Profitability and Risk

Red Hat's service/subscription model yields high gross margins. The current gross margin for the company is 83.4%, the operating margin is 16% and the net margin is 11.7%. Gross margins are typically high in this industry, and the major expense is the selling, general and administrative expensive. Containing this expense is key to profitability for Red Hat. Over the past five years, Red Hat has shown the ability to control this cost. SGA expenses were 48.6% of gross revenue in FY2011, compared with 53.5% in FY2007.

Another method of examining profitability is to analyze the cash flow statements to see where the company makes its cash. Cash flows from operations were $255 million in FY 2011, compared with $236 million in FY 2010, an increase of 8%. The company also invests in debt securities for sale with some of its free cash flow, and these net investments were $276 million FY2011. These investments provided positive cash flow in FY2010. The company embarked on a purchase of treasury stock in FY2011, increasing such purchases substantially. These figures show that the cash flow is healthy, and cash flow from operations is both stable and increasing slightly.

Red Hat has a high degree of liquidity and solvency. The company's current ratio is 1.77, and its cash ratio is 0.68. Last year, the company's current ratio was 1.99 and the cash ratio was 1.15. These figures point to a slight decline in liquidity, although the company remains liquid. Red Hat has no long-term debt. The capital structure of the firm in total is 59% equity and 41% liabilities, most of which come in the form of deferred revenue. This analysis shows that Red Hat has healthy cash flow and this cash flow is not going to be compromised by debt obligations any time soon.

Red Hat's performance is strong, but it is also important to compare the firm's performance to that of its industry peers. This is because it is important to ascertain whether the firm's performance is a reflection of its own inherent strength or just a function of operating in a generally favorable industry. It is important to consider that the Five Forces analysis determined that the industry was a generally favorable one in which to operate. Red Hat's comparisons with the industry (MSN Moneycentral, 2011) are generally substandard:

Metric

Red Hat

Industry

5-year gross margin avg

84.4%

76%

5-year net margin avg

12.7%

21.2%

Current ratio

1.8

2.5

Receivables turnover

6.8

8.4

Asset turnover

0.5

0.6

5-year ROE avg

8.4%

27.5%

5-year ROA avg

4.4%

14.6%

5-year ROC avg

6.3%

21.1%

These figures show that while the company has a slightly better gross margin it generally underperforms the industry. This could be a reflection of the company lacking economies of scale relatively to competitors. Red Hat operates in 65 countries, but earns less than $1 billion in revenue. Some of its competitors make tens of billions in revenue, so there are definitely scale disadvantages for Red Hat. Of particular note in these figures is the return on equity. The company's lack of debt in its capital structure means that it is financed predominantly with equity. As a result, its ROE is lower than that of its competitors, many of whom use leverage to improve their return on equity.

In the long-run, however, there is reason for optimism with respect to Red Hat's financial position. The company's profitability should increase...

It is more cost effective to add incremental size to existing sales offices than it is to build out new offices in order to expand the company's business. This cost issue derives from Red Hat's strategy of being a differentiated niche player, but still attempting to compete globally. Inherently, such as a strategy will put the firm at a disadvantage with respect to economies of scale in marketing -- it needs to cultivate a more mainstream customer base in order to build out scale and that means competing more directly with larger competitors, some of whom are also distributors of Red Hat products.
Forecasting

Red Hat's business is in the growth stage of the company life cycle, but is growing at a steady rather than exponential rate. There is no indication that the company is expanding into other businesses, engaging in major merger and acquisition activity or anything else that might impact on the trends in the company's business. This means that future projections for Red Hat can be expected to mirror past performance. Using these trends, future statements can be constructed.

Red Hat Forecast Income Statement

2011

2012

2013

2014

Sales

Cost of Sales

Gross Profit

SGA Expense

R&D Expense

Operating Income

Tax Expense

46.42

47.36

49.07

50.08

Net Income

Red Hat Forecast Balance Sheet

2011

2012

2013

2014

Current Assets

1945.35

LT Assets

Total Assets

Current Liabilities

LT Liabilities

Total Liabilities

1953.89

Shareholder's Equity

Total Liabilities and Equity

Valuation

The valuation of the firm can be determined by using the capital asset pricing model. The risk-free rate (1 year Treasury) is 0.446%. The market premium has historically been around 7%. The beta for Red Hat is 1.26. Therefore the company's cost of equity is as follows:

.446 + (1.26)(7) = 9.27%

Red Hat does not pay dividends, but it can be valued on the basis of its free cash flow per share. The firm's free cash flow per share is $1.17. This implies a stock price of 1.17/.0927 = $12.65. The current value of Red Hat shares is $44.93. The market is pricing in significant growth, as evidenced by the price/earnings ratio of 67. Yet, Red Hat has been growing steadily, not rapidly. This points to a conclusion that Red Hat is currently overvalued in the market.

Summary

Red Hat has experienced slow but steady growth of its business. It underperforms its key rivals, in part because it operates globally using a niche model, which results in a high selling expense for the company relative to its earnings. Thus, despite steady earnings growth and a healthy gross margin, Red Hat is less profitable than its industry peers. That said, the company's financial condition is generally healthy. Red Hat is debt-free and is growing its revenues and profits. The market has priced in strong growth that is perhaps not reasonable given the company's current growth rates, making Red Hat overvalued on the market.

Works Cited:

MSN Moneycentral. (2011). Red Hat. Retrieved November 26, 2011 from http://moneycentral.msn.com/investor/invsub/results/statemnt.aspx?symbol=RHT

Red Hat 2010 Annual Report. In possession of the author.

RedHat.com. (2011). Various pages. Retrieved November 26, 2011 from http://www.redhat.com