RealMoney Silver - In-Line Results From Red Hat

In-Line Results From Red Hat
By Bob Faulkner
RealMoney Contributor
9/26/2007 8:31 AM EDT

Updated from 2:45 p.m. EDT on Sept. 24.

Red Hat (RHT) announced results for its second quarter after the close last night that were essentially in line with expectations, and that appears to be a sigh of relief. In addition, guidance for the third quarter was essentially in line with current consensus as well.

Revenue in the quarter was $127 million (+28% year over year; +7% quarter over quarter), with pro forma EPS of $0.17 (GAAP = $0.09). Subscription revenue was $109 million in the period, up 29% from the prior year and 6% sequentially. Services were $18 million, up 23% year over year and 14% quarter over quarter. The gross margin in the period was 84.2%, an increase of 70 basis points year over year but 40 basis points quarter over quarter. The subscriptions business had a slight sequential decline in the gross margin, and the services operations are, by definition, lower on the gross margin. The higher revenue and flat sales and market expense led to an operating margin of 14.0%, however, up 450 basis points from last year and 140 basis points sequentially. Cash from operations was nearly $50 million, an improvement year over year and quarter over quarter. Cash and equivalents increased about $40 million and are currently about $880 million. Accounts receivable decreased about $3 million, sending days sales outstanding down seven days, to 63 days. Deferred revenue (important for software companies) increased about $14 million sequentially, or about 4%.

Management indicated that the ramp in services revenue was heavily skewed to Red Hat Enterprise License Release 5 -- or REL5 -- training and, as a result, is a precursor to strong REL5 sales down the road. All 25 of the top 25 licenses up for renewal were resigned at an average increase of 122% of prior license value. But this quarter, channel sales dropped back to 53% of the total vs. the 57% in the prior quarter.

The company also announced a new operating and reporting structure. All major geographies will now have a general manager and will operate on their own P&L. In addition, the products will be rearranged into three lines of business: infrastructure, middleware and online services. Each will have a general manager and will be compensated on profitability.

A surprise acknowledgement on the call was regarding JBoss, the company's application development platform (middleware). It is apparently growing in line with REL5, which is a disappointment. Management is of the opinion that it should be growing at twice the REL5 rate. A number of solutions were raised, including more channel development, which seems to have stalled somewhat. After training 300 channel partners on JBoss in the first quarter, that number dropped to 200 in the second quarter with no real explanation.

The outlook for third quarter is for revenue to be in the $131 million-$133 million range, or up 3% to 5% sequentially. Pro forma EPS are expected to be $0.18. These compare with current consensus of $132 million and $0.18.

One area that bugged me was the discussion of bookings and backlog. The deferred revenue was up 4% sequentially and, being less than the revenue growth rate, suggests a weakening of demand going forward. In response to a number of questions, the CFO felt compelled to assuage concerns by announcing the off-balance sheet backlog increased by double digits. When asked the same questions last quarter after a good number (+7% quarter over quarter deferred revenue increase), the same CFO indicated that he comments on backlog and off-balance sheet backlog annually and was not going to start doing it on a quarterly basis. I guess that position was totally dependent upon the growth rate of deferred revenue and its implications rather than some deep principle.

There were obviously a few people expecting a negative number from Red Hat last night given the move in the stock (+5% last I looked) on what were only in-line results. The company still has plenty of room for operating-margin expansion simply by controlling expenses with increased revenue. Sales and marketing plus general and administrative are still almost 52% of revenue but were down almost 200 basis points from the prior quarter. But that's still well above most other companies.

All in all, Red Hat had an OK quarter with an OK outlook and no signs of any macro-related softness. Apparently, that was enough to celebrate last night.

Red Hat Preview: Expenses Are Worrying

Red Hat (RHT) will be announcing results for its second quarter after the close tomorrow with a conference call at 5:00 p.m. EDT. The current consensus is for revenue of $125 million (+26% year over year; +5% quarter over quarter) and pro forma EPS of 17 cents.

In the prior quarter, revenue was $119 million (+42% year over year; +7% quarter over quarter) with pro forma EPS of 16 cents (GAAP = 8 cents). Subscription revenue was $103 million in the period, up 44% from the prior year and 7% sequentially. Services were $16 million, up 27% year over year and 4% quarter over quarter.

Gross margin in the period was 84.6%, an increase of 60 bps year over year and 30 bps quarter over quarter, primarily on stronger subscription revenue. However, operating margin was 12.6%, a decline of 240 bps on both comparisons with a big increase in sales and marketing and R&D expenses. Some of this was related to one-time promotions with product launches in the period.

Cash from operations was only about $40 million vs. more than $50 million a year ago, with the bulk of the change coming from working capital accounts. Cash and equivalents declined about $40 million and are currently about $840 million. Accounts receivable increased about $4 million, but days sales outstanding declined one day to 70 days. Deferred revenue (important for software companies) increased about $25 million sequentially.

Management indicated on the last call that Red Hat release 5 has commenced shipping, but the original equipment manufacturer loadings are running one to two quarters behind plan. The company's JBoss (applications development platform) is ramping (the company gave no specifics), but the company is still in the process of training partners.

The guidance for the second quarter was for revenue to be in the $124 million to $126 million range (up 4% to 6% quarter over quarter) with pro forma EPS of 17 cents.

Despite the solid year-over-year growth (fueled by acquisitions), investors are clearly concerned about RHT's prospects. The stock is down 14% year to date and 18% over the last 90 days vs. gains of 10% and 2% for the Nasdaq over the same periods. What is it that investors are saying with their selling that RHT has to refute with its results?

A good place to start from my perspective would be the company's expenses. The company announced last year that it intended to ramp its channel programs so that 60% of revenue derived from indirect sources. In the last quarter indirect "bookings" hit the 57% mark. However, despite the shift, sales and marketing expenses are running quite high. RHT's sales and marketing plus general administrative has commonly been in the 52% to 55% of sales range, whereas competitors are frequently 5% to 10% below that level.

Maybe we'll see evidence of a change in the results this quarter, but given the prior discussion it doesn't appear likely.