3 Things Red Hat Inc.'s Management Wants You to Know

Image source: Red Hat.

Red Hat (RHT) had quite a day on June 22. The open-source software veteran reported strong first-quarter results, boosted its share buyback policy from $171 million to a cool $1 billion, and announced a strategic buyout in the software development space.

The company met analysts' bottom-line expectations with adjusted earnings of $0.50 per share, 14% above the year-ago period. Sales increased 18% year over year to $568, beating Street estimates by $5 million.

But the numbers never tell the whole story. Red Hat's management shed more light on these events in a conference call with analysts. On top of that, I had the good fortune to get an exclusive one-on-one phone conversation with Red Hat CEO Jim Whitehurst. Here are three of the most important things Red Hat's management shared through those channels.

Swan-like margins

I asked Whitehurst how Red Hat's bottom-line margins managed to stay remarkably solid in spite of sales and marketing costs rising quite a bit faster than the incoming revenue. Here's how he explained it:

We're investing in sales because we think that between OpenStack, OpenShift, and storage we have three really promising categories of product. All of these, just because they're newer, have higher costs of sales. But again, we have high renewal rates and very high gross margins on those. So it's a no-brainer to invest around them.

The message overall is that we're investing a bit more heavily in sales and marketing, just given the size of these new opportunities. Our guidance for the year remained flattish to down very slightly on margins.

My analogy for that is a swan. It looks flat on the surface, kind of nice and smooth, but if you look underneath that, it's being driven by the fact that our emerging products have a higher cost of sales. Meanwhile, Red Hat Enterprise Linux (or RHEL) has a lower cost of sales and wider margins.

In other words, there's a lot of furious paddling going on below the placid surface, often invisible to investors. Red Hat balances its marketing costs according to each product's existing market presence and its promise of future growth. No smoke and mirrors here, just good old-fashioned business management.

Red Hat CEO Jim Whitehurst. Image source: Red Hat.

Handling buyouts with a light touch

By its very nature, Red Hat faces unique challenges when it comes to finding appropriate acquisition targets. Whitehurst told me that the company walks a delicate balance between economies of scale and preserving the value of its buyout targets:

We're in an interesting situation because we're an open-source company. I guess we haven't ever publicly committed to this, but at least implicitly everything we buy, we open-source, right? So we either have to buy other open source companies or buy small enough companies that it doesn't kill us to open-source them.

It's harder for us to pay, say, $500 million companies and then open-source their technology.

We try not to -- we have done it! -- but we try not to do that.

For example, the just-acquired 3scale business had a small enough price tag that SEC rules didn't force Red Hat to disclose the purchase price. 3Scale's programming interface tools will be published under an open source license, without triggering an investor panic.

Staying relevant in a changing market

Finally, let me highlight the way Whitehurst framed his entire presentation to analysts.

Digital transformation and cloud computing are changing the way companies compete in virtually every industry today. Organizations that rapidly embrace agile IT technology are succeeding as industry innovation accelerates around them. With our open source-based technologies, we are helping customers to capture the business benefits associated with this rapid rate of change.

The idea is simple. Giving clients and developers everywhere access to Red Hat's source code enables each organization to adapt every tool to its own particular needs. There's no need to wait for Red Hat to release a new version that supports the one function your business really needed -- just let your own developers loose on that issue and the solution should come quickly.

Thanks to innovative licenses and a global developer community, many of these changes are folded into Red Hat's core platforms in the end. This is how a properly managed open source development operation can meet and beat the quality of proprietary software with much larger R&D budgets.

As a Red Hat shareholder myself, I'm delighted to see the company's management reiterating this commitment to a fantastic business model, even when the open source ethos presents the company with unique challenges like the buyout conundrum.

Under this management philosophy, Red Hat's sales have grown 122% larger over the last five years while free cash flows jumped 151% higher. You simply won't find growth rates like these among Red Hat's larger rivals.