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Red Hat, Inc. (NYSE:RHT) is a provider of open source, Linux-based software for corporate IT customers. The company has been a rumored acquisition target for years, with potential suitors including Oracle (NYSE:ORCL), IBM (NYSE:IBM), and most recently Hewlett-Packard (NYSE:HPQ).

RHT stock has performed well as of late, rebounding strongly from August lows around $32 per share, buoyed by strong 2nd quarter earnings and a well-received acquisition of cloud storage provider Gluster [click all images to enlarge]:

RHT 3-month chart

RHT 3-month chart, courtesy Yahoo! Finance

Indeed, the stock has jumped by over one-third from a 52-week low of $31.77 in mid-August, to Monday's close of $44.17, an impressive run in an uncertain market. The stock has not only been a near-term star, but an impressive performer since the 2008-09 bear market low:

RHT 5 year chart

RHT 5-year chart, courtesy Yahoo! Finance

To be sure, there are reasons for the stock's strong growth. Earnings per share have grown consistently over the past 6 years (fiscal years end in February):

RHT Earnings and Free Cash Flow, FY2007-2012
FY EPS (GAAP) EPS (Non-GAAP) Free Cash Flow (MM)
2007 $0.29 $0.56 $179
2008 $0.36 $0.77 $156
2009 $0.39 $0.59 $208
2010 $0.45 $0.71 $222
2011 $0.55 $0.83 $244
2012 $0.72* $1.04** $308***
Annualized

Growth (%)

19.9% 13.2% 11.5%

* -- author estimate

** -- based on company guidance from Q2 conference call

*** -- based on midpoint of company guidance of $350-$360MM in operating cash flow, less $47MM in capital expenditures (equal to 2011 figure and double the amount invested in the first 2 quarters of FY12)

The problem for RHT is that its consistent, though unspectacular growth seems more than priced into the stock. Price to forward earnings based on the midpoint of company guidance sits at 42, and even backing out the company's nearly $1.2 billion in cash and investments (netting out the $136 million cash purchase of Gluster), the stock is trading at nearly 37 times forward earnings.

The question for RHT is whether future growth can justify such a lofty P/E, particularly when "big tech" firms such as Cisco (NASDAQ:CSCO) and Intel (NASDAQ:INTC) are trading at single-digit forward P/Es with projected growth of their own (admittedly, at rates lower than those predicted for RHT). Note that Red Hat's sales have grown at an annualized rate of 23% over the past six years, ahead of the rate for earnings or cash flow. This compression in margins requires substantial top-line growth to create the earnings power necessary to justify a 35-plus P/E.

In its 2012 guidance, Red Hat projects continued strong year-over-year revenue growth (about 25%), with equivalent growth in earnings and free cash flow. The question is: can the company maintain, or accelerate, this growth going forward, particularly on the bottom line? Analysts surveyed by Reuters expect, on average, a long-term growth rate of 18.4%, with a wide range from 7 to 25 percent annually. The company's exposure to "cloud computing", its lower cost compared to rivals such as Microsoft (NASDAQ:MSFT) and IBM (IBM), and its history of growth are all cited by RHT bulls as evidence that the company has nowhere to go but up.

That may be true. Red Hat's history proves that it has a solid executive team, an intelligent business model, and an excellent product. But that is all priced in. Assume that RHT can grow earnings at 25% annually for the next five years. This is at the top end of analyst estimates, and a feat that the company has only been able to achieve in 2012 -- in other words, an optimistic scenario.

At those rates, the company would generate roughly $2.5 billion in cash, about one-third of its current enterprise value. Assume the company hoards all free cash in its coffers, and the company in October 2016 would have $19 per share in net cash. Non-GAAP forward earnings for fiscal year 2017 would be $3.17 per share, and free cash flow would be $940 million annually. And, in October 2016, RHT stock would look like this, depending on its annual rate of return:

Projected RHT Ratios, October 2016, Based on Rates of Return
Ann. Ret. (%) Stock Price Fwd EV/E* FCF as % of EV**
0 $44.17 7.94 19.4%
5 $56.37 11.8 13.1%
10 $71.14 16.4 8.9%
15 $88.84 22.0 7.3%
20 $109.91 28.7 5.4%

* -- Forward enterprise value-to-earnings (non-GAAP)

** -- Free cash flow as a percentage of enterprise value

The point of this admittedly academic exercise is to show just how much must go right for Red Hat to justify its current valuation. For the stock to double in five years (at the 15% level of annual return), the company must surpass nearly everyone's expectations for the next five years. It must grow earnings 25% annually, to a level three times current profits, requiring either annual sales growth over 30% or an increase in margins, despite competition from Microsoft, Hewlett-Packard, VMWare (NYSE:VMW), and others.

Having executed flawlessly for five years, RHT must then be valued by the market at a pricey 22 times earnings on an enterprise basis, and 14 times free cash flow (again, on an enterprise basis), and over forty times forward GAAP earnings. Bear in mind that, right now, Oracle trades at just 11 times earnings on an enterprise basis; Intel nine; and Cisco, eight. At just 5% annual growth in its stock price, RHT in 2016 will be pricier than all of these market leaders -- assuming it executes perfectly until then.

In the meantime, Red Hat faces competition from larger companies such as Oracle, HP, Microsoft, and VMWare. The open-source nature of its software is such that corporate IT departments can manage installations on their own, or switch to lower-priced competitors. Yes, cloud computing is an industry with impressive growth potential; and everyone knows it, and is intent on getting their piece of the pie. Red Hat has executed well in the space so far, but at its current valuation, there is simply no room for error.

In the meantime, RHT stock is testing a near-term high, with a 10-year high of $49, set back in late 2010, not much further ahead. For those of us who believe, as I do, that the past week's gains in the broader market have been a sucker's rally, RHT is an excellent candidate for a short sale, and its recent strength provides an interesting entry point. High-priced growth stocks are a common casualty in market downturns; witness RHT's near 20% haircut in late September, its 30% drop between mid-July and mid-August, or the 60% fall into its lows in late 2008.

I will leave the last word to Red Hat itself. From the company's website:

And when customers are unhappy with one vendor, they can choose another without overhauling their entire infrastructure. No more technology lock-in. No more monopolies.

RHT bulls argue that the lack of a moat in the industry is a boon for the company, whose expertise and cost savings will allow it to compete with products like Microsoft Windows Server, or VMWare's vSphere. But the technology world moves quickly; competitors emerge, new solutions arise, and companies falter. Red Hat is right now priced for perfection; anything short, and RHT will feel the pain.

Source: Red Hat: Perfect Short Candidate For This Market