S&P Endorses Linux, Raising Red Hat (RHT)

You do not see too many upgrades in corporate credit ratings during this part of the business cycle, let alone in technology and software. But Red Hat, Inc. (NYSE: RHT) was just raised by Standard & Poor’s ratings today. You might even wonder if S&P is almost endorsing Linux after all these years after you look through the notes.

S&P raised the corporate credit rating on Red Hat to ‘BB’ from’BB-‘ to reflect its consistent operating performance and improvedcapital structure. S&P said that the outlook is stable. Keep inmind that this is still a “junk bond” rating, but it only has to goabove “BB+” up to “BBB-” to reach investment grade.

Also noted are the relatively narrow business profile and modestoperating scale, as well as rapid technology evolution. If you readinto the “barriers to entry” of smaller Linux players, it almost soundslike S&P believes that it is getting a lock in the Linux space forcomputers. Analyst Martha Toll-Reed said, “We believe these concernspartly are offset by barriers to entry provided by the large number ofindependent software and hardware vendors which certify their productsto work with Red Hat, as well as liquidity, balance sheet strength andcash flow that are good for the rating level.”

Red Hat shares are down today by 2% at $14.92 and its market cap isjust over $2.8 billion. We also wanted to see for ourselves what else S&P saw with our glance over the books and over expectations. It actually looks like much of the data here makes sense. At least it does on the part where thingsare not falling apart at its business. We still have some strongconcerns about what all of the $400 and under netbooks and $500 andunder notebook and desktop computers are doing to PC’s and therefore tosoftware vendors.

But as of November 30, Red Hat had $758 million in cash and shortterm instruments as well as $317.8 million in longer-term investments.All of its operating costs seem offset and its long-term liabilitiesare mostly deferred charges. We do not believe that RedHat is anywhere close to immune to the malaise out there. But analystsdo still expect it grow for now. It is expected to post over $650million in its fiscal period ending FEB-2009 and $737.7 million for thefiscal period ending FEB-2010. That does not mean that it is expectedto show earnings growth, but it is still expected to run atvery profitable levels.

S&P did not really endorse Linux here as an operating system. Butit did just give it the thumbs up on the business environment and thesafety of its business. Now our only question is if all of the old rumors about Red Hat being a takeover target have any real merit for down the road.

Jon C. Ogg

January 29, 2009