Red Hat Beats on Strong Top Line - Analyst Blog

A leading provider of open source solutions, Red Hat Inc. (RHT) reported strong fourth quarter 2011 results. Earnings per share (EPS) of 18 cents (including stock-based compensation expenses but excluding amortization) exceeded the Zacks Consensus Estimate of 16 cents based on strong top-line growth. The strong results and better-than-expected guidance caused share prices to surge $4.23 (10.58%) to $44.20 in after-hours trading.

Earnings

Earnings per share (including stock-based compensation expenses) increased 50.0% year over year from 12 cents reported in the year-earlier quarter.

Red Hat reported non-GAAP earnings of 26 cents per share (excluding stock-based compensation expenses and amortization), up 36.8% year over year from 19 cents reported in the prior-year quarter.

The strong year-over-year growth was driven by higher revenues and robust gross profit growth in the quarter.

Revenue

Revenue increased 25.0% year over year to $244.8 million in the fourth quarter. Subscription revenue increased 23.7% year over year to $209.3 million. Training and services revenue was $35.5 million, up 32.9% year over year.

The strong year-over-year growth in revenue was driven by higher demand for cloud computing technologies, as customers modernized their datacenters to facilitate the adoption of cloud computing.

Billings increased 31.0% year over year to $318.0 million in the quarter, the fastest growth in the last 12 months, reflecting strong global demand for Red Hat's virtualization and middleware products and services.

In the fourth quarter, Red Hat renewed 24 of the top 25 deals at over 130% of the prior-year value. Red Hat closed two six-figure deals in the quarter. The company continued to expand outside the core logistics, healthcare, transportation, retail and energy verticals. Red Hat achieved more than 150.0% growth within these mainstream verticals for the second year in a row.

Bookings increased significantly in the quarter, with the channel comprising 59.0% and direct sales contributing 41.0%, attributable to a number of large government and mainstream customer wins.

Operating Performance

Gross profit on a non-GAAP basis (including share-based compensation but excluding amortization of intangible assets) was $206.1 million, up 22.1% year over year from $168.4 million in the prior-year quarter. However, gross margin fell 200 basis points (bps) to 83.4% in the quarter. This was primarily attributable to a higher percentage of low-margin services in the sales mix during the quarter.

Operating income on a non-GAAP basis (including share-based compensation but excluding amortization of intangible assets) was $44.6 million, up 36.8% year over year from $32.6 million in the prior-year quarter. Operating margin was 18.2% compared with 16.6% in the year-earlier quarter. The strong growth in operating income was primarily driven by higher gross profit in the quarter.

Including share-based compensation but excluding amortization of intangible assets, non-GAAP operating expenses jumped 20.0% year over year to $126.4 million, as a result of continued investments in sales, engineering and support. However, operating expenses, as a percentage of total revenue, decreased 200 basis points to 51.6% in the quarter.

Net Income was $36.2 million, up 51.5% year over year from $24.0 million in the prior- year quarter. Net income margin was 14.8% in the quarter compared with 12.2% in the prior-year quarter.

2011 Full-year Results

Revenue increased 21.5% year over year to $909.3 million in fiscal 2011. Subscription revenue increased 21%, while Services grew 24% year over year. Red Hat ended the year with backlog in excess of $190 million, of which approximately $120 million is expected to materialize in fiscal year 2012.

Red Hat released a number of products in fiscal 2011. In addition to Red Hat Enterprise Linux 6 operating system, the company launched the JBoss Enterprise application server 5.1, JBoss Enterprise SOA Suite 5.1, JBoss Portal 5.0, Red Hat Enterprise Virtualization 2.2 that drove strong year-over-year results.

Gross profit on a non-GAAP basis (including share-based compensation but excluding amortization of intangible assets) was $762.2 million, up 19.3% year over year from $638.8 million in the year-ago quarter.

Operating profit on a non-GAAP basis (including share-based compensation but excluding amortization of intangible assets) was $164.6 million, up 27.9% year over year from $128.7 million in the year-ago quarter.

Earnings were 56 cents per share (including share-based compensation but excluding amortization of intangible assets), up 16.7% year over year, below the Zacks Consensus Estimate of 58 cents.

Red Hat acquired Makara in the third quarter of 2011, a developer of deployment and management solutions for applications in the cloud. Makara's technologies will accelerate the development of Red Hat's comprehensive Platform-as-a-Service (PaaS) solution as a part of its Cloud Foundation portfolio. Red Hat introduced Cloud Foundations in June 2010.

Balance Sheet

At the end of the fourth quarter of 2011, cash and investments were $1.19 billion versus $1.10 billion at the end of third quarter of 2011.

Operating cash flow increased sequentially by $24.2 million to $95.0 million. Total deferred revenue at the end of the fourth quarter was $772.0 million, up 20.0% from the year-ago quarter. Days' sales outstanding were 50 days compared with 51 days At the end of the third quarter and 56 days at the end of the fourth quarter of 2010.

Guidance

Red Hat forecasts revenue in the range of $1.05 billion to $1.07 billion for fiscal year 2012, representing an annual growth rate of up to 18% in U.S. dollars. This growth rate assumes that subscriptions will grow faster than services revenue.  

Red Hat expects demand for cloud computing technologies to increase further in the upcoming quarters, which will help the company to achieve revenues of around $1.0 billion in the fiscal year of 2012.

Non-GAAP EPS (excluding stock based compensation) is expected to be in the range of 94 cents to 96 cents. The Zacks Consensus Estimate is pegged at 71 cents. Management expects non-GAAP operating income of 25.7% for the fiscal year 2012.

Red Hat continues to expect operating cash flow for the fiscal year to range between $330.0 million and $340.0 million. Capital expenditure is expected to be relatively modest at less than 5% of revenue in the $40 million to $50 million range for the fiscal year.

For the first quarter of 2012, Red Hat expects revenues in the range of $252.0 million to $255.0 million, while non-GAAP EPS is projected in the range of 21 cents to 22 cents. The Zacks Consensus Estimate is pegged at 16 cents, below the guided range. Operating margin is expected in the range of 24.5% to 24.9% and the tax rate at 31.0%.

Our Take

We believe Red Hat is emerging as a significant cloud computing story over the long term. The company had a successful 2010 in the cloud space, when a number of customers using its RHEV product increased to over 500. Moreover, the acquisition of Makara will boost Red Hat's cloud computing capabilities, in our view.

However, the ongoing crisis in Japan from the earthquake and tsunami is a major setback for Red Hat that may hurt its profitability in the near term. Japan is the second most important market for Red Hat after the U.S. The company expects t least a $5 million impact on billings in the first quarter of 2012. Moreover, foreign exchange headwinds and increasing compensation costs are expected to hurt results.

Red Hat faces stiff competition from Microsoft Corp. (MSFT), Novell Inc. (NOVL) and Oracle Corp. (ORCL).

We maintain a Neutral recommendation on Red Hat in the long term. The stock currently holds a Zacks #3 Rank, which implies a short-term Hold rating given no change in estimates following fourth quarter results.