Red Hat Inc (NYSE:RHT) may not be getting much media attention. But it should be. Red Hat stock has quietly shot up over the past year. In fact, shares are up a remarkable 84% over the past year. In case you’re wondering, that makes Red Hat the 11th-best performing stock out of the S&P 500 over the past year.
While other tech stocks such as Paypal Holdings (NASDAQ:PYPL) and Amazon.com, Inc (NASDAQ:AMZN) get far more attention, they’re only marginally ahead of Red Hat on the scoreboard. Paypal is up 87% and Amazon 85% over the past year, with Red Hat at 84%.
Red Hat has earned its place among the tech superstar stocks, as it grew earnings 30% last year. And analysts forecast even bigger gains for the EPS figure for this year. As is the case after a big run, we must ask though: How much more upside could RHT stock realistically have in 2018?
Red Hat Stock Cons
Pricey Stock: Red Hat stock is fully valued, if not overpriced. Sure, analysts expect Red Hat to double its earnings this year. However, the market already priced this in by nearly doubling the price of RHT stock last year.
As a result, the PE ratio has hardly budged from its lofty perch at 83x trailing earnings. If the company meets analyst forecasts, that PE ratio will drop to 46x next year. That’s better, but hardly a bargain. Investors are often advised to avoid paying more than 10x sales for even the fastest of growth companies. Red Hat stock is at the threshold now, with its stock at 9.8x sales today.
Huge Run Last Month: Tech stocks have had a rocky run since the beginning of February. Tech stocks, as a group, fell more than 10% from peak to trough. They rallied back to marginal new highs in March, but have slid again with the Facebook, Inc. (NASDAQ:FB) and its scandal.
Despite that, RHT stock has been on a tear. Since the beginning of February, tech stocks haven’t made any progress. But RHT stock has advanced 20% over the same period. That makes it a dangerous play now, as buyers here are chasing a highly-extended move. Momentum trading works for a time, but buying after such a huge run – especially when the market is stumbling – often leads to trouble.
Minimal Capital Return: Red Hat offers little to its shareholders in the form of capital return. RHT stock pays no dividend whatever. While tech stocks aren’t known for paying large dividends, at least a small payment would be nice from a company as large and established as Red Hat.
On top of that, Red Hat only buys back a minimal quantity of their stock. In recent years, they’ve been buying back one to two percent of outstanding Red Hat stock. Ultimately, the buyback hasn’t mattered too much though. The company had 192 million shares outstanding in 2012, and 177 million today, a less than 10% decline over a five year period.
Red Hat Stock Pros
Widening Moat: Many investors have long been skeptical of Red Hat’s business model. Red Hat has built its operations around providing support and an easy user experience for software that is, inherently, free. Analysts had long doubted the tech-savvy user base that gravitated to open-source software would be willing to pay up for support.
However, Red Hat has proven that its model is working. Revenues from all three of its business segments are growing at a double-digit annual clip. The core infrastructure business (two-thirds of revenues) was up a respectable 15%. And the smaller segments are booming. Training & consulting grew 27%, with apps and emerging tech up more than 40%.
Price Target Increase: RHT stock is holding up better than peers in the face of this week’s heavy tech selling. There’s good reason for that. Raimo Lenschow, of Barclay’s, raised his price target from 145 to 165 for RHT stock on Monday.
That’s a promising sign ahead of Red Hat’s upcoming earnings report which comes out next Monday. Lenschow said that, “We continue to see long-term upside driven by the company’s attractive hybrid cloud positioning and momentum in both core and emerging products.”
This is especially nice, as it counteracts a recent downgrade. Mizuho cut RHT stock from buy to hold last week. Their analyst said that Red Hat is performing well but not enough to justify a higher share price.
Strong Cash Flow Generator: While Red Hat isn’t particularly profitable on an accounting basis, it’s doing well elsewhere. The company’s free cash flow (all the cash the company has from operations after expenses including capital expenditure) has grown a remarkable 14 out of the past 15 years, only dipping slightly in 2008.
It’s one thing to grow revenues steadily, have a large enough advertising budget and it’s not hard. But free cash flow is a different animal. Red Hat’s consistency shows that its subscription business model is highly stable, margins are defensible, and that future revenue growth will likely flow straight through to the company.
While the company hasn’t done much to reward shareholders yet, the company has a great balance sheet that should lead to favorable outcomes for RHT stock over time.
RHT Stock Verdict
Red Hat is firing on all cylinders. The company keeps reporting blow-out quarter after blow-out quarter. Expect another one soon, particularly as an analyst felt confident enough to upgrade RHT stock this week heading into earnings.
That said, it’s fully priced into Red Hat stock. It’s particularly amazing that Red Hat is up 20% over the past six weeks while tech stocks have been rocked by unusual levels of volatility. Red Hat really needs to pause or even correct to let its earnings grow enough to support the stock’s valuation. Up here, the stock is extended and vulnerable to any sort of negative catalyst.
At the time of this writing, the author owned FB stock and had no positions in any of the other aforementioned securities. You can reach him on Twitter @irbezek.
