Red Hat: A Software Investment For The Next 30 Years

Jan.22.12 | About: Red Hat, (RHT)

Need a foundation for the house you’re building? That’s easy: You can Google probably a dozen nearby contractors to come fill your big hole with concrete.

Need a foundation for the house you already own? Say what? Exactly: There’s no such thing as a replacement foundation, unless you’re going to rip your house down.

And that captures neatly the essence of a computer operating system, especially for large, enterprise-class deployments: Once it’s in place, and all your middleware, applications and customer data are piled on top, there’s no going back. Sure, you can add blades to your server or hook into the cloud, but the heart, the soul, the, ah, foundation of your architecture isn’t going anywhere.

Red Hat (NYSE:RHT) moved nine years ago to selling only server/mainframe class operating systems. And its reputation is now so strong in that arena that its single largest customer segment is the financial services industry. That’s right: Banks like Union Bank of California. Insurance companies like Geico. Stock exchanges (Deutsche Borse Group). This matters because financial services companies, with their huge databases of customers and money, are the most risk-averse customer segment when it comes to computer technology.

So for Red Hat (and by extension, Open Source-developed software) to be part of mission-critical applications at such enterprises ought to settle any concerns you might have about the viability of the company or its software code.

But what about the other relevant question: Is Red Hat a worthwhile investment? Well, put it this way: If your time horizon is about as long as the remaining time on your mortgage, the answer is unequivocally yes.

Red Hat: Safe as houses.

Data Sheet:

  • Name: Red Hat, Inc.
  • Ticker: RHT-NYSE
  • Price per share (1/20/12): $46.32
  • Market Cap: $8.95 billion
  • Trailing 12-months Revenue: $1.08 billion
  • Forward Price:Earnings Ratio (estimated): 40x
  • HQ: Raleigh, NC
  • Founded: 1995 (predecessor companies date to 1993)

Description:

Data from recent 10-k.

Red Hat is the global leader in providing open source software solutions to enterprises. The company addresses four related software segments with products for each:

  • Operating Systems: Red Hat Enterprise Linux (RHEL) – 6.2 is the current release;
  • Middleware/Application Server - JBoss AS 7 ;
  • Virtualization: Red Hat Enterprise Virtualization (RHEV) – 3.0 is the current release;
  • Storage: “Red Hat Storage” (i.e., Gluster, a company Red Hat acquired in 2011).

We estimate that over 90% of Red Hat’s revenue is related to RHEL and JBoss. RHEV and Red Hat Storage are newer service offerings and are just beginning to get marketplace traction. Red Hat also sells various other individual products and sponsors a variety of other projects (e.g., Fedora) that are in harmony with the larger ethos of Open Source software development.

Red Hat employs an Open Source software development and licensing model that uses the collaborative input of an international community of contributors to develop and enhance software. In plain English, this means the company aggregates its own and others’ software code, then sells this technology as a subscription service, including training, computer code and product support. This differs radically from traditional commercial software, where the computer code is sold as a product, usually accompanied by ancillary services for which there is an additional charge. Eighty five percent of Red Hat’s revenue is earned under subscription agreements.

Much of Red Hat’s actual software is distributed under Open Source licenses, such as the GNU General Public License, permitting access to the human-readable software source code. These licenses also provide relatively broad rights for licensees to use, copy, modify and distribute software. Software developed in this way has traditionally come with a quid pro quo: You can copy any piece of code free of charge, but you have to make any of your changes or improvements available to the party from which you got the code in the first place.

This dynamic has interesting consequences. Most infamously, Oracle sells a product known as Unbreakable Linux, which is essentially a bit-for-bit copy of Red Hat’s Enterprise Linux, along with some Oracle-specific enhancements. It would be like Pepsi acquiring the “7X” formula for Coca-Cola, then bottling and selling Coke themselves. Except that in the Red Hat /Oracle example, it’s perfectly legal. This would seem to violate any number of written or unwritten rules. However, Red Hat’s $1.2B cash balance and 33% operating cash flow margins should be proof enough that adhering to Open Source principles has no real effect on Red Hat’s ability to profit from its efforts.

Red Hat’s technologies support multiple application areas, including software as a service, cloud deployments, edge-of-network applications, information technology infrastructure (applications such as database, ERP and large web servers), mainframe computing, data centers, technical/developer workstations and corporate desktops. Red Hat does not, however, officially provide desktop versions of the Linux operating system; the company focuses almost entirely on server- and cloud-based software.

JBoss Enterprise Middleware provides an application infrastructure for building and deploying distributed applications that are accessible via the Internet, corporate intranets, extranets, clouds and virtual private networks. Examples of applications deployed on JBoss Enterprise Middleware include hotel and airline reservations, online banking, credit card processing, securities trading, healthcare systems, customer and partner portals, retail and point-of-sale systems and telecommunications network infrastructure.

Red Hat’s hosted content distribution offerings, such as Red Hat Network (“RHN”), permit various technologies to be updated and configured. Customers can provision, update, monitor and manage software in an automated fashion. Service offerings, generally made available as part of a subscription to either RHEL or JBoss, consist of training, consulting and product support.

Subscriptions to Red Hat enterprise technologies are sold directly to customers (~35% of sales) and indirectly through various channels of distribution (~65%). The latter category includes Red Hat software pre-loaded onto hardware (e.g. Dell, Hewlett-Packard (NYSE:HPQ), IBM (NYSE:IBM), Cisco (NASDAQ:CSCO), Network Appliance) and sold by that hardware vendor’s sales force. As of the end of November 2011, the average subscription contract length was 21 months, which has remained steady for at least the last two years.

Market Opportunity/Addressable Market:

Red Hat’s two primary product lines, Red Hat Enterprise Linux (RHEL) and JBoss make up over 90% of the company’s revenue. So let’s look at each line separately.

According to Gartner Group, the total operating system (OS) software market was $30B in 2010, growing about 8% annually. Of that, we believe that the OS market for traditional computers (as opposed to smartphones, for example) is $20B, growing at just over 5% annually. As of the end of November, 2011, Red Hat had trailing 12-month revenue of ~$1.1B, of which we estimate 60% is attributable to RHEL – this equates to $660m, or just 3.3% of the total server OS market. And since Red Hat’s revenue has been growing in excess of 25% for the last several years, it is most certainly taking market share in this space.

It’s worth distinguishing, however, between the “paid” and “unpaid” world of software; the above figures reflect markets and market share as tallied by dollars spent. In other realms, a variant of Linux has been credited with running as much as 60% of Web servers, usually with no-cost Linux versions such as Ubuntu,, Fedora or Mint.

We estimate that JBoss accounts for about 30% of Red Hat’s total revenue, or $330m. This equates also to about 3.3% of the total middleware market. And as with RHEL, JBoss’s growth trajectory implies that the product and company are taking market share.

Keep in mind that the aforementioned market figures are largely composed of proprietary software products. Because of RHEL and JBoss’s lower price points, if those products took 100% share in their respective markets, the total market figures would be much lower, perhaps amounting to only one quarter of their current size.

According to Red Hat itself, the virtualization market is $5B worldwide; the cloud storage opportunity is estimated at $4B. But Red Hat’s presence in both markets is de minimus at this time.

In summary, Red Hat’s market opportunity can be outlined in two steps:

  1. Linux/Open Source software is taking share from traditional proprietary/closed systems;
  2. Red Hat is taking market share within Linux, and doing so without pricing or margin pressure. (We discuss this later in the Competitive Landscape segment.)

Recent Financial Performance:

See release here.

After the market close on December 19, 2011, Red Hat reported its fiscal third quarter (November). Non-GAAP earnings per share were $0.28; this was $0.02 better than the consensus estimate of $0.26. Revenue of $290.0 m (up 24% year-over-year) was slightly ahead of the $289.6m consensus.

Subscription revenue for the quarter was $246.5 million, up 24% year-over-year. Non-GAAP operating margin was 27.2%, up a very strong 260 basis points from the year-earlier quarter. Management raised prior guidance for FQ4 (February). Non-GAAP EPS is now expected to be $0.26 - $0.27. Operating Cash Flow guidance was also raised to the high end of previously guided range.

The day after Red Hat reported its November quarter, its share price declined about 9%, signaling some disappointment with the company’s financial performance. Much of the disappointment seemed related to the company’s annual billings growth (billings = revenue plus the change in deferred revenue during the quarter), which came in at 23%. While it was reported that some investors had expected billings growth of around 30%, the 23% actually achieved, when adjusted for the impact of foreign exchange movements, was largely in line with the last two quarters (e.g. it was 24% in the prior quarter). So the price reaction seemed overdone.

Moreover, almost every other aspect of Red Hat’s FQ3 performance was unimpeachably solid:

  • Non-GAAP operating margins were 27% in the quarter, up from 25.1% a year earlier;
  • Operating Cash Flow rose 36% year-over-year;
  • Of the 25 largest software deals up for renewal in the quarter, RHT renewed all 25 at an aggregate contract value that was 130% of the original deals;
  • Red Hat signed 27 deals with total contracted revenue in excess of $1m and 5 deals > $5m; this means there is more off-balance-sheet backlog than reflected in the deferred revenue balance;
  • Subscription revenue (85% of total) was up 24% y/y.

The top three verticals for Red Hat in FQ3 were:

  1. financial services;
  2. technology; and
  3. government.

Revenue by geography in FQ3:

  • North and South America: 60%
  • Europe, Middle East and Africa: 24%
  • Asia - Pacific: 16%

Red Hat has consistently re-purchased stock in recent years and has $168m under a current authorization. It did not, however, re-purchase any in FQ3 – it bought Gluster instead. Given its history, we expect Red Hat to resume buying, especially as the stock is down about 10% from early December 2011.

Our takeaway from Red Hat’s third fiscal quarter financial performance: Red Hat is among an elite group of companies (e.g. VMware, Salesforce.com) with revenue in excess of $1 billion and growing in excess of 25% annually. Almost every aspect of Red Hat’s FQ3 performance suggests this trajectory will continue.

Concerns/Risks/Issues:

Valuation: At a forward price:earnings ratio of 40, Red Hat isn’t priced for perfection, but rather for continued excellence. The multiple is firmly ahead of the 20-30% growth rate shown by the company, so any actual (or even perceived, as we saw following the earnings release) deceleration in growth will have an immediate and negative impact on its share price.

Linearity: Red Hat management noted that the linearity of deal closure in FQ3 was more back-end-loaded than usual – closer to 20% in September, 20% in October and 60% of deals closed in November, rather than the usual 25-25-50 pattern. The company felt that the “early” Thanksgiving caused some of this, but we’re doubtful and believe it reflected larger macro concerns. If this pattern repeats in the current quarter, then the company’s valuation will likely compress to reflect it.

Integration of acquisitions: Red Hat has a history of making acquisitions. Most are small, but JBoss (acquired by Red Hat in June 2006) was bought for roughly $420 million. Red Hat’s most recent acquisition, Gluster, is not as large as JBoss, and we feel that integrating the two companies’ personnel and computer code should be straightforward. But acquisitions always bring the potential for distractions (at best) and dysfunction (at worst).

The departure of Red Hat’s senior-most sales executive. This month, Alex Pinchev, Head of Global Sales is leaving to be CEO of a smaller company, Acronis. We believe the departure is amicable, and Red Hat’s recent financial and operational execution against its own plans suggest that Mr. Pinchev is not leaving because of under-performance. No replacement has yet been announced. Certainly, if Mr. Pinchev felt the opportunity to lead another company was too good to pass up, then his departure is understandable. We look forward to Red Hat vetting and selecting Mr. Pinchev’s replacement and will be watchful for any hiccup in sales execution.

Competitive Landscape:

According to investment bank Piper Jaffray, Red Hat has 70-80% market share of the Linux Server OS market. The remaining share is owned primarily by SUSE, a wholly-owned business unit of The Attachmate Group. SUSE was established in 1992 by four German programmers, and has been through several corporate incarnations, most visibly as a subsidiary of Novell.

Like many other Open Source projects, SUSE has very staunch supporters, who value in particular SUSE’s strength in interoperability with other computing platforms. It is a fact, however, that Red Hat’s visibility and consistent execution has led it to become the leader in Linux OS technology. In short: SUSE is a worthy, but definite #2 player in this space, slowly losing its remaining market share to Red Hat.

Beyond SUSE, Red Hat competes with Microsoft’s server OS offerings, variants of the long-established UNIX operating system (e.g. Oracle’s Solaris) and traditional “big iron” mainframe operating systems from IBM and other legacy vendors. (It’s worth noting that IBM is hugely supportive of Open Source software and considers Red Hat an official partner. However, IBM’s Jeopardy-winning Watson supercomputer runs on SUSE Linux).

JBoss’s primary competition for Java-based middleware comes from IBM (~32% share) and Oracle (~16%). (link to Middleware share) We believe that JBoss is growing revenue faster than these other, larger companies and is therefore taking market share from them.

Financial Analysis (DCF and Comparative):

As part of our analysis of Red Hat Inc., we built a Discounted Cash Flow (DCF) model for the company. We used the following parameters and values to arrive at our DCF value:

  • Term: 5 years;
  • Initial Cash Flow: $311.7 million (this represents the estimated annual free cash flow for the current fiscal year, ending in February 2012);
  • Short Term Cash Flow Growth Rate: 10% (exceptionally conservative, considering the 22% CAGR over the past eight years;
  • Long Term Cash Flow Growth Rate: 5% (marginally higher than long-term GDP growth);
  • Discount Rate: 6.80% (derived using CAPM: Risk Free Rate = 3.02% from the 30–year Treasury Bond; 4.4% equity risk premium from Ibbotson; and an actual Beta of 0.86)
  • Current, Fully-Diluted Share Count: 196.468 million.

Using these inputs, our calculated DCF value per RHT share is $115.67, more than double Red Hat’s current $46/share price. While some may argue that a discount rate of 6.46% seems low, it isn’t when you place it in the context of a world with 0.25% T-bills and 3.00% 30-year Treasury bonds.

But for those of you interested, arbitrarily assigning a discount rate of 9% while maintaining the other parameter values results in a calculated DCF value of $51.74, still higher than today’s price.

Now let’s look at Red Hat compared with a variety of competitors providing operating systems, middleware and/or virtualization solutions, along with two subscription-based, software-as-a-service vendors, Symantec and Ariba.

Red Hat

Microsoft

Oracle

VMware

Citrix

Symantec

Ariba

Ticker

RHT

MSFT

ORCL

VMW

CTXS

SYMC

ARBA

Price (1/20/12)

$46.32

$29.67

$28.60

$87.68

$67.95

$16.77

$29.13

Market Cap

$8.95 b

$248.7 b

$143.7 b

$37.1b

$12.7 b

$12.4 b

$2.73b

LTM Revs

$1.08 b

$71.1 b

$36.7 b

$3.54 b

$2.12 b

$6.61 b

$443.9 m

Op CF Margins

33.2%

38.4%

35.8%

52.8%

32.5%

29.7%

17.1%

MRQ Rev Growth

23.1%

7.3%

2.4%

31.9%

19.7%

13.6%

44.6%

Forward P:E

40.3

9.83

11.2

34.9

24.8

8.84

25.6

EV: Revs

7.63

2.72

3.47

9.47

5.75

1.81

5.69

Float: Shares Out

0.994

0.898

0.779

0.183

0.995

0.996

0.987

Source:

Yahoo Finance

LTM=Last 12 months, CF=Cash Flow, MRQ=Most Recent Quarter

Click to enlarge

We had two takeaways from this data:

  • Red Hat has the highest forward price:earnings ratio among this group, but it seems proportional to its growth rate. (Note that Ariba’s higher revenue growth rate includes an acquisition made in 2011);
  • VMware stands out for its very large cash flow margins and revenue growth. It also commands a premium multiple (though its P:E is not as high as Red Hat’s), probably owing to its 85% market share in virtualization.

Conclusion (Buy, Sell or Neutral?):

In bringing a professionalism to the Open Source movement, Red Hat solved the primary flaw in commercial software: Customers are no longer imprisoned by having only access to the binaries, and not the source code. They are free to leave and can take their code with them if they choose. It turns out that almost nobody leaves Red Hat. Now, after nearly two decades the company is the acknowledged leader and probably wins some deals based on its brand name alone.

Investing in Red Hat is a classic “long tail” payoff: You’re not betting on the company having a “blow-out” quarter, because 85% of its revenue is subscription-based, so that can’t happen. What you’re betting on is that once a large-scale computer system is in place, it’s not going to be dismantled easily or quickly. And the more mission-critical data is heaped upon it, the more likely that system’s owner (e.g. a bank, stock exchange or insurance company) is going to send Red Hat money to make sure bugs are fixed, upgrades are made and interoperability is tested.

As a proxy for how well customers value this continuity and how much they’ll pay for it, note that Red Hat’s cash flow from operations climbed continuously throughout the 2006-2010 time frame. And we all know what was going on then.

We believe you need to buy/go long shares of Red Hat Inc.

Disclosure: I am long ARBA, IBM, RHT, SYMC in the Separately Managed Account product for which I am the portfolio manager and in which I am an investor.