Holders of Red Hat (RHT) shares were (apologies) in the red Tuesday, with RHT stock off a grueling 11%.
Red Hat earnings for the second quarter were encouraging — sales increased by 16% to $374.4 million and adjusted profits came to 35 cents a share, beating Street estimates of $372.1 million and earnings of 33 cents. However, sluggishness in Europe took a toll on billings, which rose only 8% to $376 million vs. expectations for a 14% improvement.
So, what’s the ruling — has Red Hat stock become an opportunity at these levels, or should you avoid RHT at all costs? To see, we look at the pros and cons of Red Hat:
Unique Business Model: Most software companies, like Oracle (ORCL) or Salesforce.com (CRM), have teams of engineers that create applications. But Red Hat instead leverages open-source software created by global communities of developers. RHT does this for free and distributes its software through the Internet. To make money, Red Hat sells value-add services, such as creating patches, helping with integration and testing, and providing ongoing support/upgrades. Red Hat believes this is much cheaper, as a company does not have to pay the hefty licensing or subscription fees for the software — an attractive aspect for many companies in light of budget pressures.
The Datacenter: This is a hot category because it powers some of the biggest trends in technology, such as cloud computing, Big Data, video delivery and social networking. Operating datacenters can be extremely expensive, so many companies look to open-source technologies to help reduce costs. To this end, Red Hat has invested heavily in this area; RHT’s cutting-edge offerings include the Enterprise Linux OpenStack, Cloud Infrastructure and Storage Server 2.1. Also helping Red Hat is its credibility with developer communities, built since its founding in 1993, and thus many of the people involved in datacenters have certifications from Red Hat to use its software as well as tools and training resources.
Strong Financials: Red Hat continues to crank out strong cash flows. In the latest quarter, RHT’s operating cash flow came to $119 million, up 15% on a year-over-year basis, and it has $1.3 billion in the bank. Red Hat has been using its cash hoard to not only buy back shares, but also for acquisitions. That dealmaking has been important in adding new systems and bolstering the overall customer base.
Competition: Red Hat’s low-cost approach is attractive, but not necessarily enough. RHT competes against rivals such as Microsoft (MSFT), Hewlett-Packard (HPQ) and VMware (VMW), which not only have huge resources but also the ability to bundle other solutions, which can be attractive to customers.
Growth: The recent drop-off in billings might be the first indication that revenue growth will start to decline. Consider that this is the third-consecutive time Red Hat has missed expectations. Then again, the global economy still stinks of uncertainty, and that could be leading to purchase decision delays. If so, RHT could see even further weakness across the next few quarters.
Valuation: Even with today’s drop, Red Hat stock isn’t cheap, trading at 59 times earnings, compared to just 12 for MSFT and 14 for ORCL.
Red Hat is positioned nicely to capitalize on the growth of the datacenter. The company has top-notch systems, a thriving community and a strong brand. It also has 20 years of experience with handling mission-critical functions for customers.
However, the weakness in billings could be a sign that Red Hat is feeling the heat from competitors as well as the challenges of the global economy, so it seems likely that RHT will see continued weakness on the top line.
So, should investors buy Red Hat stock? No — in light of its pricey valuation and risks to growth, the cons outweigh the pros for now.
Tom Taulli runs the InvestorPlace blog IPO Playbook. He is also the author of High-Profit IPO Strategies, All About Commodities and All About Short Selling. Follow him on Twitter at @ttaulli. As of this writing, he did not hold a position in any of the aforementioned securities.