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Here's Why Red Hat's Revenue Miss Really Shouldn't Scare You

Anders Bylund, The Motley Fool

Open-source software specialist Red Hat (NYSE: RHT) reported analyst-stumping earnings last week, but it's not always good enough to beat the Street on the bottom line. Investors focused on soft revenues instead, and Red Hat's shares closed 7% lower the next day.

The headlines might tell you that Red Hat's days as an explosive growth story are numbered. Digging a little deeper, you'll walk away with a different conclusion.

By the numbers

Red Hat's second-quarter sales rose 14% year over year, landing at $823 million. Adjusted earnings increased by 10%, to $0.85 per diluted share.

Your average Wall Street analyst had been looking for earnings near $0.82 per share on sales in the neighborhood of $829 million. From this perspective, we're talking about a decidedly mixed report.

Management's earnings guidance centered around $0.81 per share, based on a non-GAAP operating margin of approximately 23% and revenues somewhere between $822 million and $830 million. The company exceeded all profit targets, including a 24% operating margin, but stopped near the lower end of the projected revenue range.

The front desk at Red Hat's Raleigh headquarters, featuring the corporate logo on a bright red wall.

Image source: Red Hat.

In the CEO's own words

So I got Red Hat CEO Jim Whitehurst on the phone. He agreed that the revenue result wasn't quite what he had been hoping for.

"We did fall a little short and that was mostly due to currency exchange," Whitehurst said. "Adjusted for currency, we were in the middle of our range and we typically hit the top of our revenue guidance range or a little bit above."

As explained in the ordinary earnings call with financial analysts, Red Hat lost two large contracts during the quarter. One U.S. Army project that had been relying on Red Hat platforms was de-scoped and canceled, entirely removing that contract from the market. Among the 25 largest deals that were up for renewal, 24 signed on the dotted line -- at an average of 115% of the existing deal size -- and one did not.

"We've only had two competitive losses in the last three years that have been up for renewals," Whitehurst told me. In other words, these competitive losses are rare but not unknown.

There are many different kinds of sales

Furthermore, it might be a mistake to focus on one report's worth of imperfect revenue growth. That figure was backed by strongly positive trends in Red Hat's best tools for estimating future growth.

"Revenues grew 14%, billings grew 16%, and the total order backlog -- which is kind of a proxy for bookings -- grew 20%," Whitehurst said. "So we actually had really nice growth in the quarter. It was just a little bit masked by the fact that revenue was a bit lighter relative to last quarter's relative backlog and billings growth."

The terms here might not be crystal clear. Here's what the CEO is talking about:

  • Order bookings are contracts signed during the period, which will bring in the other types of sales-tracking figures over time.
  • Billings are invoices sent out to customers during the quarter, based on the bookings above and intended to generate actual revenues when the clients pay these bills. For subscription-based deals, which is Red Hat's preferred contract structure these days, up-front payments for a longer-term agreement are divided by the number of quarters they cover in order to arrive at a figure for billings per quarter. Red Hat estimates this metric by tracking the backlog of unpaid contract values.
  • Finally, revenues are money in the bank that has been run through the paces of the revenue recognition methods required by the tax man. Prepaid subscription sales end up in an accounting bucket known as "deferred revenues" and are doled out to the tax-calculating income statement over time.

So today's immaterial bookings turn into billings later on, followed by tax-ready revenues even later. When you see billings growing faster than revenues while order bookings outpace them both, that's evidence of an accelerating revenue curve.

That exactly what Red Hat is experiencing here, and it's a good thing. A couple of missed deals won't change that tasty long-term trajectory.

Is Red Hat a buy today?

Red Hat's business is still red hot, but the stock has taken a break from its old skyrocketing ways. The shares are now trading at less nosebleed-inducing levels of 33 times forward earnings, down from 50 times just a few months ago. This could be a great time to start a position in this exciting enterprise software expert.

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Anders Bylund owns shares of Red Hat. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.