Red Hat Well-Positioned For Continued Growth

| About: Red Hat, (RHT)

Red Hat (NYSE:RHT) is poised to become the first open-source software company with a billion dollar per year revenue run rate. Yesterday Red Hat released fiscal Q2 (ending August 31) revenue of $281 million, up 28% from the year-earlier quarter.

The alleged slowdown of the American and global economies has had little effect on Red Hat. This may partly be from the "dollar store effect": Red Hat Enterprise Linux, or RHEL, is a much less expensive operating system than its main rivals, UNIX and Windows Server, yet is roughly as capable.

Management, however, attributed the revenue growth to an expanded sales force and an expanded line of products to sell. The main products sold in addition to RHEL are JBoss, its middleware product, and RHEV, its virtualization product. Also, as major customers expand their data centers, they pay more for the number of copies of software necessary to operate the new hardware.

RHT is a great example of the power of patience, and of the importance of avoiding buying anything in a bubble. Founded in 1993 and going public in 1999, it was caught up in the Internet bubble, almost immediately reaching a share price of over $100 (implying a market capitalization of over $20 billion) despite being unprofitable and not even generating much revenue at the time. After the bubble burst you could buy RHT for less than $4 per share.

Despite the crazy price swings of the stock, the underlying company kept at its mission of providing an enterprise-quality version of Linux. As years passed, revenue grew, and profits began to accumulate. The last time you could buy RHT cheap was around November 2008, when it was around $10 per share. Today it closed at $41.52.

Right now it is a good stock to hold, but the price-to-earnings ratio could scare off many potential investors. At a time when many tech stocks showing revenue growth are trading at P/Es under 20 or even under 15, Red Hat has a (non-GAAP) trailing P/E of 70 and 1-year forward P/E of 54. That is partially justified by the rapid rate of growth; the danger would be if the rate of growth slowed.

I believe Red Hat software offers a tremendous value proposition for enterprises. While revenues are dwarfed by Microsoft Windows Server revenues ($5.9 billion in Q1 alone), and many companies have already converted from UNIX to Linux, the fact that Red Hat has such a small portion of the $50 billion annual server operating system market leaves plenty of room for growth. RHEL also competes with free Linux distributions. Given the staffing it takes to run a free Linux at the enterprise level, total cost of ownership can be cheaper when businesses pay for RHEL and the support services that go with it.

I expect Red Hat will continue to do well as a company. Since its product is software, it has high margins and earnings tend to grow faster than revenues. For Q2, GAAP earnings grew 67% over the year-earlier quarter, but it was an exceptional quarter.

Disclaimer: I don't own Red Hat, and have no intention to buy it in the next 3 days.