Let there be no doubt that Red Hat (NASDAQ:RHAT) the company has become a monster success story. We'll get to Red Hat the investment in a bit, but all the folks who doubted that an essentially free product could be repackaged with services and sold at a premium must feel a bit silly now. I never publicly said so, but you can count me among one of the former doubters. I always thought Linux the product would do well, but I had my doubts about Red Hat making much on it.

The sales numbers validate that the story is a success. By using partnerships with server vendors such as IBM (NYSE:IBM), Dell (NASDAQ:DELL), and HP (NYSE:HPQ) and a subscription model that provides for regular updates and support has allowed Red Hat to turn the corner. Total revenue was up 56% for the quarter and 58% for the year; likewise profits were up 200% for the year. It's pretty breathtaking, as long as you ignore the dilution.

I believe management is correct that the company will grow like gangbusters and that there is room for plenty of growth internationally. But whether or not Red Hat is a market-beating investment is a mixed bag at today's prices, because it depends on growth robust enough to outstrip dilution by a material amount. In the company's fact-laden press release, you'll find that Red Hat had cash flow from operations -- not free cash flow mind you, which was $86.2 million -- of $122.2 million for the year, but spent $54.8 million during the last quarter to stem dilution and just less than $100 million on the year.

Taking the time to back out all of the money that was spent to buy stock and mask the dilution of stock options, you'll find that Red Hat didn't generate any free cash flow for shareholders this year. In fact, due to the dilution-masking, the company was free cash flow negative. This free cash flow calculation I've used is not as you'll find it normally explained because I'm pulling the share repurchases number from the financing activities section of the cash flow statement. You can make an argument that the share buybacks should not be counted toward free cash flow, but my take is that this is compensation expense, and because compensation expense is an operating expense, I'm just putting it back in where it belongs.

While management referenced a flat share count of 210 million shares as its target for fiscal year 2006, it remains to be seen how expensive it will be for Red Hat to meet that number. It will be interesting to see the most up-to-date numbers on possible dilution in the company's proxy statement and 10-K when they're filed with the SEC, which should be in the not too distant future.

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Fool contributor Nathan Parmelee has no financial interest in any of the companies mentioned.

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