- Red Hat has delivered yet another strong quarter.
- The company's strategy of bundling OpenStack and OpenShift with its core RHEL products seems to be working well.
- Red Hat shares, though pricey, have good long-term potential.
King of open source Linux software Red Hat (NYSE: RHT), has reported yet another stellar quarterly result that managed to beat both top-and bottom line consensus estimates. Red Hat reported Q2 FY 2016 revenue of $504.15 million, good for 13.1% Y/Y growth and $9.5 million better than estimates. EPS of $0.47 was 12% better than the prior year and $0.03 above estimates. This marked the 7th straight quarter that the company beat earnings expectations.
Red Hat Earnings Surprise History
Despite the continued strong performance, Red Hat share performance has been lackluster, as investors fretted over whether the company’s new revenue streams such as OpenStack and OpenShift would be able to grow fast enough to offset the slowdown in the company’s core RHEL subscriptions. The market has also been wary of Red Hat’s steep valuation. The shares sport a PE ratio of 71, way above the sector average of 23.
Red Hat YTD Share Return
Despite these worries, there are some solid reasons to believe that Red Hat shares are a good long-term investment.
Sustainable Business Model
Red Hat is widely recognized as the world’s largest open source company. The company operates a unique revenue model where it gives away Linux and other software products and then charges for support and services. Red Hat Enterprise Linux, or RHEL, continues to be a strong revenue driver for the company. To increase its value proposition to enterprises, Red Hat frequently bundles RHEL with OpenStack, an opensource IaaS platform, and OpenShift, an open source PaaS platform. This has helped the paid Linux distributions (of which RHT is the overwhelming market leader) account for a healthy 27% of the server OS market compared to 20% for free Linux, while Windows and Unix account for a combined 53% share.
Giving away free software and charging for support services has enabled Red Hat build a strong franchise. Red Hat maintains a significant pricing advantage over its competitors, which has helped it to successfully defend its economic moat.
OpenStack and OpenShift Maturity
OpenStack, the world’s largest IaaS cloud platform, is the brainchild of RackSpace Hosting (NYSE: RAX) and NASA which they jointly launched in 2010. OpenStack operates a lot like AWS including S3 and EC2, and in fact was primarily developed to counter the dominance of AWS. The strongest selling proposition of OpenStack is that it lacks any kind of vendor lock-in.
Red Hat has now become the second largest contributor of code to the OpenStack platform, an important fact since code is currency in the open source world. OpenStack has come a long way from its early roots, and is now widely deployed by organizations that need the convenience of AWS without the accompanying vendor lock-in. OpenStack offers better value proposition for companies with large workloads who would otherwise find it expensive to deploy other IaaS platforms.
Red Hat took the first steps to monetize OpenStack last year when it replaced its old Cloud Management and Virtualization division with the OpenStack division. The company says that most of its current deals involve bundling OpenStack.
Meanwhile, Red Hat now bundles OpenShift, an open source cloud PaaS platform, with its traditional RHEL products. OpenShift is growing rapidly due to the growing popularity of DevOps, a process by which developers share code remotely thus accelerating the development platform. The popularity of OpenShift has helped Red Hat’s Application Development and Emerging Technologies segment to become the company’s fastest growing, contributing more than 20% of the company’s revenue, up from nothing two years ago.
Shares can grow into their pricey valuation
Red Hat is expected to post earnings growth of 14.25% during the current fiscal year, and a healthy 15% CAGR over the next five years. This would allow the valuation to fall to a PE ratio of just 38.6.
It’s more likely that the market will continue to give Red Hat a significantly higher valuation that its peers due to its position as the industry leader. The shares are more likely to sport a PE ratio of around 45-50 five years down the road, which will allow gains of about 60%.