Red Hat: Good Growth, Tricky Valuation

NEW YORK (TheStreet) -- I didn't give virtualization giant Red Hat a glowing endorsement ahead of the company's fiscal fourth-quarter earnings report.

While concerns still remain and the company did, in fact, miss on revenue as I predicted, I'm nonetheless impressed the report arrived "less bad" than expected. However, I do wonder how long investors will wait for Red Hat to produce the sort of premium presumed by its stock price.

Investors are still betting the company will outperform the likes of Oracle and VMware in cloud and virtualization services. Given Red Hat's soft operating margin, which is more than half that of Oracle and lower than both VMware and Microsoft , investors are still playing the wrong odds.

This is a recurring theme for Red Hat. The margin situation has not been appealing for some time. But I did notice some improvement this quarter. Unfortunately, Oracle is improving as well. Red Hat's investors have never appeared bothered by this sort of detail as long as the top line looks good. To that end, the company delivered.

Revenue arrived up 17% year over year, but only advanced 1% sequentially. However, even though Red Hat was coming off of a strong third quarter, which produced 18% revenue growth that then advanced 7% sequentially, the fact that this quarter's sequential improvement was almost flat was not a surprise.

Essentially, after Oracle's revenue miss, which arrived down 2%, it wasn't hard to expect unfavorable results from Red Hat, especially since VMware had issued weak guidance for this quarter. Also, according to Richard Williams, an analyst at Cross Research, who has a hold rating on the stock, "The channel checks showed that activity just stopped after the first week of December."

He was proven right. Consequently, Red Hat reported sales of $347.9 million for the quarter, which was shy of Street estimates of $349.3 million. That being said, 17% is still solid in this environment. But investors were disappointed by fourth-quarter billings. This is the metric that indicates the strength of future sales. Billing arrived at $454 million, which was more than 3% shy of estimates.

The company did make up for this in profitability, which arrived strong. Not only did net income improve, growing 19% year over year to $43 million, the company also beat on earnings per share - posting 36 cents versus estimates of 30 cents. Unfortunately, management didn't guide as if it expects this level of performance to continue. It guided for both EPS and revenue to come below Street expectations.

Here again, investors are left of reflect on what these numbers and the soft guidance might actually mean. The fact that the virtualization/cloud industry appears to always be in transition introduces doubt. This makes Oracle's results, from a relative perspective, even more critical.

However, unlike Red Hat, Oracle is more diversified. This brings us back to the issue of leverage. If Red Hat can improve that, the stock would be less risky.

Bottom Line

I've made this point once before: Despite Red Hat's strong Linux business, the company has not shown much differentiation in areas like middleware, where Red Hat still lags behind Oracle, IBM and .

What's more, in Red Hat's core business, the company still has to fight off rivals including VMware and Citrix . In other words, the company is being attacked from all angles. At some point, investors have to decide is the double-digit growth worth the sleepless nights.

At the time of publication, the author held no position in any of the stocks mentioned.

This article was written by an independent contributor, separate from TheStreet's regular news coverage.

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