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What's Really Behind Red Hat's Recent Drop in Earnings? Investments

Earlier this month, in a post called "Behind Red Hat's Consistency: A Surprising Concentration on Investing," I discussed a very interesting post from Savio Rodrigues called "Is Red Hat a Software Firm or Financial Institution?" In that post, Rodrigues noted that big proprietary software companies including IBM, Microsoft and Oracle derive less than 10 percent of their net income from "Other Income" that they report, which refers to income generated outside their core software businesses, typically from interest-bearing investments. By contrast, Rodrigues noted that over the past two years Red Had got a whopping 48 percent of its net income from "Other Income" investment sources. How did this affect the financial performance that Red Hat reported this week?

Today, Rodrigues is out with an update to his original post, found here. In it, he notes that Red Hat reported a 27 percent decline in net income (earnings), from $22 million in the fourth quarter of 2007, to $16 million in the fourth quarter of 2008. However, he also notes that Red Hat's full-year net income was actually up three percent over the full year 2007's net income.

Rodrigues' original post on Red Hat's capital structure noted that nearly half of its net income over the past two years came from investments in cash and bonds, plus the sale of equity holdings, and currency transactions. In other words, Red Hat has a core software and support business, but its earnings are very much affected by its activities in investing. Rodrigues notes this:

"Amongst all of 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."

And he notes this, from Red Hat's annual report (p. 48):

"...however interest rate yields on our investments are expected to decline, resulting in reduced interest income.”

Then Rodrigues delivers the real specifics:

"The profit decline is largely attributable to other income declining from $18M in fiscal 2008 to $5M in fiscal 2007. This represents a 72% decline in profit from outside of Red Hat’s core-business. Of this $13M YTY decline, $4.7M was attributable to a one-time gain in the sale of Red Hat’s equity position in a 3rd party company (which appears to have been MySQL)."

This is one of the better pieces of analysis of Red Hat's performance recently that I've seen. Securities and investments, not software and support, were the key issues for Red Hat in its last quarter. Few people seem to realize how the company balances its sofware and support efforts with investment efforts. Its overall good results for the past two years, and its recent earnings hiccup both have everything to do with this.

In these times, I think it's shrewd of Jim Whitehurst to diversify the company's profit-seeking efforts in this way, and that's part of how Red Hat has been so consistent compared to players such as Sun and Novell. It's also interesting to consider how much the various wounded startups and underwater businesses out there might benefit at this point from  good investing, where  the stock market at least, is showing signs of recovery.

• Red Hat
• Earnings
• Investments

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