rose just 12% from last year.

SEE: Analyzing Operating Margins

Can Red Hat Win in the End?
I've raised the question before of whether software-as-a-service companies like Salesforce.com (NYSE:CRM) can ever attain the margin leverage that will allow them to produce the robust cash flows seen by the earlier generation of software growth giants like Microsoft (Nasdaq:MSFT) and Oracle (Nasdaq:ORCL). I have the same concerns about Red Hat and its service-oriented model.

Companies like IBM (NYSE:IBM), Oracle and CA Technologies (NYSE:CA) are stepping up their efforts to claw back business that has been lost to upstarts like Red Hat. If my fears about the company's rate of new billings growth are accurate, the combination of weakening new business and poor SG&A leverage suggests that the company is having to fight harder and harder for less and less benefit. That's not a winning formula, particularly for a company whose stock is already so richly valued.

As I've written before, companies like Oracle and IBM are trying to undercut Red Hat on support/service offerings, and Red Hat's moves into application servers (JBoss) and storage (Gluster) are only going to increase the pressure for these larger companies to fight back.

SEE: Equity Valuation In Good Times And Bad

The Bottom Line
I mentioned in the open that investors need to guard against overreacting to any particular quarter from a company like Red Hat, and I do believe that. However, I also believe that a stock that trades at nine times trailing revenue and 40 times trailing EBITDA has much less margin for error or disappointment. Moreover, I do believe the persistent absence of operating leverage is an issue that long-term investors cannot just ignore or assume will be fixed by more top-line growth.

Even with a forward free cash flow growth rate in the double digits, Red Hat looks expensive today. Growth investors probably won't care so long as the revenue keeps piling up, but it is ultimately profits and cash flow that make companies successful.

At the time of writing, Stephen D. Simpson did not own shares in any of the companies mentioned in this article.

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