Clouds of Doubt Rain Over Red Hat

NEW YORK (TheStreet) -- Investors who once cast their lots on stocks having anything to do with the cloud and virtualization are adjusting their expectations. I don't blame them. Doubt now reigns over an industry once perceived as infallible Now the entire virtualization/cloud industry appears to be in transition. The culprit -- weak spending in enterprise IT.

These concerns have placed more attention on companies like Red Hat ( RHT), whose stock is down 13% this year. Investors fear that despite its strong Linux business, Red Hat lacks differentiation in areas such as middleware, the software that lies between an operating system and specific software applications. That will weaken Red Hat's leverage against two of the market leaders, Oracle ( ORCL) and IBM ( IBM).

Meanwhile, in its core open-source Linux business, Red Hat has to fight off rivals including VMware ( VMW) and Citrix ( CTXS). These companies are building up their capabilities with partnerships and entering related areas like mobile data traffic. Red Hat is being attacked from all angles. With its fiscal first-quarter earnings report due out Wednesday, management must provide answers and affirm that this company's still a good long-term bet.

The Street is looking for earnings of 31 cents per share on revenue of $359.8 million. The revenue number suggests year-over-year growth of only 1%, which seems odd given since Red Hats' revenue rose 17% in its fiscal fourth quarter and 18% in its third quarter.

I wouldn't be surprised if Red Hat were to miss its revenue target; I believe management hinted at this possibility in the fourth quarter.

Billings, also known as deferred revenue, is the metric that indicates the strength of future sales. Although billings were at decent levels of $454 million in the previous quarter, they were 3% shy of Wall Street's estimates. Accordingly, management's estimates for first-quarter revenue and earnings per share were below analysts' views.

While I don't there's a bigger underlying issue here, it doesn't bode well for confidence, either. Complicating matters is the stock's valuation still presumes perfection. That is despite the recent drop. If management can make up for the weak revenue with better profits, then an argument can be made for the stock's valuation, now close to 60 times earnings.

But without better margins, it's tough to justify why Red Hat would trade at a price-to-earnings ratio that is four times that of Oracle's and three times that of Microsoft ( MSFT), which is building virtualization/cloud capabilities of its own. Although I am not a Microsoft bull per se, I believe Microsoft presents better long-term value and is a safer bet.

I'm not discounting Red Hat's solid enterprise footprint, nor am I suggesting that the company is on the verge of elimination. But I don't believe that Red Hat has differentiated itself enough from a being just a niche Linux support operation.

The company has made some progress in middleware, but not enough to support its stock's current valuation or make it a threat to the likes of Oracle and IBM. And VMware and Citrix, rivals to Red Hat in the virtualization/cloud sector, have become stronger through strategic partnerships, leaving Red Hat on the outside looking in.

At the time of publication, the author held no position in any of the stocks mentioned.

This article was written by an independent contributor, separate from TheStreet's regular news coverage.

Richard Saintvilus is a private investor with an information technology and engineering background and the founder and producer of the investor Web site Saint's Sense. He has been investing and trading for over 15 years. He employs conservative strategies in assessing equities and appraising value while minimizing downside risk. His decisions are based in part on management, growth prospects, return on equity and price-to-earnings as well as macroeconomic factors. He is an investor who seeks opportunities whether on the long or short side and believes in changing positions as information changes.

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