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Red Hat Looks Poised for Further Gains After a Solid First Quarter

By Mukesh Baghel - Jun 25, 2014 at 10:00AM

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Red Hat did well in a quarter affected by seasonality, and it could get even better.

 Although Linux provider Red Hat ( RHT ) got off to a slow start this year, things are about to get better for the company. Red Hat recently posted strong first-quarter results, beating consensus estimates in a seasonally slow quarter, and saw positive deal activity. The company has its groove back and is reporting solid growth despite competition from Oracle ( ORCL 1.31% ) and Microsoft ( MSFT 2.68% ).

Off to a positive start
Red Hat's revenue for the quarter increased 17%, year over year, to $424 million, while non-GAAP operating income rose 2% to $88 million on a year-over-year basis. The company's performance shows that it is getting traction in its core Linux business. In fact, its first-quarter results have provided a fitting reply to critics who felt that Red Hat's Linux business was slowing down due to market saturation. To sustain its momentum, Red Hat entered into an agreement to acquire eNovance, which offers services for running the open-source OpenStack software platform for machine virtualization.

Red Hat is seeing strong demand for its Linux, middleware, and cloud offerings. The company landed some record-breaking deals during the quarter, inking four deals that were more than $5 million each and one worth more than $10 million. It also observed strong renewal rates. Red Hat was able to renew all 25 deals that were up for renewal at the end of the last quarter, setting the stage for a solid performance going forward.

Focus on innovation and acquisitions
Red Hat launched its latest version of the operating system Red Hat Enterprise Linux 7, or RHEL7.0. This has new features such as enhanced application development, delivery, portability, and isolation through Linux containers across all types of production. In addition, RHEL7 has enhanced security features and improvements in its file system, management, and performance. Red Hat has also partnered with SAP, which will enable it to have greater access to SAP's portfolio of solutions. 

To bolster its position in the industry, Red Hat acquired InkTank, which is the driving force behind the open-source project Ceph. This new software, combined with Red Hat's storage address, might lead to strong growth going forward.

As mentioned earlier, Red Hat has also announced its intention to acquire eNovance, which provides cloud infrastructure services for enterprises and service providers like Red Hat and InkTank The privately held eNovance is at the forefront of the OpenStack community. It is one of the top 10 contributors to the upstream OpenStack project, and is the only European Gold Member company on the OpenStack Foundation.

The company has approximately 150 global customers, including Alcatel-Lucent, Cisco, Cloudwatt, and Ericsson. So, this acquisition will help Red Hat reach more customers with world-class OpenStack technologies and implementation services. 

The company is optimistic about the performance of its two new acquisitions. Management believes that together, they will add around $2 million of subscription revenue and $8 million of services revenue in the current fiscal year. 

The competitive climate
Red Hat's strategy looks sound as the company is focusing on a mix of acquisitions and innovation to drive growth. This is important, especially because Red Hat faces stiff competition from Oracle and Microsoft in the virtualization space.

Oracle releases clones of Red Hat's Linux software. For example, last year, after the release of RHEL 6.5, Oracle cloned the source code and introduced its own Oracle Linux 6.5. Oracle added a slate of new and unique features of its own during the cloning process. In fact, Oracle Linux 6.5 includes production support for Linux Containers, along with improvements to InfiniBand support. The Oracle clone can also be run as a Hyper-V guest on Windows Server 2008 and 2008 R2. 

Microsoft is a bigger player than Red Hat in the virtualized server market. Microsoft's virtualization platform commanded 13.2% of the server market in 2013 as compared to Red Hat's 11.3%. Microsoft has continually improved the experience that it delivers with Hyper-V, its virtualization platform, by adding more features.

In addition, Microsoft has the advantage of using its existing Windows client relationships to make a mark in the virtualization market. Moreover, because Hyper-V is cheaper than market leader VMware's vSphere Enterprise Edition, it might see solid adoption going forward. 

The bottom line
Red Hat has done well in a difficult competitive environment. The company should be able to do well on the back of its new products and new acquisitions. Analysts expect the same, as Red Hat's earnings are expected to grow at a compound rate of 15% for the next five years, indicating that it is a good buy.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis – even one of our own – helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.

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