Red Hat consolidated all of the numbers in today's report with those of two newly acquired companies, Cygnus Solutions and Hell's Kitchen Systems, both of which were completed in January, 2000. This complicates the already enigmatic task of trying to gauge Red Hat's prospects.
The press release gave lots of indications that the Linux operating system continues to catch on. Linux currently occupies 25% of the server market worldwide, and management noted that there are now 2000 Linux-compatible software applications available. Red Hat has focused on expanding its market share through lower prices for its standard system, though 70% of its revenue comes from its deluxe package. Overall unit sales increased 40%.
Red Hat has expanded its sales efforts in the enterprise sector, and it seems to have yielded results so far. The press release revealed that total enterprise customers rose to 140 compared to 60 last quarter, including Home Depot (NYSE: HD) and Cisco Systems (Nasdaq: CSCO). Management stated that there were multiple $100,000-plus deals in the quarter and that the sales pipeline remains strong.
Red Hat intends to gain an additional 25% in annual sales from acquisitions over the next five years, though that figure would depend upon finding the right deals. The company has plenty of capacity for acquisition. Its cash balance sits at $242 million, eight times current liabilities, after Red Hat raised $261 million in a secondary public offering on Feb. 3. In addition, the company has a large balance of authorized shares available for use in acquisitions.
Management estimated that revenue from existing operations would grow 75% annually over the next five years. The company hopes to translate those sales into gross margins of 70% and operating margins of 30%. Next year, however, should see higher losses on lower margins as the company focuses on reinvestment and gaining market share.
It's a little difficult to understand how one arrives at those estimates. Linux may be catching on more and more all the time, but it has already realized quite a bit of exposure. This year's 28% revenue growth, at a time when a young company should be seeing hyper-growth, seems disappointing. Also, costs of sales for the year swelled 80% over last year, much faster than revenue, as gross margins fell from 61% to 46%. That number is up from 41% last quarter, but it is a cause for concern. Furthermore, Red Hat is not alone in its market. It competes with VA Linux (Nasdaq: LNUX), Corel (Nasdaq: CORL), Caldera Systems (Nasdaq: CALD), and TurboLinux, just to name a few.
Red Hat may be the leader among Linux providers, but it remains far from clear that the company can increase revenues substantially enough to justify its price. The company sports a $8.6 billion market cap -- and that's after dipping 63% from its high-water mark. Even if Red Hat stays at its present valuation, after five years of 100% revenue growth, its price-to-sales ratio would stand at 6.4, which is higher than Computer Associates (NYSE: CA) or IBM (NYSE: IBM).
The market has priced extremely high expectations into Red Hat. We'll have to see much better performances in the future than we saw this year.