Let me start by saying that Red Hat’s 4Q and full year core business results were solid. Nicely done.
Full year revenue was up 25% to $653M. Expectedly, 4Q revenue growth was lower than full year growth, coming in at 18% to $166M.
Also expectedly, Red Hat reported a 27% decline in Net Income (NI aka profit) from $22M in 4Q07 to $16M in 4Q08. For the full year, NI increased 3% to $78M, well short of the 18% full year increase in revenue. Fear not, the tepid increase in profit does not point issues with Red Hat’s core business; the sale, service and support of software.
I’d previously covered the fact that nearly half (48%) of Red Hat’s overall profit came from *outside* its core business. Specifically, the profit came from interest on cash/bonds, from the sale of investments including equity holdings, and gains from currency transactions. Amongst all of these items, interest income appeared to be the largest driver of Red Hat’s non-core-business income.
With interest rates declining to generational lows, interest income would take a hit. As a result, all things equal, Red Hat’s NI would decline. Red Hat said as much in its 2008 annual report (pg 48):
“..however interest rate yields on our investments are expected to decline, resulting in reduced interest income”
The profit decline is largely attributable to other income declining from $18M in fiscal 2008 to $5M in fiscal 2007. This represents a 72% decline in profit from outside of Red Hat’s core-business. Of this $13M YTY decline, $4.7M was attributable to a one-time gain in the sale of Red Hat’s equity position in a 3rd party company (which appears to have been MySQL).
Redoing my analysis of Red Hat’s “Other Income” we see that Red Hat is coming closer into line with software industry peers.
However, it’s still surprising that over one-third of Red Hat’s profit comes from activities that are outside of their core business.
Wall St. likes to apply a multiple to the company’s profit (per share) to arrive at price targets for the company. When such a significant portion of a company’s profit comes from byproducts of the core business, simply applying a multiple can be a poor judge of the company’s core business. But then again, can Wall St. really judge the quality of any company’s core business?
I am not suggesting Red Hat is doing anything wrong or shady. My findings could be explained by how Red Hat is required to recognize multi-year subscriptions. For instance, a $5M deal over 5 years would result in Red Hat having to bank $4M in year one and recognize and use it to pay for related costs over the subsequent 4 years. The resulting interest would be counted in “Other Income”. However, I could argue that IBM’s business, especially the Global Services division, deals with having to recognize large multi-year deals. And yet, IBM’s Other Income is in the low single-digits. Still scratching my head…