Tip a Hat to Red Hat's Quarter (RHAT)

Monday’s 10Q filing (following the June 28th call) added another strong fundamental quarter to Red Hat’s (RHAT) upward trajectory. The stock has tumbled, but unfortunately, tumbles don’t necessarily turn growth stocks into value plays: before the dip, the price impounded unwordly growth expectations. After, merely extraordinary. The conference call Q&A conversation puzzled me with a focus on short-term, model-tweaking assumptions like the modest write-down on JBoss’ deferred revenue adjustment. After the price drop, RHAT is priced with a forward P/E multiple of 40x to 80x (such a wide range on fiscal year 2007, in light of guidance given, ought to itself earn an uncertainty discount).

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: