Investors are buying up shares of technology companies quickly this summer as fears of an economic collapse begin to dissipate and margins for many companies are quite attractive.  Red Hat, Inc. (RHT), the provider of open source operating systems for enterprises has seen its stock rocket 268% from the low set last November.  Investors are now willing to pay a hefty premium for the stock due to it’s stable track record of sales and earnings growth.

Last week, the company announced results for its fiscal second quarter (Red Hat operates with a February fiscal year end).  The results came in ahead of expectations with the company posting earnings of $0.20 per share from revenue of $184 million.  Sales were up 12% above the same quarter last year which indicates that businesses are willing to invest in technology even while the purse strings are held tight for many other expenditures.

These purchases are often made with the assumption that stronger technology will help companies operate more efficiently as many are looking for ways to maintain business levels while laying off employees.  This helps to explain why productivity levels have increased on a macro scale even while unemployment rises to new levels.  Red Hat is capitalizing on this trend and offering significant value to customers.

IT organizations continue to move ahead with purchases of high value solutions, and Red Hat is capitalizing on this demand as a result of our strong customer relationships and proven value proposition. ~Jim Whitehurst, President & CEO

Merrill Lynch (MER) had spent the last quarter with Red Hat at a “hold” ranking, but after the quarterly release the brokerage firm raised it’s price objective and once again recommended clients buy this well known technology stock.  Last quarter, Merrill had become concerned with a declining level of billings, but with year-over-year billings now increasing to 8% from a low 3% last quarter the picture appears a bit brighter.  Merrill cited three primary reasons for it’s positive assessment of Red Hat:

1. Forward Metrics Strengthening – A growing backlog of business appears to ensure that the company will be able to maintain revenue growth for quite some time.
2. Upsell Thesis Playing Out – The company is seeing its premium products (with higher margins) move off the shelf with 23 of the top 30 renewals opting for higher margin products
3. Share Gain Potential – There are quite a few high profile competitor renewal contracts which will come up over the next three years.  Merrill estimates $240 million of potential new business from these contracts.

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So as far as the business is concerned, it looks like Red Hat is firing on all cylinders and growing profit at a steady clip.  This is just what we want to see as growth stock investors – but there is just one problem.  The price of the stock more than accounts for this attractive growth.  In fact, it appears investors are completely ignoring the economics of what they are paying for this cash generating company.

Consider this: Analysts are expecting the company to book 67 cents of revenue in fiscal 2011 (which ends in five short months).  The following year, the company is expected to grow earnings by 12% as the economy theoretically continues its recovery from the economic turbulence.  So that puts next year’s earnings at about $0.75 cents if you believe that these analysts are accurate in determining future earnings.

Now look at the stock price:  Investors are currently paying roughly $27.50 for this company which means that you are paying 37 bucks for every dollar that the company generates.  Now I don’t mind paying that kind of multiple for a small company with the potential to grow by 30% to 50% annually for several years.  Small companies offset the risk of buying too high with the potential for very aggressive earnings growth.

But Red Hat is a $5 billion dollar company.  It’s not the young hot technology company it was in 2000 when the stock price hit a high of $150.  We’re also not in the same environment where investors are likely to go nuts and pay triple digit multiples for technology stocks.  The tech bubble of 2000 and the financial crisis of 2008 is still fresh on investors minds and I believe we are approaching the upper limits for what investors are willing to pay for a maturing technology stock with estimated 12% growth.

Now shorting Red Hat today could be extremely risky.  Just a few days ago, the stock made a new 52 week high which is not the kind of pattern you want to have when betting for lower prices.  But the stock is running up against what should be very strong resistance in the $28 to $32 area.  If the stock begins to falter running into this region, it may be worthwhile to slowly begin building a short position, and then add to your trade once you start to see unrealized gains.  It may also be worthwhile to develop an options strategy that will minimize risk but still allow you to participate if and when the stock begins to decline.

Red Hat is a name that I would like to own at the right price.  Buying the stock at 20 times earnings (or roughly $15) might be a bit aggressive but out of respect for the franchise the company has built I think this would be a relatively attractive spot to own RHT.  But for now, the risk seems significant and any surprises will likely cause selling and not additional buying.

FD: Author does not have a position in RHT

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