Red Hat's Off!

 | Mar 28, 2013 | 9:00 AM EDT
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After the close Wednesday, Red Hat (RHT) reported fiscal fourth-quarter revenue of $348 million, up 17%, and full-year sales of $1.33 billion. But, while those results were in line with investor expectations, the guidance for fiscal 2014 was disappointing. Investors didn't like the forward outlook for revenue, nor for software billings -- that is, invoices sent to customers -- and the stock sold off in the after-hours session.

On the conference call management told investors to expect first-quarter revenue of between $358 million to $361 million, and earnings per share of $0.30 to $0.31. For all of fiscal 2014, Red Hat predicted a top line of $1.51 billion to $1.54 billion and EPS of $1.31 to $1.35, below the consensus estimates of $1.55 billion and $1.38 per share, respectively.

While management blamed weakness in Europe and uncertain government spending, analysts focused on what Red Hat calls "unbilled backlog," which Red Hat defines as the difference between bookings and billings. This number is growing faster than billings, and it is not recorded on the balance sheet, since it doesn't represent a liability or revenue. I like to think of it as a promise from customers that maybe someday they'll buy some software.

While it may seem like quibbling over terms, growth investors watch the ratio of bookings to billings quite carefully. Investors are also obsessed with deferred revenue, or sales that will be earned within the next 12 months and have been billed. Since it's a liability, deferred revenue is listed on the balance sheet. Investors want to see deferred revenue growth, since it represents money in the bank.

Savvy customers with big orders try to hold out until a few days before the end of the quarter in order to extract better terms. It all amounts to a big game of chicken: Who will blink first? Over the last few years, Red Hat has seen the number of large orders -- i.e. those totaling more than $5 million -- increase dramatically as it has focused on selling products into Fortune 500 companies. Customers with a $5 million purchase order will hold on to that check pretty tightly.

So, by watching the growth rate of these numbers, you can figure out how willing the company is to give up gross margin in order to close deals. Software is always tricky, because customers can often delay implementation by a quarter or two in order to get better pricing.

In Red Hat's defense, the first quarter has always been very difficult for this company. It has botched the first quarter in fiscal years 2011, 2012 and 2013 -- so it isn't surprising that this first quarter, for fiscal 2014, is messy as well. Considering that some 14% of revenue comes from the financial sector and 13% comes from governments, it's remarkable the quarters aren't lumpier.

I would be interested in Red Hat shares closer to $40 than $50, which is around where they closed Wednesday's session. The company has a 12-month trailing gross margin of 85%, which I believe is too high to generate more than mid-teens sales growth. If the company were willing to lower its gross margin down to 80%, I think it could kick the top line into high gear, which would drive the stock higher much faster. For now, Red Hat is a wait-and-see.

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