Red Hat Is Red Hot

Shares of Red Hat (Nasdaq: RHAT  ) have been red hot, rising from $3 a year ago to above $13, and not just because a bull market has lifted stocks. The company is growing sales at the high-growth clip of more than 30% year over year and recently earned its first operating profit.

Red Hat is a leading open source software company (open source meaning the code is made public and can be improved upon by outsiders). The firm went public in late 1999, rocketed (you'll recognize this story) to a split-adjusted $200, then fell to about $10 within a year.

From there, the stock dove into the watery realm of "penny stocks," only to emerge like a creature from the red lagoon with a smile on its face, climbing this year to solid ground.

It's at this stage in the firm's young life that advanced, yet risk-conscious investors might reasonably consider the stock. The high-risk speculators that bought Red Hat in the single digits, before the company could prove profitability, have been rewarded for that risk. But if Red Hat has a strong future, plenty of upside could remain for new investors.

The bigger question may be, how much risk remains?

Investing in risk, safely
First, let's set the investing stage of sorts...

There's a funny dichotomy. As a rule, the lower the share price, the higher the business risk -- but the lower the valuation risk (yes, the stock may go to $0, but that's true at any price, and only sometimes truer at $3 vs. $20). As a stock rises, usually it's a sign that business risk has declined, but as the stock does rise, the valuation risk grows. You trade one risk for the other. Fortunately, every investor has a sweet spot -- a comfortable mix where risk and possible reward seem right.

My sweet spot and investing focus lean toward the aggressive, riskier side. High-growth stocks have accounted for a majority of my investment gains over my lifetime. That said, I focus on risky stocks while maintaining a portfolio of stable growers, too -- holding blue chips that offer low risk alongside attractive returns.

(I also use options to earn extra monthly income, a strategy I've come to really appreciate -- but that's anotherstory.) Because blue chips don't require much attention, I can spend a majority of my time finding fast growers, or stocks that can really boost returns.

A portfolio of risk, balanced by stability, makes looking at a Red Hat, coming out of a bear market and recording its first operating profit, possible... and enjoyable. Will the stock double again in the next three to five years? If this is a good possibility with reasonable downside risk, then a balanced portfolio owner is in a great position to consider it. First, make sure your portfolio has the right mix of risk (because you want outsized rewards) and stability (because you don't want to lose what you have).

Red Hat's open for business
Now, drawing the curtains for the main show.

Like Yahoo! (Nasdaq: YHOO  ) , Netscape and Google, Red Hat's history can be traced to a university student. In 1991, Finnish student Linus Torvalds created a software operating system (OS) based on the Unix system booming at the time. He made his OS source code publicly available and allowed the public to add to and improve on the software, so long as all the code remained public. The operating system was called Linux.

As the popularity of Linux grew, entrepreneurs had the idea of packaging the operating system and adding improvements, upsells, and technical support in order to form a business around it. This is how Red Hat came to life. This year, it'll see more than $100 million in revenue.

Linux is praised for flexibility, stability, and, of course, its ability to be tweaked by others. Red Hat's Linux is popular because the company employs a large team of open source programmers to produce a version of Linux that is stable, powerful, scalable, has added features, and is backed by support. The software can also be cheaper to run than competing systems.

Red Hat has until recently sold OS platforms aimed at two main markets: 1) Red Hat Linux for the retail consumer (the personal or small business user), and 2) Red Hat Enterprise Linux for the big-money commercial or enterprise market. According to IDC research, Linux is the world's fastest-growing server operating system (really, what other competition is out there growing against Microsoft (Nasdaq: MSFT  ) ?). Enterprise sales account for a vast majority of Red Hat's revenue.

The company recently ended its Red Hat Linux consumer line (increasing near-term risks), in favor of an open source Fedora software project that will receive less support (lower costs). Meanwhile, new versions of Red Hat's Enterprise Linux products are released approximately every 12 to 18 months, because deployment of enterprise software is a larger task for corporations, and updates are not undertaken as frequently.

Investors know software can be a high-margin business blessed with regular product renewals and upgrades, which bring revenue from the same customers in an annuity fashion (if not quite annual). Linux has its place -- and it is a growing place -- in the market, and Red Hat has top brand recognition. The trends suggest long-term market acceptance, which should translate into steady revenue growth for Red Hat.

But, is there any value to be had in the shares? Let's consider some financials.

Can Red Hat grow beyond its market cap?
At $13.50 per share, Red Hat has a market value of $2.3 billion. With $306 million in cash and investments and no long-term debt, its enterprise value (EV) is about $2 billion. The company has managed free cash flow (FCF) the last three quarters to the tune of approximately $12.8 million. Naturally, its EV/FCF multiple is high, at 156, given that it's just recently FCF positive.

The question is how quickly might FCF grow, thereby contracting that multiple? Red Hat's margins are still slight because it hasn't gained an enormous market, and its fixed costs (namely employees and services) need to be maintained. A sizable gain in revenue would propel FCF (the company is right on that cusp), but revenue is only expected to rise a relatively modest 27% next year, to $155 million.

Here's a look at six months of results (the most recent available), reported Sept. 18.

  Six months ended                 Aug. 31, 03   Aug. 31, 02Subscrip. Rev ($000):  Enterprise      $27,207         $12,723  Retail            7,583           6,527  Embedded          1,136           1,802Total sub. rev.    35,926          21,052Service Rev.:   Enterprise      18,186          17,810   Embedded         1,919           1,814Total service rev. 20,105          19,704Total revenue      56,031          40,756Costs of sub. rev.  5,194           3,798Costs of services  11,320          10,840Total rev. costs   16,733          14,888Gross profit       39,298          25,868Sales and market.  18,322          16,387R&D                11,883           9,604G&A                 8,415           7,055Total oper. exp.   40,120          37,779Gain from operation (822)         (11,991)Net income          4,856          (6,539)Net income/share    $0.03          $(0.04)Diluted shares    181,185         169,902

In the most recent quarter, operating income was positive (the last six months, it's still slightly negative), while net income was again boosted by interest income. But the move to operating income, along with $8 million in free cash flow last quarter, is what investors are excited about.

Free cash flow could grow -- given the expected rise in sales and greater efficiencies -- to likely at most $40 million over a period of 12 months. If so, the stock's FCF multiple would fall from 156 to 50 in about a year. That's still expensive, but such a severe value contraction could attract investors and support the stock. Even so, we remain in highly speculative territory -- no longer with the business, which is here to stay (at least for a number of years), but in terms of valuation, especially as one product line is dropped.

As for net profits, the company is expected to earn $0.08 per share this year, and nearly double that, $0.15 per share, in 2004. The stock trades at 90 times the 2004 estimate, suggesting almost no margin of safety. Risk-averse investors will want to look elsewhere or wait for a price nearer $9 or $10, where there would be a margin for error built in. The current balance of risk vs. reward simply looks too risky for me.

I'll want to revisit the stock after the next quarterly result to see if FCF can grow much faster than earnings, in which case, perhaps a more positive valuation argument can be made, and opportunity will present itself again.

Thank you for reading... and have a great weekend!

Disagree? Want to discuss specifics on Red Hat, including those pesky SCO lawsuits and competitors Sun Micro (Nasdaq: SUNW  ) and IBM (NYSE: IBM  ) ? Visit the Red Hat discussion board (free trial required).

Jeff Fischer doesn't own shares of companies mentioned, and as with all Fool writers, welcomes feedback. The Fool is investors writing for other investors.


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