When the price impounds so much forward-looking high-growth expectation, inquiry ought to especially focus on strategic concerns (i.e., products, channels, customers and competitors). Nothing visible has eroded Red Hat’s excellent position in software, for the moment: mainstream mindshare has endorsed open-source (e.g., Linux, PHP, mySQL) and subscription-based models. Red Hat dominates the Linux market, itself projected by IDC to grow to almost 40% of the server market within three years. While Red Hat used to be a straighforward 1:1 product:market analysis (Red Hat:Linux server), it is befittingly becoming more complicated by smart management moves; e.g., desktop, international markets, middleware, virtualization.
You can’t much see jBoss’s “unexpected drag” on guided profits from a distance (last three bars are interpolated estimates based on the revised guidance):
What impresses me about the quarter is their continuing cash flow strength; the blue line plots adjusted operating cash flow (removes current account changes) against reported EPS:
Other highlights from the quarterly filing:
* The mix shifted even more to subscriptions and the subscriptions themselves were even more profitable. In light of 84% gross margins and 12% G&A expense (excluding FAS 123R expense), I cannot find any way to fret about a 75 basis point (0.75%) hit introduced by jBoss. Please, talk to me about real problems…
* Cash and cash-like increased from $800 million to about $930 million
* Revenue outside the Americas (Asia Pacific & EMEA) grew 42% year-over-year
The reason I cannot buy the stock is the valuation. There is a very wide range on the 2007 full year EPS estimate, which is strange only because management basically populated the worksheet on the call. I can find two explanations (since much of the economic model is stable, relative to the typical software company): (1) management is correct that the analyst projections contain many non-GAAP estimates (i.e., without FAS 123R and therfore higher than GAAP) and (2) reasonable people could use divergent values for non-operating income.
If I try to be conservative, I can get to the low end ($0.21 diluted EPS, FY 2007). Here is a back-of-the-envelope: $400 MM revenue x 20% operating margin = $80 MM. Plus conservative $20 million in net non-operating income gets to $100 MM in pre-tax earnings. Minus the $36 MM pretax, non-cash charge for option expense (management estimate) equal $64 million. Remove 37% in paper taxes for about $40 million in GAAP net income. Over about 180 MM diluted shares (nothing fancy, no adjusting for the convertible debenture), that’s about $0.22
But I more naturally get to a somewhere between the low and the average ($0.39 diluted EPS, full fiscal year 2007). The higher numbers only seem possible if you exclude the FAS 123R charge and/or make generous assumptions on non-operating income, or something else I suppose. In short, I love the fundamental prospects of this company, but I can’t talk myself into believing that RHAT has forward P/E of much less than 50x.
RHAT 1-yr chart: