A Software Investment For The Next 30 Years

Red Hat moved nine years ago to selling only server/mainframe class operating systems. And its reputation is now so strong in that arena that its single largest customer segment is the financial services industry. That’s right: Banks like Union Bank of California. Insurance companies like Geico. Stock exchanges. This matters because financial services companies, with their huge databases of clients and money, are the most risk-averse customer segment when it comes to computer research.

We estimate that over 90% of Red Hat’s revenue is related to RHEL and JBoss. RHEV and Red Hat Storage are newer service offerings and are just beginning to get marketplace traction. Red Hat as well sells various other individual products and sponsors a variety of other projects that are in harmony with the larger ethos of Open Source software development.

Open Source software development

Red Hat employs an Open Source software development and licensing model that uses the collaborative input of an international community of contributors to develop and enhance software. In plain English, this means the company aggregates its own and others’ software code, at the time sells this research as a subscription service, including training, computer code and product support. This differs radically from traditional commercial software, where the computer code is sold as a product, normally accompanied by ancillary services for which there is an additional charge. Eighty five percent of Red Hat’s revenue is earned pursuant to this agreement subscription agreements.

Red Hat’s technologies support multiple application areas, including software as a service, cloud deployments, edge-of-network applications, information innovation infrastructure, mainframe computing, data centers, technical/developer workstations and corporate desktops. Red Hat does not, but, officially provide desktop versions of the Linux operating system; the company focuses almost utterly on server- and cloud-based software.

Application infrastructure for building

JBoss Enterprise Middleware provides an application infrastructure for building and deploying distributed applications that are accessible via the Internet, corporate intranets, extranets, clouds and virtual private networks. Examples of applications deployed on JBoss Enterprise Middleware include hotel and airline reservations, online banking, credit card processing, securities trading, healthcare systems, customer and partner portals, retail and point-of-sale systems and telecommunications network infrastructure.

Red Hat’s hosted content distribution offerings, just as Red Hat Network, permit various technologies to be updated and configured. Clients can provision, update, monitor and manage software in an automated fashion. Service offerings, as a rule made available as part of a subscription to either RHEL or JBoss, consist of training, consulting and product support.

Subscriptions to Red Hat enterprise technologies are sold directly to clients and indirectly through various channels of distribution. The latter category includes Red Hat software pre-loaded onto hardware, IBM, Cisco, Network Appliance) and sold by that hardware vendor’s sales force. As of the end of November 2011, the average subscription contract length was 21 months, which has remained steady for until further notice the last two years.

Red Hat’s two primary product lines, Red Hat Enterprise Linux and JBoss make up over 90% of the company’s revenue. So let’s look at each line separately.

According to Gartner Group, the total operating system (OS) software market was $30B in 2010, growing about 8% annually. Of that, we believe that the OS market for traditional computers is $20B, growing at just over 5% annually. As of the end of November, 2011, Red Hat had trailing 12-month revenue of ~$1.1B, of which we estimate 60% is attributable to RHEL – this equates to $660m, or just 3.3% of the total server OS market. And since Red Hat’s revenue has been growing in excess of 25% for the last several years, it is most undoubtedly taking market share in this space.

We estimate that JBoss accounts for about 30% of Red Hat’s total revenue, or $330m. This equates as well to about 3.3% of the total middleware market. And as with RHEL, JBoss’s growth trajectory implies that the product and company are taking market share.

The market close on December 19

After the market close on December 19, 2011, Red Hat reported its fiscal third quarter. Non-GAAP revenues per share were $0.28; this was $0.02 better than the consensus estimate of $0.26. Revenue of $290.0 m was slightly ahead of the $289.6m consensus.

Subscription revenue for the quarter was $246.5 million, up 24% year-over-year. Non-GAAP operating margin was 27.2%, up a very strong 260 basis points from the year-previously quarter. Management raised prior guidance for FQ4. Non-GAAP EPS is now expected to be $0.26 - $0.27. Operating Cash Flow guidance was as well raised to the high end of earlier guided range.

The day afterwards Red Hat reported its November quarter, its share price declined about 9%, signaling some disappointment with the company’s financial performance. Much of the disappointment seemed related to the company’s annual billings growth, which came in at 23%. During it was reported that some investors had expected billings growth of around 30%, the 23% as a matter of fact achieved, when adjusted for the impact of foreign exchange movements, was largely in line with the last two quarters. So the price reaction seemed overdone.

Our takeaway from Red Hat’s third fiscal quarter financial performance: Red Hat is among an elite group of companies with revenue in excess of $1 billion and growing in excess of 25% annually. Nearly every aspect of Red Hat’s FQ3 performance suggests this trajectory will continue.

According to investment bank Piper Jaffray, Red Hat has 70-80% market share of the Linux Server OS market. The remaining share is owned primarily by SUSE, a wholly-owned business unit of The Attachmate Group. SUSE was established in 1992 by four German programmers, and has been through several corporate incarnations, most visibly as a subsidiary of Novell.

Like many other Open Source projects, SUSE has very staunch supporters, who value in particular SUSE’s strength in interoperability with other computing platforms. It is a fact, nevertheless, that Red Hat’s visibility and consistent execution has led it to become the leader in Linux OS innovation. All things considered: SUSE is a worthy, however definite #2 player in this space, slowly losing its remaining market share to Red Hat.

JBoss’s primary competition for Java-based middleware comes from IBM and Oracle. We believe that JBoss is growing revenue faster than these other, larger companies and is in a word taking market share from them.

Classic long tail payoff

Investing in Red Hat is a classic "long tail" payoff: You’re not betting on the company having a "blow-out" quarter, because 85% of its revenue is subscription-based, so that can’t happen. What you’re betting on is that once a large-scale computer system is in place, it’s not going to be dismantled easily or quickly. And the more mission-critical data is heaped upon it, the more likely that system’s owner is going to send Red Hat money to make sure bugs are fixed, upgrades are made and interoperability is tested.