There was plenty to like about Red Hat's (NYSE:RHT) recently completed fiscal 2017 first quarter: revenue climbed double digits yet again, earnings per share (EPS) soared, and big-ticket sales reached a record high. Those types of results would generally translate to a boost in stock price. Unfortunately for Red Hat shareholders, it was not to be.
Not only did Red Hat's stellar start to its fiscal year fail to impress, but its stock price is still down 10%, just as it was shortly after announcing Q1 results June 22. The culprit cited for the downturn was Red Hat's guidance, which fell a bit short of vaunted analyst expectations; this was due in part to its recent acquisition of 3Scale, a "leading provider of application programming interface (API) management technology," for an undisclosed sum.
While Red Hat's short-term stock decline hasn't done much for existing shareholders, it offers a world of opportunity for value investors with some patience.
Just the facts
CEO Jim Whitehurst said much of Red Hat's 18% jump in revenue in Q1 to $568 million was attributable to customers adopting its suite of "digital transformation and cloud computing" solutions, including a whopping 39% year-over-year leap to $98 million in app development and other emerging market sales. The rapid growth of Red Hat's cutting-edge product offerings more than made up for its subscription revenue of $403 million, an improvement of "just" 14%.
Granted, a healthy piece of Red Hat's 27% jump in EPS last quarter to $0.33 was the result of an accounting change that added $0.04 a share, but 12% bottom-line growth less the reporting change is still nothing to sneeze at. Both sales and earnings were in line with expectations, but non-GAAP (excluding one-time items) EPS expectations of $2.19 to $2.23 for fiscal 2017 were below the $2.24 forecast by analysts.
The thing is, even the low end of Red Hat's EPS guidance for fiscal 2017 would be a 15% year-over-year gain. As for revenue, Red Hat expects to generate about $2.4 billion this year: a 17% improvement. Those kinds of "worst-case scenario" results certainly don't warrant a 10% share-price nosedive, and therein lies the opportunity.
Where to from here?
The sheer magnitudes of the cloud and global digitization markets -- in part because of the Internet of Things (IoT) -- are ideal for open-source solution providers. Developing an end-to-end, cloud-based IoT software and infrastructure solution in-house would be a massive undertaking. This is why even usually close-to-the-vest Microsoft (NASDAQ:MSFT) opened its .NET doors to the masses, made its SQL Server Linux-friendly, and gave Red Hat Enterprise Linux a home in its Microsoft Azure cloud platform.
And Microsoft is hardly alone. IBM (NYSE:IBM) has quickly become a key player in the cloud and IoT markets, but it's not trying to conquer these fast-growing opportunities without the help of the world's developer community. Recently, IBM also open-sourced a laundry list of its solutions, including its Apache Hadoop, business software, and big-data platforms, among a host of others.
As Red Hat is quick to point out, it's "the world's leading provider of open source solutions." Combined with Whitehurst's strategic focus on growing Red Hat's cloud and digitization results -- again, a key driver of last quarter's impressive revenue gain -- there's no reason to think it won't continue to garner more than its fair share of what some expect to be trillion-dollar-plus markets.
Which brings us back to Red Hat's current, downtrodden share price. Even the analysts that bemoaned Red Hat's "weak" guidance have an average price target of $87.97 a share -- 23% higher than its current price. And don't be surprised if this price target proves conservative over time.
Red Hat's ongoing, double-digit revenue growth, success in the fast-growing cloud and IoT markets, and the decision to boost its share buyback initiative to $1 billion are all compelling reasons for value investors to get onboard.