Monday, April 16, 2007

Red Hat (RHT): Growing Value in Linux?

Red Hat (RHT) was the darling of investors in 2000: they paid over $150 per share for it, even though it had not shown a profit and had only a few million dollars in annual revenue. Now it is no longer even part of the Nasdaq 100 index. Is Red Hat an old dog no longer worthy of investor attention? I don't think so. Yet I would not characterize the stock, at this point, as very underpriced.

To get management's current assessment of themselves see my summary of their March 29, 2007 analyst conference.

I think many investors, and sometimes even professional analysts, fail to pay enough attention to history. Going back two or three years in a company's history, or even going back a full decade, can give some real insight into the present and future. Red Hat's past is a glorious example of how investor enthusiasm, or disregard for fundamentals, can affect a stock's price.

Today Red Hat has a market capitalization of $4.3 billion, based on a price of $22.28 per share. Full 2007 revenue was a bit over $400 million, so the stock is valued at over 10 times revenues. GAAP net income was only $20.5 million in Q4 2006. If you believe in Non-GAAP net income, you could use $32.7 million instead. Let's compromise and say 2007 net income will be in the range of $100 million. That gives an EPS of over 40 per share.

So unless you think revenues and profits are going to grow rapidly at Red Hat, you would be better off putting your money in a CD.

But revenues may grow rapidly. They were up 40% between Q4 2005 and Q4 2006. If net income grows in a similar fashion, and you are willing to pay prices now based on projections two or three years out, Red Hat's price today could be proven to be undervalued. I also like the fact that they have $1 billion in cash.

How can you inform a decision where the numbers are unclear? In this case you need to know about technology and about history.

The reason so many investors were buying Red Hat in 1998 (as venture capitalists) and in 1999 and 2000 was simple: it was billed as the new Microsoft (See my Microsoft page). Most investors, including me, regret not buying Microsoft stock when we were young. But there was a reason we did not buy Microsoft: there appeared to be better opportunities available. A whole bunch of companies in some aspect of the microcomputer business in 1983 ended up being nearly valueless by 2000. The big exceptions were Intel, Microsoft, Apple, and Compaq (which is not part of HP).

In retrospect I can be as brilliant as any analyst: I recommend that you buy Red Hat at $3 per share in July 2001. But there were good reasons RHAT did not look to be worth even that at the time. Neither past revenues nor EPS justified it. Only future growth justified it.

Whatever the technological merits of Linux, the problem with it from an investor standpoint is that it is free. If you want you can build your own Linux server package and deploy it to as many servers or clients as you have and not pay anyone a penny. Unlike Microsoft Vista or Server.

But Red Hat is making money. They are able to charge for their support services and do charge for their enterprise Linux distribution. Most companies find it cheaper to pay Red Hat or another Linux provider for their package and expertise than to try to do it "free" in-house because the cost of labor is greater in-house than when outsourced. It does not make sense for hundreds of thousands of IT people around the country to be fiddling with Linux details when one person at Red Hat can do it for them.

It is clear that Linux is a very real competitor to Microsoft. It has mostly driven all other versios of UNIX from the field except for Sun's Solaris.

So the real problem is predicting Red Hat's future growth is their competition within the Linux market. Just as Napster, RealNetworks and others fight over the scraps left from Apple's dominant music download position, a bunch of companies, small and large, fight over the Linux market.

Sun, of course, is a formidable competitor. They recently made their Solaris product free, believing they can make money on support services. Oracle is now in the Linux business; no one says they are not a formidable competitor. Both Sun and Oracle have a lot of clients to cross-sell to gain Linux market share.

So I would not place any big bets on Red Hat unless you know something the rest of us don't. I think, on the whole, it is slightly underpriced, but that assessment jumbles a lot of variables that are hard to quantify. However, if Red Hat continues to grow in 2007 as fast as it did in 2006, then the stock should move up pretty quickly.

See also my Red Hat page.

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