Doff your chapeau for leading Linux vendor Red Hat
That would make perfect sense in a lot of cases, because great sales with middling earnings typically points to bad things happening to the margins. But if that's how you think about Red Hat, you're barking up the wrong tree.
In an exclusive interview after the first-quarter report, I asked CEO Jim Whitehurst what metrics he uses to manage his business. He said that he's making some concessions to keep analysts happy:
"I measure it by revenue growth, but you know, we have sort of reached a negotiated settlement with Wall Street. In general, analysts like to see margin improvement so we've committed to 100 basis points of operating margin improvement a year, and then we invest the rest in the business. So that's exactly what we do. I'm very focused on continuing to grow the business, which we've demonstrated we can do well."
And that was exactly what he did again this quarter; the non-GAAP operating margin expanded from 23.7% a year ago to 24.6% this time around, which is a 90-point boost. Let me remind you that this is exactly how Reed Hastings manages Netflix
What makes Red Hat so different?
Some investors are overlooking Red Hat because of that unusual but attractive level of control over its bottom-line destiny. Others are missing the company's strengths because it's a very different business than most of its peers and rivals.
"We are often bundled with companies like salesforce.com
VMware is expanding the virtual computing market, and salesforce controls a large part of the cloud-based business management industry. But Red Hat's core market is the very mature server platform industry, which isn't growing much these days. "Unlike companies that lead or create categories, we fundamentally enter existing categories and take share," Whitehurst said. "Frankly, for us is a lot less important whether the software market is $21 billion or $21.5 billion a year, but much more important how much share we take."
In other words, it's immaterial to Red Hat whether Microsoft
Out of left field
Red Hat already looks like a different breed of duck, based on its financial goals and audacious business model, but there's still more. Here's the part that paints the company as a platypus in a flock of mere mallards:
"We literally don't have any assets. I mean, we don't even have any intellectual property -- we give it all away! So our passion and broader commitment to open source is critical to getting the most out of our people."
Almost everything Red Hat sells can be had for free, because it's all open-source software. The company creates value for its customers by putting together and testing the heck out of its software packages, and then by providing world-class support for it all. How many software companies can you name that follow this path?
The birth of a deep discount
All of these complications make it difficult for classically trained investors to make heads or tails of Red Hat. The company could generate much bigger profits if it wanted to, but prefers to reinvest in business growth instead -- just like Netflix. This is how mismatches between market value and true business value are born, which is why I'm happy to let my winning "outperform" call on Red Hat ride in CAPS. You can join me in just a couple of clicks.
Fool contributor Anders Bylund owns a few Netflix shares, but holds no other position in any of the companies discussed here. Microsoft is a Motley Fool Inside Value pick. Salesforce.com and VMware are Motley Fool Rule Breakers recommendations. Netflix is a Motley Fool Stock Advisor choice. Motley Fool Options has recommended a diagonal call position on Microsoft. The Fool owns shares of IBM and Microsoft. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. You can check out Anders' holdings and a concise bio if you like, and The Motley Fool is investors writing for investors.
More from The Motley Fool
3 Disruptive Stocks That Justify Their High Valuations
For long-term holders, it pays to pay up for disruptive potential.
Microsoft Earnings: Will Strong Growth Persist?
Can strong growth in cloud services and Office 365 help revenue rise nicely in Q2?
Netflix Earnings: What to Watch
Can Netflix convince investors it can maintain strong momentum in 2018?