The Real Scoop On Red Hat's Plunge

I'm a little miffed at the fact that I'm writing this article right now. You see, I'd rather take advantage of this tremendous buy-in opportunity on Red Hat (NYSE: RHT  ) than write about it. According to our Foolish disclosure policy, I must now wait until next week before touching the stock. Chances are that the discount might be gone by then.

Oh, well. I'm also excited about guiding you through Red Hat's story, particularly because I’ve got some info to share. Read on to see what I'm talking about.

Why so excited, dear Fool?
You see, Red Hat shares were crushed for ridiculous reasons. The Linux vendor reported first quarter revenue of $315 million, just ahead of the $310 million analyst consensus, while boosting non-GAAP bottom-line earnings by 25% year-over-year to $0.30 per share -- again ahead of Street targets set at $0.27.

That's a solid beat on both the top and bottom lines, but shares immediately plunged as much as 11.5% in after-hours trading, anyhow. And it's not like Red Hat was riding some magical wave of investor enthusiasm into this report: As of Wednesday night, shares had swooned about 8% from the fourth-quarter report.

So what's the problem? It’s a non-GAAP number that just serves as a proxy for something Red Hat can't even directly measure.

The power of one artificial metric
Meet the billings proxy. Red Hat mostly sells subscription services, as the direct software licenses really play second fiddle to multi-year support contracts. The open-source business philosophy is cool like that.

This means that a significant portion of Red Hat's sales need to be amortized over the life of the underlying contracts, which they classify under the accounting term “billings.” To create this so-called billings proxy, the company adds the change in deferred revenues to the standard revenue number.

That's the number that disappointed Red Hat traders this week. Deferred revenue grew 16% year-over-year to $913 million. While respectable, that line grew slower than the 19% revenue boost. Ergo, red flags go flying.

But Red Hat doesn't build its business plan around billings. On the earnings call, CEO Jim Whitehurst reminded analysts that “We don't manage to billings. It's not a necessarily relevant number to us. And we hit our plan on the measures we use internally, which are around bookings.”

Rather than looking at the artificially smoothed-out billings number, Whitehurst plans around the booking of new contracts. On that measure, “We met or exceeded our plans on every measure around bookings,” he told me in a follow-up call. In particular, “Bookings, which is the number we manage to, actually exceeded billings,” which is a sign of good revenue visibility and strong growth momentum.

What's the real story?
In short, Red Hat shareholders panicked over the wrong number. There's nothing wrong with the business. Red Hat eyes dramatic growth prospects in China and Brazil, and reported its strongest growth in the troubled economies of Southern Europe this quarter. “Value sells in difficult economic situations,” as Whitehurst put it.

That's why Red Hat steals market share from computing giants Oracle (Nasdaq: ORCL  ) , Microsoft (Nasdaq: MSFT  ) , and even a resurgent IBM (NYSE: IBM  ) in times like these. The big boys choose to protect the huge sticker prices on their premium enterprise products. But even so, the gross margins of Red Hat's service-centric model beat all-comers. That's the power of open source innovation for you.

To me, this sudden price drop is an obvious misunderstanding. A scary accounting mirage plays second fiddle to the strength that really matters. Four quarters from now, this quarter's billings proxy will be forgotten, while Red Hat cashes in checks from the new bookings that still rush through the company.

So, yeah, this is a discount on parade.

Haven't we seen this movie before?
These misunderstandings happen a lot, actually. A similar situation brought Netflix (Nasdaq: NFLX  ) shares below $70 again. In that case, investors were spooked by the mathematical effects of seasonality and churn on a very large customer base. No matter how management and well-informed analysts explained the matter, many shareholders misread it as a sign of impending doom, stalled growth engines, and saturated markets. Like Red Hat, Netflix will bounce back when the proof-flavored pudding is served in coming quarters. Short-term molehills have been amplified into crisis-worthy mountains by the megaphones of myopic traders and superficial analysts.

But don't just take my word for it. Citigroup analyst Walter Pritchard underlined his “buy” rating on Red Hat with a $68 price target. The firm notes that Red Hat has an opportunity to explain its financial workings at next week's annual analyst confab.

Which is just another reason why I nearly dumped this story to make an investment, instead. But I owe it to my readers to share this opportunity.

Red Hat has absolutely crushed the market since 2009, thanks in no small part to budget-conscious customers in the financial crisis and its aftermath. David Gardner has his eye on a new-age medical equipment builder that has kept up with Red Hat's four-bagger growth in the last three years. Find out why David is so excited about this proven Rule Breaker in this free report, and decide for yourself if Red Hat might meet his strict criteria, too. (Spoiler alert -- I think it does!) Get your hands on the report right now, because it won't be free forever.

Fool contributor Anders Bylund owns shares in Netflix, and has also created a bull call spread position on that stock, but he holds no other position in any of the companies mentioned -- yet. Check out Anders' holdings and bio, or follow him on Twitter and Google+. The Motley Fool owns shares of Netflix, IBM, Microsoft, and Oracle. Motley Fool newsletter services have recommended buying shares of Netflix and Microsoft. Motley Fool newsletter services have recommended creating a synthetic long position on IBM and creating a bull call spread position in Microsoft. The Motley Fool has a disclosure policy. We Fools may not all hold the same opinion, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.


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