Red Hat's Valuation Finally Matters

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."

So, assuming Red Hat doesn't immediately fix its "large deal arrangements" deficiency, how much longer are investors willing to wait for management to harvest the sort of premium presumed by its stock price? While I'm not ready to say Red Hat is suddenly losing its way, management, by virtue of its own guidance, suggests that growth is expected to slow.

For the December quarter, revenue is expected in the range of $381 million and $384 million, which implies year-over-year growth of (only) 13% and 2% sequentially, falling short of Street estimates. Investors must reflect on what these numbers and the soft guidance might actually mean.

Again, this is where Red Hat's valuation, which, even after the 12% decline, doesn't leave much margin for error. That the stock is still trading at 30 times next year's fiscal estimates is discounting the fact that the virtualization/cloud industry is always in transition. Today's leader can easily be tomorrow's has-been. And Red Hat, which is now being attacked from all angles, not only must prove which path it's on, but that it deserves -- what still remains -- an expensive valuation.

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 StockSaints.com 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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