(RHT) Red Hat Earnings Beat Expectations – Raises Outlook

A leading provider of open source solutions, Red Hat Inc. (RHT) reported strong first quarter 2012 results, which beat the Zacks Consensus Estimate by two cents.

Earnings per share (EPS) of 18 cents (including stock-based compensation expenses but excluding amortization) increased 28.6% year over year from 14 cents reported in the year-earlier quarter.

The year-over-year earnings growth was driven by strong revenues, which increased 26.6% year over year to $225.5 million in the first quarter.

Operating Performance

Net income on a non-GAAP basis (including stock-based compensation expenses and amortization) was $35.9 million compared with $27.0 million in the prior-year quarter. Net income margin shot up 60 basis points in the quarter. Excluding stock-based compensation and amortization, net income was $47.0 million or 24 cents per share, compared with $35.6 million or 18 cents per share in the year-ago quarter.

Strong bottom-line growth was primarily driven by higher revenues and operating margin, which fully offset a slight decline in gross margin and higher tax rate in the quarter.

Gross profit on a non-GAAP basis (including share-based compensation but excluding amortization of intangible assets) was $223.3 million, up 26.4% year over year from $176.6 million in the prior-year quarter. However, gross margin dipped 10 bps to 83.4% in the quarter. This was primarily attributable to a higher percentage of low-margin services in the sales mix during the quarter.

Operating income on a non-GAAP basis (including share-based compensation but excluding amortization of intangible assets) was $50.3 million, up 29.7% year over year from $38.8 million in the prior-year quarter. Operating margin was 19.0% compared with 18.5% in the year-earlier quarter.

Including share-based compensation but excluding amortization of intangible assets, non-GAAP operating expenses jumped 25.5% year over year to $173.0 million, primarily attributable to higher sales & marketing (up 30.5% year over year), research & development (up 18.8% year over year) and general & administrative (up 18.5% year over year) expenses. However, operating expenses, as a percentage of total revenue, decreased 60 bps to 65.3% in the quarter.

Revenue

Subscription revenue increased 26.0% year over year to $225.5 million. Training and services revenue was $39.2 million, up 30.4% year over year.

The strong year-over-year growth in revenue was driven by higher demand for cloud computing technologies, as customers are increasingly upgrading their datacenters to facilitate the adoption of cloud computing.

Billings increased 28.0% year over year to $266.0 million in the quarter, reflecting strong sales execution and an improved IT spending environment. Bookings increased significantly in the quarter, with the channel comprising 63.0% and direct sales 37.0%, attributable to a number of large government and mainstream customer wins.

In the first quarter, Red Hat renewed all the top 25 deals at over 130% of the prior-year value. Red Hat secured 14 deals worth over $1 million or greater in the quarter, including one deal in excess of $5 million. Cross-selling and up-selling was strong, and all of the top 30 deals in the first quarter were worth more than $500,000 each. Within the top 30, approximately 40% included the middleware component, with 5 being standalone middleware deals.

Balance Sheet

At the end of the first quarter of 2012, cash and investments (including long term) were $1.27 billion versus $1.19 billion at the end of fourth quarter of 2011.

Operating cash flow declined roughly $5.0 million sequentially to $90.2 million. Total deferred revenue at the end of the first quarter was $786.0 million, up 26.0% from the year-ago quarter.

Red Hat repurchased approximately 437,000 shares for $19 million during the first quarter. The company currently has $186 million remaining under its share repurchase authorization.

Guidance

For the second quarter of 2012, Red Hat expects revenues in the range of $270.0 million to $272.0 million, while non-GAAP EPS is projected in the range of 24 cents to 25 cents. The Zacks Consensus Estimate is pegged at 17 cents, below the guided range. Operating margin is expected in the range of 25.4% to 25.6% and the tax rate is 31.0%.

Red Hat raised its fiscal year 2012 revenue guidance in the range of $1.07 to $1.085 (prior guidance $1.05 billion to $1.07 billion). Non-GAAP EPS (excluding stock-based compensation) is expected in the range of 98 cents to $1.00 (prior guidance 94 cents to 96 cents). The Zacks Consensus Estimate is pegged at 71 cents. Management expects non-GAAP operating income of 25.7% for fiscal 2012.

Red Hat continues to expect operating cash flow of between $330.0 million and $340.0 million for the fiscal year.

Our Take

We believe Red Hat is emerging as a significant cloud computing story over the long term. Red Hat introduced a number of products during the first quarter, which includes CloudForms, an Infrastructure-as-a-Service offering and Openshift, a Platform-as-a-Service offering. These new solutions position Red Hat as a premier cloud technologies vendor going forward.

Red Hat boasts of an impressive product line up and expects to invest heavily for developing innovative products.

The company also expanded its relationship with large public cloud customers including Amazon Web Services, International Business Machines Corp. (IBM) and NTT during the first quarter. Red Hat also became a part of the Open Virtualization Alliance (OVA), of which Hewlett-Packard Co. (HPQ), IBM and Intel Corp. (INTC) are the other premier members.

We believe these partnerships will help Red Hat deal with the stiff competition from Microsoft Corp. (MSFT)VMware Inc. (VMW) and Oracle Corp. (ORCL).

However, the declining gross margin remains a concern going forward. Moreover, increasing investment may hurt profitability over the long term.

We maintain our Neutral recommendation over the long term (6-12 months). Currently, Red Hat has a Zacks #3 Rank, which implies a Hold rating in the short-term.

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