Red Hat: The good, the bad and the ugly
Few people with certain knowledge of IT infrastructure haven't hear about this company. Red Hat (NYSE: RHT) provides one of the most widely used operating systems for servers. The reason why some of our readers may have not heard about this operating system is because Red Hat is mainly for organizations, specially those who are willing to pay a premium for improved security. Therefore, Red Hat isn't just another IT stock. The name is synonym of security, reliability and fast performance in the industry: 3 must-have success factors that many startups would love to possess. And Red Hat has them all.
This article develops a bull case for Red Hat taking into consideration the latest earnings results (June 19, 2013), where the company missed the revenue consensus but won against the street earnings estimates. To maintain neutrality in the analysis, I present every fact about this stock that should be known: the good, the bad and the ugly.
Red Hat's revenue continues growing: first quarter revenue came out at $363 million (up 15% y/y), first quarter subscription revenue came out at $316 million (up 16% y/y) and operating cash flow came out at $142 million (up 14% y/y). The best thing is that revenue is getting more and more diversified, which is a good signal that Red Hat knows how address an extremely dynamic and competitive IT industry. In 2005 the company revenue was 100% derived from a subscription business model but now Red Hat is more into cloud computing. Now subscriptions continue being the main revenue driver, but there are some promising businesses like the training and services component ($47 million, up 13% y/y) and middleware services' revenue.
Also, if you take a look at Red Hat's operating expenses, you will see a promising focus on spending on growth opportunities for the future. R&D grew 27%, reflecting additions from last year's acquisitions and hiring new engineers for cloud management, Red Hat OpenStack and OpenShift technologies, among others. These services are Red Hat's future and it makes sense to invest heavily on them now. Eventually, the company will reap the rewards from these investments.
Sure, Red Hat Storage Solutions, OpenStack and OpenShift technologies do not produce any significant revenue at the moment but the picture is likely to change enormously in the next 2 years. Investing now means getting in at a very early stage of the cycle of Red Hat's cloud businesses. The earlier you get in, the higher the potential returns on investment get.
The growth rate of revenue continues decreasing. Growth has decelerated from 20% to somewhere in the 10s over the last year. Management mentions words like "macroeconomic challenging environment" as possible explanations for this decrease. The truth is that the U.S. federal business, which is extremely important for Red Hat, was quite weak in the May quarter. Add to this the fact that many European organizations and governments are still focussing on austerity and you have a pretty strong negative macroeconomic effect on Red Hat's revenue. Earnings were also hurt due to adverse currency fluctuations, specifically, yen depreciation.
The upside is that the federal business may recover in the next quarter. According to Charles Peters, CFO and Executive Vice President:
" So on the fed business, what I said is that we've continued to see impact in Q1 from fed budget-related issues, I guess, in my view, sequestration or otherwise. And we do have, I'd say, high confidence that in the current quarter, the second quarter for us, we're going to see a nice increase on our federal business ".
Red Hat's most promising future products include the version 7 of Red Hat Enterprise Linux (RHEL) and Red Hat Storage Server, which is software that allows companies to manage server hardware infrastructure easily, just like Amazon (NASDAQ: AMZN) Web Services. RHEL7 (which I expect to be available by the end of 2014) will definitely be a hit, as there hasn't been any major release in the past 2 years. The problem is Red Hat Storage, because competition in this business segment is extremely fierce.
Amazon Web Services (AWS) will be a hard to beat competitor. AWS may be so powerful that it could be one of the reasons why Red Hat's negative momentum improved in the past 6 months. And while Red Hat may target different clients than AWS, the truth is that many companies are considering moving their operations from private cloud environments (where Red Hat is a must have) to AWS. Notice also that according to Morgan Stanley, AWS is expected to increase from 0.6% of workloads to 2.3% in the next 3 years, which implies less pricing power for Red Hat and a fierce fight for customers.
That being said, we at least can be sure that Red Hat and its storage solutions will continue being the best choice for many federal organizations and financial institutions. Therefore, fierce competition may cause further deceleration in revenue growth rate, but not as much to cause revenue levels to decrease y/y.
At any rate, further deceleration in revenue is probably the worst scenario considering that Red Hat happens to keep an ace up its sleeve: Red Hat Open Stack, which will be included in its operating system very soon. Open Stack can be thought as a product specifically designed to compete against AWS: an open source project for building either a public or private cloud running on standard hardware.
Open Stack has one more backer: Rackspace (NASDAQ:RAX). Like Red Hat, Rackspace's stock performance has been poor in the past 12 months, as the company continues facing pricing pressures in its hosting solutions. But Rackspace and Red Hat have more than one thing in common: both or them are suffering the consequences of Amazon Web Services. Therefore, it makes sense that both of them are together in the same project. Will Open Stack manage to drive significant revenue in the next quarters? I believe that the product has nothing to envy to AWS, but we may not see any revenue effect soon. Open Stack needs time to get some relevant market acceptance. But once it gets this, it could become the leading open source cloud computing platform standard and bring significant revenue to Rackspace and Red Hat.
It is too early to make any final conclusions about the success of Open Stack. But precisely because it is "too early", this could be an excellent moment to be long Red Hat. Stock price is close to reach its 52 weeks low and the overall atmosphere is bearish, which suggests that the street does not believe in Red Hat's potential to become a leading cloud computing company by 2015. However, as I mentioned in the beginning, Red Hat is taking concrete steps towards that goal. Furthermore, a better macroeconomic environment, the launch of RHEL 7 and Open Stack are all strong reasons to believe Red Hat's revenue growth is about to see some acceleration in the next months.