Investing in Penguins and Fedoras
With the current recessionary environment, perhaps it’s not such a bad time to take a look at investing in penguins and fedoras. When I say penguins, I mean Tux, the official mascot of the Linux kernel and when I say fedoras, I mean Red Hat, the Raleigh, NC-based provider of open source enterprise solutions.
Red Hat’s a fairly unique company; one that prides itself on a corporate culture
that promotes openness and creativity. That’s not surprising given the company’s position in the world of open source software
. Open source contrasts itself with proprietary software
While it’s been asked before how can a company profit off of something that is free and open, Red Hat has done a fairly good job of it over the years. Red Hat makes its living off of providing its products and support for its products in a subscription-based service.
For businesses, there are many benefits to using open source software. The open source model allows bugs to be more easily detected and fixed. Open source also provides companies with a greater level of flexibility and customization. Of course, the biggest selling point goes straight to the bottom line - open source software tends to lower costs for companies.
Perhaps that explains why Red Hat might be the type of company that actually benefits in a recessionary environment where companies are trying to cut costs. Red Hat benefitted from the dot-com bust and their most recent earnings announcement suggests they might be benefitting right now, as well. With that, it’s time to take a look at the numbers. Revenues and Margins
Red Hat’s gross margins have stayed fairly consistent over the past few years as they have hovered between the 83% - 85% range. They produced an 83.9% margin for the most recent quarter. However, this might be a bit deceiving since their two primary revenue categories, subscription and service, produce very different margins.
Red Hat’s subscription margin has varied between 91.5% and 93.5% over the past three years, but there seems to be gradual improvement on that front, as they hit their 93.5% peak in the most recent quarter. Service margin has varied more wildly, falling anywhere between 28.6% (Q4 of FY ’07) to 46.2% (Q1 of FY ’07). There seems to be gradual improvement in those margins over the past couple of quarters, but due to the inconsistency, it is difficult to tell.
What’s not difficult to tell is that service revenues have grown considerably over the past three years. They’ve shot from $13 million in Q1 of FY ’07 to nearly $30 million in the most recent quarter (Q3, FY ’09). Subscription revenues have likewise grown, but not quite as astronomically, as Red Hat pulled in $71 million in Q1 of FY ’07 and brought in roughly $135.5 million most recently.
The only troubling sign is that Red Hat’s revenues did not really grow in the most recent quarter, but they still experienced phenomenal year-over-year growth and perhaps more impressively, they saw a 100% subscription renewal rate amongst their top 25 customers who subscriptions were up in the third quarter. That’s impressive and suggests that companies might see real value in using Red Hat.
Operating margins for Red Hat have stayed with a fairly consistent range, typically going anywhere from 13% to 17% with a few outliers over the past few years. As a percentage of revenues, operating expenses seem to hover around the 70% range. Income, Balance Sheet, and Cash Flows
Net income figures have not been particularly consistent for Red Hat, but they have shown improvement over time. For the most recent quarter, they turned a $24.3 million profit, up from $21 million in Q2 and up from $20.3 million in the previous year. However, it would appear that most of the difference was explained by a lower provision for taxes. Still, Red Hat did manage to slightly reduce interest expenses as a result of lowering their debt load.
As of the end of Q3, Red Hat had a debt-to-value ratio of 45%, a significant drop from 52% the prior quarter. If one were to venture further back into their past, one would find they had a 63.7% debt-to-value ratio at the end of FY ’06 and a 68.1% ratio at the end of FY ’05. That’s a fairly impressive drop over the past few years and I believe that they are now in an ideal range (between 40% - 50%).
Red Hat has also managed to increase their book value fairly significantly over the past two years going from a value of $3.75 per share at the end of FY ’07 to $5.19 per share at the end of the most recent quarter. They have been lowering the number of diluted shares in the market, as well, which will mean greater rewards in the future for current stockholders. There were 220 million diluted shares for Q2 but only 208 million for Q3 and the company has signaled that this number will drop even further next quarter.
While income figures have been relatively decent for Red Hat, their cash flows have been even more impressive. Cash flows from operations have been healthy over the past three years ranging from 18 cents per share (Q1, FY ’08) to 29 cents per share (Q1, FY ’09). Free cash flows have looked very good ranging from 15 cents per share (Q1, ’08) to 26 cents per share in this most recent quarter.
Over the past three quarters, Red Hat has brought in 73 cents per share in free cash flows despite being hurt by foreign currency translations in the most recent two quarters. In fact, their growth in FY ’09 looks even more impressive when you consider that they benefitted from those translations in FY ’08, but have been on the other end in ’09. However, it’s possible that the dollar will continue to rise against other currencies meaning that Red Hat might not see benefits of more favorable currency translations for awhile. All the same, their performance improvements make them look all the more interesting as an investment.Scenarios and Forecasts
In order to great a rough valuation for Red Hat, I decided to set up a number of quickie DCF scenarios. We’ll start off with two moderate growth scenarios. For all my scenarios, I assumed Red Hat would bring in about 20 cents per share in free cash flows for the 4th Quarter. This might be a bit conservative, but should not change my valuations dramatically in any case. I also assumed a 10% cost of capital. Moderate Growth
For the first moderate growth scenario, I assumed that Red Hat brought in 90 cents per share for free cash flows [FCFs] for FY ’10. This also seems a bit conservative to me, as it appears they could be closer to 95 cents to $1.00 per share for FY ’09. However, their cash flows and earnings have always been somewhat inconsistently, even while steadily improving over the long-term.
After FY ’10, I assumed a 6% growth rate in free cash flows from through FY ’13, then a 5% growth rate from ’14 to ’16 and a 4% growth rate thereafter. Based on that, I came up with a valuation in the $19.50 to $20.00 range.
Under a second moderate growth scenario, I used the same growth rates, except I assumed they brought in $1.00 per share in FCFs for FY ’10. Based on this, I come up with a valuation in the $21.00 to 21.50 range. Strong Growth
For the strong growth rate scenario, I set the FCFs for FY ’10 at 95 cents per share and assumed rates of growth between 6 – 8% for various years up till FY ’17. After that, I shifted to a 4% growth rate for about another decade before leveling off at 3%. I come up with a valuation around $22 based on this scenario. Aggressive Growth
For the aggressive scenario, I set FCFs for FY ’10 at $1 per share. I start with a 9% growth rate and gradually decrease to a 5% (by FY ’17) before leveling off at 3% by FY ’25. Based on this, I come up with a valuation of around $23 --- not all that much more than our strong growth scenario. Conservative Growth
For my first conservative growth scenario, I start with FCFs of 90 cents per share in FY ’10, use a 4% growth rate till FY ’13 before leveling off at 3%. Amazingly, I still come up with a value in the $17.75 to $18 range.
For a second “stale growth” scenario, I simply changed the growth rate to 3% for the entire duration and still came out around $17.50.
Finally, I decided to do an “erratic scenario” where we assume that Red Hat’s FCFs continue to be wildly inconsistent for the next several years with virtually no real growth in cash flows over that time. Eventually, after FY ’16, I assume a consistent 3% growth rate in FCFs. Using this scenario, I get a valuation near $16.50 per share. Analysis
Based on everything compiled here, it would appear to me that Red Hat might offer some considerable value to shareholders if it can continue to be a growth story. The current recessionary environment seems to help them as companies seek to cut costs. Moreover, there appears to be a gradual move towards open source.
Another thing to think about --- we might finally be reaching a point where average consumers are willing to buy home PCs with Linux-based systems installed. Ubuntu has gained a lot of popularity and there seems to be some level of backlash against Windows. From a manufacturer’s perspective, selling PCs with Linux pre-installed means lower costs which they can then market to consumers. I cannot say for certain how much acceptance Linux-based systems will achieve, but I think a shift towards open source in the home PC market might signal a broader acceptance of open source in the market. This may help Red Hat whether or not people are using Fedora (Red Hat’s sponsored system) or other systems. It remains to be seen, but I think one way or another, open source is an attractive option for companies looking to cut costs and greater visibility for open source should only help sell it to key decision makers.
From my own scenarios, I would assign Red Hat a valuation of around $19-20 per share. I think with the current market environment, you might want to discount that closer to $17 per share. As Red Hat has recently been trading in the $14 to $16 range, that would suggest to me that it is slightly undervalued.
While I hesitate to call any stock in the IT-sphere low-risk, I think Red Hat is considerably safer than a lot of other companies in a recessionary environment. I’d classify it as medium-risk, all the same, but it has the added benefit of appearing to benefit during downturns. Plus, while free cash flows have fluctuated some, Red Hat has been consistently profitable and there seem to be no fears that they are going to disappear from the scene any time in the near future.
Back in November, RHT’s stock traded all the way down in the $7.50 range. I’d have to say it would be a steal at that price, especially when you consider the risk level as there would appear to be no reason they would be priced so close to book value with such strong cash flows. If Red Hat falls below $12 again, it provides considerable value and becomes a buy. The $12 to $19 range is more debatable, but I think this could turn out to be a good buy even at $14 or $15 and might be the type of company one can buy-and-hold for another decade at least. Red Hat provides a relative amount of safety, while still offering some significant upside from growth prospects, so keep an eye out --- if you can get in at the right price, penguins and fedoras might be a great investment right now.