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Why Red Hat’s Missed Guidance Isn’t That Bad

Redhat
Redhat

If you’re a current Red Hat investor Wednesday’s earnings release must have felt like getting caught in the rain without an umbrella while wearing your favorite Borsalino.

Red Hat’s stock gained about 10 percent from a year ago and remains in a bullish trend. Red Hat’s CEO James Whitehurst announced passing of the billion-dollar mark in annual revenue.

While part of the weakness looking forward is blamed on the strong dollar and economy, investors need to know that this is what happens when you invest in a company with a price-to-earnings ratio that takes over half a century in earnings to pay for a share (price-to-earnings of 50). At least most of the market cap losses appear to be baked in the cake at this point.

Stocks with a price-to-earnings ratio over 20 have historically underperformed the market. Does this mean you should not invest in growth companies sporting multiples above 20? No; however, it does mean when you consider an investment such as Red Hat, you better be ready for a bumpy ride. Wednesday’s fall was more turbulence than a shifting sentiment in the company or management.

Oracle’srecent earnings release was met with tempered enthusiasm and price appreciation. Everyone (except of course Red Hat) loves Microsoft again after displaying the new Surface laptop/tablet/gizmo. Even with trumpets blaring for the Surface, the Internet is where everything is happening, and where there is Internet, there is Linux.

Where there is Linux, there is Red Hat making sure pages are served quickly and correctly.

Based on my experience with gap downs following guidance similar to Red Hat, investors will likely see the short-term low Thursday or Friday. With Wednesday’s closing price of $56.50 and after hours trading closing near $51, more downside pressure probably won’t last long.

Bargain hunters and the few short sellers covering positions could push the price up over $52 by the end of the month. Looking at the chart, I expect short-term resistance near $55. Round numbers often attract like a price magnet and repel, causing a bounce.

Expect a lot of volume to trade near $50 a share Thursday, but also be prepared for bargain hunters to start positions under $49 as an entry.

Red Hat doesn’t have debt and while the price-to-earnings multiple is still high compared to the S&P 500 index, the company simply didn’t miss by much. In fact, it would not surprise me in the least if the company “pushed” some future sales into this quarter to break the billion-dollar mark. It’s good for employee morale and really doesn’t take much to make it happen.

If you are looking for Wednesday’s drop to signal a buying opportunity, you are likely going to find Thursday or opening on Friday to be near the sweet spot.

At the same time, there is no hurry jumping on board with Red Hat. Stocks dumping as a result of lowered guidance usually take a full two good earnings quarters to recover. I believe the odds favor a faster-than-normal recovery.

Operating margins, while already low compared to Microsoft and Oracle appear closer to International Business Machines and CA.

Without a strong dollar, operating margins may improve, but don’t count on Europe for any favors.

For an idea what a disappointing earnings report gap down usually looks like, take a look at Dell’s chart. Dell disappointed and traded from $15 down to an intraday low of $12.31.

Also, take close note of the next few days after earnings. Use your software to look at charts from the past few quarters and review the ones that gapped down the next day. The high placed a couple of days after the gap down in Dell is now resistance. This is a classic pattern.

The main difference between Dell and Red Hat is this: Red is still clearly executing, but just slightly missed on guidance in a quarter that they reported a billion in yearly revenue. All in all, the earnings release is a good one and with Red Hat Storage coming online shortly, I expect the storm clouds to pass quickly.

From the conference call on Wednesday, Chief Financial Officer Charles Peters:

...On a year-over-year basis, we had 16 percent billings growth in U.S. dollars and 20 percent in constant currency; revenue growth of 19 percent in U.S. dollars or 22 percent in constant currency; and more importantly, subscription revenue growth of 21 percent in U.S. dollars and 24 percent in constant currency. We also had non-GAAP operating income growth of 22 percent and operating cash flow growth of 38 percent. 55 percent of bookings came from the Americas, 25 percent from EMEA and 20 percent — excuse me, and 20 percent from Asia Pacific.

The top 30 deals set a first-quarter record for deals over $1 million. In the quarter, we had 25 deals of $1 million or greater, nearly double from the prior year first quarter. Two deals were in excess of $5 million. And cross-selling was strong with more than 40 percent of the deals, including a middleware component and three being stand-alone middleware deals.

What’s the best play with Red Hat? There should be a very attractive trade coming up Thursday or Friday. Near the end of the day, if still trading lower, sell out of the money puts . Fear of continued losses tends to push portfolio insurance prices up dramatically, while at the same time the stock should bottom.

It’s not one to get greedy with — hold on for a few days and as the implied volatility falls (hopefully with a nice dead cat bounce) exit out with a quick hit and run for profits. Otherwise for longer term investors, the best play is to wait until we are closer to the next earnings release for an entry.

—By TheStreet.com Contributor Robert Weinstein

Additional News: Red Hat Shares Fall on Weak Results

Additional Views: Red Hat CEO on Stock’s Recent Red-Hot Run

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Disclosures:

TheStreet’s editorial policy prohibits staff editors, reporters, and analysts from holding positions in any individual stocks. Robert Weinstein holds no positions in any of the stocks mentioned.

Disclaimer

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