As Cloud Kings Go, Red Hat Stock Isn’t Looking Very Regal Right Now

Red Hat stock - As Cloud Kings Go, Red Hat Stock Isn’t Looking Very Regal Right Now

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Red Hat (NYSE:RHT) has been a player in the digital space for awhile, and Red Hat stock has essentially tripled over the last five years, but it is a whole new environment, now.

Earlier this year, CNBC personality Jim Cramer made the case for a new group of superstar “Cloud Kings’ stocks that he said were better bets than the FANG stocks.

These Cloud Kings include: Adobe Systems (NASDAQ:ADBE), (NASDAQ:CRM), ServiceNow (NYSE:NOW), VMware (NYSE:VMW), Splunk (NASDAQ:SPLK), Workday (NASDAQ:WDAY) and, of course, Red Hat.

Some of those are more established than others. Regardless, in any case, it’s a pretty imposing group of companies. That leads to the question: Does Red Hat stock deserve to be included in this bunch?

Red Hat Stock and the Rise of the Cloud Kings

Cramer referred to these group of companies as “anointed winners.” These seven companies are still in the “early stages” of the cloud transformation, Cramer suggested.

They rebounded strongly and rapidly since February’s tech sell off, making a technical argument for owning this grouping of stocks. And he makes a fair point.

Historically, with each market cycle, a new set of stocks will power the market to fresh highs. While previously the FANGs led the market, one could argue that in 2018, these smaller software names have been among the key drivers powering the NASDAQ to fresh highs.

And oftentimes, the market’s leaders will keep rising until a bear market hits suggesting that the Cloud Kings could have plenty of momentum left in the tank.

The underlying outlook for the group is promising. While the FANG stocks still get the most press, they’re far from the only winners in the current digital revolution.

The Cloud Kings offer access to a variety of diversified fast-growing tech companies that have much more runway left for growth than the much larger tech titans.

Are They Overpriced?

Of course, with high growth prospects come high valuations. Even Mr. Cramer agrees. He said that: “In many cases, their stocks are indeed expensive up here. The kings come at a cost. Regular viewers know I do hate to chase. But on the rare occasions when these names give you a dip, they have been fabulous outright buys.”

Is it worth chasing the Cloud Kings, including Red Hat stock, up here? It’s worth remembering that Mr. Cramer has gotten overly excited about tech revolutions before. His “Winners of the New World” list in 2000, for example, included far more duds than hits. Anyone remember outstanding winners such as InfoSpace.com724 Solutions, or Inktomi?

That said, the Cloud Kings are far more mature and developed companies than his picks from that previous tech craze. The stocks are expensive, yes, but they are fast-growing and are either meaningfully profitable today, or have the potential to get there relatively quickly.

Red Hat Stock: Set For A Fall?

Fellow InvestorPlace contributor Luke Lango recently suggested that Red Hat stock was set for a major decline following a lukewarm earnings report. Lango wrote:

“The problem with Red Hat stock is that it wasn’t priced for this mixed [earnings] 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.”

Indeed, the stock is trading at more than 60x trailing earnings, 50x for 2018’s full-year earnings, and almost 40x for 2019. Given Red Hat’s relatively slow 17% compounded revenue growth rate over the past five years, those are some pretty aggressive PE multiples.

This is where Lango’s other concern rears its head. Previously, Red Hat had been seeing strong margin growth. By driving its profits higher per dollar of sales, Red Hat was able to post excellent earnings growth even with a more pedestrian sales growth rate. But that all changes if what we saw last quarter turns into a trend.

In Defense of Red Hat as a Cloud King

Lango makes great points. The combination of slowing revenue growth and a huge PE ratio puts Red Hat in a precarious position. But bulls aren’t without a solid case as well.

The big thing now is that Red Hat is diversifying its business. Red Hat is best known for offering paid solutions to support the Linux platform for servers. However, this market may be maturing. Paid Linux installations already constitute more than a quarter of the market, and Red Hat has 75% share within that category. It’s unclear how much more room there is for growth there.

But Red Hat now has two other divisions. Its training and services segment is a $250 million/year (11% of total revenues) business growing at the same rate as the core Linux line. Additionally, and most excitingly, Red Hat has its apps and emerging technologies operation. This is approaching a $500 million/year business, and is growing at almost 40%/year compounded. If that sort of growth rate continues, it will pull Red Hat’s overall revenue growth rate back up in coming years.

Red Hat Stock Verdict

Red Hat stock is really expensive. There’s no denying it. The question going forward is if revenue and earnings growth rates will recover or not. The business is losing a good deal of momentum. Red Hat is simply too expensive if revenue growth continues to slow down.

At the time of this writing, the author held no positions in any of the aforementioned securities.

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