Friday, March 28, 2008

Red Hat Tricks

Red Hat (RHT) reported it results for its fiscal Q4 2008, which ended February 29, 2008, on Thursday. Analysts were particularly interested in seeing if any slump in sales occurred in January or February due to the turmoil in the mortgage security market and its effects on the U.S. economy. For a detailed report on results and answers to analysts' questions, see my summary of the Red Hat (RHT) analyst conference on March 27, 2008.

Red Hat distributes and supports the Linux open source operating system and the complimentary middleware, JBoss. It clients are mainly large corporations that have datacenters running large numbers of servers.

From Red Hat's point of view, the economy is doing just fine. Revenues were $141.5 million, up 5% sequentially from $135.4 million in the November quarter and up 27% from $111.1 million in the year-earlier quarter.

Usually rapidly growing, profitable companies have a high price-to-earnings (PE) ratio. But there are different ways to calculate earnings. The safest bet is usually (but not always) GAAP earnings per share (EPS). GAAP means Generally Accepted Accounting Principles. But there are other measures worth looking at if you are trying to value a stock.

Red Hat's GAAP EPS were $0.10, flat sequentially from $0.10 and from $0.10 in year-earlier quarter. Which would seem to mean profits are flat despite growing revenues, which is usually a negative sign.

Non-GAAP EPS measures have been used unscrupulously at times in the past to inflate the value of a stock. But some times they are more realistic than GAAP measures; it just depends on what you exclude from GAAP EPS and why. Red Hat reported non-GAAP EPS of $0.20, up sequentially from $0.19 in Q3 and up from $0.16 year-earlier. That is 25% annual growth.

Difference with GAAP numbers is due to stock-based employee compensation of $10.0 million and $10.7 million difference in provision for income taxes. These are not cash expenses, but the stock-based employee compensation does tend to dilute the shares of people already owning stock.

If you want to exclude history and see how a firm really did in a quarter, a good indicator is cash gains. Operating cash flow was $71.6 million, or about 50% of revenue. That is $0.32 per share. In addition, the company has $1.3 billion in cash and equivalent securities on its balance sheet.

How do we choose? Red Hat is a relatively new company that has had high startup costs. Under GAAP, many of the cash expenses of yesteryear show up in today's profit and loss statements. So the money, which came from venture capitalists and those who bought into the IPO, was spent long ago. But the money coming in today is real. As long as everything is kept in perspective, I think the cash is the leading indicator in this situation.

Take the low extreme and you have a company generating GAAP earnings of $0.10 per share per quarter, or $0.40 per year, and not growing profits. Even in normal times you would not want to pay more than about $8.00 per share for its stock.

Keep your eye on the cash and you have $0.32 per share per quarter or $1.28 per year, and rapid growth. A ratio of 30 in that situation would be considered conservative in a bull market, plus you would add in the $1.3 billion. That would make Red Hat worth about $38 per share. But of course we are not in a bull market.

Any price between those extremes $8 and $38 per share is arguable. Red Hat stock ended trading today at $18.49 per share, up over 5% during the day on a day the stock market fell considerably.

I own Red Hat. My portfolio rules allow me to buy more, and I might, but there are a lot of undervalued stocks to choose from right now.

Keep diversified.

More data:
Red Hat investor relations page
My Red Hat (RHT) page (with links to past analyst conference summaries)

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