Don't worry about Red Hat's 2009 profit decline

Red Hat's profit decline is largely attributable to profit declines outside its core operations

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 2 percent to $653 million. Expectedly, 4Q revenue growth was lower than full-year growth, coming in at 18 percent for $166 million.

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Also as expected, Red Hat reported a 27 percent decline in net income (NI, aka profit) from $22 million in 4Q07 to $16 million in 4Q08. For the full year, NI increased 3 percent to $78 million, well short of the 18 percent full-year increase in revenue. Fear not, the tepid increase in profit does not point to issues with Red Hat's core business: the sale, service, and support of software.

I'd previously covered the fact that nearly half (48 percent) 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. Among 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, with all things being 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 $18 million in fiscal 2008 to $5 million in fiscal 2007. This represents a 72 percent decline in profit from outside Red Hat's core business. Of this $13 million year-to-year decline, $4.7 million was attributable to a one-time gain in the sale of Red Hat's equity position in a third-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.

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However, it's still surprising that over one-third of Red Hat's profit comes from activities outside of its 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 by-products 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 know 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 multiyear subscriptions. For instance, a $5 million deal over five years would result in Red Hat having to bank $4 million in year one and recognize and use it to pay for related costs over the subsequent four years. The resulting interest would be counted in "other income." However, I could argue that IBM's business, especially the Global Services division, also has to recognize large multiyear deals, yet IBM's "other income" is in the low single-digits. Still scratching my head...

Follow me on twitter at: SavioRodrigues

p.s.: I should state: "The postings on this site are my own and don't necessarily represent IBM's positions, strategies, or opinions."

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