Red Hat (RHT) has seen some small decreases in profitability margins YoY as it is a high valued company in its market. We predict that RHT will not be able to maintain its current level of profitability in the coming fiscal year and that it will under perform competitors. RHT has recently announced collaborations that will expand its presence in the public sector, a move that we believe brings the company only a modest amount of opportunity. There is a possibility that the company could maintain performance despite the ever-growing competition, or that this public sector opportunity could be larger than we anticipate. All in all we are confident in our new price target of $33 that given the sell and buy points, $26 and $36 respectively, is how we determine our rating at "Sell."
Red Hat is an application software company that provides open source software solutions to its company customers around the world. In addition to its open source software offerings RHT also offers enterprise-ready open source operating system platforms. Some of its main products are Red Hat Enterprise Linux, an operating system designed for enterprise computing; Red Hat JBoss Middleware, a collection of middleware offerings to facilitate developing, deploying, and managing applications; Red Hat Virtualization, a virtualization solution for server and desktop computers. Alongside these products RHT also develops enterprise technologies like Red Hat Messaging, Real-time, and Grid as well as Red Hat Directory Server that centralizes different settings, profiles, data, etc. into a network-based registry. RHT sells subscriptions to its product services through annual or multi-year contracts. Some of RHT's most strategic business alliances are with Intel Corporation, Amazon.com, Inc., and International Business Machines Corporation, among others. RHT, which was originally named Red Hat Software, was founded in 1993 and is headquartered in Raleigh, North Carolina.
RHT's current PE is at 68.7, a value that is much higher than the industry average of 18.9 PE. The future PE is 36.8, a projection that predicts RHT to grow in the coming fiscal year. If the future PE is projecting growth why is this company rated as a "Sell?"
RHT saw a 19% increase in YoY fourth quarter subscription to $303 million, and full fiscal year subscription revenue of $1.15 billion, up 19% YoY. From this increase in revenue RHT experienced fourth quarter revenue up 17% YoY to $348 million, and a 17% increase in full fiscal year revenue to $1.33 billion. RHT also saw fourth quarter operating cash flow of $137 million, up 7% YoY, and full fiscal year operating cash flow of $465 million, up 19% YoY. Jim Whitehurst, CEO of RHT, expressed his thoughts on the performance of the company in the Q4 fiscal report stating, "we continued to see momentum with large deals in Q4, closing a record number of deals in excess of $5 million and $10 million. We now provide solutions to over 90% of Fortune 500 companies as well as tens of thousands of smaller companies." This presence across Fortune 500 companies is partially attributable to investments RHT has made over the past fiscal year. RHT invested aggressively in new product areas through internal initiatives and three acquisitions in the second half of the fiscal year. Despite these investments RHT saw the increases we stated earlier in this section. Other market competitors, such as Salesforce.com (CRM) and CA technologies (CA) saw changes in revenue and will tell us more about RHT's value in comparison. CRM saw an increase of 32% YoY in revenue to $835 million. CA reported a 4% decrease in revenue to $1.195 billion in Q3 earnings. CRM stands in the middle of these two competitors in terms of fluctuation in revenue YoY. Moving forward RHT is predicted to remain in the middle of competitors in terms of revenue.
RHT ended the year with an ROA at 5.7%, ROIC at 9.9%, and ROE also at 9.9%. CRM ends the year with ROA at -5.6%, ROIC at -11.4%, and ROE at 2.4%. Lastly for CA's key ratios, their ROA is 7.9%, their ROIC is 12.7%, and their ROE is 16.6%. RHT is not the top performer of the market, which means it is overvalued at present. Their high PE combined with their performance in comparison to other companies is what justifies our rating at "Sell." In the next section we will see what will move RHT's stock price down in the coming fiscal year.
RHT finds itself in an industry that is based on innovation, which leads to constant competition. Any technology market, especially application software, is an industry where products and services become obsolete quickly so constant innovation is an absolute necessity. RHT has a long list of competitors, some of which include Microsoft Corporation (MSFT), Oracle Corporation (ORCL), Novell Inc. (privately held), CA, and CRM. In March of this year RHT announced collaboration with Code for America (CfA), a non-profit organization that partners with local governments to foster civic innovation, in order to bring further cloud enablement to city governments. In this collaboration, CfA will use RHT's product OpenShift Platform-as-a-Service (PAAS) free of charge for one year. Then CfA's partner cities - Kansas City (Missouri and Kansas); Louisville, Ken.; New York; Oakland, Calif.; San Francisco; San Mateo County, Calif.; South Bend, Ind.; and Summit County, Ohio - will also receive an option of one additional year of hosting and services free of charge. The total value of RHT's contribution to this project is approximately $300,000. OpenShift will enable CfA Fellows to build, text, deploy and manage applications with the benefits of ease of use, flexibility and scalability for their applications. RHT is expanding its already impressive list of clientele to government customers, the Canary Islands. Without any other aggressive moves from RHT and ever-rising competition we believe RHT will under perform over the next fiscal year.
RHT proudly boasts that it is "…the world's leading provider of open source software solutions, using a community-powered approach to reliable and high-performing cloud, Linux, middleware, storage and virtualization technologies." RHT also advertises its very long lists of customer companies and organizations. But economic moat is not about quantity or presence. A strong economic moat means a company has a unique product that is only found in one place, their company. Many other competitors mentioned in previous sections offer similar products and services paired with support, training, and consulting services, just as RHT does. Another important aspect to economic moat is "barriers to entry," which are a preemptive barrier to competition. Even if some of RHT's services and products are somewhat unique we do not see any mechanisms in place that prevent competitors from encroaching. We believe RHT has a light economic moat.
Revenue and EPS Outlook
Our price target analysis predicts that ultimately RHT's stock value will depreciate over the fiscal year about by approximately 31% to land around $33. We calculate that over the next 5 fiscal years RHT will increase operating income 79% from the current $204 million to $365 million in 2016. RHT's current and future PEs are overestimating growth potential. In order for RHT to become more fairly valued, in the 20-25 range, one of two things would need to happen. Either the price would have to fall to around $18.25, or they would have to bring their EPS up drastically. RHT's EPS is currently 0.31 and is expected to grow to 0.33 next quarter, and then to increase again by the end of the current fiscal year to 1.34. But in order to bring the company to a more fair-valued PE RHT would have to increase its EPS to 1.88. For this to happen RHT would have to grow its earnings 150% by 2014. Our price target analysis only estimates approximately 42% growth in this time period. This amount of growth is insufficient, which is why we have rated this company at "Sell."
Price Target Analysis
The following price target was configured through a 5-year projected discounted cash flow analysis. The model projects operating income, taxes, depreciation, capital expenditures, and changes in working capital. Using that information, we can project what the company is worth. We can then use that projection and compare it to current prices.
Here is how to calculate price targets using discounted cash flow analysis (all figures in millions):
Project operating income, taxes, depreciation, capex and working capital for five years. Calculate cash flow available by taking operating income - taxes + depreciation - capital expenditures - working capital.
Available Cash Flow
Calculate present value of available cash flow (PV factor of WACC * available cash flow). You can calculate WACC, but we have given this number to you. The PV factor of WACC is calculated by taking 1 / [(1 + WACC)^# of FY years away from current]. For example, 2016 would be 1 / [(1 + WACC)^4 (2016-2012). WACC for RHT: 8.45%
PV Factor of WACC
PV of Available Cash Flow
For the fifth year, we calculate a residual calculation. This number is calculated by taking the fifth year available cash flow and dividing by the cap rate, which is calculated by taking WACC and subtracting out residual growth rate. Residual growth rate is typically between 2-6%. 4% is average growth for industry. Companies with high levels of growth have higher residual growth, while companies with lower growth levels have lower residual growth. This is why higher growth companies tend to have higher PE ratios. We will give you cap rate. Cap Rate for RHT: 2.45%.
Available Cash Flow
Divided by Cap Rate
Multiply by 2016 PV Factor
PV of Residual Value
Calculate Equity Value - add PV of residual value, available cash flow PVs, current cash, and subtract debt:
Sum of Available Cash Flows
PV of Residual Value
Interest Bearing Debt
Divide equity value by shares outstanding:
Profit/Value Industry Comparisons
Q1 - Q3 2011
Return on Equity
RHT has seen a slight decrease in two of its profitability margins YoY. The operating margin decreased slightly from 18.1% to 15.4%. The gross margin increased from 83.9% to 85.0%, and ROE decreased slightly from 7.9% to 7.2%. How do these margins compare to competitors?
CA increased operating margin from 5.8% to 20.4%, they decreased gross margin from 86.9% to 86.6%, and they increased ROE from 15.6% to 17.3%. SAP AG ADR's (SAP) operating margin increased from 20.8% to 34.3%, gross margin increased from 68.8% to 69.4%, and ROE increased from 19.8% to 30.6%. Insight Enterprises, Inc. (NSIT) maintained operating margin at 2.8%, gross margin increased from 13.4% to 13.6%, and ROE decreased slightly from 17.6% to 14.3%. CRM's operating margin decreased from -1.5% to -3.6%, gross margin decreased from 78.4% to 77.6%, and ROE also decreased from -0.8% to -13.9%. In this range of high profitability margins to negative margins RHT falls in the middle. They are at the high end of gross margins amongst competitors but other margins, operating and ROE are modest for the market.
As discussed before, RHT has a current PE of 68.7 and a future PE of 36.8. How does this higher-valued company compare in the market? CA's PE is 12.9 and has a future PE of 10.0. SAP has a current PE of 26.4 and a future PE of 20.3. NSIT has a current PE of 10.0 and a future PE of 8.3. Lastly, CRM does not have a current PE and has a future PE of 69.9. RHT is the highest valued company in this market comparison with the sole exception CRM's future PE at 69.9. This comparison shows that RHT is over-valued and though the PE is forecasted to drop, we do not see this as sufficient.
Our argument proposes that RHT will not be able to maintain its current profitability during the forward fiscal year. What could cause RHT perform differently? There is a possibility that rising competition could ultimately become too much for the company. Without any aggressive product or service developments market competitors could steal RHT's business and cause major problems. On the other hand there is also a possibility that RHT could see unpredicted increases in revenue, perhaps even from its initiative with CfA. Even though the public sector does not seem the most likely place to generate large profits there is a possibility this could be a larger opportunity for RHT than we anticipate.
The Bottom Line
Overall taken the past fiscal history and how that projects maintained profits and growth for the future fiscal year, we believe that a "Sell" is the most appropriate rating for RHT. This company is overvalued and since we also do not see a large opportunity for major increases we believe this company merits the rating we have chosen. Without a strong economic moat or any aggressive developments on the horizon for products or services we predict fairly sustained numbers for the coming year and our confident in our "Sell" rating.