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Red Hat Inc. (RHT - Snapshot Report) reported fourth quarter 2012 earnings of 19 cents per share, which failed to beat the Zacks Consensus Estimate by a penny. Earnings per share (EPS) (including stock-based compensation expenses but excluding amortization) remained flat when compared with the year-earlier quarter.

Revenue

Total revenue increased 21.0% year over year to $297.0 million, which not only surpassed management’s guided range of $289.0 to $292.0 million but was also above the Zacks Consensus Estimate of $291.0 million.

Subscription revenue increased 21.9% year over year to $255.2 million. Training and services revenue was up 17.7% year over year to $41.8 million. The strong year-over-year growth in revenues was driven by higher demand for Red Hat technologies and efficient sales execution in addition to upselling and cross selling of Red Hat products and services.

Billings increased 31.0% year over year to $418.0 million in the quarter. Bookings remained flat when compared with previous-year quarter, with the channel comprising 59.0% and direct sales 41.0%. Geographically, 60.0% of the bookings came from the Americas, 26.0% from Europe, Middle East and Africa (EMEA) and 14.0% 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 30 deals worth over $1.0 million, including three deals in excess of $5.0 million. Of the top 30 deals, approximately 40% were related to middleware component.

Operating Performance

Gross profit on a non-GAAP basis (including share-based compensation but excluding amortization of intangible assets) was $253.4 million, up 24.2% year over year from $204.2 million in the prior-year quarter. Gross margin expanded 190 basis points (bps) to 85.3% in the quarter. This was primarily driven by an increase in services gross margin and a better revenue mix.

Non-GAAP operating expenses, including share-based compensation but excluding amortization of intangible assets, jumped 25.2% year over year to $199.8 million, primarily attributable to higher sales & marketing (up 30.6% year over year), research & development (up 23.5% year over year) and general & administrative (up 11.9% year over year) expenses. Operating expenses, as a percentage of the total revenue, increased 210 bps to 67.3% in the quarter.

Operating income on a non-GAAP basis (including share-based compensation but excluding amortization of intangible assets) was $53.6 million, up 20.6% from $44.6 million reported in the prior-year quarter. Operating margin was 18.0% compared with 18.2% in the year-earlier quarter.

Net income on a non-GAAP basis (including stock-based compensation expenses and amortization) was $37.6 million compared with $37.4 million in the prior-year quarter.

Balance Sheet

At the end of the fourth quarter of 2012, cash and investments (including long term) remained flat sequentially at $1.30 billion. Operating cash flow was $128.0 million compared with $96.6 million in the previous quarter. Total deferred revenue at the end of the reported quarter was $946.7 million, up 23.0% year over year.

Guidance

For the first quarter of 2013, Red Hat expects revenues to be in the range of $307.0 million to $311.0 million. Non-GAAP EPS is projected in the range of 25 cents to 27 cents. Management expects non-GAAP operating margin to be in the range of 24.0% to 24.2%.

Red Hat expects fiscal 2013 revenue in range of $1.34 billion to $1.36 billion and non-GAAP EPS guidance in the range of $1.16 to $1.20. Management expects non-GAAP operating margin in the range of 24.7% to 24.9% in fiscal 2013.

Moreover, management expects operating cash flow for fiscal 2013 to be between $440 million and $460 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. Additionally, the company’s offerings in the cloud computing market coupled with server virtualizations and middleware section is expected to be incrementally beneficial in the long run.

Moreover, significant partnerships with large public cloud customers such as Amazon Web Services, International Business Machines Corp. (IBM - Analyst Report), NTT and Swisscom 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 - Analyst Report), VMware Inc. (VMW - Snapshot Report) and Oracle Corp. (ORCL - Analyst Report).

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 #3 Rank, which implies a ‘Hold’ rating in the short term.

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