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The Glowing Red Hat

I'm dead set against evaluating a company solely on its income statement, which is why I find it annoying when companies issue earnings releases without a balance sheet or cash flow statement. However, it's hard to look at the income statement performance of Red Hat (Nasdaq: RHAT  ) and not come away impressed.

For its third quarter, total sales increased 43.6% to $73.1 million, and, because software companies scale well once they get enough sales flowing through the business, net income rose an even larger 114%, and diluted earnings per share doubled to $0.12. With such a large increase in profits relative to sales, you might expect that margins improved. And you'd be correct. They improved at both the gross and operating levels.

At the net income level, there are a couple of unique things going on. First, the company collects a fair amount of income on its cash and investments (both long- and short-term), which now totals $1 billion. And second, the company has a low 7% effective tax rate for the first nine months of its fiscal year. I haven't looked into the details on the tax rate, and the company does have fairly substantial overseas operations that could help to keep its effective rate down. But 7% is very low and unsustainable, so I'd expect this to increase over time. Regardless, it's a dynamic that an investor should understand before investing in the company.

On the cash flow statement, Red Hat's performance is just as strong, turning in free cash flow ($49.7 million) well above its net income ($23.2 million). This is largely due to its subscription business model, through which the company collects cash in advance of providing its product support. Through the first nine months of the year, free cash flow is up to $124.1 million on $136.5 in cash flow from operations (CFFO). On the conference call, the company raised its guidance for full-year CFFO to greater than $175 million. Given the new CFFO guidance, it seems reasonable to me that free cash flow should come in above $155 million for the year.

On the company's conference call, management pointed toward strong renewals, with 24 of its largest 25 customers renewing. It would be helpful if the company could provide such a renewal metric across its entire customer base instead of just the top 25, and on the call it sounded as though it was heading in that direction. Assuming that overall renewals are firm, the company can still grow its Linux business by taking share from the UNIX platform and through its partnerships with Dell (Nasdaq: DELL  ) and Hewlett-Packard (NYSE: HPQ  ) on server sales. And, to a lesser extent, Red Hat can benefit from the sales of PCs in general. I'm not suggesting that Red Hat can take share from Microsoft's (Nasdaq: MSFT  ) Windows platform, because there's not much evidence to date that this is happening, though it is entirely possible in the future and something to watch for.

Considering that this company is growing like wildfire, about the only thing that keeps it from qualifying as a Rule Breaker is that it is profitable. Just kidding! My Rule Breaking colleagues have chosen other companies with profits and strong growth potential. But, I must admit, I think Red Hat is a Rule Breaker in many ways and has an interesting future ahead of it.

For related Rule Breaking Foolishness:

Dell is aMotley Fool Stock Advisorrecommendation. Microsoft is aMotley Fool Inside Valuerecommendation.

NathanParmelee owns shares in Microsoft but has no financial stake in any of the other companies mentioned. The Motley Fool has an ironclad disclosure policy.

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