Red Hat Stock’s Lofty Valuation Is Much More Dangerous Than You Think

Red Hat stock - Red Hat Stock’s Lofty Valuation Is Much More Dangerous Than You Think

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A few months ago, CNBC personality and former hedge fund manager Jim Cramer put together a group of Cloud King stocks, which he said were set to be big winners for the next several years thanks to massive tailwinds in cloud-hosted services adoption.

But I didn’t think all of Cramer’s Cloud King stocks would remain kings for that long. Indeed, there were a few Cloud King stocks that I was bearish on, and Red Hat (NYSE:RHT) was one of them.

Fast forward a few months, and Red Hat stock is dropping big after the company reported decent quarterly numbers alongside weak guidance. The weak guide points to further deceleration in revenue growth, and actually implies that the present margin expansion narrative is going to pause in the near-term.

The problem with Red Hat stock is that it wasn’t priced for this mixed news. Going into the report, the stock was trading at nearly 50-times this year’s guided earnings. When you report slowing revenue growth and halted margin expansion with your stock trading at 50-times forward earnings, the stock tends to drop in a big way.

This pain isn’t over.

The Red Hat growth story is slowing down by a bunch to the point where this is a sub-20% earnings growth company. But Red Hat stock still trades at over 40-times this year’s guided earnings.

That makes no sense. As such, I think the lofty valuation in Red Hat stock is just starting to unwind.

Here’s a deeper look.

Red Hat’s Numbers Weren’t Good Enough

The business RHT is in is a very good one.

The company provides cloud-hosted solutions that help other enterprises digitize and modernize their businesses. Growth has been boosted recently by Red Hat’s pivot into the private cloud markets, which has given them broad exposure to the hyper-growth hybrid cloud space.

But despite the strong business narrative, the numbers just aren’t that good at Red Hat. Last year and the year before that, revenue growth has been stuck in this 20% or lower range. That isn’t particularly noteworthy for a cloud player.

Meanwhile, margins aren’t roaring higher, which is especially unusual for a cloud player. Other cloud giants are pivoting their business models to high-margin subscription models, and consequently, margins are zooming higher. But RHT has already largely made that transition. And its subscription business is only growing at 20%-per-year. So margins aren’t heading higher with much velocity.

The numbers got worse this quarter, and are expected to get even worse for the foreseeable future.

Revenue growth this quarter was just 17%. That is expected to fall to 14% next quarter, and 16% for the full year. Gross margins were flat and operating margins fell 10 basis points, versus 80 basis points of expansion last year. Meanwhile, operating margins are expected to be flat for the full year.

This slowing revenue growth coupled with maxed out margins is leading to a huge reduction in the earnings growth rate. Earnings this year are expected to grow just 16%, versus over 30% growth last year.

Those numbers (16% revenue growth, 16% earnings growth, flat margins) just aren’t good enough for a richly valued stock like RHT stock.

Red Hat Stock Could Keep Dropping

In the big picture, Red Hat stock is a tough buy here.

Revenue growth is slowing from an already small base of 20%. That means that over the next 5-10 years, revenue growth will likely run around 10-15%. Meanwhile, margins may be able to expand again next year, but the rate of expansion will be anemic (25 to 50 basis points). Thus, operating margins in a long-term window won’t have that much more room to run higher.

With revenue growth of 10-15% and only slight margin expansion potential, RHT is a sub-20% earnings growth company over the next several years.

But Red Hat stock trades at over 40-times this year’s guided earnings. A sub-20% earnings growth company is a tough buy at 30-times earnings, let alone 40-times earnings.

I get that investors are willing to pay a premium for Red Hat stock because it is a big moat, high margin subscription business that has staying power and a solid long-term outlook. But a 40 multiple for sub-20% growth seems like too much of a premium.

Bottom Line on RHT Stock

Red Hat stock is a dangerous short because investors have been willing to pay a premium. But with growth now materially slowing and margin drivers fading, investors might not be so willing to pay that big premium.

I wouldn’t be surprised to see RHT stock struggle over the next several quarters as its valuation normalizes to a more fundamentally supported level.

As of this writing, Luke Lango did not hold a position in any of the aforementioned securities.

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