Red Hat's EPS In Line, Revs Beat

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Red Hat Inc. (RHT) reported third quarter 2013 earnings of 20 cents (including stock-based compensation of $26.7 million), which came in line with the Zacks Consensus Estimate. However, earnings per share declined 4.8% from the previous-year quarter. The year-over-year decline was a result of higher operating expenses.

Quarter Details

Revenue for the quarter increased 18.5% year over year to $343.6 million and was well ahead of the Zacks Consensus Estimate of $338 million. Including currency related adjustments of $6.7 million, revenue for the quarter increased 20.8% year over year to $350.3 million. Reported revenue also surpassed management’s guided range of $336.0 million to $339.0 million.

The strong year-over-year growth was primarily driven by 19.3% surge in subscription revenue (86.0% of total revenue). Moreover, revenue from training and services (14.0% of total revenue) was up 13.6% on a year-over-year basis due to growth in new online classes in North America and enrollment registrations in Europe.

In the reported quarter, billings increased 18.0% year over year to $379.0 million. Channel contributed 65.0% of the bookings, while the rest came from direct sales. Geographically, 60.0% of the bookings came from Americas, 23.0% from Europe, Middle East and Africa (“EMEA”), and 17.0% from Asia-Pacific. Additionally, Red Hat secured 30 deals worth over $1.0 million, including 5 deals in excess of $5.0 million and 1 deal was over $10.0 million.

Red Hat’s gross profit (including stock-based compensation) surged 18.9% year over year to $291.9 million. Gross margin expanded 30 basis points (“bps”) to 85.0% in the quarter. This was primarily driven by a favorable revenue mix.

Operating expenses (including stock-based compensation) increased 25.9% annually to $236.1 million. The year-over-year growth was primarily attributable to higher sales & marketing (up 24.3% year over year), research & development (up 27.9% year over year) and general & administrative (up 27.0% year over year) expenses. Operating expenses, as a percentage of the total revenue, expanded 400 bps to 68.7% in the quarter.

This higher-than-expected jump in operating expenses had a negative impact on operating income, which declined 3.6% year over year to $55.9 million in the reported quarter. Operating margin contracted 380 bps to 16.2% in the quarter.

Non-GAAP net income (excluding share-based compensation and amortization) was $56.9 million or 29 cents per share compared with $55.7 million or 28 cents per share in the year-ago quarter. However, including stock based compensation of $26.7 million, net income came at $38.8 million, which was down from $41.3 million in the previous-year quarter.

At the end of the third quarter, cash and investments (including long term) was $1.35 billion compared with $1.36 billion reported in the previous quarter. Cash flow from operating activities was $100.2 million compared with $103.9 million in the previous quarter.

Guidance

For the fourth quarter of 2013, Red Hat expects revenues in the range of $347.0 million to $350.0 million, reflecting a year-over-year increase of 17% to 18%. Earnings on a non-GAAP basis are projected in the range of 29 cents to 30 cents per share. Management expects non-GAAP operating margin to be around 24.0%.

However, Red Hat hinted a sequential decline in its services revenue in the upcoming quarter due to lesser customer engagements during the holiday season.

Recommendation

Though Red Hat reported encouraging top-line growth in the reported quarter, yet higher-than-expected operating expenses were responsible for its bottom line contraction. However, we expect the investments made by the company to expand its product portfolio through new product launches in the cloud and virtualization segments, and acquisitions are the near-term positives for Red Hat. Moreover, strong product portfolio will help Red Hat to counter stiff competition from Microsoft Corp. (MSFT), VMware Inc. (VMW) and Oracle Corp. (ORCL) going forward.

Moreover, we believe that the customer wins in various verticals, especially in the financial space is a positive catalyst going forward.

However, we believe that sluggish macroeconomic environment could negatively impact IT spending and significant foreign exchange volatility will act as a headwind in the near term. Moreover, seasonality in the services business and increasing investment may hurt profitability in the near term.

We maintain our Neutral recommendation over the long term. Currently, Red Hat has a Zacks #3 Rank (Hold).

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