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Higher Expenses Dent Red Hat's 2Q

RHT

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Red Hat Inc. (RHT - Snapshot Report) reported earnings of 18 cents per share (including stock-based compensation of $25.8 million) in the second quarter of 2013, missing the Zacks Consensus Estimate of 21 cents. The miss was primarily due to higher operating expenses that fully offset strong top-line growth in the quarter.

Quarter Details

Total revenue jumped 14.7% year over year to $322.6 million, which inched past management’s guided range of $320.0 to $322.0 million as well as the Zacks Consensus Estimate of $322.0 million. The strong year-over-year growth was driven by a 17.0% surge in subscription revenue. Training and services revenue climbed 1.9% annually.

In the reported quarter, billings increased 15.0% year over year to $349.0 million. Channel contributed 66.0% of the bookings, while the rest came from direct sales. Geographically, 58.0% of the bookings came from the Americas, 24.0% from Europe, Middle East and Africa (“EMEA”) and 18.0% from Asia-Pacific.

In the reported quarter, Red Hat secured 27 deals worth over $1.0 million, including four deals in excess of $5.0 million and two deals over $10.0 million. Of the top 30 deals, approximately 50% were related to middleware component and four were standalone middleware (“JBoss”) deals.

In the reported quarter, gross profit (including stock-based compensation of $2.2 million) surged 17.0% year over year to $275.9 million. Gross margin expanded 160 basis points (“bps”) to 85.5% in the quarter. This was primarily driven by a favorable revenue mix.

In the quarter, operating expenses (including stock-based compensation of $21.7 million) soared 23.7% annually to $220.5 million. The year-over-year growth was primarily attributable to higher sales & marketing (up 23.9% year over year), research & development (up 23.1% year over year) and general & administrative (up 22.0% year over year) expenses. Operating expenses, as a percentage of the total revenue, expanded 490 bps to 69.7% in the quarter.

This higher-than-expected jump in operating expenses had a negative impact on operating income, which declined 4.0% year over year to $55.4 million in the reported quarter. Operating margin contracted 330 bps to 17.2% in the quarter.

Net income (excluding share-based compensation and amortization) was $54.9 million or 28 cents per share compared with $56.5 million or 29 cents per share in the year-ago quarter.

At the end of the second quarter, cash and investments (including long term) was $1.36 billion compared with $1.30 billion reported in the previous quarter. Cash flow from operating activities was $103.9 million compared with $124.4 million in the previous quarter. Total deferred revenue (including long term) increased $31.1 million sequentially to $944.4 million.

During the quarter, Red Hat acquired a couple of companies namely FuseSource and Polymita, which it expects to integrate with JBoss technologies going forward.

Guidance

For the third quarter of 2013, Red Hat expects revenues in the range of $336.0 million to $339.0 million. Earnings on a non-GAAP basis are projected in the range of 28 cents to 29 cents per share. Management expects non-GAAP operating margin to be around 24.0%.

Red Hat trimmed its outlook for fiscal 2013. The company now expects revenue of $1.32 billion to $1.33 billion (down from the prior guidance of $1.34 billion to $1.36 billion). Operating margin is expected to be in the range of 24.4% to 24.6% (down from prior guidance 24.7% to 24.9%).

Earnings are expected to be in the range of $1.15 to $1.17 (down from prior guidance $1.16 to $1.20 per share). Moreover, management expects operating cash flow of $460.0 million for fiscal 2013 (prior outlook was $440.0 million to $460.0 million).

Recommendation

We believe that Red Hat is emerging as a significant cloud computing story over the long term. Red Hat boasts an impressive product lineup and expects to invest heavily for developing innovative products. However, we believe that sluggish IT spending and significant foreign exchange volatility will keep the stock range bound in the near term. Moreover, a sluggish services business and increasing investment may hurt profitability in the near term.

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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