Red Hat's Sales and Revenues Up Smartly in Fiscal Q2

by Timothy Prickett Morgan

Last week, investors in commercial Linux distributor Red Hat were slap-happy after the company announced its financial results for the fiscal 2006 second quarter ended August 31 and brokerage firm SunTrust Robinson Humphrey moved up Red Hat's ratings to a buy from neutral last Thursday, setting a price target of $22 a share. Red Hat's stock almost immediately jumped to that level, rising to just under $5 a share, an increase of about 30 percent from the Wednesday close.

While Red Hat's stock saw some profit taking in the past few days, and is trading at just under $21 a share, giving Red Hat a market capitalization of $3.745 billion--notably larger than the current $2.845 billion market capitalization of rival operating system supplier Novell, which saw its shares rise by 7 percent last week--and my guess is on Red Hat's news and its plans to buy back $200 million in its own shares (which we reported on last week).

Red Hat's enterprise Linux customers only care about how the company's stock is doing in as much as the stock price and performance over time affects what strategies Red Hat's executives back, since they are motivated by compensation plans to put forth strategies that will, over the long haul, drive up Red Hat's stock price. That is the nature of public companies, after all.

So why was Wall Street and the investment community so excited? Well, Red Hat is making money. Plain and simple, which one of the things (but surely not the most important thing) that we like to hear about Linux hardware, software, and services suppliers. If Linux businesses don't make money, enterprises won't trust investing in these companies. The company bottom line is, for better or worse, the ultimate measure of success or failure of a product.

Red Hat is definitely succeeding, if its most recent quarter is any measure, but is still, in my opinion, far short of the initial expectations for the commercialization of Linux that Red Hat set when it went public in the summer of 1999. In the fiscal second quarter, Red Hat posted overall sales of $65.72 million, up 42 percent compared to the same quarter last year and up 8 percent from the fiscal second quarter. Subscription revenues for the quarter came to $53.76 million, up 58 percent, with embedded product sales of $569,000, up 34.5 percent. On the services front, Red Hat booked $19.68 million in services revenues relating to its enterprise products, which was just a smidgen more than this time last year, and services on its embedded products declined by 22 percent to $707,000. (Red Hat bundles its retail Linux product sales in with its enterprise products, but as it boosts its desktop Linux offering, it may eventually break it out.) Red Hat spent $20.2 million on sales and marketing expenses and $10.45 million on research and development (about 15.9 percent of revenue and about the same level that Microsoft spends as a percentage of its sales); it generated $45.8 million in cash flow from operations. The company brought $16.73 million to the bottom line, and after taking into account that it bought back $11.6 million in common stock in the quarter, per share earnings came in at 9 cents; the Wall Street consensus was for profits of 7 cents a share.

Because Red Hat sells its software on a subscription basis, it does not recognize revenue from a sale all at once, but over time. Red Hat closed out Q2 with a deferred revenue balance of $184 million, up 85 percent compared to last year and up 17 percent sequentially. During the quarter, billings, which means the sum of revenue plus quarterly change in deferred revenue, were $91.8 million, up 58 percent. Red Hat ended the quarter with $966 million of cash and equivalents.

During a conference call with Wall Street analysts, Matthew Szulik, Red Hat's chairman, president, and chief executive officer, said that Red Hat expected the adoption of Linux in the enterprise, supporting databases, directory servers, file systems, and other functions, would follow an adoption curve that was similar for the adoption of Linux and related open source technologies relating to Web serving. He was quick to point out that we are at the front end of such an adoption curve, but he also reminded everyone that the Linux platform has a 70 percent market share among Web servers installed around the world. He said that the majority of the 25 biggest deals that Red Hat closed in the second quarter were for such data center deployments, running big databases, ERP suites, data warehouses, and other mission-critical applications.

Szulik added that the company brought in 12,000 new customers in the quarter, with a lot of them coming through the OEM channel (mostly through server makers like Hewlett-Packard, Dell, IBM, and a few others). Notably, he said that the unit volume growth at HP for Linux preinstalled on servers was 10 times larger than HP's shipment growth in the past calendar quarter, and at Dell, Red Hat-on-Dell server shipments grew by a factor of 3 compared to Dell's overall server shipments. He added that the international market is becoming increasingly important, with sales outside of the North American market growing at more than 100 percent.

Charlie Peters, Red Hat's chief financial officer, said that Red Hat had more than $100 million in bookings in the quarter--the first time that ever has happened--and that the company had 215,000 Linux licenses sold, up 13 percent sequentially. (Red Hat would not say what its total installed base was.) In the second fiscal quarter, 51 percent of sales came from the Americas region, with 49 percent coming from the rest of the world.

Looking ahead, Peters said Red Hat expected to post sales of $70.5 million to $71.5 million in sales in the fiscal third quarter, and even with slighting increasing expenses, earnings per share would come in at around 9 to 10 cents a share. For the full fiscal 2006 year, Peters said that it had tightened up its guidance for sales, with the expectation of $270 million to $275 million. Red Hat boosted its earnings per share estimates by 3 cents to 31 cents to 35 cents a share for the full year.