Red Hat Rebound

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Linux provider Red Hat Software (Nasdaq: RHAT) has been crumpled a bit of late. In addition to bruising ad campaigns from behemoth competitor Microsoft (Nasdaq: MSFT) and uncertainty over the fate of the open-source OS due to SCO Group's (Nasdaq: SCOX) lawsuits, the firm had some accounting changes and a CFO departure that gave investors a few bouts of the willies.

Yesterday's second-quarter results show continued strength in the business, which does little to explain today's 13% haircut. Revenues of $46 million were up 60% over the prior-year quarter, and the recent trend is for accelerating sales growth -- a very good sign. At the bottom line, $0.06 per share tripled last year's showing.

Another noteworthy improvement is the growth in gross margin to 79% from 73%. It's still a long way from the standard achieved by the likes of Adobe Systems (Nasdaq: ADBE), but, to look at that a bit more optimistically, it means there's plenty of room for increased profitability.

Linux is still in its infancy. With the major players like IBM (NYSE: IBM), Sun Microsystems (Nasdaq: SUNW), Novell (Nasdaq: NOVL), Hewlett-Packard (NYSE: HPQ), and others both competing and playing nicely with each other, the question will be whether Linux can gain enough market share for everyone to rake in the bucks.

Given Red Hat's leadership in the field, it looks ideally positioned to take the lion's share of growth. But it will be a bumpy road. Even after its continuing slide, it can get scarier, as investors dump it today in response to guidance that was lower than analysts had hoped. But therein lies opportunity.

The balance sheets are strong: With $1 billion in cash and little in the way of long-term red ink, the $1.4 billion enterprise has put up $54 million in free cash flow in the first half of the year. That makes it look pretty cheap for a software leader putting up double-digit revenue growth and triple-digit earnings uptakes.

For related Foolishness, read:

• Beware the wrath of Linux.
• Review Red Hat's red flags.

Seth Jayson has no position in any company mentioned in this article.