Red Hat's Growth Strategies Deserve a Tip of the Cap

NEW YORK ( TheStreet) -- Software giant Red Hat ( RHT) will report results for its fiscal second-quarter on Monday after the market close.

From a valuation point of view, I haven't been the Red Hat's biggest fan -- not when the stock carries of price-to-earnings ratio of 67, which is five times more than both Oracle ( ORCL) and Microsoft ( MSFT).

I don't mind disclosing that, as a value investor, I've always resented Red Hat for its costly premium. You can save your "keep emotions out of investing" emails -- I'm over it now. I've come to accept there's not much a company can do when the Street has already made up its mind that it's going to love the stock no matter what, especially companies having anything to do with the Cloud and software virtualization.

To that end, while I won't make an all-out plea for investors to jump in the stock today, after a solid June quarter by Red Hat that included new strategic growth initiatives such as Open Shift and Open Stack, Red Hat may have uncovered new ways to justify investors' trust. As with "Big Data" and other recent IT buzzwords, Open Stack, which has attracted interest from Microsoft, Hewlett-Packard ( HPQ) and VMware ( VMW), has begun to generate considerable momentum.

What's more, unlike Oracle, which had an absolutely brutal June quarter and a less-than-joyful first quarter Wednesday, Red Hat's management continues to do an excellent job of balancing expectations with actual performance. So, as with IBM ( IBM) and Oracle, which have shown eroding growth trends, growth has never been an issue for Red Hat.

With revenue climbing more than 15% in the June quarter, I've had no choice but to tip my cap to the company's management, especially since Oracle produced growth of less than 1%. Unlike Oracle and, to some extent, IBM, Red Hat continues to outperform in its subscription business, which grew 16% year over year and 4% sequentially. Not to mention, the company beat earnings-per-share estimates by 1 cent.

Now, Red Hat bears and perhaps Oracle bulls might suggest that I'm "exaggerating" the June performance. But in the context of a weak enterprise spending environment, which (pretty much) killed hope for any growth in software sector, I can counter that argument and suggest that it's "sour grapes."

Along those lines, while I'm not willing to go "tit-for-tat" as to which software companies are better managed than others, it certainly appears as if Red Hat has begun to steal some meaningful share from its rivals. Before you disagree, consider that the company posted a 3% miss in its "billings" or deferred revenue target in the March quarter, which (then) prompted management to guide down.

However, in the June quarter, Red Hat's billings, which is the metric that indicates the strength of future sales, increased 12% year over year. I don't believe that level of improvement was manufactured out of thin air. The question is if this can continue. On Monday, we are certain to find out. The Street is looking for 33 cents in earnings per share on revenue of $372 million, which represents year-over-year revenue growth of 15.3%.

Although management did issue both revenue and profit outlook that were in line with analysts' expectations, on the basis of Red Hat's sequential improvement I'm expecting the company to beat both estimates. As is often the case, how the stock reacts will be based on how the company guides. With still no clear signs that enterprise spending will be back to robust levels, I expect that management will play it conservatively and not divert too much from consensus estimates.

The good news is Red Hat is no longer just a niche Linux operator. Investors have long feared that despite the company's strong Linux business, Red Hat lacked differentiation in areas such as middleware, which is the software that lies between an operating system and specific software applications. With Open Stack gaining traction and both revenue and earnings trending in the right direction, expensive stock or not, "green" is the only color Red Hat sees.

These realities have prompted investors to sell off the stock this year by as much as 13%. The stock still hasn't entered my value threshold yet, however.

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 co-founder of where he serves as CEO and editor-in-chief. After 20 years in the IT industry, including 5 years as a high school computer teacher, Saintvilus decided his second act would be as a stock analyst - bringing logic from an investor's point of view. His goal is to remove the complicated aspect of investing and present it to readers in a way that makes sense.

His background in engineering has provided him with strong analytical skills. That, along with 15 years of trading and investing, has given him the tools needed to assess equities and appraise value. Richard is a Warren Buffett disciple who bases investment decisions on the quality of a company's management, growth aspects, return on equity, and price-to-earnings ratio.

His work has been featured on CNBC, Yahoo! Finance, MSN Money, Forbes, Motley Fool and numerous other outlets.

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