Red Hat: The Face of Linux

Author's Avatar
Sep 21, 2014

In this article, let's take a look at Red Hat Inc. (RHT, Financial), a $10.95 billion market cap company, which is a leading provider of Linux operating systems for enterprises, and related middleware and virtualization software offerings.

Business Strategy

The company plans to generate a great adoption of its technologies by enterprise users around the world. Also, it continuously focuses on revenues and the way to raise them from its user base by renewing subscriptions, as well as giving additional consulting and other services.

Finally, it plans to expand into the data center, with its unique business model sure it would be a success. Customers have improved the Linux OS, surpassing Unix in features. Red Hat sells service agreements related to the software, as well as it offers support and other services to ensure effective software solutions. With an open-source model throughout the data center worlds, it leads for projects that include storage, virtualization, middleware, and IT management tools.

Strategic Acquisitions

In 2006, the company acquired JBoss for $420 million. In 2008, it acquired Qumranet (a provider of virtualization software for managing Microsoft desktops) for $100 million.

Since 2010, the firm acquired more than a dozen companies In 2011, it was the turn of Gluster (a cloud management software company), for $140 million. Then it comes ManageIQ, (a provider of enterprise cloud management and automation solutions), for $105 million in 2012.

This year, the acquisition was of Inktank Storage, a company which offers open-source storage solutions. The deal was for $180 million.

Other Regions

Red Hat plans to expand its business in regions such as the Asia/Pacific and Latin America, following the acquisition made in 2006, of local operations of its master distributor in Argentina and Brazil.

Revenues, Margins and Profitability

Looking at profitability, revenue growth by 16.65% but earnings per share remained flat in the most recent quarter compared to the same quarter a year ago ($0.20 vs $0.21). During the past fiscal year, the company increased its bottom line. It earned $0.93 versus $0.77 in the prior year. This year, Wall Street expects an improvement in earnings ($1.54 versus $0.93). With respect to the gross profit margin, it is currently high, at 88.32%. Despite this, net profit margin of 8.90%, is similar to the industry average.

Finally, let´s compare the best measure of performance for a firm's management: the return on equity. The ROE is useful for comparing the profitability of a company to that of other firms in the same industry.

Ticker Company ROE (%)
RHT Red Hat 12.11
NOW ServiceNow Inc. -37.86
N NetSuite Inc. -39.34
ORCL Oracle Corporation 24.10
SYMC Symantec Corp 17.11
 Industry Median 6.25

The company has a current ROE of 12.11% which is higher than the industry median and also higher than the ones exhibit by ServiceNow (NOW, Financial) and NetSuite Inc. (N, Financial). In general, analysts consider ROE ratios in the 15-20% range as representing attractive levels for investment. So for investors looking those levels or more, Symantec (SYMC, Financial) and Oracle (ORCL, Financial) could be the options. It is very important to understand this metric before investing and it is important to look at the trend in ROE over time.

03May20171356251493837785.png

Relative Valuation

In terms of valuation, the stock sells at a trailing P/E of 62.8x, trading at a premium compared to an average of 22.9x for the industry. To use another metric, its price-to-book ratio of 7.18x indicates a premium versus the industry average of 2.50x while the price-to-sales ratio of 3.93x is above the industry average of 1.98x.

As we can see in the next chart, the stock price has an upward trend in the five-year period. If you had invested $10.000 five years ago, today you could have $25.844, which represents a 20.8% compound annual growth rate (CAGR).

03May20171356251493837785.png

Final Comment

The company has about two-thirds of the Linux server OS market, which we think it is very positive for the future. We must mention that Linux OS has been the fastest-growing server OS in the last ten years, replacing Unix and others as well. Further, its exclusive business model will help it to maintain a key position in the data center segment.

Hedge fund gurus like Louis Moore Bacon (Trades, Portfolio), Jeremy Grantham (Trades, Portfolio) and Ron Baron (Trades, Portfolio) added this stock to their portfolios in the second quarter of 2014.

Disclosure: Omar Venerio holds no position in any stocks mentioned,