Where Are Red Hat's Earnings?

Linux veteran Red Hat (NYSE: RHT  ) may sell affordable software, but the stock is terribly expensive. Right?

I mean, the stock is trading for 40 times forward earnings. Non-GAAP earnings in the just-reported first quarter jumped from $0.18 to $0.24 per share, or 33% year-over-year growth. While it's not small potatoes, that growth rate doesn't seem to support that lofty P/E ratio.

Yet the market received the news warmly, giving Red Hat a 4% price boost. The stock has now gained 13% in three months and 44% over the last year. Clearly, somebody thinks the company earns its keep. But how could that be?

Beware the P/E ratio
In short, Red Hat doesn't aim for plumper earnings. Management runs this business with other targets in mind. I think they're better targets, because they help the company make and keep more money.

In the words of CEO Jim Whitehurst:

I measure it by revenue growth, but you know, we have sort of reached a negotiated settlement with Wall Street. In general, analysts like to see margin improvement so we've committed to 100 basis points of operating margin improvement a year, and then we invest the rest in the business. So that's exactly what we do.

And that's still what's going on here. Operating margins improved by 30 basis points, or 0.3%, from the year-ago quarter. Red Hat could have shown stronger bottom-line results, but that would be at the cost of long-term growth and a weaker foundation for the very business: research and development expenses increased by a healthy 19%, while sales and marketing took an even higher 30% leap.

Whitehurst isn't throwing his money away on solid-gold restroom sinks or lavish executive retreats. This cash is doing something.

Red Hat collected $90 million of operating cash flows on a mere $32 million of GAAP earnings. That's 49% cash-flow growth year over year, far outpacing earnings growth as various non-cash deductions come into play.

Same strategy, different markets
If this reminds you of Netflix (Nasdaq: NFLX  ) pouring surplus cash into digital movie licenses, you're on the right track. It's exactly the same growth-focused strategy in a different industry -- and these guys are not alone:

• Amazon.com (Nasdaq: AMZN  ) produced three dollars of operating cash for every dollar of GAAP earnings in the last four quarters.
• Aruba Networks (Nasdaq: ARUN  ) plays in a whole 'nother ballpark, with $45 million of trailing cash from operations on a piddling $2.9 million in net income. Granted, we're talking about a turnaround story only just peeking into consistent black ink, but no one ever doubted the company's cash-generation powers.
• The real master of this black art is Nuance Communications (Nasdaq: NUAN  ) . The voice and character recognition expert collected $335 million of operating cash in the last year, but only reported $2.3 million in earnings. That results from heavy amortization and stock-based compensation.
• Even satellite radio monopolist Sirius XM Radio (Nasdaq: SIRI  ) knows how to play this game. Though capital cash expenses are substantial and make operating cash flows less useful, Sirius still makes about four times as much free cash as it does in GAAP net income.

You'll also note that none of the stocks mentioned trade for less than 73 times trailing earnings. In a nutshell, that cash focus explains why Red Hat shares fetch 40 times forward earnings, while archrival Microsoft (Nasdaq: MSFT  ) has to settle for 9. On top of terrific revenue growth, Red Hat's business model is less earnings-focused than Mr. Softy's.

Come to think of it, Red Hat (and some of the other fast-growers listed above) sounds a lot like a Rule Breaker -- a supposedly overvalued top dog with smart management. Maybe I should get on the horn with our Breaker team to ask why Red Hat isn't on their list yet.