Thursday, October 26, 2006

Calls of Note Part 1

- Lots of comments on Red Hat (NASDAQ:RHAT) today after Oracle announced its intentions to enter the enterprise Linux paid support market, specifically providing support for code based on Red Hat Enterprise Linux. As part of Oracle's announcement, it suggested that it would be offering support for Red Hat Enterprise Linux customers at a discounted price ranging from 50% to 60% off Red Hat's published list pricing for RHEL ES and AS.

- JMP Securities is reducing their rating on Red Hat from Market Outperform to Market Perform. While they believe Red Hat remains well positioned to benefit from the proliferation of open source software, the depth of Oracle's announcement regarding its entry into the Linux support market is likely to create an overhang on Red Hat's shares. In particular, Oracle's suggesting that it has developed a technical network capable of supporting and migrating Red Hat customers. Its endorsement from a number of channel partners and its aggressive pricing are likely to make selling conditions quite difficult for Red Hat over the near term. Absent hard evidence suggesting that Oracle's efforts are proving less than successful, the firm believes Red Hat's shares may remain under pressure. The firm is lowering their FY07 operating cash flow estimate from $0.91 per share to $0.85 per share and FY08 operating cash flow estimate from $1.15 per share to $1.02 per share. They are reducing FY07 EPS estimate from $0.52 to $0.50, in line with consensus, and FY08 EPS estimate of $0.70 to $0.61, $0.05 below consensus. Using the aftermarket price of $16.33, Red Hat trades at a FY08 P/FCF estimate of 18x.

- Deutsche Banks thinks the likely impact on pricing and Oracle's position within the IT data center could significantly cap Red Hat's fundamental growth and valuation multiple. Firm maintains Hold rating while lowering estimates and target price to $15.

Oracle has an expansive support organization to create a competitive offering. In addition, it is clear from the press releases that a number of major customers and partners (Southern Co, McKesson, Dell, Intel, IBM) appear to be endorsing Oracle's Linux offering. Even if Oracle does not have immediate success with its offering, they believe the 50% price discount to Red Hat will likely enable Red Hat customers to be aggressive in gaining pricing concessions vs. Red Hat.

Firm likens the situation to Microsoft's competitive threat to Symantec and McAfee in 2005. While it is still unclear what Microsoft's impact will be on SYMC and MFE's business,
SYMC/MFE EV/FCF multiples compressed roughly 56% from a peak of 20x/19x in Dec '04 to 10x/8x in April '05. The impact on RHAT is unclear, but they believe further multiple compression is possible. At $16.33 (after-market indication) RHAT is trading at 15x reduced forecasts. This still represents a premium to the group.

Notablecalls: I would not play RHAT for a bounce today. Think there will be more downgrades
over the next couple of days that will force the price even lower. But I do think that RHAT will become a nice bounce candidate after that as ORCL's entry will take some time and will not have an immediate effect on RHAT's results. Also, check out how MFE performed in 2005.

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