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Red Hat's Curious Valuation


The important thing to understand here is that the economic value of maintaining an operating system is not as significant as providing value added applications up the stack.

Red Hat's (RHT) stock price is the eighth wonder of the world.

First a little background... Red Hat essentially provides its version of a Linux operating system, maintenance, and a bridge to a community of open source users and developers. By its very definition, Linux is a commodity. However, because there were no worthy competitors, for several years RHT had the luxury of selling its enterprise class version of the OS (RHEL), with maintenance, as though it was proprietary. In part for this reason, the stock has been priced as a growth stock. Today, RHT faces stiff competition, primarily from Novell (NOVL) (after the Company bought SuSE Linux three years ago). Since that acquisition, NOVL began undercutting RHT in an effort to build distribution and cross-sell its value-added applications. More recently, NOVL inked a deal with Microsoft (MSFT) whereby Gates & Co. basically legitimized SuSE through indemnification, agreed to co-distribute it, and, together with NOVL, work on interoperability between the Windows and SuSE OSs. In exchange for dancing with the devil, NOVL (and other Linux providers that have inked similar deals) would be given amnesty as MSFT seeks to prove that Linux violates about 235 MSFT patents.

The important thing to understand here is that the economic value of maintaining an operating system is not as significant as providing value added applications up the stack
. (This is in part why RHT risked alienating partners Oracle (ORCL) and IBM (IBM) with the JBoss acquisition last year. ORCL reacted by deciding to compete directly with RHT via its "Unbreakable" Linux, based on the RHEL distro itself.) RHT's business has deteriorated on just about every metric that would imply growth, with the exception of deployment of new Linux servers on an absolute basis. This, of course, is due to the increasing number of servers that have been deployed into enterprise infrastructure. However, as I have pointed out in the past, virtualization will create a headwind to the absolute number of servers and, despite the need for more 'instances' of operating systems in a virtual environment, the value of those OS's will continue to erode and take margins with them.

Wednesday, RHT reported 1Q earnings and, despite the stock being down about 6% on the report, I still think the Street is giving the company a pass. Revenue was up 42% from the same quarter last year, yet net income rose only 18% to $16 million (mature, healthy software companies typically get improved earnings leverage from increases in the top line). The company stated that the current FY guidance seems 'reasonable'; for a company that is typically very promotional on its calls (think: infomercial), this is unlikely to give the longs much comfort.

Okay, now that we've gotten through the 'good news', let's talk about where the rubber meets the road. Operating cash flow decreased YoY (from $54.4 mln to $52.3 mln), operating margins dropped from 24% to 20% YoY, and deferred rev. experienced a mere 6% growth YoY (the slowest in five quarters). Yet, the stock trades on a forward looking basis at 11x sales, 17x operating cash flow, 33x earnings, and with an EV/EBITDA multiple (my favorite metric for evaluating software companies) of an astounding 33x. Add the business headwinds the company faces and It seems like even Lorena Bobbitt impersonating a drunk moyel with a butter knife couldn't pare this down to a valuation that makes any fundamental sense in the near term.
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