How Red Hat, Inc.'s Second Quarter Stunned the Street

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Red Hat (NYSE: RHT) shares bounced more than 7% higher on Thursday morning, sparked by a strong second-quarter report posted on Wednesday night.

By the numbers

The vendor of Linux platforms and other open-source software saw sales rising 19% year over year, to $600 million. Adjusted earnings increased by 17%, landing at $0.55 per share. Analysts would have settled for earnings of $0.54 per share on roughly $593 million in top-line revenue, so these results were a clean sweep.

Looking ahead, Red Hat set third-quarter and full-year projections above current analyst estimates. In particular, the midpoint of the company's full-year revenue guidance was set above the absolute top end of Wall Street's estimates.

Among Red Hat's three geographical segments, Asia Pacific led the way, with 27% currency-adjusted sales growth. Drilling down to product categories, application development tools saw revenue rising 33%.

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Subscription sales largely kept pace with the overall growth trend, ticking 18% higher compared to the year-ago quarter. Deferred revenue from these renewable and high-margin contracts rose 19%, to stop at $1.68 billion.

Red Hat reported strong interest in Linux containers, which allow for quick and flexible enterprise application deployments on a large scale. The company also released new versions of key software, such as the JBoss middleware platform and the Ceph Storage suite. Long story short, customers are getting addicted to Red Hat's software tools. That's why they're more willing than ever to pay up for a long-term support contract, which is the core driver of Red Hat's deferred revenue balances.

Red Hat CEO Jim Whitehurst. Image source: Red Hat.

What's wrong with this idyllic picture?

So far, so good. But as they say back home, if there's nothing to complain about, something's wrong. As a Red Hat shareholder on the hunt for imperfections, I couldn't help but notice that operating expenses are skyrocketing. That's generally fine for a modestly sized company growing into its large-cap breeches, but the rising costs did not come from a big investment in R&D, or even sales and marketing. Instead, general and administrative expenses led the way with a 25% year-over-year jump.

On the phone with Red Hat CEO Jim Whitehurst, I had to ask about this uncomfortable mix. As it turns out, Whitehurst had a perfectly reasonable answer to my nitpicky worries:

Looking at one quarter, there is a lot of volatility. Red Hat Enterprise Linux sales increased by 25% in the first six months, which frankly was faster than we intended.

The only people who outperformed our salespeople were our people people that are recruiting.We even said that we would moderate our growth rate in the second half of the year so our people growth rate looks more like our revenue growth rate.

For instance, our new-hire orientations doubled year over year. Going quarter by quarter, these spikes in people will drive jumps in G&A costs. You should not expect to see this on a normalized basis.

Red Hat is indeed committed to investing in R&D and sales. Sometimes, that commitment leads to these off-color G&A increases, as the new engineers and salespeople need training and equipment before even reaching their desks.

So now, I'm not even worried about that expense imbalance. It's just an accounting quirk that actually points to stronger sales and R&D budgets in future quarters.

All in all, I'm a happy shareholder. Red Hat stubs are trading near multi-year highs again, and the long-term story remains as thrilling as ever.

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Anders Bylund owns shares of Red Hat. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days.

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