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Red Hat Inc. (RHT - Snapshot Report) reported second-quarter 2014 earnings of 24 cents per share, which beat the Zacks Consensus Estimate by a couple of cents. Earnings including stock-based compensation but excluding amortization of intangible assets and facility costs surged 20.0% from the year-ago quarter.

However, shares of Red Hat dropped 8.05% ($4.26) in after-hours trading due to weak billings, which were affected by continued sluggish environment in Europe, currency volatility, slowdown in services, and lower amount of invoicing (15.0% of total contract value worth $20.0 billion) related to two top deals in the quarter.

Revenue Details

Revenues increased 16.1% year over year to $374.4 million, which came marginally ahead of the Zacks Consensus Estimate of $372.0 million. Accounting for currency related adjustments of $3.3 million, revenues increased 17.1% year over year to $377.7 million. Revenues were also ahead of management’s guided range of $370.0 million to $373.0 million.

The strong year-over-year growth in revenues was primarily driven by a 17.2% (18.2% increase when adjusted for currency impact) increase in subscription revenues and 9.0% (10.0% increase when adjusted for currency impact) increase in revenues from training and services.

Billings increased 8.0% year over year to $376.0 million. Adjusted for currency, billings increased 9.0% from the year-ago quarter to $380.0 million. Channel contributed 70.0% of the bookings, while the rest came from direct sales.

Geographically, 60.0% of the bookings came from the Americas, 23.0% from Europe, Middle East and Africa (EMEA) and 17.0% from Asia-Pacific.

Red Hat secured 30 deals worth $1.0 million each, of which three were in excess of $5.0 million and one was worth over $10.0 million. Among the secured deals, 40% had a middleware component and six of them were standalone middleware deals.

Government and technology/media were the top two verticals from where the company secured most of the deals. During the quarter, Salesforce.com (CRM - Analyst Report) and Red Hat expanded their relationships by signing a new multi-year deal.

In the second quarter, the company launched Red Hat Storage Server 2.1. Red Hat Enterprise Linux OpenStack platform and Red Hat Cloud Infrastructure were also made available during the quarter.

Operating Details

Gross margin (excluding amortization of intangible assets) expanded 30 basis points (bps) to 85.8% in the quarter, primarily driven by improving product mix.

Operating expenses as percentage of revenues increased 20 bps on a year-over-year basis to 68.6% in the quarter. Sales & marketing and research & development as percentage of revenues increased 30 bps and 130 bps, respectively. The increase in spending was primarily due to continued hiring.

The growth in these two expense lines was partially offset by lower general & administrative expense as a percentage of revenues, which contracted 150 bps in the quarter.

Operating margin (excluding amortization of intangible assets and facility exit costs) remained flat year over year at 17.2%. Net income margin was 12.3% compared with 12.1% in the year-ago quarter.

Balance Sheet & Cash Flow

At the end of the second quarter, cash and cash equivalents were $596.8 million compared with $597.9 million at the end of the previous quarter. Cash flow from operating activities was $119.0 million compared with $142.0 million in the previous quarter.

Guidance

For the third quarter of 2014, Red Hat expects revenues in the range of $381.0 million to $384.0 million, with majority being subscription revenues. Management expects operating margin to be around 24.5%. Earnings are expected to be in the range of 34 cents to 35 cents for the upcoming quarter.

Red Hat revised its guidance for fiscal 2014. Revenues are expected to range between $1.51 billion and $1.52 billion, reflecting sluggish service revenue growth in the second half and continued softness in Europe. Management expects unfavorable currency to negatively impact revenues by $10.0 million.

Management revised up its operating margin outlook by 50 bps to 24.5% for fiscal 2014. Red Hat now expects fiscal 2014 earnings to be in the range of $1.36 to $1.38 per share. Operating cash flow for fiscal 2014 is still expected to be between $500.0 million to $520.0 million.

Our Take

We believe that weak billings growth is a major concern in the near term. The soft European macro-environment, currency headwinds, lower services revenues and sluggish IT spending will hurt the top line in the near term.

Moreover, Red Hat’s strategy of sacrificing service revenues to allow its partners deliver more service in order to grow subscription revenues over the long term will further hurt top-line growth over the next couple of quarters.

Nevertheless, Red Hat continues to gain market share and its Linux servers are well positioned to compete with Microsoft’s (MSFT - Analyst Report) Windows servers in the enterprise market going forward. We believe that the company has significant growth potential in the public cloud segment over the long term.

We believe that Red Hat’s strong product pipeline, continuing investments to expand product portfolio and partnerships with the likes of International Business Machines (IBM - Analyst Report) will drive growth going forward.

Currently, Red Hat has a Zacks Rank #3 (Hold).

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