Red Hat May Be a Buy After Turning the Corner

TheStreet.com

NEW YORK (TheStreet) -- Another quarter is in the books for software giant Red Hat and the valuation debate lingers.

The fact that Red Hat's price-to-earnings ratio of 60 is twice the P/E of Oracle and Microsoft put together is tough to reconcile.

But it's been this way for a while. Although several analysts didn't give the company much of a chance ahead of Red Hat's fiscal first-quarter earnings report, management continues to do an excellent job stating their valuation case pretty strongly.

Interestingly, given the lackluster results posted by Oracle and IBM , it's starting to look as there's a divergence within a sector that has often traded in tandem.

While I'm inclined to believe that tough IT spending environment has had an impact on both Oracle and IBM, I can no longer ignore the possibility that Red Hat is beginning to steal share in areas like middleware. Valuation concerns aside, this is beginning to look interesting.

Revenue growth has never been an issue at Red Hat; nor was it an issue this quarter, with sales climbing 15.4% year over year. The company also did well growing subscription revenue 16% year over year and 4% sequentially. Adjusted net income rose to 32 cents from 30 cents per share -- enough to beat estimates by 1 penny.

Billings, also known as deferred revenue, is the metric that indicates the strength of future sales. These were up 12%. This is a pretty significant improvement from the fourth quarter where Red Hat posted billings that were 3% shy of Street estimates, which (then) prompted management to lower guidance. Not this time. Management issued outlook for both sales and profits were in-line with analysts' expectations.

As is often the case, though, margin showed some struggles, falling off a bit for the fourth consecutive quarter. More than any other reason, this constant lack of leverage has been my biggest sticking point with Red Hat, particularly in the face of stff competition from the likes of Citrix and Salesforce.com .

I can't knock the bear who insists on raising this point. Management needs to sort this part out. Margins can't continue to contract and then expect concerns about valuation to go away. Investors will want to know what they're paying for.

But given Red Hat's solid beat on the top and bottom lines, I'm now willing to look slightly the other way.

It was certainly encouraging that Red Hat's CEO, Jim Whitehurst, didn't appear too concerned about the companies competitive situation. In an interview with TheStreet's Chris Ciaccia, Whitehurst cited (among other things) Red Hat's plans to enter new categories including Open Shift and Open Stack. He also noted:

"The power of Open Stack is that it has massive participation. It has everyone from Microsoft to VMware , to Hewlett-Packard to us participating in it. An industry is coalescing around an open source standard. There's a lot of momentum and a lot of interest in Open Stack, but it's still early days."

Whitehurst has essentially given investors reason to be patient. Investors have long feared that despite the company's strong Linux business, Red Hat lacked differentiation in areas such as middleware, which is the software that lies between an operating system and specific software applications. Open Stack seems to be the answer.

If Red Hat can duplicate its Linux success into these new initiatives, investors will end up doing well. But these are some pretty big ifs. Both Oracle and IBM have equal motivation to enter these markets. I'm not discounting Red Hat's capabilities. But I also understand that the company is behind both IBM and Oracle in some pretty meaningful enterprise categories.

These realities have prompted investors to sell the stock this year by as much as 13%. The stock still hasn't entered my value threshold yet. But after a solid first-quarter earnings report, which included new strategic initiatives, I think Red Hat deserves a chance -- even if it is on the basis that "the worst is over."

It's not a glowing endorsement. But with an improving enterprise spending environment and a market that continues to show a strong bias towards cloud-based tech companies, sometimes that's all you need.

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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