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Red Hat has a jolly Q3

Except for that lawsuit settlement

The smart choice: opportunity from uncertainty

Commercial Linux distributor and platform wannabe Red Hat ended the year with a peachy quarter. For the third quarter of fiscal 2010, ended November 30, sales jumped 17.5 per cent to $194.3m.

But the company is having trouble growing its profits, and even if you want to be kind and ignore an $8.75m charge to settle a class action lawsuit, which Red Hat announced last week and booked in fiscal Q3, profits would have been flat. You can't ignore the class action suit, however, and Red Hat's net income plummeted by 34.7 per cent.

In the aftermath of the Enron scandal, everyone was a bit jumpy about revenue recognition. Red Hat said back in July 2004 that it would change the way it recognized revenue for software subscriptions, shifting from a monthly recognition scheme to a daily one, forcing the company to restate its revenues for 2002, 2003, and the first quarter of 2004 (fiscal years, not calendar).

Red Hat's stock took a 20 per cent haircut in one day, and the lawyers smelled blood, eventually filing two class action lawsuits alleging that Red Hat had manipulated quarterly earnings and materially and artificially inflated its financial results. On December 15, more than five years after the rejiggering of its financials, Red Hat said in a statement it had reached an agreement to settle the class action lawsuit, which was pending in the US District Court for the Eastern District of North Carolina and it did not admit any wrongdoing or say anything other than it had booked a charge to cover the settlement, which has to be approved by the court.

For the three month period, Red Hat's software subscription sales kept rolling along, climbing 21.4 per cent to $164.4m. Training and services sales were up a fraction of a percent to $29.9m. The cost of subscriptions rose by 25.5 per cent to $11m and costs for training and services rose by 4.6 per cent to $18.6m, which put pressure on profits during Q3. Sales and marketing expenses were up smartly (22.2 per cent) to $71.5m, research and development costs were up 11.8 per cent to $38.6m, and other costs were up 5.4 per cent to $26.1m.

Basically, that extra business isn't leading to extra money hitting the bottom line, just extra costs. Red Hat spent $52.3m in its cash to buy back 1.9m of its own shares in the quarter, and has spent an incredible $146m so far this fiscal year to buy back 7m shares. Red Hat is sitting on $959.1m in cash and equivalents and $618.7m in deferred revenues. The company has no debt.

The question is, can Red Hat make more money?

Wall Street seems to think so, if Red Hat's market cap is any guide. The company's shares are trading north of $31 a pop in after hours trading as we go to press, giving Red Hat a market capitalization of just under $5.6bn. That's a pretty hefty valuation for a software company that has yet to break $1bn in annual sales.

The company is approaching the historical highs it hit in early 2004 and early 2006, although they are well short of the dot-com peak Red Hat experienced in 2000, when shares were trading almost five times as high. No one sued Red Hat for the dot-com bubble bursting, but the company's initial public offering was arguably the last and biggest hurrah for the bubble party.

Charlie Peters, Red Hat's chief financial officer, said that sales in North America helped push up the numbers in the third fiscal quarter. "We are beginning to see some industry recovery in some markets," Peters said when asked about the interplay between the economy and IT spending, and he added that he believed that this was not just end-of-year budget blowouts, but more optimism on the part of IT managers as calendar 2009 closes out and they build their budgets for 2010.

Jim Whitehurst, Red Hat's president and chief executive officer, said that Red Hat showed "very strong" performance in the Americas region and "solid" performance in Asia/Pacific and Europe. "Americas is picking up more quickly than EMEA, but we are seeing strength across the board," Whitehurst added.

On the call, Peters said that in fiscal Q3, 62 per cent of its revenues came from channel partners, up from 59 per cent in the second fiscal quarter. This is the direction that Red Hat wants the trend to move. The company's free-to-pay initiatives, which seek to get customers using freebie Red Hat Enterprise Linux to move to commercial support, generated $1.5m in revenue, and of the top 30 deals (ranked by revenues) done in the quarter, two of them were free-to-pay deals.

Peters said that 23 of those deals were for the high-end Red Hat Advanced Platform stack, and eight of them had JBoss middleware components. JBoss, by the way, is still growing sales faster than the overall Red Hat business, and Peters said it had a "strong pipeline." Of the top 25 deals that came up for renewal in the quarter, Peters said they all renewed, and in aggregate the contracts renewed at 120 percent of the value of the prior deals at these customers.

Looking ahead into fiscal Q4, Peters said that Red Hat expected revenues to be in the range of $191m to $193m, and reminded everyone that the holiday would adversely impact training sales. For the full fiscal year, Red Hat expects revenues in the range of $743m to $745m, which is up $10m from the company's previous guidance. ®

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