It's extremely difficult to turn in a better financial performance than Red Hat (Nasdaq: RHAT) did in its fiscal second quarter earnings report, which it released after the close of trading on Wednesday. Sales growth rose 42% versus a year ago, and earnings per share increased by an even larger 50%. The stronger bottom-line performance was due to share repurchases and the operational leverage of the business, which resulted in a relatively smaller 37% increase in operating expenses. Investors cheered the news, sending the stock of the Linux software company up more than 26% in Thursday's midday trading.
There are signs that Red Hat's business should continue to perform well for quite some time. On the company's conference call, management noted that information technology spending is improving beyond the Web serving space and into the more traditional database and enterprise resource planning (ERP) environments. The company also noted that its sales cycles have shortened, it's receiving higher dollar amounts per transaction, and the businesses are scaling well operationally.
Surely, Red Hat has good products. And its partners, such as Hewlett-Packard (NYSE: HPQ), Dell (Nasdaq: DELL), and IBM (NYSE: IBM), provide customers with the option of using Red Hat software on the servers they sell. But perhaps more interesting is that Red Hat's unit software sales to customers purchasing these original equipment manufactured (OEM) servers are increasing more quickly than the unit sales of the servers themselves.
These are all great data points on the health of the business, but I'm most intrigued by the strong 45% growth in free cash flow that the company's subscription-based business model generated in the quarter. This growth means that the company has plenty of cash to invest in its business, remain competitive, and pursue new opportunities.
While I came around quite a while ago to the notion that Red Hat's business model was working, I remained skeptical that the stock was a good buy because of the company's tendency to increase share count and dilute existing shareholders. Looks as though I may have been overly cautious on this count. It's time to revisit my skepticism.
For investors, the current bogeyman is the valuation of Red Hat shares, because such amazing performance never comes cheap. It's hard to imagine paying 85 times earnings for Red Hat or for any other company. But with such a solid earnings performance, not to mention its somewhat strong balance sheet, I'll be adding Red Hat to the list of companies I keep close tabs on.
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Nathan
Parmelee
has no financial interest in any of the companies mentioned. The Motley Fool has an ironclad disclosure policy.
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