Microsoft (MSFT.O) and Apple (AAPL.O) have been hogging the limelight when it comes to operating systems, leaving Red Hat Inc. (RHT.N), the largest distributor of the Linux operating system, to fly under the radar. Red Hat differs from its heavyweight rivals in that its business isn’t about developing and selling a proprietary software system based on closely guarded code, but rather on providing middleware services and other applications based on Linux’s “open source” software. This OS code is available to anyone, meaning that developers can change and customize applications to meet their specific software needs, a stark contrast to Microsoft and Apple. Red Hat’s client list includes many Fortune 500 companies who run their servers on Linux systems; the company also is making headway in the “cloud” computing space as well, forming partnerships with leaders in this arena such as Amazon (AMZN.O) and IBM (IBM.N). The cloud is proving to be a growing source of revenues for Red Hat, whose annual revenues topped $1 billion for the first time in its last fiscal year (ended February, 2012.) Not only is Red Hat a player in one of the hottest parts of the technology world, it also appears to be generating earnings that are remarkably sustainable over the coming year, based on the company’s score of 91 on StarMine’s proprietary Earnings Quality Model.
To generate these Earnings Quality (EQ) scores, StarMine uses computer-driven models to analyze the financial statements of thousands of publicly traded companies and to calculate a ranking for each of them. These scores have proven to be reliable predictors of the degree to which a company generates earnings that are sustainable over the coming quarters, with those companies recording the highest StarMine EQ scores being the most likely to be able to sustain their past earnings track record. (For a more detailed explanation of this model, please refer to this recent article about the earnings quality of American Express.) This examination of Red Hat earnings is the second in a series of articles looking at the earnings quality of companies across North America that rank either especially low or high with respect to their earnings quality.
The chart below shows Red Hat’s net income and free cash flow (FCF) on a quarterly basis over the last five years, with the green portions of each bar telling us the extent to which FCF exceeds the company’s net income. The gains in the company’s net income over this five-year timespan are encouraging, but even better news is provided by Red Hat’s strong FCF, which consistently exceeds net income. Moreover, the company’s FCF hit a record $113 million in the quarter ended February 2012. Whenever a company’s earnings are backed by strong cash flows, as is clearly the case with Red Hat, those profits tend to be more sustainable.
Source: Thomson ONE / StarMine
Red Hat’s margins also have been improving steadily since early 2009. In the latest period for which results are available – the fourth quarter, ended February 2012 – the company reported operating profit margins of 17.6% for the trailing four quarters; that is represented by the blue line in the chart below. Those margins now stand at their highest level in five year and far above the industry median (represented by the gold line in the chart below) of only 12.9%. , Operating margins are one measure of a company’s operating efficiency, and any increase, especially when combined with higher revenues, is a positive sign for future earnings. In Red Hat’s case, those revenues have been increasing for an astonishing 40 quarters in a row, and have risen at a rate of more than 20% in each of the last six quarters.
Source: Thomson ONE / StarMine
During Red Hat’s annual earnings conference call at the end of March, Jim Whitehurst, the company’s president and CEO, told listeners that 99% of its clients renewed their contracts during its fiscal year. That kind of retention rate may well be the envy of the industry, and provides insight into the value those customers place on Red Hat’s products and services. That’s particularly intriguing in light of Red Hat’s history. When it first went public in the heady days of the first Internet boom, the company’s share priced more than tripled on its first day of trading, hitting $52 a share after being priced at $14. (It would eventually trade north of $270 a share, before falling alongside others as the dot.com bubble popped.) Even then, however, questions swirled around the company’s business model. Was it a software developer, like Microsoft, or a services and consulting company? How well could it fare when it doesn’t control the basic code on which its products are based? Over time, Red Hat has put those doubts to rest; today the company is winning larger contracts worth more than $1 million apiece and its management team has suggested that analysts may have underestimated how much it can earn during its current fiscal year, ending February 2013. The company’s solid earnings and revenue performance, its bullish outlook and its strong StarMine EQ score combine to signal that Red Hat is a company likely to continue to deliver strong earnings in the coming quarters.
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