Red Hat's Q2 Profit Drop Disappoints Wall Street

Published: October 3, 2006

by Timothy Prickett Morgan

Last week, after The Linux Beacon went to press, commercial Linux distributor Red Hat announced its financial results for its fiscal second quarter ended August 31. With revenue growth of 52 percent, its sixth consecutive quarter of adding at least 10,000 new customers, and its 18th consecutive quarter of revenue growth, you would think that Wall Street would be happy. But radically increased expenses, due to the development of Enterprise Linux 5 and the integration of JBoss, knocked down net income by 34 percent.

While Red Hat has been bringing an absurd amount of money to its bottom line in recent quarters, as far as investors and brokerage houses are concerned, bringing 12 percent of revenue to the bottom line is not good enough. Particularly in contrast to the prior fiscal Q1, when Red Hat had sales of $84 million in the fiscal first quarter ended May 31, and brought $14.7 million, or 18 percent of revenue, to the bottom line. And neither of these quarters compares well, in terms of profits, to the fiscal second quarter, when Red Hat brought $18.1 million to the bottom line against sales of $65.7 million, or about 28 percent of sales. The JBoss acquisition and the disruption in sales, due to training of the Red Hat sales force to peddle JBoss products, as well as the ongoing development of RHEL 5 have had a big impact on the bottom line. Red Hat obviously believes--and correctly so--that such investments are key to its future in the software business, but Wall Street doesn't always like to think long term. Long term for a trader is a few hours, and for an analyst, maybe 13 weeks at best.

Red Hat's subscription revenue during the second fiscal quarter of 2006 was $84.9 million, up 56 percent, while training and services sales came to $14.7 million, up 29 percent. Total sales in the quarter came to $99.7 million, up 52 percent. JBoss middleware sales accounted for $7 million in the quarter. Charlie Peters, Red Hat's chief financial officer, reminded everyone on the conference call with Wall Street analysts that the company had been expecting the second quarter to be its weakest in terms of cash flow and profits, and said further that sales were above the $96 million to $98 million guidance for the quarter when it reported its Q1 results.

Peters also said that 54 percent of its revenues in the quarter came from its reseller channel, with 46 percent coming from direct sales, which was a pretty significant shift compared to the 61 percent channel sales and 39 percent direct sales that Red Hat had in the year-ago quarter. Peters said the bulk of that shift was due to the fact that JBoss sold mostly through its own sales force, and that as Red Hat channel partners became certified to push JBoss standalone and integrated RHEL-JBoss products like the Application Stack announced two weeks ago, the shift would return to channel sales. Incidentally, Peters said that fewer than 20 percent of the company's sales typically come from the big server makers, who peddle RHEL on an OEM basis. Other reseller and channel partners account for the remainder of the company's Linux sales.

On a geographical basis, about 61 percent of Red Hat's sales came from the Americas region, with 23 percent coming from Europe, the Middle East, and Africa and 16 percent coming from Asia/Pacific. The bulk of JBoss sales were done in the Americas and the formerly independent company did not have a presence in AP and had a weak one in Europe, and now Red Hat is gearing up to push JBoss products into EMEA and AP through its channels as well as direct sales.

Red Hat had gross margins of 84 percent, which is about right for a software company, but sales and marketing, research and development, and general and administrative costs all rose significantly--by 85 percent, 73 percent, and 59 percent, respectively--pushing total expenses up to $73.8 million. That is an increase in expenses of 75 percent against a revenue increase of only 52 percent. Because Red Hat stopped to train its sales people to sell JBoss, it sacrificed a little on both its top and bottom line. So, consequently, net income fell to $12 million, down 34 percent from $18.1 million in the year-ago quarter. (Stock-based compensation was part of the hit.) This worked out to 5 cents a share, compared to 9 cents a share a year ago. Red Hat exited the quarter with just under $838 million in cash and equivalents in the bank and $211.4 million in deferred revenue, which is quite a war chest and a nice cushion.

On the call, Red Hat's chairman and chief executive officer, Matthew Szulik, was asked if he was seeing a slowdown in Linux sales, which some market analysts are projecting. "I believe that the deployment rate has not gone down," Szulik said, referring only to Red Hat's business, but he did add that the level of complexity of the deals and the expectations that customers place on Red Hat have both increased.

Looking ahead, Peters said that Red Hat expected to have sales of between $103.5 million and $105 million in the fiscal third quarter of 2006. Red Hat's stock price dropped quickly from around $26 a share to just above $20 a share in the wake of Red Hat's reporting its financial results, a decline which precipitated a drop of about $1 billion in market capitalization. Red Hat's market cap as we go to press is just over $4 billion.

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