Red Hat Shares — 3 Pros, 3 Cons

Free software is a plus that's difficult to outweigh

In yesterday’s ugly market, only a few stocks were able to eke out gains. One of the standouts: Red Hat (NYSE:RHT). Its price was up 3% to $41.49.

Then again, the software company posted strong quarterly results. Revenues increased by 27% to $281.3 million, and earnings spiked 67% to 20 cents per share. Red Hat also enjoyed a 20% increase in operating cash flows to $77 million.

Such a performance is typical for Red Hat. Keep in mind that the company’s shares have seen an average annual return of 29.50% during the past three years.

So what about the future? Can Red Hat continues its impressive growth ramp? To see, here’s a look at the pros and cons:


Powerful business model. Red Hat focuses primarily on open-source software. Essentially, this is technology that is free and maintained by a developer community. So how does Red Hat make money? For the most part, it sells services, training and updates. These are critical for customers who want to maximize the usefulness of open-source software.

Mega-trends. The software industry is undergoing tremendous change. Some of the new developments include virtualization and cloud computing. And yes, Red Hat has various services that help customers with these categories.

Strong customer base. In the latest quarter, Red Hat’s top 30 deals were all over $1 million. The company also made three transactions over $5 million. What’s more, Red Hat was able to get a 100% close rate on the top 25 deals up for renewal. In other words, the company has fairly strong customer loyalty.


Competition. Through acquisitions, traditional software operators have entered the open-source market. For example, Oracle (NASDAQ:ORCL) owns the highly popular MySQL database. IBM (NYSE:IBM) and Microsoft (NASDAQ:MSFT) also have their own offerings. In the virtualization market, Red Hat must compete against companies like VMware (NYSE:VMW).

Platform as a service (PaaS). This allows companies to operate and customize their information technology systems via the Internet. For this, they pay an ongoing subscription fee. While still early, the PaaS approach is getting lots of traction because of its flexibility and low cost. In fact, one of the leaders in the segment is (NYSE:CRM). Over the next few years, PaaS systems could represent a serious threat for Red Hat.

Valuation. Red Hat’s stock is far from cheap. It currently trades at a price-to-earnings ratio of 69.


So might the tough macroeconomic environment hurt Red Hat? Perhaps so. Yet the company has the advantage that its software is free. Consider that some of the hardest-hit sectors — such as financial services and the government — have shown continued demand for Red Hat’s services.

For example, Red Hat has raised its guidance for the fiscal year 2012. Revenues are forecast at $1.12 billion to $1.13 billion, up from $1.07 billion to 1.085 billion. As for the non-GAAP earnings, they are expected to range from $1.03 to $1.05 per share, which compares to the prior guidance of 98 cents to $1.

And yes, the main drivers include secular changes in technology, as well as a bigger emphasis on lower-cost technology offerings — all of which Red Hat provides. Thus, in light of such things, the pros outweigh the cons for the company’s stock.

Tom Taulli is the author of “All About Short Selling” and “All About Commodities.” You can also find him at Twitter account @ttaulli. He does not own a position in any of the stocks named here.

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