Friday, December 22, 2006

Color on news: Red Hat (NYSE:RHT)

Several firms are commenting on Red Hat (NYSE:RHT) after the co reported stronger than expected results last night:

- Merrill Lynch notes 1) Billings of $133.4mn (up 3% q/q, 50% y/y, highest y/y growth in 5 quarters) vs. est of 131.9mn and expectations ($110-115mn). 2) Cash flows ($59.6mn) handily beat ML est ($51.0mn) and expectations ($43-44mn). 3) Deferred revenue up 10% q/q and above expectations of 4%. Contrary to fears that Red Hat offered special discounts on long-term subscriptions, long-term deferred revenue was 27% of total deferred revenue, basically unchanged from two quarters back.

Impact from ORCL/NOVL seems limited. Although Red Hat had five weeks of competition in the quarter, it lost only a few customers. Oracle's Linux push is validating the market and expanding the pie which is driving more business for Red Hat, attested by 12K new customers in 3Q07 (up 20% q/q).

ML is raising their 4Q07 raising pro forma 4Q07 EPS by a penny (from $0.14 to $0.15) due to potential operating margin expansion (from 20.8% to 21.8%) but trimming revenue est to $113mn (from $114.6mn) and cash flows est (from $54.6mn to $44.6mn). Firm's 4Q07 cash flow est of $44.7mn is conservative and leaves potential room for upside. The firm is raising their FY08 pro forma EPS (from $0.65 to $0.69), mainly due to interest income and also trimming FY08 cash flow est (from $250.6mn to $240.5mn).

Tgt goes to $30. Rating maintained at Buy.

- Deutsche Bank notes Red Hat's execution in F3Q was solid as the company delivered upside
across almost every metric, especially considering the potential for distraction given the Oracle and Microsoft/Novell announcements. However, these competitive risks remain longer-term and the firm believes this will limit the multiple expansion potential for the stock.

The introduction of RHEL 5.0 at the start of next year should be a positive driver for the company given the current momentum in server virtualization and RHEL 5.0's integration of Xen virtualization support. The larger issue in firm's opinion though, is what impact Oracle
and Microsoft/Novell will have on Red Hat's pricing negotiations with customers. While it does not appear to be having a large impact yet, they believe it is still early and the potential impact could be significant.

Maintains Hold.

- UBS has the best note on RHT saying the focus, as usual, was on billings and cash flow, with each metric handily exceeding the pessimism of the street. Billings for the quarter came
in at $133m or +19% sequentially which compares to firm's conversations with investors that suggest that any level of growth this quarter would have been considered a positive surprise. Regarding cash flow, $60m was above consensus of $47m, with firm's view that the market was looking for a number more in the $42-$45m range. While many expected cash flow guidance for the current fiscal year to come down, given the level just posted, the company only needs to generate about $42m in its fiscal 4th quarter in order to hit the midpoint of its prior range.

In all, while there was more upside than they expected, last night's results confirm our recent field checks, where conversations with 15+ resellers highlighted that Red Hat's business was not as impacted in the quarter from the Oracle and Novell/Microsoft announcements as many had anticipated. While the firm had thought a good deal of short covering had occurred going into last night's print, the limited activity in the aftermarket (given the stock is now traded on the NYSE) would suggest otherwise. UBS notes that the November data (as of November 15th) indicated that 20m shares (11% of shares outstanding) of Red Hat were sold short, which represents the highest level since July 2005. With liquidity likely to be below average today given we are entering a holiday weekend, they believe the volatility of the stock will likely be exacerbated.

Although firm's checks suggest the near-term impact on Red Hat will be muted at best, and with 75% of resellers suggesting pipelines for Linux server demand in 2007 appear to be tracking above 2006 levels, they believe the key question will be whether or not Red Hat will face pricing pressure 6-9 months down the road. On this point, just over 50% of firm's reseller contacts suggest that Red Hat pricing will need to decline in the 15-20% range over the next 6-18 months.

With the stock looking as if it will gap up to $20 or so at the open today, suggesting a 23x multiple on CY07 CFO, the firm believes the question on pricing needs to be evaluated in more detail before making a commitment to the stock either way.

Firm ups their tgt to $19 from $17.50 but maintains Neutral rating.

Notablecalls: RHT trades around 40x CY07 EPS and has ORCL coming to challenge them on their own turf. I suspect the short interest is the main thing keeping the stock afloat here. Watch for some of the short positions being unwind. That may provide an interesting shorting oppy. Call me paranoid but I think that moving to NYSE was management's way of making short-selling in the stock more difficult.

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