Red Hat's Numbers Get a Boost

Red Hat announced solid results and expects to reach profitability in Q1. But it's painfully clear it beat estimates by cutting costs and with the help of an acquisition. In the conference call last night, though, the company said it continues to expect more profits on less revenue. In short, it looks as if the company is engaging in defensive tactics to achieve profitability.

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By Mike Trigg (TMF Tonto)
March 23, 2001

Linux-based software vendor Red Hat (Nasdaq: RHAT) announced positive fourth-quarter results after the market's close yesterday and that it expects to reach profitability in Q1, a full quarter ahead of expectations. At first sight, the announcement looks like a winner, but it's clear Red Hat beat estimates by cutting costs and with the help of an acquisition. For a high-growth software company, more profits on lower revenues gives little reason for excitement. 

Adjusting for onetime items, Red Hat reported a loss of $600,000, or breakeven, compared to a loss of $5.6 million, or $0.04 per share, in the year-ago period. The Street expected a loss of $0.01 per share. Revenues more than doubled in the year-over-year period, to $27 million. But the top-line results included $5.5 million from its recent acquisition of consulting firm Planning Technologies. Without that contribution, Red Hat would have posted a loss of $0.05 per share.

In addition to the acquisition, Red Hat beat estimates by cutting expenses. The company cut back its research & development expenditures, for example, potentially jeopardizing future growth. R&D is an investment that helps companies develop new technologies that maintain competitive advantage. This is particularly important in high-tech industries, where the rapid pace of technological change breeds product obsolescence. Here are Red Hat's R&D expenditures over the past year:

Quarter          R&D 
Q4-00            27%
Q1-01            21%
Q2-01            20%
Q3-01            22%
Q4-01            14%

In the conference call last night, CFO Kevin Thompson said the company continues to expect more profits on less revenue. He forecasted Q1 revenue to be flat at $27 million, below the Street's expectation of $31.1 million. Thompson gave no earnings estimate. For 2002, the company expects earnings of $0.10 per share, compared to the Street's expectation of $0.04 per share, and sales of $140 million. The Street was expecting revenue of $152.2 million.

Where to from here?
Linux was originally designed to offer personal computer users a low-cost or free operating system (OS), compared to traditionally more expensive Unix systems. Demand continues to grow for Linux-based solutions, as businesses seek out ways to reduce their cost of ownership. But with only 4% of desktop computers Linux-based, compared to 87% running Microsoft (Nasdaq: MSFT) software, commercial acceptance remains an uphill battle.

As a result, Red Hat has built its business around server-based applications and the embedded software market. Embedded operating systems are invisible to the end user, traditionally powering things like robots and radar systems. But with computing resources expanding past PCs to newer devices like handheld computers, a big opportunity exists. Red Hat's possibilities also expanded recently, after IBM (NYSE: IBM) said it would spend $1 billion on the open-source system in 2001.

Despite its opportunities, there are other Linux companies vying for a piece of the open-source pie, and Red Hat is still essentially trying to sell something that can be downloaded for free. Still, investors are applauding Red Hat's 100%-plus revenue growth and march toward profitability today with shares up nearly 20%. Given the revenue slowdown and efforts to cut essential investments, however, it looks as if the company is engaging in defensive tactics to achieve profitability, perhaps leaving bottom-line-minded investors with better places to put their money.

Mike Trigg hopes Crouching Tiger Hidden Dragon wins best picture at the Oscars. His holdings can be viewed in his personal profile. The Motley Fool is investors writing for investors.

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