Shares of Red Hat (NYSE:RHT) tumbled during after-hours trading on June 21, after the enterprise software company followed up its first-quarter earnings beat with tepid guidance. Its revenue rose 20% annually to $813.5 million, beating expectations by about $6 million. Its non-GAAP net income climbed 28% to $133 million, or $0.72 per share, clearing estimates by $0.03.
But for the current quarter, Red Hat expects just 14% to 15% sales growth, compared to the consensus estimate of 18% growth. Its forecast for 5% non-GAAP EPS growth also missed expectations for 16% growth. Red Hat's full-year revenue forecast for 16% to 18% missed the consensus estimate of 19%, but its earnings guidance for 15% to 17% growth exceeded expectations.
Despite the recent pullback, Red Hat's stock remains up nearly 20% for the year, and it still isn't cheap, at over 40 times this year's earnings. So, is it time to sell Red Hat, or does this dip represent a long-term buying opportunity?
What does Red Hat do?
Red Hat provides open-source software products -- including Red Hat Enterprise Linux, the Red Hat Virtualization (RHV) platform, and JBoss middleware -- to enterprise customers. Most of Red Hat's software products are free, but it sells subscriptions for support, training, and integration services for those products.
Red Hat's subscription revenue grew 19% annually to $712 million last quarter and accounted for 87% of its top line. Within that total, its subscription revenues from infrastructure-related services rose 14% to $522 million, while revenues from application-development and emerging technology services rose 37% to $189 million.
Red Hat benefits from the rise of hybrid cloud deployments, in which large enterprises move part of their data to the public cloud while retaining some data in on-premise servers. It holds partnerships with Microsoft (NASDAQ:MSFT) and IBM (NYSE:IBM) in that market.
Red Hat integrates its OpenShift platform with Microsoft's Azure, the second largest cloud infrastructure platform in the world. That integration makes it easier for enterprise developers to shift between Azure, a public cloud platform, and on-premise environments. It also integrates OpenShift into IBM's software and cloud services, which helps Big Blue modernize its portfolio with Linux "containers" -- which isolate applications from the rest of the system.
During the quarter, Red Hat reported a 48% year-over-year increase in deals worth over $1 million -- and 70% of those deals included one or more components from its higher-growth application-development and emerging technologies unit. Mid-market deals worth over $250,000 rose 138% annually. Red Hat also added over 100 new customers to its Linux container platform OpenShift, as its subscribers for Ansible, which automates software tasks, jumped about 70% to over 1,000.
Understanding the tailwinds and headwinds
Red Hat's core business is well-poised for growth as the hybrid cloud market expands. The company's unique business model and partnerships with enterprise giants like Microsoft and IBM give it plenty of room to upsell and cross-sell other services.
Last quarter, 25 of Red Hat's largest deals that were up for renewal renewed in aggregate at over 120% of their previous values. 70% of its cross-selling deals also cleared $1 million.
Yet two main headwinds could throttle Red Hat's near-term growth. First, Red Hat expects a strengthening dollar to reduce its full-year reported revenues by $50 million. Second, an ongoing shift from physical deployments to container environments is throttling Red Hat's middleware growth. Red Hat partly offsets that softer growth with the stronger growth of its emerging technologies unit, but it's still causing its sales and earnings growth to decelerate.
Should you buy Red Hat on the dip?
Red Hat is a compelling long-term play on the hybrid cloud and the modernization of IT systems. Unfortunately, the stock's valuations aren't supported by its growth forecasts. Therefore, investors should wait for the stock to drop to lower levels before starting a position.