The world’s leading producer of Linux software and operating systems, Red Hat Inc (NYSE:RHT) may be one of the remaining exciting growth stories left whose share price hasn’t inflated in the current bull market. In fact, shares of Red Hat Inc (NYSE:RHT)are much closer to their 52-week lows than they are to the highs. With tremendous growth projected over the next several years, a strong balance sheet, and a very well-regarded product line, is Red Hat Inc (NYSE:RHT) poised to deliver another leg up for its shareholders, or is it still a bit overpriced?
About Red Hat
Red Hat Inc (NYSE:RHT) provides a variety of open source software products, including its Enterprise Linux and JBoss Middleware. Linux is an operating system for enterprises that is designed to run on servers, workstations, and PCs. The company’s JBoss Middleware is an assortment of technologies for developing and managing software applications, and the company’s product offerings can be deployed via the cloud, which is one of the fastest-growing areas in computing today.
The company operates all around the world, and splits its operations into three separate business units: The Americas; Europe, Middle East, and Africa; and Asia Pacific. The company plans of aggressively expanding its operations, particularly in Asia and Latin America, where it recently established a corporate location.
Very Expensive, or Is It?
At over 39 times last year’s earnings, Red Hat Inc (NYSE:RHT) appears to be a very expensive company, but don’t be fooled. Red Hat Inc (NYSE:RHT) has an excellent history of growth, and has barely begun to tap their full potential as companies that use their software are just beginning to upgrade to a cloud computing-based infrastructure. Also worth nothing is that Red Hat has almost $900 million in cash on its balance sheet and no debt, which is a very positive trait for a prospective long-term investment.
Red Hat is projected to earn $1.33 per share for the current fiscal year (2014), and this is expected to grow to $1.58 and $1.87 in fiscal years 2015 and 2016, respectively. This corresponds to annual earnings growth rates of over 18% each year, which along with the cash more than justifies the higher P/E multiple.
Other Plays on the Sector
As far as rapidly growing software companies, I think Red Hat is pretty much in a class by itself. As an alternative, you could invest in a larger, more established software provider such as Adobe Systems Incorporated (NASDAQ:ADBE), or even a very diversified software and hardware company such as Microsoft Corporation (NASDAQ:MSFT), both of which should provide more stability and yield at the cost of high growth potential.
Adobe Systems Incorporated (NASDAQ:ADBE) is well-known for its software programs designed for creative applications, such as Photoshop, Acrobat, and Creative Suite. Although Adobe Systems Incorporated (NASDAQ:ADBE) is growing at a respectable rate, and is projected to average 10% annual earnings growth going forward, the current valuation of about 30 times earnings is simply not justified. Adobe Systems Incorporated (NASDAQ:ADBE) would need to drop by about 30%, or put up stellar numbers in their next quarterly report to get me to even consider the company as a long-term investment.
Microsoft, on the other hand, is a very good value, even after its recent gains. In addition to being the world’s largest software producer with its Windows operating system and Office productivity software, the company generates substantial income from internet advertising (Bing) as well as through sales of their Xbox video game consoles and recently, their tablet PCs.
Microsoft trades at just 18 times TTM earnings, which is very low considering the following two points. First, the consensus calls for earnings growth of 8.7% and 8.0% in the next two years, which I think is actually a bit conservative due to low expectations for their tablets and new software versions. Second, Microsoft is one of the most cash-rich companies in the market, with about $51.5 billion in net cash, or 18% of their entire market cap. Combined with a healthy 2.7% yield and Microsoft is looking pretty solid right now.
Conclusion
If you want rock-solid stability, good yield, and relatively predictable and stable growth, buy Microsoft. There is absolutely nothing wrong with going this route. If, on the other hand, you have a bit more risk tolerance and want to get in early on what could be the “next big thing” in computing (cloud computing), Red Hat is as good a way as any to play it.
The article A Great Play on Cloud-Based Software originally appeared on Fool.com.
Matthew Frankel has no position in any stocks mentioned. The Motley Fool recommends Adobe Systems (NASDAQ:ADBE). The Motley Fool owns shares of Microsoft. Matthew is a member of The Motley Fool Blog Network — entries represent the personal opinion of the blogger and are not formally edited.
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