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TheStreet Open House

Red Hat's Valuation Finally Matters

Stock quotes in this article: RHT, AMZN, CRM, ORCL, VMW, MSFT

NEW YORK ( TheStreet) -- In the world of financial writing, the surest way to lose friends is to complaining about valuation. You might as well complain that water is wet. Investors of companies like, say, Amazon (AMZN) and Salesforce.com (CRM), whose price-to-earnings ratios are at nosebleed levels, never want to hear it. That is, of course, until valuation matters.

While I've always had my doubts about Red Hat's (RHT) long-term growth potential in cloud and virtualization services, management systematically found ways to convince the Street that the company was turning the corner and averting threats from rivals including Oracle (ORCL) and VMware (VMW).

So, ahead of the company's fiscal second-quarter results, investors -- still casting their lot towards long-term revenue growth -- didn't mind paying 67 times earnings for the stock, which at the time was five times more than both Microsoft (MSFT) and Oracle.

However, following Red Hat's announcement, which included worse-than-expected guidance, the valuation issue finally came home to roost. As the stock dropped to an intraday low of 12%, I still wasn't convinced that investors got the message.

This has been a recurring theme for Red Hat. Truth be told, I don't believe the company's results, which included 16% year-over-year increase in revenue ($374 million), were that bad. Further, the company posted a 25% year-over-year increase in adjusted earnings per share of 35 cents. Essentially, Red Hat managed to beat Street expectations for both revenue and profits.

The thing is, however, the company's "billings" grew just 8% year over year to $376 million. This is the metric that indicates the strength of future sales. In the software sector 8% is typically considered a solid number. But when you consider that Red Hat posted 12% increase in billings in the June quarter, this recent drop is certainly worth looking into.

Analyst, however, including Piper Jaffray and Pacific Crest, didn't waste any time downgrading the stock, fearing what the weak billings might suggest. Red Hat's management, meanwhile, blame it on "modest IT spending in Europe and the impact of large deal arrangements."

Now, there's no denying the competition in the software/cloud space has always been cut-throat. To an extent, given that Oracle is still struggling with growth, it's certainly possible that weak enterprise spending in the U.S. and Europe are weighing heavily on Red Hat. Even so, the company's claims regarding "large deal arrangements" (whatever that means), goes against what Tibco's (TIBX) CEO Vivek Ranadive, who said in TIibco's recent conference call, "We won every single deal."

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