Red Hat Turns Green

In an all-too-appropriate but unintended homage to the season, Red Hat (Nasdaq: RHAT  ) mixed a lot of green in with its classic crimson yesterday in reporting its third-quarter fiscal 2005 results. The top U.S. provider of the Linux computer operating system said that earnings rose to $10.8 million, or $0.06 per share, up 155% from last year's $4.3 million. Sales, too, rose dramatically, to $50.9 million, up 10% from last quarter's $46.3 million and 55% from last year's $32.9 million.

More impressive, however, was the rise in Red Hat's free cash flow, which for the first nine months of the year tripled from fiscal 2004. That has undoubtedly played a part in the firm's decision to buy back nearly $100 million worth of its shares. But it's not like Red Hat is buying its stock on the cheap to boost the earnings pie for shareholders. Quite the contrary, actually.

As Foolish colleague Seth Jayson pointed out previously, Red Hat's appetite for stock options is positively ravenous. The buyback is helping to stem dilution, but not by a whole lot. The company's diluted share count -- which includes stock options that could be exercised because they're "in the money" -- actually rose by more than 9 million from the first nine months of fiscal 2004, or 5%. That's high, but down from the 7% dilution seen at the midpoint of the 2005 fiscal year.

Interestingly, it wasn't the dilution that had investors dumping Red Hat shares in after-hours trading. It was guidance. The company said in its conference call that fourth-quarter earnings should come in between $0.06 and $0.07 per share on sales of $55.5 to $56.5 million in sales. Wall Street was expecting $58 million. But that's nothing new, really. Wall Street was expecting $51.8 million in sales this quarter, but the company missed the mark there, too. Even Red Hat's prodigious cash flow came up short of expectations.

What's so silly about the fuss over guidance is that Red Hat isn't attributing the so-called misses to problems with production, distribution, or even pricing. Nope. This is just a business that isn't growing as fast as the Street would like. OK, but so what? Is the business improving? Yep. Is its core market growing? Undoubtedly. Is the balance sheet in good shape? Well, cash and long-term investments are more than a third higher than debt, and deferred revenue was up 22% sequentially, so yeah, it is. Now tell me again what the problem is?

For related Foolishness:

Just how important is Linux these days? Can it change the world the way Red Hat and others think? What about Microsoft? How much should it fear the Linux pirates? All this and more at the Linux User's Group discussion board. Only at Fool.com.

Fool contributor Tim Beyers doesn't own any red hats, nor does he own any shares in Red Hat, or any other company mentioned in this story for that matter. You can find out what stocks Tim owns by checking out his Fool profile, which is here.


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