Red Hat: Stock Sells Off As The Company Is No Longer Red Hot

Sep.24.13 | About: Red Hat, (RHT)

Shares of Red Hat (NYSE:RHT) sold off after the latest earnings release. Investors are hot happy with the outlook and reported billings, while second quarter earnings beat consensus estimates.

The valuation has become more appealing over the past year as operations grew, while the stock fell. Yet I remain on the sidelines for now. The downside potential is not enough to justify a short position, while it is too early to initiate a long position.

Second Quarter Results

Red Hat generated second quarter revenues of $374.4 million, up 16% on the year before. This compared to consensus estimates of $372.1 million. Revenues were up 3.0% compared to the second quarter.

Net income rose from $35 to $40.8 million, as earnings per share rose by three cents to $0.21 per share. The business saw little positive operating leverage as sales leverage was re-invested in the business.

Non-GAAP earnings came in at $0.35 per share, beating consensus estimates by two cents.

Looking Into The Results

Revenue growth was strong, as adverse currency movements shaved off a full percent point from reported growth rates. Subscriptions generated a full 87% of total revenues for the quarter.

Gross margins came in unchanged at 87.15% of total revenues, while operating expenses rose by 64 basis points to 70.31% of total revenues. The increase in costs was mostly related to $2.2 million in facility exit costs as general and administrative cost control allowed the firm to boost expenditures in selling and marketing efforts, as well as research and development.

As a result, net income advanced to nearly $41 million as earnings per share saw a modest boost from the fact that the company repurchased roughly 2% of its shares outstanding over the past year.

And The Remainder Of The Year

Red Hat sees third quarter sales between $381 and $384 million. This implies that growth is expected to slow down to 13.2% on an annual basis and 2.2% on a sequential basis at the midpoint of the range. The revenue guidance fell short on consensus estimates of $391.5 million.

Full year sales are seen between $1.51 and $1.52 billion, just missing consensus estimates of $1.53 billion. The full year earnings guidance of $1.36 to $1.38 per share on a GAAP basis beat consensus estimates of $1.35 per share.


Red Hat ended the second quarter with almost $1.29 billion in cash, equivalents and investments. The company has no debt outstanding for a solid net cash position.

Revenues for the first six months of the year came in at $737.7 million, up 15.8% on the year before. Net income advanced by 12.0% to $81.2 million in the meantime.

Factoring in losses of around 10% in a response to earnings, the market values Red Hat at some $9.0 billion, valuing operating assets at around $7.7 billion. This values operating assets at 5.1 times annual revenues and 30 times GAAP earnings.

Red Hat does not pay a dividend at the moment.

Some Historical Perspective

Shares of Red Hat have seen very solid returns over the past decade as they rose from lows of $10 in 2005 to highs around $60 last year. Shares have been trading in a tight $45-$55 trading range so far this date, trading around $48 per share in after-hours trading.

Between the fiscal year of 2010 and 2013, Red Hat has increased its annual revenues by a cumulative 78% to $1.33 billion. Net income rose by 73% to $150 million in the meantime.

Investment Thesis

So the main reason behind the sell-off are lower bookings which are partially driven by lower demand as well as a changed method in billings.

Billings for the quarter came in at $376 million, for a book-to-bill ratio of 1.00. The 8% growth rate fell short of analyst consensus growth rates which ranged between 14% and 17%. According to analysts, billings should have approached the $400 million mark for the quarter.

A slowdown in Europe, partially driven by unfavorable exchange rates, took a toll upon bookings. Customers are also moving contract terms to longer payment terms, which means billings are being transformed into unearned deferred revenue. As deals get larger, customers want more flexible payment options.

Red Hat continues to focus on open-source software, focusing on the transformation of the traditional data center to an open hybrid cloud infrastructure. Its Linux OpenStack platform and the Cloud Infrastructure became generally available during the quarter, aiding Red Hat's customers in achieving their objectives.

Exactly one year ago, I last took a look at Red Hat's prospects. At the time shares traded in their mid-fifties and I concluded that investors should stay away from this "Red Hot" stock.

In the meantime shares have fallen some 15% over the past year, while revenue and earnings continue to grow at a healthy rate, thereby boosting the valuation appeal. A year ago, Red Hat was valued at 8 times revenues and 70 times earnings, multiples which have fallen to roughly 5 times revenues and 30 times earnings.

While I still think the valuation is a bit rich, I see less downside risk at the moment compared to a year ago, especially as cloud and technology valuations have only increased compared to last year, making the relative valuation of the company much more appealing.

I remain on the sidelines as I still don't like the absolute valuation too much. I have a slightly bearish stance, but see less downside potential then I did last year. I think it is still too early to initiate a long position, but might reconsider if shares were to fall to levels around $40 per share.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.