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Shares of Red Hat (RHT) have a stellar 1-year performance of returning 31.01%. At $55.81 per share, the stock is trading at 25.2x the NTM EBITDA and 45.4x the NTM EPS. The high valuations are associated with market's high expectations for the company's future growth driven by its solid market position and the excellent management team. I tend to agree with many of the positive comments (here, here, and here) on RHT and believe in management's ability and the company's strong competitive advantage as well as market position will likely continue drive the growth down the road. But the lofty valuations stop me from making my bet on the stock as the risk/reward profile appears to be unfavorable.

In this article, I will illustrate the rationales that support my bearish view on RHT through a relative value analysis.

The value analysis includes a list of comparable peers in the system software sector. The estimated stock value is then determined by equally weighting the valuations calculated by five different peer-average multiples - EV/Sales, EV/EBITDA, P/S, P/E, and EV/FCF.

RHT's growth prospects are superior relative to the peer averages. Consensus estimates predict the revenues, EBITDA, and EPS to rise by a 2-year CAGR of 17.4%, 36.2%, and 16.1% over the current and next fiscal years. Accounting for the earnings growth potential, the stock is trading at 2.4x PEG, a substantial premium over the peer average of 1.2x, suggesting market's extreme enthusiasm towards the firm's future growth (see comparable analysis table below).

In terms of performance in profitability margins and corporate capital returns, RHT only outperform the peer averages in LTM gross margin. Its LTM margins of EBITDA, EBIT, and net income, as well as ROE and ROIC are significantly lower than peer averages. It is noted that RHT's LTM EBITDA margin, ROE, and ROIC are even the lowest among the group (see comparable analysis table below).

On the liquidity side, RHT's LTM FCF margin of 23.1% is just marginally lower than the average of 24.9%. The company carries no debt relative to peers' average debt to capitalization of 17.6%, but both the current and quick ratios are again below the averages (see comparable analysis table below).

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Based on the above comparisons, RHT only outperforms the peer groups in the growth potential, and it only makes sense to me if the stock is trading at a not very large valuation premium, likely 20% to 30%, to account for RHT's growth story.

Nonetheless, the current stock price of $55.81 implies a huge 147% valuation premium over the five peer average multiples, suggesting an exaggerated valuation level. Applying a more reasonable but still substantial 40% valuation premium, the stock price will drop to $32.70, indicating a 41% downside (see relative valuation tables below).

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Bottom line, RHT's valuations may continue to be supported by market's high expectations. But over the long term, the stock appears to be fragile as the market has assumed almost no mistake for the management in their executions. For conservative long-term investors, RHT is not your choice.

All tables are created by author and all financial data is sourced from Capital IQ and Morningstar.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Source: Investors Should Be Careful Of This System Developer