Street Blue on Red Hat

Analysts voice concerns about several metrics as the shares tumble.
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Investors punished shares of

Red Hat

(RHAT)

Thursday after the Linux vendor's third-quarter sales failed to meet analyst targets and the company warned of more soft revenue on the horizon.

Shares of Red Hat fell to as low as $13.36 earlier. They were recently down 1.45, or 9.6%, at $13.62.

Analysts expressed disappointment with a number of Red Hat's third-quarter metrics, including flat new enterprise subscriptions and declining cash flow, and suggested the company might be losing some market share as competition heats up with rivals

Novell

(NOVL)

and

Sun Microsystems

(SUNW) - Get Report

.

Pacific Crest analyst Brendan Barnicle noted that Red Hat's new subscriptions may have been flat to down in its November quarter, while Novell's Linux subscriptions increased by 14,000 in its most recently reported quarter. (To many analysts' chagrin, Red Hat has stopped breaking out new subscriptions from renewals and providing average sales price data.)

"While Red Hat remains the Linux leader, Novell may be taking some market share and may be a factor in Red Hat's slower subscription adoption," Barnicle wrote in a morning note. (Barnicle has a sector perform rating on Red Hat and an outperform rating on Novell, and his firm hasn't done banking with either company.)

Other analysts took an even more bearish stance. "Between pricing pressures from fellow Linux vendor Novell, as well as Sun Microsystems, the climate appears cloudy at best," wrote CIBC analyst Curtis Shauger, who maintained his sector underperformer rating on the stock. "We would use the recent strength in its share price as a source of funds." (His firm hasn't done banking with Red Hat.)

On Wednesday, Raleigh, N.C.-based Red Hat reported net income of $10.8 million, or 6 cents a share, in the third quarter, which ended Nov. 30. That was in line with the consensus estimate gathered by Thomson First Call and more than double net income of $4.3 million, or 2 cents a share, in the same period a year earlier.

Excluding taxes, Red Hat earned $11.3 million, compared with $4.3 million in the year-ago quarter and $11.2 million the quarter before that.

Red Hat's revenue rose 55% from a year ago to $50.9 million and 10% from the previous quarter. That fell slightly short, however, of the consensus estimate among analysts calling for $51.8 million in sales.

The company's guidance for fourth-quarter sales also was low. The company projected that it would earn 6 cents to 7 cents a share on revenue ranging from $55.5 million to $56.5 million in the fourth fiscal quarter. Analysts were expecting earnings of 7 cents a share on $58 million in sales.

Red Hat said it expects to generate between $34 million to $37 million in cash flow from operations in the fourth quarter. That's up from the $29.7 million in cash flow from operations in the third quarter, which failed to meet the company's targeted range of $32 million to $34 million.

The new subscriptions count also proved disappointing. The company said total subscriptions reached 132,000 units, including 119,000 enterprise subscriptions. That's down from 144,000 total subscriptions in the previous quarter. One analyst, Prudential Securities' Brent Thill, had expected enterprise subscriptions alone to total 131,800 by the end of the quarter. (Thill raised his rating on Red Hat to overweight from neutral weight on Nov. 29; his firm doesn't do investment banking.)

Analyst estimates for how many of those enterprise subscriptions were new (vs. renewals) ranged from 74,000 to 89,000 -- roughly flat to down from their estimates for the previous quarter.

One bright spot in the quarter was deferred revenue -- a key measure of subscription sales -- which climbed $21.7 million, or 22%, sequentially to $121.4 million, driven by strong sales bookings. That also could reflect the company signing an increasing number of multiyear contracts, analysts said.

With pricing pressure in the Linux server market a big concern on Wall Street, analysts peppered Red Hat executives about pricing trends and renewal rates, which the company has stopped tracking.

CFO Charlie Peters would only say that "pricing has been relatively stable." He also noted that about 20% of bookings were for subscriptions of more than one year, in which the company may charge less per unit to reflect the savings from not having to resell to the customer within a year.

But such comments failed to comfort analysts. "Price erosion could intensify as competitive products launch in the first-quarter calendar 2005 and as multi-year contracts with meaningful discounts become a more significant portion of bookings," noted SIG analysts Jason Kraft and Chris Kwak, who maintained their neutral rating on Red Hat. They estimated new enterprise subscription average selling price has fallen to $390 from $525 over a one-year period. (Their firm doesn't do investment banking.)

Competitive pressure has been intensifying with an announcement from hardware vendor

Dell

(DELL) - Get Report

in October that it would offer a

Novell version of Linux as a standard product at a much lower cost than Red Hat. In addition, Sun said last month it will offer

the next version of its operating system, the most commonly deployed commercial version of Unix for servers, for free.