Red Hat Remains Aggressively Priced

Sep.25.12 | About: Red Hat, (RHT)

After the close on Monday, Red Hat (NYSE:RHT) announced Q2 earnings that met analyst estimates (assuming the removal of acquisition costs). The concerning part remains that earnings were flat year-over-year. Sure, the company is ramping up marketing and research expenses, but most stocks have a difficult time remaining at 40x multiples during those transitions.

The interesting part though is that the stock was only down 3% as of writing this article. After a decent rally this year, a normal stock would get hit harder off these weak numbers.

The company is a leading provider of open source software solutions, taking a community-powered approach to reliable and high-performing cloud, Linux, middleware, storage and virtualization technologies.

Q2 Earnings Highlights

The reported numbers for Q2 show a company with decent growth impacted by a weak currency. On a constant currency basis, revenue grew a solid 20%.

Below are the highlights:

  • Total revenue for the quarter was $322.6 million, an increase of 15% in U.S. dollars from the year-ago quarter, or 20% measured in constant currency.
  • Subscription revenue for the quarter was $278.8 million, up 17% in U.S. dollars year-over-year, or 22% measured in constant currency.
  • After adjusting for stock compensation and amortization expenses, as detailed in the tables below, non-GAAP operating income for the second quarter was $79.2 million, up 4% year-over-year. Non-GAAP operating margin was 24.6%.
  • After adjusting for stock compensation and amortization expenses, as detailed in the tables below, non-GAAP net income for the quarter was $54.9 million, or $0.28 per diluted share, as compared to $56.5 million, or $0.29 per diluted share, in the year-ago quarter. The year-ago quarter would have been $0.28 per diluted share excluding a discrete tax benefit of $2.1 million, or approximately $0.01 per share.
  • Operating cash flow was $103.9 million for the second quarter, as compared to $77.1 million in the year-ago quarter.

Guidance

The company provided the following earnings guidance on the earnings call:

  • Q3 revenue of $336M-$339M and EPS of $0.28-$0.29, slightly below a consensus of $340.1M and $0.30, respectively.
  • For FY13, the company now expects revenue of $1.32B-$1.33B and EPS of $1.15-$1.17 vs. a consensus of $1.33B and $1.17, respectively.

These numbers are not acceptable for a company trading at a very rich multiple of 40x 2014 earnings estimates.

Cash Flow

The generation of cash remains a key focus of this stock market. Investors have fallen in love with companies that rake in cash from prepaid contracts such as Red Hat.

The issue is it that the company has $944M in deferred revenue that contributes to the $1.36B in cash. This means the company has a vast majority of the cash tied up in future services that require significant expenses.

The free cash flow came in right at $84M. On an annualized basis, the company would generate a significant $336M, though again a large percentage of the cash flow comes from the growth in deferred revenue.

Conclusion

Red Hat remains a very innovative company. The valuation remains at a lofty level with the company currently having to outspend revenue growth.

The company is seeing huge demand for the new storage products. This demand will allow for continued growth in the future. The problem is that the potential just doesn't support the high valuation. After all, analysts only forecast a 19% long-term earnings growth rate. Why would an investor willing pay 40x those estimates?

Disclosure: I have no positions in any stocks mentioned, but may initiate a short position in RHT over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Please consult your financial advisor before making any investment decisions.