Red Hat Beats on Q1 Earnings; Buys eNovance - Analyst Blog

Red Hat Inc. RHT reported first-quarter 2014 earnings of 23 cents per share (including stock-based compensation but excluding one-time items), beating the Zacks Consensus Estimate by a penny. However, earnings decreased 2.9% year over year due to margin contraction in the quarter.

Revenues

Revenues increased 16.7% year over year to $423.8 million and beat the Zacks Consensus Estimate of $415.0 million. Revenues were higher than management's guided range of $412.0 to $415.0 million.

Subscription revenues (87.8% of revenues) increased 17.0% year over year to $372.0 million. Subscription revenues for infrastructure related offerings (RHEL) increased 14.0% from the year-ago quarter to $319.0 million.

Subscription revenues for the application development related and emerging technologies jumped 45.0% year over year to $53.0 million.

Training & services revenues (12.2% of revenues) increased 9.2% from the year-ago quarter to $51.8 million.

Billings increased 17.0% year over year to $404.0 million. Channel contributed 67.0% of the bookings, while the rest came from direct sales. Geographically, 56.0% of the bookings came from the Americas, 25.0% from Europe, Middle East and Africa (EMEA) and 19.0% from Asia-Pacific.

Red Hat was able to renew all 25 deals scheduled in the quarter. The top 30 deals were over $1.0 million in value. Four deals were in excess of $5.0 million and one deal was greater than $10.0 million. Cross-selling was strong and top verticals were telecom, cloud and healthcare.

During the quarter, the company expanded its relationship with SAP AG SAP. The company also previewed its recently launched flagship product RHEL 7.

During the quarter, Red Hat acquired Inktank. Most recently, the company announced the acquisition of eNovance, a cloud-based infrastructure provider. eNovance has a strong clientele of approximately 150 customers that include Alcatel-Lucent, Cisco CSCO, Cloudwatt and Ericsson.  

Margins

Gross margin (including stock-based compensation) expanded 10 basis points (bps) to 85.4% on a year-over-year basis. However, gross margin (excluding stock-based compensation and other one-time items) contracted 20 bps to 84.8% in the quarter.

Subscription gross margin declined 10 bps to 92.5%, while training & services gross margin fell 190 bps to 29.2%.

Operating expenses as percentage of revenues (including stock-based compensation but excluding one-time items) increased 360 bps on a year-over-year basis to 71.4% in the quarter.

Operating expenses as percentage of revenues (excluding stock-based compensation and one-time items) surged 380 bps to 72.8%. Sales & marketing expenses, as a percentage of revenues, increased 250 bps, while research & development increased 90 bps. General & administrative expense, as a percentage of revenues, increased 30 bps in the quarter.

Operating margin (including stock-based compensation but excluding other one-time items) contracted 340 bps from the year-ago quarter to 14.1% due to higher operating expense.

Operating margin (excluding stock-based compensation and other one-time items) contracted 310 bps to 20.8% in the quarter, more-or-less in line with management's guidance. The Inktank acquisition negatively impacted operating margin.

Net income (excluding stock-based compensation and other one-time items) was $64.2 million or 34 cents compared with $61.6 million or 32 cents in the year-ago quarter. Earnings were slightly better than management's guided range of 32 to 33 cents per share.

Balance Sheet & Cash Flow

At the end of the first quarter, cash and cash equivalents were $564.1 million compared with $646.7 million at the end of the previous quarter.

Cash flow from operating activities was $164.6 million compared with $185.0 million in the prior quarter. The company exited the quarter with deferred revenues of $1.27 billion, an increase of 20.0% on a year-over-year basis.

Guidance

For the second quarter of fiscal 2015, Red Hat expects revenues in the range of $432.0 to $436.0 million, while the Zacks Consensus Estimate is pegged at $428.0 million. Management expects operating margin to be around 23.0%.

Non-GAAP earnings are expected to be approximately 38 cents per share for the upcoming quarter, much higher than the Zacks Consensus Estimate of 25 cents.

For fiscal 2015, revenues are expected to range between $1.760 billion and $1.785 billion (up from prior outlook of $1.730 to $1.755 billion), slightly above the Zacks Consensus Estimate of $1.748 billion. Inktank and eNovance are expected to contribute approximately $2.0 million of subscription revenues and $8.0 million of services revenues for the rest of the year.

However, these acquisitions will negatively impact operating margin and earnings per share. Management expects non-GAAP operating margin to be around 23.0% (down from prior guidance of 23.5%) for fiscal 2015.

Red Hat expects fiscal 2015 earnings to be in the range of $1.52 to $1.54 (down from $1.54 to $1.56 per share), much higher than the Zacks Consensus Estimate of $1.07 per share.

Operating cash flow for fiscal 2015 is expected to be between $580.0 million and $600.0 million.

Our Take

Red Hat's raised revenue guidance is a positive. Although acquisitions will hurt margin and earnings per share in 2015, we believe they are a good addition to Red Hat's product portfolio and will drive top-line growth over the long term.

Red Hat continues to gain market share and its Linux servers are well positioned to compete with Microsoft's MSFT Windows servers in the enterprise market. We believe that the company has significant growth potential in the public cloud segment over the long term.

Additionally, Red Hat's strong product pipeline, continuing investments to expand product portfolio and partnerships with the likes of IBM, Dell and Intel will drive overall growth.

However, sluggish IT spending and intensifying competition remain the major headwinds in the near term. Also, Red Hat's strategy of sacrificing service revenues in order to increase subscription revenues in the long run is expected to hurt top-line growth over the next couple of quarters. This coupled with negative margin impacts from the acquisitions will be an overhang in the near term.

Currently, Red Hat has a Zacks Rank #3 (Hold).