Enterprise open-source software leader Red Hat (NYSE:RHT) is set to report third-quarter numbers after the bell on Monday, December 17. Given positive demand trends in the open-source industry and recent strong earnings reports from peer cloud players, Red Hat should report strong, above-consensus numbers after the bell. Those strong numbers should push Red Hat stock slightly higher.
But, RHT is trading based on a much bigger catalyst than Q3 earnings. That catalyst is a potential buyout.
Red Hat, An Acquisition Target
Earlier this year, legacy technology giant IBM (NYSE:IBM) announced that they were going to acquire Red Hat for $190 per share. Since then, Red Hat stock has traded largely sideways around the $170 to $180 range.
But there are rumors that IBM’s proposed acquisition may actually start a bidding war. Specifically, a recent proxy filing from Red Hat states that three other companies held M&A talks with Red Hat prior to IBM’s acquisition offer. Those three companies are largely believed to be the three other big cloud players: Amazon (NASDAQ:AMZN), Microsoft (NASDAQ:MSFT), and Google (NASDAQ:GOOG).
With this in mind, the bull thesis for Red Hat stock here is as follows. If Red Hat reports strong third quarter numbers, that would increase the likelihood of a competing bid from Amazon, Microsoft, or Google. This is especially true since Google Cloud is now under new management, and is desperate to re-accelerate growth after losing share to Amazon and Microsoft over the past several years.
Thus, if Q3 numbers are strong, you could see a competing bid from Google. Both Google and IBM are desperate to re-invigorate cloud growth. As such, that bidding war could be intense, and Red Hat stock could end up being a big winner.
Why Open Source Is a Big Trend
Over the course of the past several years, Red Hat has developed a reputation for consistently topping Street estimates. The company hasn’t missed on earnings estimates in a long, long time, and there’s only a handful of revenue misses over the past five years.
The backstory behind this consistent above-consensus performance is the widespread and mainstream emergence of enterprise open source software solutions. For a long time, proprietary software licenses dominated the enterprise computing world since they were the only viable solutions. Then, in the 1980’s and 1990’s, open source software solutions like Linux started to appear. But, those solutions were increasingly niche, narrow and lacked financial backing, especially relative to the proprietary software licenses of the day. Consequently, open-source software was more of a hacking tool than an enterprise application.
This trend has sharply changed over the past few years. Several huge companies like Red Hat have emerged out of the ashes to broaden, diversify and support open-source software solutions so that enterprises could build businesses on top of that open source architecture. Adoption rates of this new enterprise oriented open source software have been huge for three big reasons.
First, the code lends itself to customization, so enterprises can build personalized solutions and fix bugs themselves. Second, it is a low-cost model. Third, it leverages the power of crowd-sourcing to develop less buggy, higher quality code. As such, open source software demand has been significant and climbing among the enterprise ranks.
Why Red Hat’s Q3 Number Should Be Good
Red Hat has emerged as a leader in this field. Because of this, over the past few years, Red Hat’s numbers have been very strong, and Red Hat stock has done very well.
It doesn’t look like this trend is slowing at all. Open source peers Pivotal Software (NYSE:PVTL) and MongoDB (NASDAQ:MDB) recently both reported double-beat-and-raise quarters in December. Meanwhile, other enterprise cloud companies like Twilio (NASDAQ:TWLO), New Relic (NYSE:NEWR), Tableau Software (NYSE:DATA) and Rapid7 (NASDAQ:RPD) also reported strong numbers recently.
Broadly speaking, the open-source and cloud trends remain as strong as ever. That strongly implies that Red Hat’s numbers are also as good as ever, and that the Q3 print should be another beat-and-raise report.
What That Means For Red Hat Stock
The implications of a strong Q3 earnings report from Red Hat stock are largely positive.
If Red Hat reports great numbers, that will underscore the secular bull thesis for Red Hat as the leader in a rapidly growing open source software industry. The stronger that bull thesis gets, the more M&A interest will pick up. The more M&A interest picks up, the higher the likelihood Amazon, Microsoft, or Google emerges as a second bidder for Red Hat. If that happens, you could get a bidding war which will ultimately result in a higher Red Hat stock price.
This thesis looks especially compelling considering recent executive moves at Google. Namely, after consistently ceding market share to Amazon and Microsoft, Google Cloud is now under new management. This new management’s job is recapture lost market share. The quickest way to do that would be to acquire Red Hat.
Thus, realistically speaking, the situation surrounding Red Hat stock could quickly evolve into a bidding war between two cloud giants who are desperate to reinvigorate growth. In that scenario, Red Hat stock will move sharply higher.
Bottom Line on RHT Stock
The bull thesis for Red Hat stock isn’t too complex here and now.
Red Hat should report strong third-quarter numbers. Those strong numbers could start a bidding war, and that bidding war could be intense. Ultimately, it will result in a higher Red Hat stock price.
As of this writing, Luke Lango was long IBM, AMZN, and GOOG.