With markets tumbling everywhere you look, I’ve started shifting focus to the Best of Breed stocks that will weather a correction… or worse. If economic growth slows or if investors just get a little jittery, I want to be in stocks that dominate their market and have rock-solid balance sheets to get them over a rough spot.

While market weakness or general economic disappointment might weigh on these stocks, they’ll be able to withstand the environment far better than competitors and will emerge stronger. 

#-ad_banner-#One of my favorite Best of Breed stocks isn’t resting on a huge lead within its market, it’s expanding into other markets and cross-selling new products. While competitors will see lower sales on any economic pullback, this company may actually increase sales as customers entrench their business with one provider that can provide bundled discount offers. 

This Best of Breed Is Expanding Its Market
Red Hat (NYSE: RHT) is the de facto source for the Linux open source operating system. Popularity of the Linux OS has grown and it now drives more than half of all servers with Red Hat supporting 75% of paid Linux deployments. The company has a strong competitive advantage in its ability to leverage the open-source community to provide basically free research and development around Linux and other software projects.

Research firm IDC Client expects the Linux operating system to control 61% of the server OS market by 2018 with subscription services increasing at an annualized 13%, well over an annualized decline of -3% in the Unix and Windows OS.

Subscription revenue is growing at an 18% annual rate and the company could be moving into a turning point. Red Hat is aggressively positioning in enterprise cloud services and using the growing adoption of open source to upsell customers into other products. Deals containing both an infrastructure-related contract and an application development or emerging tech service have grown at a 26% annualized rate over the two years through 2015, accounting for 68% of business last year. 

Sales for the company’s application development and emerging tech segment are growing at an annualized 41% a year, booking $237 million in 2015. Management expects to expand its addressable market to $67 billion by 2018, an eight-fold increase over its 2005 market, through cross-selling storage, virtualization, middleware and other services.

As a result of the company’s cross-selling, deals including five to 10 technologies accounted for 32% of Red Hat’s business in 2015. That was up from 12% in the year before and marked a compound annual growth of 133% over a two-year period. Not only does the cross-selling increase revenue substantially but it locks customers in to the company’s suite of products and makes it harder to switch to a competitor. 

What’s even more surprising about Red Hat’s strong double-digit annual growth is that it’s not a new tech upstart. The company is one of the Founding Fathers of the internet age, opening its doors in 1993, but still books growth that would make other tech heavyweights jealous. The fact that Red Hat has grown beyond its startup needs for heavy capital spending but is still growing sales rapidly means it is generating amazing amounts of cash every year.

Red Hat Has Strong Cash Flow And A Bright Future
Operating cash flow and free cash flow have grown at a compound annual rate of 20% over the last five years and revenue has grown for 53 consecutive quarters. The company has bought back $1.12 billion in shares over the last five years, 55% of its cash expenditures. Red Hat has an extremely strong balance sheet with $1.2 billion in cash and just 34% of the company financed with debt which isn’t due until 2019.

As the company develops its offerings in new markets and cross-sells services, cash flow could surge. Sales are expected to grow by greater than 14% this year and I believe earnings could increase 15% to $2.10 per share. Shares currently trade for 44 times trailing earnings, relatively high against the general market but well below the company’s five-year average price multiple of 69.5 times earnings. Even at the current multiple, shares could be worth $92.40 over the next year. 

There’s an even bigger upside for investors over the next two years as the company expands its addressable market and cross-sells into different technologies. While operating cash flow increased by 15% in 2015, free cash flow surged 29% as the company focused less on acquisitions and more on implementation of existing technologies. Share repurchases nearly doubled to $535 million, reducing the share count by 1.6% over the period. 

Since the cross-selling strategy requires only marginal annual capital investment, cash flow should continue to increase over the coming years. Red Hat may continue to aggressively buy back its own shares, lowering the share count and increasing EPS. Institutional and mutual fund owners are already positioned for the upside in shareholder cash return, holding 98% of the shares outstanding. 

Risks to Consider: Shares of Red Hat trade relatively expensively and could be volatile around general market weakness.

Action to Take: Position in shares of Red Hat as it expands its market and uses Linux dominance to cross-sell other products and services. Growing cash flow means the company may increase shareholder cash return through more buybacks and eventually a dividend. I would be a buyer under $95 per share and have a price target of $105 per share on strong cash flow and multiple expansion.

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