Second quarter earnings at Red Hat Inc. (RHT, $46.73) came in better than expected today, but the market is concerned with decelerating revenues, and the stock fell $6.20 in Tuesday trading.The core Linux business continues to slow down, while margins have bottomed and are improving.
Bookings growth has fallen from 30%+ in recent years, to 17% in fiscal 2013 (ended Feb. 28), and 11% expected in 2014.Reuters reported six Wall Street firms cutting target prices and ratings for Red Hat on Tuesday.
Red Hat provides commercial support for open source infrastructure software.Earnings per share (EPS) are expected to grow 10%, 17% and 16% in the next three years, although these numbers could be subject to revision after today’s future revenue disappointment.
The price-earnings ratio (PE) is 35.The stock is trading at a premium to its peers, which is unwarranted by the slowing revenue growth.As a general rule of thumb – which varies by industry – the fair value PE should be in-line with earnings growth.For example, if Red Hat had a PE of 18, the share price would be $24.
The stock peaked in April 2012 at $62.75, and the trading range has been ratcheting downward ever since, most recently trading between $45 - $56.While it’s somewhat unlikely that the stock will fall through support, it’s tremendously overvalued, and shareholders are gambling by holding on.
Shareholders should devise an exit strategy -- maybe selling now, maybe selling on a bounce to $49 – and reinvest their capital in a growth stock with a much lower PE, thereby minimizing overall risk.
