Red Hat's third-quarter earnings suggest resilience

On Monday Red Hat reported its fiscal third-quarter earnings, saying it generated $165.3 million in total revenues for the quarter, an increase of 22 percent from the third quarter of 2007 and a slight bump of 1 percent from the second quarter of 2008. While revenues barely missed analysts' expectations, profits exceeded expectations by 4 cents per share.

Red Hat's earnings came on the back of strong subscription revenue, which hit $135.5 million in the quarter or 82 percent of total revenues, rising 17 percent year over year but flattening out sequentially. Red Hat expects to hit $166 million to $167.5 million in its fourth-quarter 2008 revenues.

To put this in perspective, last quarter Red Hat grew 29 percent over its first-quarter revenues, while in third-quarter 2007 it grew revenues year over year by 28 percent.

In other words, the third fiscal quarter of 2008 (which ended November 30) demonstrated another solid performance by Red Hat, as Red Hat CFO Charlie Peters and CEO Jim Whitehurst reported, but clearly the recession (and particularly the fluctuating exchange rates) is having an effect on Red Hat's ability to grow, just as it is on everyone else. Even so, 22 percent growth in the wake of one of the worst financial meltdowns in history is no mean feat.

One of the big talking points from the earnings call is currency devaluation, which hit Red Hat for $7 million in revenue (last quarter the dollar hurt Red Hat to the tune of $1 million in revenue), and was blamed for the lower-than-expected overall revenues and net income. Currency devaluation, of course, was a product of the global recession, which was the subtext for the entire call, but importantly, Red Hat delivered strong results through a terrible economic environment.

For me, the biggest indicator of Red Hat's strength is that it renewed each of its top-25 contracts that came due in the quarter at 106 percent of contract value. This represents a little lower attainment than in the past in terms of contract value, but this decline apparently stems from one or two large financial services deals that came at lower value than others in the top-25.

Even so, the fact that those financial services companies renewed at all is telling, given that they were hemorrhaging. Indeed, Red Hat's Peters indicated that Red Hat has now renewed all of its significant financial services customers.

A few additional data points from the call:

• Red Hat now has over 3,000 application certifications (with over 2,100 ISV partners), making it the Linux application leader;
• 23 percent operating margin, an improvement of 100 basis points over Q2;
• 82 percent of Red Hat's revenue is recurring and subscription based, delivering 93 to 94 percent subscription margins, which has remained steady over the past few years (Q3 services revenue was 43 percent in margin, up from 39 percent in Q2);
• Red Hat boosted its deferred revenue balance by 20 percent on a year-over-year basis to $505.1 million, which represents a 2 percent sequential gain. This means Red Hat continues to sell longer-term deals or fewer longer-term deals with a greater dollar value. Either way, Red Hat has money parked in the bank, waiting to be recognized;
• Revenue was 58 percent from the Americas, 25 percent from the European/Middle Eastern/African region, and 17 percent from the Asian/Pacific region. Emerging markets like Latin America and Asia Pacific generated the strongest growth for Red Hat, though Peters, when asked, was careful to note that Europe (though not the UK) remains stable for Red Hat;
• Red Hat nailed 14 deals of $1 million or more, and four deals topped $5 million. Media, Technology, and Government made up the bulk of the top-30 deals. One of the top-30 deals was a free-to-paid conversion (meaning, Red Hat managed to bring in a Fedora or CentOS customer and convert them to RHEL). Government was called out as a healthy area of accelerating growth;
• On JBoss, Red Hat expects JBoss to continue to grow "substantially faster than the core business" (RHEL). Red Hat is notching bigger and bigger JBoss deals and is taking BEA deals after Oracle hiked prices for BEA;
• Red Hat generated 55 percent of its total revenues through the channel with 45 percent direct, which compares to 52 percent (channel) and 48 percent (direct) in Q2 2008;

Red Hat continues to lead in the market, but the real test will be next quarter, when the market has digested the economic panic and turns to 2009 budgets and decides where to spend them. If Red Hat can grow its fourth-quarter 2008 revenue significantly, that may be proof enough of the sustainability and even superiority of its model, in good times and bad.