Are Investors Underestimating Red Hat?

Open-source provider Red Hat  (NYSE: RHT  ) announced good results for the fourth quarter, and the following day, its stock went down. It's hard to understand the wisdom of crowds here, but two likely explanations are that Red Hat's operating margin is decreasing, and its EPS guidance for 2014 is lower than analysts thought.

Behind the scenes, Red Hat is investing a lot, particularly in OpenStack, an open-source platform for cloud computing. Looking farther into the technology future and not just at this year's financials, will Red Hat deliver, and will its investments turn into solid profits?

A wrap-up of the results
Red Hat's revenue for the year was $1.53 billion, up 15% from the year before and at the upper end of guidance. Subscriptions made up 88% of total revenue, and were up 16% year over year. The estimates for next year are also positive: revenue of $1.730 billion to $1.755 billion, a growth of up to 14%.

The core business is doing well. Subscription renewals are solid (99 of the 100 largest contracts renewed), and the size of the renewals is, on average, 120% of the subscription's earlier value. Red Hat Enterprise Linux (RHEL), the company's main offering, is used widely on public clouds and in 90% of Fortune 500 companies, according to Red Hat management. While Unix-to-Linux conversions are slowing, Red Hat believes there are still a few years of good business there. At the same time, Windows-to-Linux conversions are picking up.

So what's the bad news? First, Red Hat's guidance for EPS was $1.54 to $1.56, and this fell short of the analyst consensus of $1.63. Second, operating margins for the year are slated to drop to 23.5% (a 1% drop from last year), with an even lower 21% operating margin predicted for the first quarter. Red Hat justifies this by citing an increase in hiring and marketing, particularly related to OpenStack, its big bet on the future.

OpenStack, a huge opportunity
Cloud computing is one of the hottest new trends in IT, and a number of big names -- Amazon, Google, Microsoft -- are all in on it. VMWare, which has also joined the fray with its vCloud Hybrid Suite, estimates the market to be worth $16 billion.

Enter OpenStack, an open-source cloud platform supported and developed by a consortium of companies including HP, AT&T, IBM, and Red Hat. The appeal of OpenStack for cloud infrastructure mirrors the appeal of Linux for servers -- lower costs and fewer restrictions than with a big, proprietary software vendor.

The year 2013 saw rising interest in OpenStack, with several large companies publicly announcing that they will be using it for their own cloud platforms. In particular, Ericsson recently signed on to use a version of OpenStack provided by start-up Mirantis for an estimated $30 million. Red Hat CEO Jim Whitehurst confirmed the growing buzz on the fourth-quarter conference call, stating, "There is substantially more interest in OpenStack, frankly, than there has been really in any product since Linux."

Can Red Hat profit here?
Red Hat is already one of the main contributors to OpenStack. Much like with RHEL, it offers an enterprise-ready version of OpenStack, as well as related consulting and training. While some large companies will use the free version of OpenStack, many (like Ericsson, above) will be willing to pay good money for an enterprise version.

In 2013, Red Hat closed some OpenStack deals, and it expects to close even more in 2014 as the technology matures. It also provides OpenStack certification, which is a great way to convince IT insiders in potential client companies to use the Red Hat version of OpenStack down the line. Finally, there's some crossover -- Red Hat claims that its role in OpenStack is opening doors to accounts that were previously inaccessible.

The prospects are good, but when will all this begin to make an impact on the bottom line? Not so soon, apparently. Red Hat cautioned analysts that revenue from OpenStack will probably remain light in 2014. However, consulting and training services might pick up and, according to management, training precedes sales. Keep an eye out for 2014 services revenue to get an idea of Red Hat's future performance.

In conclusion
Red Hat's EPS and operating margin guidance for the next year are lower than expected, and this probably led to a share-price drop in spite of good revenue growth. The company is investing heavily in the future through its support of the emerging OpenStack technology, where it's poised to be a key player. In 2014, Red Hat will likely not see much income from OpenStack, but training and consulting revenue might indicate sales down the line.

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