Earnings Preview: Red Hat Inc. - Analyst Blog

A leading open source solution provider, Red Hat Inc. (RHT) is scheduled to release its fourth quarter and fiscal year 2011 results on March 23, 2011, after the market closes.

Red Hat's third quarter results were in line with the Zacks Consensus Estimate and the company has raised its fiscal 2011 guidance based on the strong quarter.

Third Quarter 2011 Results

Red Hat reported third quarter earnings (including share-based compensation but excluding amortization and litigation expenses) of 15 cents per share, up 15.4% year over year from 13 cents reported in the year-ago quarter. The year-over-year earnings growth was driven by strong revenues and operating margin expansion in the quarter.

Total revenue increased 21.2% year over year to $235.6 million, driven by robust demand for Red Hat solutions globally. Higher renewal rates on large deals and an increasing number of deals were the primary growth drivers.

The top 30 deals for the quarter included 16 deals of approximately $1 million or above, with one deal in excess of $5 million. The middleware business was particularly strong, accounting for approximately half of the deals won during the quarter.

In the third quarter of 2011, non-GAAP gross margin (including share-based compensation but excluding amortization of intangible assets) was 83.5%, down 180 basis points from 85.3% in the prior-year quarter.

Outlook

During the third quarter earnings call, Red Hat raised its fiscal 2011 guidance. Red Hat expects full-year revenues in the range of $898.0 million to $900.0 million versus its previous expectation of $877.0 million to $885.0 million.

Non-GAAP earnings are expected to be in the range of 78 cents to 79 cents per share versus previous guidance of 76 cents to 77 cents per share. The current Zacks Consensus Estimate is pegged at 58 cents, well below the guided range. Management expects non-GAAP operating income to expand 100 basis points for the fiscal year 2011.

For the fourth quarter of 2011, Red Hat expects revenues in the range of $234.0 million to $236.0 million and non-GAAP EPS is projected in the range of 21 cents to 22 cents. The Zacks Consensus Estimate for the fourth quarter is pegged at 16 cents. Operating margin is expected in the range of 24.6% to 25%, while the tax rate is estimated to be 35%.

No Movement in Estimates

According to research firm IDC, Linux server demand improved in the fourth quarter, with revenue increasing 29.3% year over year to $2.5 billion. Linux picked up 1.8 bps of market share during the past year to end the quarter with a 17.0% share. UNIX system revenue was relatively flat, down 0.4% in the quarter and resulting in a market share decline of 5% compared to the year-ago quarter. UNIX comprised 25.3% of total server revenue in the quarter.

We believe the increasing demand for Linux will drive growth for Red Hat in the upcoming quarters. Moreover, we expect Linux to take market share from UNIX, adding to its gains.

IDC also believes that servers based on the x86 architecture will continue to dominate the market in 2011 (65.0% of the total revenue). Mainframes and Unix-based servers are expected to grow 2.5% in 2011.

As Linux works on a much wider variety of hardware systems (x-86-based, blades, mainframes, International Business Machines Corp. (IBM) Power systems and UNIX oriented hardware) than the predominantly x86-based Windows platform, we believe strong growth in x86 and renewed growth in mainframes and UNIX-based servers will boost Red Hat's top-line growth over the long term.

We maintain a Neutral rating on Red Hat over the long term (6–12 months) as Red Hat continues to face tough competition from Microsoft Corp. (MSFT), Novell Inc. (NOVL) and Oracle Corp. (ORCL).

Given no change in the Zacks Consensus Estimate for the fourth quarter EPS in the last 60 days, Red Hat is expected to report in line results. The shares are expected to remain range bound in the near term. The lack of estimate revisions is reflected in the Zacks #3 Rank for Red Hat, implying a Hold rating over the short term.