Editor’s note: Raleigh-based Red Hat (NYSE: RHT) beat the Street again in earnings and revenue on Thursday but did forecast growth a bit below expectations. However, analyst Andrew Smith at Technology Business Research sees plenty of good news in the latest earnings report even as IBM, Cisco and others gear up for their own OpenStack cloud efforts to take on the Hatters. Red Hat reported earnings of 44 cents per share, 3 better than estimates from Thomson Reuters. Revenues hit $481 million, up 14 percent from a year ago. That was nearly $10 million better than expected. For the current quarter, Red Hat sees earnings of 44 cents and revenue between $492-496 million. Analysts expect 45 cents and $493 million in revenue.

HAMPTON, N.H. – Red Hat is targeting success in the OpenStack cloud market by following the same strategy it has in the enterprise Linux market. In other words, Red Hat wants to be the “Red Hat for OpenStack” the same way it was the “Red Hat for Linux,” establishing itself as the primary player in the market through a robust ecosystem of developers and partners.

And the results suggest Red Hat is solidly executing a winning game plan. 2Q15 marks another quarter of double-digit year-to-year revenue growth for Red Hat at 14% to $481 million.

Red Hat’s continued growth reflects the vendor’s successful development and go-to-market efforts for cloud solutions based on open source technology and platforms. Moving forward, TBR expects Red Hat to prioritize higher growth opportunities among its applications and emerging technology solutions. However we believe margin expansion will remain the vendor’s major challenge during 2016, as it faces increased competition to attract and train cloud developers on its OpenStack solutions.

OpenStack’s success in the enterprise, particularly for private cloud deployment, continues to make waves in the technology industry. As an OpenStack early mover, Red Hat finds itself in a position to leverage its reputation and expertise to quickly gain share in a growing market, while laggards scramble to add OpenStack capabilities to their portfolio or blaze ahead with their own proprietary private clouds.

Over the next two years, TBR believes Red Hat will continue to grow revenue primarily from its core OpenStack cloud offerings, as evidenced by the 2Q15 release of Red Hat Cloud Suite for Applications, which bundles OpenShift, Red Hat Enterprise Linux OpenStack Platform, and CloudForms into a single package. Higher adoption of OpenStack in the enterprise will also help Red Hat allay customer concerns around TCO, security, and reliability of OpenStack private clouds.

However, Red Hat’s future isn’t devoid of complications or competitors. TBR believes the vendor’s success will be challenged by a growing list of cloud and virtualization vendors, particularly as industry heavyweights like EMC, Oracle, IBM, and Cisco increase their focus on the OpenStack ecosystem.

We also expect VMware and Red Hat to remain on a collision course over the next year, trading blows across hybrid cloud management, storage, and virtualization markets. Finally, as application-oriented workloads creep up the production list of OpenStack deployments, TBR believes Red Hat’s flagship virtualization solution, KVM, faces heightened competition from container-based alternatives like Docker, potentially eroding market share of one of Red Hat’s largest revenue streams.

Larger vendors bolster their OpenStack portfolios, increasing pressure on Red Hat’s emerging technology products to deliver innovation and new revenue streams

In recent months IBM acquired Blue Box, Cisco snapped up Piston, and Oracle grabbed engineers from defunct OpenStack private cloud provider Nebula. IBM will leverage Blue Box in order to capitalize on the skills and support gap and managed services opportunities surrounding OpenStack deployments. Cisco’s purchase of Piston follows its 2014 acquisition of Metacloud and is aimed at solidifying its InterCloud initiative and streamlining the addition of OpenStack technology within its hybrid cloud enablement push.

After lagging in cloud for years, Oracle looks to increase its focus and the onboarding of Nebula engineers, along with the earlier purchase of Nimbula, provide pieces of technology and in-house skills the vendor needs to regain lost ground against cloud competitors.

As these industry behemoths build and buy their way further into the OpenStack market, they will add credibility, support, and innovation to the OpenStack ecosystem from which Red Hat may ultimately benefit. However the financial and human assets these vendors can put behind their OpenStack development should give Red Hat pause.

As larger vendors gain traction with new OpenStack products and services, they will come in direct competition with Red Hat’s emerging products portfolio for storage, networking, and management, leaving emerging products and services like Ceph, JBoss, and the Cloud Innovation Practice vulnerable to increased competition.

As a result, TBR expects Red Hat to increase its R&D contributions. The vendor grew R&D 8.3% year-to-year in 2Q15 to $97.4 million.

Red Hat faces fewer financial hurdles as it drives subscription revenue growth associated with application, development, and emerging technology products

Many larger competitors entering cloud markets face financial disruption due to the revenue recognition changes inherent in cloud and as-a-service markets. The erosion of legacy license and maintenance agreements in favor of bundled, ratable subscription fees forces many software vendors to navigate a business model transformation and incur short term costs associated with building a pipeline of subscription fees.

TBR believes Red Hat’s traditional business model based on subscription fees (which accounted for 88% of the vendor’s revenue in 2Q15), allows Red Hat to avoid the majority of this transition and quickly ramp up subscription-based sales of new products which feed into its existing subscription streams and minimize short-term margin erosion.

With the business model complications largely out of the way, TBR believes Red Hat is able to focus more time and resources on driving innovation and integration of new products as the relentless march of commoditization erodes profitability across IaaS and PaaS layers.

Red Hat earned approximately 85% of 2Q15 subscription revenue through its infrastructure-related offerings, while the remaining 15% came from the vendor’s application, development and emerging technology solutions.

As this ratio tips toward emerging technology over the next two years – application and emerging technology revenue grew 34% year-to-year, compared to slower, 11% growth in infrastructure subscriptions – TBR believes Red Hat’s margins face ongoing pressure as costs associated with the creation and integration of new hybrid cloud products rise. Red Hat’s operating margin has hovered at 14% for the past four quarters, as investments in R&D, sales and marketing rise. Despite this dynamic, TBR expects Red Hat’s margin headwinds to be easier to manage when compared to some of its software peers, because the vendor’s foundational business model was built around technology and support provisioning on a subscription basis.

(C) TBR