Skip to main content

Red Hat


, the fast-growing Linux software developer, is in the penalty box and is likely to stay there until investors are convinced that the issues that forced a disappointing second quarter are safely behind.

In recent trading on Wednesday, the morning after the company reported, shares had plunged by $6.07, or 23.1%, to $20.22.

"Red Hat has little time on its side to disprove the bears. Disappointing second-quarter billings call into question the true health and trajectory of the core business. The third quarter is a pivotal quarter for Red Hat," wrote Citigroup analyst Brent Thill.

The earnings report caught Wall Street by surprise. The stock had run up prior to Tuesday's announcement, and most analysts figured the company would report a solid quarter. By some measures, it did: On a non-GAAP basis, Red Hat beat expectations by a penny, and sales were up a robust 52%.

But investors focused on a drop in billings, which are seen as a forward-looking measure of growth for a company with Red Hat's complex subscription business model, and on cash flow.

Cash flow from operations slipped to $43.9 million from $45.8 million a year ago. And with revenue and deferred revenue from newly acquired JBoss backed out, organic billings came in at $106.8 million, a sequential drop of 7%, according to Goldman Sachs analyst Rick Sherlund. The analyst noted that the figure represented a year-over-year gain of 16%, but that's "a significant slowing in growth," said Goldman Sachs.

The company's third-quarter forecast also didn't inspire. Red Hat said it expects a third-quarter profit of 12 cents to 13 cents a share on revenue of $103.5 million to $105 million. Analysts were expecting 12 cents from earnings and a top line of $105.7 million.

Also hurting the stock, said Sherlund, are persistent rumors that


(ORCL) - Get Oracle Corporation Report

TheStreet Recommends

will disrupt Red Hat's business by offering its own version of Linux. (Goldman Sachs has an investment-banking relationship with Red Hat.)

Asked about Oracle's intentions, CEO Matthew Szulik said in an interview, "I don't know anything more about that than you do," and added that Oracle and Red Hat have a longstanding working relationship.

On a GAAP basis, the company earned $11 million, or 5 cents a share, on total revenue of $99.7 million. A year ago, the Raleigh, N.C., company earned $18 million, or 9 cents a share, on sales of $66.7 million.

Profit was hurt by a sharp increase in operating expenses, which rose 75% to $73.8 million from $42.2 million a year earlier. Red Hat said that because of taxes and stock-compensation expenses between fiscal 2006 and 2007, net income was not directly comparable between these periods.

After adjusting for these accounting differences, non-GAAP adjusted net income for the second quarter of fiscal 2007 was $23.7 million, or 11 cents a share. This compares with non-GAAP adjusted net income of $17.7 million, or 9 cents a share, in the year-ago quarter.

Analysts polled by Thomson First Call were looking for earnings of 10 cents a share before items on revenue of $97.1 million.

CFO Charlie Peters said the just-reported quarter will likely be the "low point" of profitability and cash flow.

The major culprits in the slide were a loss of productivity as salespeople and even engineers took time from their primary duties to learn about JBoss, which was acquired by Red Hat earlier this year; organizational changes including a shift in leadership in the Asia-Pacific area; and a higher proportion of three-year deals in which only the first year of revenue is recognized immediately.

"Red Hat was clearly trying to juggle too many business changes," commented Citigroup's Brent Thill. "We believe this was a short-term misstep -- RHAT acknowledges this mistake and is taking proactive steps to address

the issues." Citigroup makes a market in Red Hat but does not have an investment-banking relationship with the company.

Although revenue in the three-year deals will likely be recognized in the future, operating cash flow is hurt in the short run, because fewer dollars go to the balance sheet.

Quarterly gross margin improved to 84% from 82% in the year-ago period.

During the quarter, Red Hat closed its acquisition of JBoss, an open-source application server company. The company said JBoss contributed $7 million in revenue in the quarter, which was somewhat better than expected, and the new unit is on track to reach its target of $22 million to $23 million in the fiscal year.