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Why It’s Time to Take Profits in Red Hat: Pro

Richard Saintvilus|Contributor
Friday, 24 Aug 2012 | 11:12 AM ET
Johner | Getty Images

Red Hat, a leader in open-source technology and cloud computing, is trading at what are arguable grossly expensive valuations. So are its chief rivals VMware and Salesforce.com.

This is nothing new for technology stocks, which have often traded at a considerable premium to their current performance.

But when stocks trade at such valuations they can be vulnerable because any little slip-up or sign of imperfection can send shares spiraling lower.

Red Hat investors should keep this in mind, particularly when this stock has already gained 40 percent so far this year.

After the company’s most recent quarter, I’m beginning to sense that it just might be time to take profits.

Sure, the company continues to perform. In Red Hat’s most recent earnings report, the company produced almost 20 percent annual revenue growth, while increasing sales by 6 percent sequentially. The company attributed the better-than-expected performance to stronger growth in its subscription services.

What’s more, Red Hat’s margins are improving slightly year-over-year and sequentially.

Nevertheless, I’m concerned when a stock is trading at nine times trailing revenue and 40 times trailing Ebitda.

As Chipotle’s recent earnings demonstrated, high growth expectations are only great as long as you are perfect. But expecting perfection is unrealistic and investing on this assumption can be catastrophic.

And Red Hat’s price-to-earnings ratio of about 75 leaves no margin for error.

At some point, investors will realize that focusing solely on top-line growth to justify such lofty valuations is not enough.

In addition, I think Red Hat will hit a stumbling block as VMware, Salesforce.com, Oracle, Microsoft, and International Business Machines will start to apply considerable pressure to seize any advantage that Red Hat may have in the enterprise services market.

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In anticipation of this, it would appear the prudent thing to do would be to take profits — particularly in a stock like Red Hat that is already expensive.

This is not to say the company does not deserve credit for what it has been able to do to this point. Clearly, Wall Street has high expectations for this company.

Nonetheless, increased pressure will likely weaken the company’s top-line momentum, as well as its ability to acquire new business.

What’s more, the sequential and year-over-year improvements in its margins may soon show signs of weakness in the coming quarters.

The days of Red Hat being considered only a Linux niche business are over as the company is now (deservedly) highly regarded as a true threat to the likes of Oracle, Microsoft, and IBM. But now those competitors are coming to take back that business.

—By TheStreet.com Contributor Richard Saintvilus

Additional News: Red Hat Earnings Beat the Street

Additional Views: Why Red Hat’s Missed Guidance Isn’t That Bad

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Disclosures:

TheStreet’s editorial policy prohibits staff editors, reporters, and analysts from holding positions in any individual stocks. At the time of publication, Richard Saintvilus held no position in any of the stocks mentioned.

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