While doing some quick number crunching for my previous post, I noticed something very odd about Red Hat’s net income. The most watched number by investors is earnings per share (EPS). EPS is simply the net income divided by the number of shares outstanding. To arrive at Net Income (NI), you add “Operating Income” plus “Other Income,” subtract “Interest Expense,” and subtract “Provisions for Income Tax.” If you had $100, $12, $3, and $40 as figures for Operating Income, Other Income, Interest Expense, and Provisions for Income Tax, respectively, the company’s Net Income would be {[($100 + $12 -$3) -$40] = $69}.

Clearly you want NI to be a large, positive number because it suggests that the company is very profitable. However, you also want to ensure that the overwhelming majority of NI is driven by Operating Income. Operating Income is a measure of the profitability of the company’s core business and its value proposition in the eyes of customers. Other Income is not related to the company’s core value proposition. Other Income includes items such as interest on investments such as bonds, gains from the sale of real estate, or gains from currency instruments. Simply put, Other Income does not accurately measure the strength of the underlying business.

With this background in mind, let’s look at Red Hat. See a summary of my analysis in the table below or my original data file, complete with URLs to the SEC data (see the “Data” tab):

Over the past two years, 48 percent of Red Hat’s income before taxes has come from “Other Income,” specifically interest income and capital gains on investments. For comparison, “Other Income” drives well under 10 percent of Microsoft’s, Oracle’s, and IBM’s income before taxes. I wondered if Red Hat’s revenue base, (in the hundreds of millions vs. these other vendors whose revenue is in the billions), was a reason for the difference. So I selected Tibco Software, whose revenue base is within $100M of Red Hat’s and was founded in 1997, two years after Red Hat. Only 12 percent of Tibco’s total income before taxes comes from “Other Income.” I tried to look at Novell, but they’ve gone through years of negative Operating Income, so the ratios don’t compute.

As far as I can tell, the contribution from “Other Income” to Red Hat’s Net Income, and hence EPS, is wildly out of sync with its peers. Nearly half of Red Hat’s EPS is driven by items that have nothing to do with Red Hat’s core software business; well, unless Red Hat recently picked up an investing banking division.

I’ll have to spend some more time digging to see if I can explain why this may be. But I wanted to blog this in case a reader can save me the trouble!

P.S.: I should state: “The postings on this site are my own and don’t necessarily represent IBM’s positions, strategies, or opinions.”