Telling investors that their stock is too expensive is the surest way to lose friends. They don't want to hear it. It's like complaining that water is wet. It only matters when the street begins to agree. And Red Hat (NYSE:RHT) has suddenly fallen prey to this realization.
Even though Red Hat's long-term growth has been a source of concern, the company has always done enough to convince analysts that its cloud and virtualization services were sustainable businesses. This is even though rivals like VMware (NYSE:VMW) and Citrix (NASDAQ:CTXS) have shown signs of deteriorating growth.
So, ahead of the company's fiscal fourth-quarter results, investors were still betting a lot. That Red Hat shares traded at 4-times the P/E of both Microsoft (NASDAQ:MSFT) and Oracle (NASDAQ:ORCL) presumed strong expectations. Unfortunately, Red Hat couldn't deliver - at least, not on a relative basis.
Red Hat reported fourth-quarter adjusted earnings-per-share of 39 cents. This was up more than 8% year over year from 36 cents and beat consensus estimates by 2 cents. Total revenues rose 15% year over year to $400.40 million. Analysts expected revenues of $398.92 million. So the company beat on both the top and bottom lines. Yet the stock declined by roughly 7% on above average volume, continuing what has been a consistent decline for the past 3 weeks.
So with shares now at 3-month lows, what are investors to do? Even more interesting, I believe Microsoft should begin to ponder this same question. Microsoft's new CEO Satya Nadella, who just opened up Office to Apple's (NASDAQ:AAPL) iPad, needs a way to offset that lost leverage. Microsoft needs another source of revenue growth, including one that can cement its position in the enterprise.
Given that Red Hat has customers like Amazon (NASDAQ:AMZN) and Dell, Microsoft should see this as way to inject its Azure platform with the credibility of Linux. Nadella should not ignore this opportunity. Because although Red Hat issued better-than-expected results, management didn't forecast the sort of confidence investors needed to see from a stock that's already expensive.
For fiscal first-quarter results, which started March 1, the company said it expects adjusted earnings of $1.54-$1.56 per share. The high range was still below consensus estimates by 7 cents. Management also told analysts that it expected full-year revenue to rise 14% year over year. Further, Red Hat issued a revenue range of $1.73 billion to $1.75 billion, compared with average estimate of $1.76 billion. The company said foreign exchange rate fluctuations and higher U.S. tax rates would affect its profit.
This is understandable. But while management did excite analysts by suggesting an initiative into its OpenStack and other technologies, investors got spooked when management guided for a 1% decline in first-quarter adjusted operating margin. This is down from 24.5% a year ago. For the first quarter, the company said it expected an adjusted profit of 32 cents to 33 cents per share on revenue of $412-$415 million. Analysts were expecting a profit of 38 cents per share on revenue of $415.9 million.
From our vantage point, management has forecasted considerable weakness against the likes of Microsoft and VMware in the corporate enterprise. It begs the question, is there still a strong market for Linux? Although Linux demand has been stable, given the increase in companies working to build their cloud infrastructure, but how long can that market thrive? And does the outlook support Red Hat's expensive stock price?
This continues to be a recurring theme for Red Hat. It's possible that management has taken Linux as far as it can go. But Microsoft can utilize the existing Linux environment to sell more enterprise services tools and services.
So, assuming Red Hat doesn't immediately fix its growth deficiency, how much longer are investors willing to wait for management to harvest the sort of premium presumed by its stock price? While I'm not ready to say Red Hat is suddenly losing its way, management, by virtue of its own guidance, suggests that growth is expected to slow.
That the stock is still trading at 28 times next year's fiscal estimates is discounting the fact that the virtualization/cloud industry is always in transition. Today's leader can easily be tomorrow's has-been. Red Hat, which is now being attacked from all angles, is on the verge of being a has-been. And Microsoft is paying attention.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
Business relationship disclosure: The article has been written by Wall Street Playbook's tech sector analyst. Wall Street Playbook is not receiving compensation for it (other than from Seeking Alpha). Wall Street Playbook has no business relationship with any company whose stock is mentioned in this article.