Red Hat's 3scale Buy Is Misunderstood

| About: Red Hat, (RHT)
This article is now exclusive for PRO subscribers.


Red Hat fell 5% on earnings that were in line with estimates.

The company's purchase of 3scale, which manages APIs, may have been confusing.

RHT has made itself essential to large enterprises and will be worth buying.

Red Hat (NYSE:RHT) fell overnight despite reporting record earnings that were in line with analyst estimates.

The company delivered $61.2 million in net income, or 33 cents per share, against $48 million, or 26 cents per share, on revenue that was up 18% year over year at $567 million. The projection for the next quarter was just one cent/share, short of analyst estimates at 55 cents, yet the stock fell about 5%. The company also announced it will buy back $1 billion in stock - the current market cap is about $14.5 billion.

None of that is bad news. Certainly not bad enough to justify a big sell-off. What is more likely to me is that investors don't understand its purchase of 3scale, which provides technology that manages application program interfaces, or APIs. They probably remember the recent attempt by Oracle (NYSE:ORCL) to make APIs proprietary and think Red Hat is getting itself into trouble, an area of the business that could prove legally controversial or dodgy.

It's not. APIs, sets of instructions that tell programmers what programs do, are becoming an essential element in corporate computing, and even organizing them is becoming a huge challenge to corporate IT departments. The acquisition of 3scale will let Red Hat manage these APIs as a service, and go even further into the corporate data center.

Again, you can hear the bears scream at that one. But the fact is that corporations are managing a slow march from client-server systems to cloud, with public cloud replacing the customer-facing operations and private cloud replacing the corporate "crown jewels" that must be kept safe. By delivering tools that manage the transition, Red Hat makes itself even more essential to these customers.

It's no longer enough for Red Hat, or any company, to tout its open source bonafides. Open source has become the mainstream for software development. Standard tools that allow developers to collaborate freely require management behind them, and that's what this deal helps Red Hat fill in, behind its open source operating systems, middleware, and cloud tools.

When I first joined Seeking Alpha, open source was controversial, and people wondered how anyone could make money with it. It is no longer controversial, and Red Hat's ability to profit from it is now proven. The shares are up 94% over the last five years, which beats the performance of the NASDAQ average, and while the company's current price/earnings multiple is high at 74, it's still growing on both the top and bottom lines.

My spidey sense tells me Red Hat could still be bought by a giant software company still anxious to prove its open source worth - Microsoft (NASDAQ:MSFT) and IBM (NYSE:IBM) both come to mind - but be aware that's pure speculation. Let the stock settle, and then know it is still worth buying on its own merits.

Disclosure: I am/we are long MSFT.

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.