Red Hat's Minor Restatement Shakes Up Wall Street

by Timothy Prickett Morgan

Wall Street sure is jumpy about commercial Linux distributor Red Hat these days, and Red Hat isn't helping matters. On July 13, Red Hat announced that it would have to restate its revenues and earnings for the past three years as it shifted the revenue recognition for Linux software subscriptions from a monthly equation to a daily one. Wall Street doesn't like such surprises, and within a month, Red Hat has surprised investors a number of times.

There's nothing wrong with what Red Hat did, and the changes in revenue recognition shave a few million of dollars off its sales in fiscal 2002, 2003, and 2004 (all ended in February of those years) as well as the first quarter of fiscal 2005 ended this May and had almost no material effect on profits. A few quarters that were barely profitable were pushed into the red by the change, but these were quarters in 2002. (You can look at the numbers for yourself at the U.S. Securities and Exchange Commission's site.) Red Hat's CEO, Michael Szulik, correctly called the net effect of the accounting change, but he seemed to miss the larger point that people are nervous about what is going on inside Red Hat these days and that, despite the fact that Red Hat made the accounting change based on advice from its auditor, PricewaterhouseCoopers, the timing of the announcement and the fact that is was not recognizing revenue in the proscribed manner already cause eyebrows to go up.

"The restatement is not expected to reflect any material difference in the meaningful historical trends of our business, nor will it adversely affect our business outlook, which remains strong," said Szulik. Well, that may be true of the numbers in and of themselves, but the SEC is apparently looking at statements Red Hat made in its annual report and is launching an informal inquiry. Couple the restatement--which should have been announced in mid-June when Red Hat announced the fiscal first quarter results--with the fact that chief financial officer Kevin Thompson is leaving the company and with what seems to be a minor SEC inquiry, and Wall Street starts thinking something is wrong. Even if something isn't. And now, Red Hat is going to be punished by the inevitable shareholder lawsuits that follow a rapid decline in stock price as the company underwent last week.

Class action lawyers are attracted to rapid stock declines like sharks are to blood in the water. In early June, Red Hat's shares were kissing $30 a share, and after all of these surprises, the stock has been hammered below $15 a share. To say that there are a lot of angry Red Hat investors right now is probably an understatement, and the only thing that is not surprising is that a bunch of them have banded together to launch class action lawsuits against Red Hat. There are reports that Red Hat had at least seven such cases filed against it right now. They may all be combined into a single class at some point, which might simplify the situation for Red Hat a bit, but the company has better things to do than spend its time in court.