As Apple (AAPL) continues to execute time and time again, the valuation becomes increasingly lucrative (click here for explosive possibility). This tech giant is growing at breathtaking rates, defying the "law of big numbers", and yet trades at just 14.7x forward earnings. I view the long story of Apple as almost a mirror image of what is going on at Red Hat (RHT). For the year to date, both companies have gained around 48% in shareholder value. The only difference is that Red Hat's free cash flow doesn't support the company's valuation compared to what is the case for Apple.
While I recommend Red Hat to speculative investors looking for high-risk adjusted returns, I recommend Apple and Oracle to conservative investors looking for a value discount.
In this article, I will run you through my DCF model on Red Hat and then triangulate the result with a review of the fundamentals compared to Oracle (ORCL) and Apple. I find that Oracle and Apple are more attractive investments than Red Hat right now.
First, let's begin with an assumption about the top-line. Red Hat finished FY2011 with $1.1B in revenue, which represented a 24.6% gain off of the preceding year: acceleration. Analysts model a 18.7% per annum growth rate over the next half decade or so, which appears reasonable given the low base that the firm has to grow off of.
Moving onto the cost-side of the equation, there are several items to consider: operating expenses, capital expenditures, and taxes. I model cost of goods sold as 15.6% of revenue versus 48.2% for SG&A, 18.5% for R&D, and 4.6% for capex. Taxes are estimated at around 30% of adjusted EBIT (ie. excluding non-cash depreciation charges to keep this a pure operating model.)
We then need to subtract out net increases in working capital. I estimate this figure hovering around -4.3% of revenue over the explicitly projected time period.
Free cash flow comes out to around $305M by 2015. This means that the $11.8B company is trading at nearly 14x my 2015 free cash flow estimate.
All of this falls within the context of admittedly attractive operational momentum:
I'm pleased to report that we delivered fourth quarter results that exceeded the high end of our guidance, and it represented a very strong finish to another record year for Red Hat. Red Hat associates around the globe have contributed to 40 straight quarters of sequential revenue growth, culminating in fiscal 2012 revenue that exceeded the $1 billion mark.
Red Hat has become the first pure-play open source company and one of a few select software companies to have ever achieved this milestone.
From a multiples perspective, however, Red Hat is relatively expensive. Red Hat trades at a respective 81.2x and 42.6x past and forward earnings. This compares to corresponding figures of 17.2x and 11.8x for Apple and 15.4x and 11.1x for Oracle.
Consensus estimates for Apple's EPS forecast that it will grow by 68.4% to $46.62 in 2012 and then by 15.5% and 12.9% in the following two years. Assuming a multiple of 14x and a conservative 2013 EPS of $49.50, the stock would hit $693 for 14.9% upside. The iPad has delivered stellar returns and there is no telling what the next Apple breakthrough could hold. Apple TV?
Consensus estimates for Oracle's EPS forecast that it will grow by 9% to $2.42 in 2012 and then by 8.7% and 9.9% in the following two years. Assuming a multiple of 14x and a conservative 2013 EPS of $2.59, the stock would hit $36.26 for 24% upside. Oracle is led by top management but, like software peer Microsoft (MSFT), has lost much of its luster with the rise of Apple and other tech darlings. As the macro economy hits full employment, I expect these mature firms to outperform Red Hat.