(RHT) Red Hat Beats The Street by a Penny

Red Hat Inc. (RHT) reported third quarter 2012 earnings of 20 cents per share, which beat the Zacks Consensus Estimate by a penny. Earnings per share (EPS) (including stock-based compensation expenses but excluding amortization) increased 37.4% from 15 cents reported in the year-earlier quarter. Strong bottom-line growth was primarily driven by higher revenues and gross margin.

Revenue

Total revenue increased 23.1% year over year to $290.0 million. This was in line with the high end of management’s guided range of $288.0 to $290.0 million but was slightly above the Zacks Consensus Estimate of $289.0 million.

Subscription revenue increased 24.0% year over year to $246.5 million. Training and services revenue was up 18.4% year over year to $43.5 million. The strong year-over-year growth in revenue was driven by higher demand for cloud computing technologies, as customers are increasingly upgrading their data centers to facilitate the adoption of cloud computing.

Billings increased 23.0% year over year to $322.0 million in the quarter. Bookings increased significantly in the quarter, with the channel comprising 64.0% and direct sales 36.0%. Geographically, 60.0% of the bookings came from the Americas, 24.0% from Europe, Middle East and Africa (EMEA) and 16.0% from Asia-Pacific. The company witnessed solid double-digit growth across all the regions during the reported quarter.

In the reported quarter, Red Hat secured 27 deals worth over $1 million, including five deals in excess of $5 million. Of the top 30 deals, approximately 40% were related to middleware component, with 4 being standalone middleware deals.

Operating Performance

Gross profit on a non-GAAP basis (including share-based compensation but excluding amortization of intangible assets) was $245.5 million, up 24.8% year over year from $196.7 million in the prior-year quarter.

Gross margin expanded 110 basis points (bps) to 84.6% in the quarter. This was primarily driven by a 720-bps increase in services gross margin, which fully compensated for a slight decline in subscriptions gross margin. Higher services margin was attributable to better performance and better utilization rates in both consulting and training.

Including share-based compensation but excluding amortization of intangible assets, non-GAAP operating expenses jumped 21.7% year over year to $187.5 million, primarily attributable to higher sales & marketing (up 27.1% year over year), research & development (up 25.2% year over year) and general & administrative (up 0.8% year over year) expenses. However, operating expenses, as a percentage of the total revenue, decreased 80 bps to 64.6% in the quarter.

Operating income on a non-GAAP basis (including share-based compensation but excluding amortization of intangible assets) was $58.0 million, up 36.0% from $42.7 million reported in the prior-year quarter. Operating margin was 20.0% compared with 18.1% in the year-earlier quarter.

Net income on a non-GAAP basis (including stock-based compensation expenses and amortization) was $39.3 million compared with $28.7 million in the prior-year quarter. Net income margin shot up 140 bps in the quarter.

Balance Sheet

At the end of the third quarter of 2012, cash and investments (including long term) were $1.22 billion versus $1.30 billion at the end of the second quarter of 2012. Operating cash flow declined roughly $19.5 million sequentially to $96.6 million. Total deferred revenue at the end of the reported quarter was $819.6 million, up 20.0% year over year.

Acquisition

In October this year, Red Hat announced the acquisition of Gluster Inc., a leading provider of scale-out, open source storage solutions for standardizing the management of unstructured data, for approximately $136.0 million in cash.

The acquisition is expected to have no material impact on Red Hat’s revenue this fiscal year but should begin to be accretive next year due to higher subscriptions. However, non-GAAP operating margin for fiscal 2013 is expected be approximately 150 bps lower than fiscal 2012 due to additional investments related to Gluster.

Guidance

For the fourth quarter of 2012, Red Hat expects revenues in the range of $289.0 million to $292.0 million, while non-GAAP EPS is projected in the range of 26 cents to 27 cents. The Zacks Consensus Estimate for the fourth quarter of 2012 is pegged at 19 cents, below the guided range. Operating margin is expected to be around 25.5% and tax rate 31.0%.

Red Hat raised its fiscal 2012 non-GAAP EPS (excluding stock-based compensation) guidance to the range of $1.07 to $1.08 (prior guidance: $1.03 to $1.05). The Zacks Consensus Estimate for fiscal 2012 is pegged at 78 cents. Management expects non-GAAP operating income to exceed 26.0% for fiscal 2012.

For fiscal 2012, Red Hat raised its operating cash flow guidance to $370.0 million – $375.0 million from a previous guidance of $350.0 million – $360.0 million.

Recommendation

We believe Red Hat is emerging as a significant cloud computing story over the long term. Red Hat boasts an impressive product line up and expects to invest heavily for developing innovative products. During the reported quarter, Red Hat launched a public beta version its next-generation virtualization management product RHEV 3. Red Hat also launched the latest version of its flagship operating system RHEL 6.2 during the quarter. We expect the new products to drive significant growth going forward.

Moreover, significant partnerships with large public cloud customers such as Amazon Web Services, International Business Machines Corp. (IBM) and NTT are expected to boost its top-line growth going forward. We believe that these partnerships will help Red Hat counter stiff competition from Microsoft Corp. (MSFT), VMware Inc. (VMW) and Oracle Corp. (ORCL).

However, we believe that increasing investment may hurt profitability over the long term. Moreover, sluggish IT spending and significant foreign exchange volatility will keep the stock range bound going forward.

We maintain our Neutral recommendation over the long term (6-12 months). Currently, Red Hat has a Zacks #2 Rank, which implies a Buy rating in the short term.

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