Why Red Hat's Third-Quarter Forecast Is No Valuation Threat

NEW YORK (TheStreet) – Red Hat (RHT)  issued a strong second quarter earnings performance late last week, but shareholders of the Linux maker panned the company for its fiscal third-quarter outlook. Shares of the open source company have fallen a total of 7% since it released its results after the market's close on Thursday.

On Monday, Red Hat ended the day at $56.67 a share. The company's investors apparently have a fear factor going on, after it forecast third quarter revenue of $449 million to $452 million -- pointing to a year-over-year revenue growth rate of 13% to 14%, compared with Wall Street's expected 18% to 20% rate based on revenue of $457.8 million. And it didn't help that earnings of 40 cents per share fell a penny short of consensus estimates.

This sell-off is an overreaction. And here's why:

Red Hat beat Wall Street's non-GAAP estimates by three cents. Accordingly, I raised my 2016 fiscal year earnings projections by a similar degree, putting my projections at an earnings per share of $1.83. This represents an 18% year-over-year jump in earning. (See my chart below)

Likewise, following the company's strong 19% increase in subscription revenue, my model now calls for 2016 revenue of $2.08 billion, which is 2.4% higher than Wall Street's expectations of $2.03 billion, according to Yahoo! Finance.


Red Hat's shares should rebound once the dust settles. And while I think analysts' current 12-to-18-month price target for the stock is high at $85 per share, I believe $65 a share is doable and that still gives investors a 16% gain.

And although some investors looking at Red Hat's valuation may consider its price-to-earnings ratio of 61 expensive compared to its software peers like Microsoft (MSFT) and Oracle (ORCL) , which trade at multiples of 17 and 16, respectively, the open source company has continued to deliver the growth that investors have been paying for.

Additionally, it also makes sense to compare Red Hat with its rivals in the virtualization technology market like VMware (WMW) and Citrix (CTXS) , which carry multiples of 40 and 39, respectively. With virtualization, companies can run multiple operating systems and applications on a single computer, which reduces the downtime of the computer's central processing unit (CPU), aka computer's brain.

Red Hat's recent partnership with Cisco (CSCO) and its acquisition of FeedHenry also suggest Red Hat has no plans of slowing down. 

In a recent phone interview, Red Hat CEO Jim Whitehurst explained how Cisco and Red Hat plan to collaborate around OpenStack, as well as Cisco's Application Centric Infrastructure and Intercloud to bring cloud-ready solutions to large corporate customers and service providers. Whitehurst believes there's potential for incremental revenue gains for Red Hat in this area.

In other words, Red Hat's CEO is positioning the company to become the leader in private clouds, which house network and application infrastructures for individual companies and organizations who want their data in their own cloud, rather than multiple companies storing their data in the same public cloud.

Whitehurst is positioning Red Hat to be a leader in this area, so it's short-sighted for investors to sell off the stock based on guidance for one quarter.

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

Follow @Richard_WSPB

This article represents the opinion of a contributor and not necessarily that of TheStreet or its editorial staff.

TheStreet Ratings team rates RED HAT INC as a Buy with a ratings score of B. TheStreet Ratings Team has this to say about their recommendation:

"We rate RED HAT INC (RHT) a BUY. The company's strengths can be seen in multiple areas, such as its robust revenue growth, impressive record of earnings per share growth, increase in net income, largely solid financial position with reasonable debt levels by most measures and increase in stock price during the past year. We feel these strengths outweigh the fact that the company shows weak operating cash flow."

You can view the full analysis from the report here: RHT Ratings Report

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