Description

Red Hat is a company that provides service for open-source software.  It has benefited from a focus by enterprises on reducing their software spend, and has reported impressive retention statistics.  However, the valuation is fairly egregious, the stock has run-up based on recent inclusion in the IBD 100 and end-of-quarter portfolio window dressing, and some aggressive accounting.  In addition, most sell-side price targets are below the current share price.

Here are some of the red flags, as I see them:

1) Declining billings growth:

2) Reported GAAP EBIT is basically flat for several years:

3) "Non-GAAP" EBIT excludes stock compensation and amortization (2 quarters ago, only excluded stock compensation), and stock comp has been increasing-guidance is for 13m a quarter for f10

4)  Prepaid expenses have increased dramatically.  While this also includes a deferred tax asset amount, the company has not explained this adequately.

5) Valuation is aggressive

Red Hat will be paying full taxes over the next year.  Ignoring amortization but including stock comp as a true expense, company guidance is for ~$125m of EBITA in f2010.  This means the stock trades, net of cash, at 36x taxed EBIT.  This seems too high for a company that sells service on a free product (and thus can be replaced fairly easily over time) and is growing under 10% with flat GAAP EBITA for the last few years.  There is currency risk, and the benefit to reported EPS from buying in their convertible note (and thus reducing share count) will only help for one more quarter.

6) Downgrades are coming

Catalyst

downgrades

end of momentum buying/ window dressing

accounting issues

billing slow-down