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Red Hat (NYSE:RHT)

Q3 2013 Earnings Call

December 20, 2012 5:00 pm ET

Executives

Tom McCallum

James M. Whitehurst - Chief Executive Officer, President and Director

Charles E. Peters - Chief Financial Officer and Executive Vice President

Analysts

Stewart Materne - Evercore Partners Inc., Research Division

Walter H. Pritchard - Citigroup Inc, Research Division

Mark R. Murphy - Piper Jaffray Companies, Research Division

Kash G. Rangan - BofA Merrill Lynch, Research Division

Jason Maynard - Wells Fargo Securities, LLC, Research Division

Heather Bellini - Goldman Sachs Group Inc., Research Division

Steven M. Ashley - Robert W. Baird & Co. Incorporated, Research Division

Joel P. Fishbein - Lazard Capital Markets LLC, Research Division

Michael Turits - Raymond James & Associates, Inc., Research Division

Abhey Lamba - Mizuho Securities USA Inc., Research Division

Brian J. Schwartz - Oppenheimer & Co. Inc., Research Division

John S. DiFucci - JP Morgan Chase & Co, Research Division

Ross MacMillan - Jefferies & Company, Inc., Research Division

Scott Zeller - Needham & Company, LLC, Research Division

Adam H. Holt - Morgan Stanley, Research Division

Brad R. Reback - Stifel, Nicolaus & Co., Inc., Research Division

Operator

Good afternoon. My name is Jay, and I will be your conference operator today. At this time, I would like to welcome everyone to Red Hat's Q3 2013 Earnings Conference Call. [Operator Instructions] I would now like to hand the call over to Mr. Tom McCallum, Vice President of Investor Relations. Please go ahead.

Tom McCallum

Thank you, Jay. Hello, everyone, and welcome to Red Hat's earnings call for the third quarter of fiscal 2013. Speakers for today's call will be Jim Whitehurst, President and CEO; and Charlie Peters, Executive Vice President and CFO.

Our earnings press release was issued today after the market closed and may be downloaded from redhat.com on the Investor Relations page. Also on this page, you will be able to find historic reconciliation schedule of GAAP to non-GAAP financial metrics, as well as the schedule on currency rates.

Various remarks we may make about the company's future expectations, plans and prospects, including the statements containing the words believe, anticipate, plan, project, estimate, expect, intend, will, constitute forward-looking statements for the purposes of the Safe Harbor provisions under the Private Securities Litigation Reform Act of 1995. Actual results may differ materially from those indicated by these forward-looking statements as a result of various important factors, including those discussed in the company's most recent quarterly report on Form 10-Q filed with the SEC, as well as the Safe Harbor statement in today's press release.

In addition, any forward-looking statements represent our estimates or views only as of today, December 20, 2012, and these estimates or views may change. While the company may elect to update forward-looking statements at some point in the future, we specifically disclaim any obligation to do so even if our estimates or views do change, and therefore, you should not rely on these forward-looking statements as representing our estimates or views at any date subsequent to today.

And with that, I'd like to turn the call over to Jim.

James M. Whitehurst

Thank you, Tom. Welcome, and happy holidays to everyone joining us on today's call. We continue to deliver steady performance in our business and strong results with over 20% growth on a constant currency basis in our key subscription revenue metric. We also continue to focus on the needs of our customers as they navigate global economic uncertainty and the need for faster innovation. I'm pleased to report that all of our top 25 deals that were up for renewal this quarter not only renewed but did sell with a value of well over 120% of the original value. These results are a great endorsement of our customers for our reliable, open source solutions that enable ROI and investment in the data center.

We're providing our customers with the roadmap to deploy and manage open hybrid cloud environment. The path starts with core platform and middleware technologies. From there, we continue to add and advance our technologies to move further towards hybrid cloud computing. Our comprehensive portfolio of open source solutions addresses a wide range of challenges facing enterprises as they deploy and manage applications in the next generation of data centers.

Let me discuss a few of our recent announcements that help set a clear, open path towards cloud computing based on Red Hat's industry-leading open source technologies.

Starting with middleware. We are executing with our plan to merge the technologies of Polymita and FuseSource, which we acquired earlier this year, into our middleware portfolio. Our opportunity for middleware software is evolving to higher-level integration capabilities that include business rules management and BPM. We already provided foundational integration offering with JBoss Enterprise SOA and Enterprise BRMS, and we will be completing -- complementing these existing products with additional technologies that enhance application integration and drive greater ease of use amongst business users.

Second, we held a webinar to upgrade -- to update our progress on Red Hat Storage with customers, partners and the open source community. As we've discussed in the past, our movement to this complementary storage space represents a significant expansion of our addressable market opportunity.

In addition, this is a major source of IT spend that is right for a disruptive offering, and we believe Red Hat Storage has strong promise. Explosive growth of unstructured data is driving interest in Red Hat Storage, which is evidenced by the fact that we now have over 125 companies around the globe running POCs with growing use cases both on premise and in the cloud.

We have enabled 30 channel partners to broaden the reach of our storage solutions, including Synnex, Carahsoft and HP, and we have grown the community around the open source project by 160%. We continue to be excited about the potential of this technology and the big data and cloud storage spaces.

Third, we launched the latest version of Red Hat Enterprise Linux -- sorry, Enterprise Linux Virtualization 3.1, or RHEV, which incorporates several new key features to enable increased scalability of guest virtual machines and update its benchmark setting, KVM hypervisor. A key addition to RHEV 3.1 is integration with Red Hat Storage, Red Hat Scala open source storage software solution, and includes file and object structured and unstructured.

Fourth, we had several important technology announcements from Platform-as-a-Service to Infrastructure-as-a-Service to hybrid cloud management. In December, we launched OpenShift Enterprise PaaS, which established the industry's first comprehensive open on-premise PaaS for enterprises. This solution provides enterprise users with access to a cloud-based application platform, enhancing an enterprise's ability to quickly build its application and to have them run in a cloud architecture. It automates much of the provisioning and systems management of the application platform stack in a way that enables the IT operations team to more easily meet growing business demand for new application services.

Developers are now able to choose among leading application development languages and tools for their jobs, and IT operations leaders can choose to deliver these application stacks to their enterprise on their choice of cloud. OpenShift Enterprise accomplishes this with high reliability through the backing of Red Hat's full stack.

In the Infrastructure-as-a-Service space, we announced a developer preview of the Red Hat OpenStack cloud platform based on the recent Folsom release. Leveraging our leadership role in the OpenStack community, we are moving further down the path of commercializing an enterprise version of this important technology.

Finally, we announced availability of CloudForms 1.1, our hybrid cloud management technology. CloudForms was first released in June of this year and is now being enhanced with an interface for workload automation, making it simpler to deploy and manage workloads across various cloud sites.

Today's big news for Red Hat is the cloud -- in the cloud management space is the acquisition of ManageIQ, a developer of cloud management software that enables the operational management of cloud and virtual infrastructures across public, private and hybrid clouds. ManageIQ brings an adaptive and integrated approach to important cloud management capabilities such as server and storage provisioning, workload optimization, policy-based compliance, charge-back, virtual machine life cycle management, discovery and control and analytics.

ManageIQ's offerings can manage heterogeneous environments including Amazon EC2, VMware, Microsoft and Red Hat. It has proven itself in large-scale production deployments. ManageIQ's technology combines well with the direction that we are headed in developing cloud management for open hybrid clouds. In the coming weeks, we will hold an event to discuss the integration of ManageIQ technologies.

In conclusion, with thoughtful planning centered on next-generation IT challenges, Red Hat is one of the few vendors that have built a comprehensive portfolio of infrastructure technologies that can make the hybrid cloud a reality for the enterprise customer. We're also uniquely positioned to participate in the growth of numerous IT growth drivers including open source, virtualization, cloud and big data.

On a personal note, this month marks my fifth year here at Red Hat as CEO. As I look back, I'm impressed by the tireless contributions from Red Hat associates around the globe. The business has more than doubled in that time, while our opportunity in the data center has continued to increase immensely. I've never been more excited about Red Hat's position and the opportunities in front of it. I want to thank each of our Red Hat associates for making it happen. I also want to welcome new Red Hat associates from ManageIQ.

With that, let me turn the call over to Charlie.

Charles E. Peters

Thanks, Jim. I would reiterate that we're very pleased with the company's performance in the third quarter. We have continued to see good demand for our core technologies, as well as positive, early interest in our investments in new growth opportunities.

Before digging into the results, it's worth pointing out upfront that currency volatility continued to be a factor in Q3. So similar to last quarter's call, I'm going to base most of my comments on U.S. dollar comparison, but where appropriate, I may add comments in constant currency terms using last year's rates.

With that said, here are a few of the financial highlights on a year-over-year basis. Subscription revenue grew 22% in constant currency or 19% in U.S. dollars. Short-term deferred revenue and total deferred revenue both grew 21% in U.S. dollars. Q3 operating cash flow exceeded the $100 million mark, and year-to-date cash flow is up 25% when compared with the first 3 quarters of last year. And we continue to experience real strength in large deals and renewals. Our top 30 deal metrics reflect continued wins across multiple global industry verticals. For the first time ever in the third quarter, all of the top 30 deals exceeded $1 million, including 5 deals that were in excess of $5 million and one that was over $10 million.

Financial services was particularly strong and represented the leading vertical of our largest 30 deals. We had several large wins across a spectrum of financial services companies including large banks and investment firms, insurance companies and financial service information providers. In Q3, we also saw strong wins with public cloud providers with telecom/service provider vertical accounting for 10% of the top 30 deals and all of them were public cloud service providers.

Now let's turn to our financial performance. Despite the macroeconomic uncertainty on currency headwind, we continued to see double-digit constant currency growth across our major geographies. In U.S. dollars, 60% of bookings came from the Americas, 23% from EMEA and 17% from Asia Pacific. The Q3 sales distribution mix was 65% from the channel and 35% from the direct sales force versus a 66%-34% split in Q2. This marks the third consecutive quarter where channel bookings exceeded our goal of 60%, indicating that we are broadening our reach to market.

As I mentioned earlier, our billings proxy for the quarter, which we calculate by adding revenue plus the change in deferred revenue on the cash flow statement, was up 18% year-over-year to $379 million. If one also factors in the year-over-year foreign exchange impact on revenue in this calculation, billings grew by 20% on a constant currency basis.

Now let's shift to the income statement. Third quarter revenue was $344 million, a 21% year-over-year increase in constant currency and an 18% year-over-year increase in U.S. dollars. Subscription revenue was the main driver of our total revenue growth. This renewable revenue component now constitutes 86% of total revenue.

Subscription revenue was up year-over-year 22% on a constant currency basis and 19% in U.S. dollars to $294 million. The training and services component of revenue was $49 million, up 16% in constant currency and 14% in U.S. dollars from last year. The training part of the services business rebounded from recent quarters as new online classes in North America and open enrollment registrations in Europe both grew well.

Now I'll discuss the rest of our results on a non-GAAP basis, excluding stock compensation and amortization expense, starting with gross margin. Subscription gross margin was 94%, consistent with last year and last quarter. Training and services gross margin was 38%, up 30 basis points year-over-year. Overall, Q3 gross margin was 86%, 30 basis points higher than last year. The improvement in overall gross margin resulted mainly from the higher percentage of subscriptions in the mix and improved services margins.

Moving on to non-GAAP operating expenses. We continue to focus on investing in growth opportunities in storage, middleware, virtualization and the cloud, including 3 acquisitions in the past 13 months and another one announced today. Q3 non-GAAP operating expense came in at $212 million, up 25% in U.S. dollars year-over-year. For sales, marketing and R&D, this includes $4 million related to the Polymita and Fuse acquisitions, which I mentioned on our last earnings call. It also includes program expenses related to new cloud and virtualization technology launches and the continuing build-out of Red Hat Storage among others.

These acquisitions have increased our addressable market opportunity, and we're ramping investment and spending in these areas to capitalize on them. As the results indicate, we have strong momentum in our core businesses even though we are still in the early stages of realizing the benefits of these new growth investments.

Faster growth in G&A cost this quarter and for the year is temporary and is principally related to projects that will pay back for years to come. Specifically, we completed in Q3 the implementation of major systems upgrades and improvements to managerial reporting. And we are continuing major facilities moves to reduce cost per square foot and provide space to grow.

We also incurred approximately $1 million of acquisition-related costs in the quarter. It's expected that next year, G&A cost will resume the decline as a percentage of revenue that we experienced in prior years.

Q3 non-GAAP operating income was $83 million, producing an operating margin of 24%, in line with our guidance. During the quarter, we added approximately 270 associates, including approximately 60 due to acquisitions. We are on track to add between 900 and 1,000 new associates to Red Hat this fiscal year.

Interest and other income was slightly over $1 million, and our estimated annual effective tax rate remains at 32% for both GAAP and non-GAAP results. Non-GAAP diluted earnings per share came to $0.29, which is at the high end of our guidance range.

As I said, foreign exchange volatility and foreign exchange headwinds remain high, especially year-over-year. To highlight the impact, using average currency rates from Q3 last year, this Q3 would have shown revenues $7 million higher, expenses $5 million higher and operating income $2 million higher.

Now let's turn to the balance sheet and the cash flow statement. We ended the quarter with cash and investments of approximately $1.3 billion and quarterly operating cash flow of $100 million. Collections remain strong, and foreign exchange adjusted DSOs were at 61 days, in line with Q3 last year. As a reminder, since days sales outstanding is traditionally a measure of receivables compared to billings, our DSO was calculated using our billings proxy.

Total deferred revenue at quarter end was $988 million, an increase of $168 million or 21% over the same quarter a year ago. In U.S. dollars, current deferred revenue grew 21%, and long-term deferred revenue grew 20% from one year ago.

Sequentially, deferred revenue increased approximately $43 million from last quarter. To isolate the foreign exchange impact, let me break down the components of deferred revenue for you. Short-term deferred revenue, which ended Q2 at $704 million, had a real increase in Q3 of $26 million, an increase of an additional $6 million as a result of changes in foreign exchange spot rates, ending Q3 at $736 million. Long-term deferred revenue, which ended Q2 at $240 million, had a real increase in Q3 of approximately $9 million, an increase -- an additional $3 million as a result of changes in foreign exchange spot rates, ending Q3 at $252 million. The total increase in deferred revenue without the impact of currency changes was over $35 million and can be found in our statement of cash flows.

Turning to guidance. I have assumed in my estimates that average foreign exchange rates for Q4 are: euro at $1.31; and JPY 82 to $1. If currency rates stay at these levels in Q4, then rates will be approximately in line with the average rates from a year ago when the euro was at $1.31 and the yen was at JPY 78 to $1.

I've also assumed our usual seasonality in the service business, which normally declines sequentially in Q4 as a result of holiday downtime with our customers. We expect the same this year with the sequential services decline of about $4 million. Additionally, I would point out that Q4 has one fewer day than Q3 this year or Q4 last year. One day less of subscription revenue equates to over $3 million of impact.

With those assumptions in mind, I offer the following outlook for Q4. Q4 revenue is estimated to be approximately $347 million to $350 million. Non-GAAP operating margin, including the dilutive impact of acquisitions, is estimated to be in the 24% area. Interest and other income should be about $1 million, and non-GAAP EPS is estimated to be approximately $0.29 to $0.30 a share, assuming the same 32% estimated annual effective tax rate.

If these estimates for Q4 are achieved, then that means the full year estimates for these same measures are revenue at $1,328,000,000 to $1,331,000,000, non-GAAP operating margin for the full year of 24.6% and non-GAAP EPS for the full year of approximately $1.16 to $1.17, assuming the same 32% estimated annual effective tax rate.

As you know, I do not guide quarterly cash flow. However, in light of our continued strong cash flow, I believe that our annual operating cash flow will be near $460 million, the high end of our annual guidance set at the start of this year.

In summary, we continue to execute well and grow steadily even in an uncertain economic environment. We also continue to invest and innovate, which is expanding our addressable market opportunity.

Before turning the call over to the operator, I'd like to invite our financial community to the Red Hat 2013 Analyst Day, which will be held on June 25 in New York City, about 2 weeks after this year's Summit event. Please save the date, and invitations with more details will be forthcoming.

Operator, I'd now like to turn it back over to you for the first question.

Question-and-Answer Session

Operator

[Operator Instructions] Our first question comes from Kirk Materne with Evercore Partners.

Stewart Materne - Evercore Partners Inc., Research Division

I guess, Charlie maybe or Jim, I think we've all heard that the financial services industry has been, obviously, trying to cut back on costs. So I was just curious, with some of the bigger deals that you did in there, can you go into a little bit more detail on product mix? Were there some new products in those deals, whether it's RHEV or even the storage product? And maybe what drove some of the strength in that market?

Charles E. Peters

Sure. So I mean, the financial services market for us was very strong this quarter. It was the strongest vertical we had. The mix of products, I think, we're good. The operating system continues to be, by far and away, the largest item that we're selling. But they had a mix of developer support, some JBoss training. Just looking at the list now. It was really across the board. It wasn't just here in the U.S. either. We also had a good financial services business in Europe. I think it's a combination of, first, a strategic use of technologies, more important than saving cost. The benefit is that we also help save the customers costs so they get a real significant win when they choose Red Hat.

Operator

Next, we have a question from Walter Pritchard with Citigroup.

Walter H. Pritchard - Citigroup Inc, Research Division

Charlie or Jim, just wondering if you could talk a bit about JBoss specifically. I think in the past, you talked about how many of the larger deals include JBoss. Just wondering if you could give us color on what you're seeing in that business.

Charles E. Peters

Sure. I mean, the JBoss business in the quarter continued to grow faster than the base business on the subscription side. And as it was representing the large deals, the interesting thing this quarter was there was such strength in the large deals on the RHEL side. We saw a cross-sell in JBoss in the 20% range there. But as I say, overall, very strong performance in the businesses below the top 30 and still growing faster than the base business.

Operator

Next, we have Mark Murphy with Piper Jaffray.

Mark R. Murphy - Piper Jaffray Companies, Research Division

Jim, I wanted to ask you on Gluster. At what rate do you think the storage world is evolving to these software-based solutions? How quickly do you think that will happen? How critical is the linkage to RHEL product-wise? And then finally, if you can maybe offer any insight, how do Gluster ASPs compare to the ASPs for the rest of your product offerings?

James M. Whitehurst

Well, certainly, we are seeing tons and tons and tons of interest in software-based storage, mainly because we can deliver storage at about $0.30 a gigabyte including the hardware. So we have a phenomenal value story to tell there. Yes, as we said and as you heard me measure it, I measured it in POCs at this point, with -- we GA-ed the product in June, and what we're finding is it does take a long time to go through POCs before people are going to trust their storage. So we have interest across the board to the point we're having to tell our salespeople that we're having to pull back on the number that we can do. So again, it looks really strong, but it's still early days. And so when people start writing big checks, we'll have more to be able to tell you on that.

Operator

Next, we have Kash Rangan with Bank of America.

Kash G. Rangan - BofA Merrill Lynch, Research Division

Charlie, I hate to disappoint you, so I have to ask you the same question that I keep asking you. Of all the levers you've had in this RHEL 6 product cycle, the components being RHEV, the ASP uplift you get from pricing, the free to fee, the JBoss, what surprised you the most this quarter relative to how these levers played out in the last quarter? And also, if I could, if you don't have the time, that's okay, we can pass. But Jim, if you could comment on the video management capabilities that you have acquired with ManageIQ. Part of me says this is -- has the potential to be a really big deal. You have companies like VMware that are launching big cloud suite with significantly higher ASPs. The management component of virtualization, just more broadly speaking, managing your operating system instances, is a option that you guys have not really talked about, and this is a huge, $15-plus million industry. Could this really be the beginning of RHEL 7?

Charles E. Peters

Thanks, Kash. Let me take the first in terms of levers driving the business. I think, Kash, still the same levers. UNIX to Linux migration continues unabated. As I said this quarter, the top 30 deals, 3 of the top 30 deals were public cloud providers. So cloud is driving it. Linux is growing faster than Windows, and we're seeing some Windows to Linux move. Free to pay is still moving along. The large deal traction was very strong. On the pricing side, the gradual move over time of people from RHEL 4 and RHEL 5 to RHEL 6 and its slight change in pricing has a very moderate change quarter-to-quarter. All those things are still having a positive impact on our business. I'll ask Jim to answer your question about the ManageIQ acquisition and his comments.

James M. Whitehurst

Yes. ManageIQ, again, I'd certainly hope you're right. We actually do see a sizable opportunity there as people look to move to these hybrid cloud models, and the ability to do management discovery charge-backs, all those components, is a sizable opportunity. Obviously, we're in very, very, very early days of that. So we're very excited about the technology. It is a fantastic group of people we're bringing onboard. So we are excited about it. I think it's too soon to call it something like the next RHEL. But again, we do think it's a big opportunity, not just directly in that space but also to bring along our other set of products.

Operator

Next, we have Jason Maynard with Wells Fargo.

Jason Maynard - Wells Fargo Securities, LLC, Research Division

I apologize if I missed this, but did you guys give a breakdown of either revenue or bookings by product line?

Charles E. Peters

We do not. Our segments are by geography and by subscriptions and services, and so that's all we provided.

Jason Maynard - Wells Fargo Securities, LLC, Research Division

Okay, I apologize. I thought there was a -- you were characterizing a little bit of the JBoss or something like that.

Charles E. Peters

Yes, okay. So what I commented on was the fact that the middleware business continues to grow at a faster rate than the base business. And in the top 30 deals, 20% of the top 30 deals had a cross-sell this quarter. And we saw a much larger pickup on the deals below the top 30 for the JBoss.

Operator

Next, we have Heather Bellini with Goldman Sachs.

Heather Bellini - Goldman Sachs Group Inc., Research Division

I guess, I was just wondering, you've been investing aggressively in some very promising secular opportunities. I was just wondering, Jim, if you could share with us how you see these opportunities building in terms of kind of what customers are waiting for or data sets they're waiting for to get more aggressive in these areas. And then kind of how do you see these playing out if you fast forward a few years in terms of the impact on deferred growth?

James M. Whitehurst

Well, the issue, just to be clear, with all these technologies, they're massive spaces, and the question is, frankly, how we pick the right solutions. Now I could argue that software storage, depending on how you want to split out a typical appliance, the software storage market is larger than the operating system market. And it's certainly growing more quickly, and the economics of commoditization looks the same. So I can build a story saying that storage could be larger than operating systems for us long-term, but again, that would be a superlative pass that I'd be willing to say today. Same thing as we look on the management side, whether that's around virtualization or now with ManageIQ. Yes, it's very clear that open hybrid cloud, which is what we're -- have been pushing hard, has been very interesting to customers. We're seeing -- without a doubt, we're going to see hybrid clouds. We're seeing large enterprises most predominantly looking at private cloud. We obviously have the public clouds out there. So we're going to have hybrid clouds. We're obviously pushing open. It's a message that people -- that resonates well with customers. So we feel good across all of these. Again, each one of these that we've added has its total addressable market that's 10x Red Hat's revenues. So they have all have the massive potential. The key is to get one or more of them to really deliver.

Operator

Next, we have Steve Ashley with Robert W. Baird.

Steven M. Ashley - Robert W. Baird & Co. Incorporated, Research Division

Great. Talking about your middleware offering, it's really made you more strategic. And I'm wondering, when you go in, Jim, and you talk to people about your middleware offering, other than price, what are the benefits and the competitive advantages that you are really trying to promote?

James M. Whitehurst

Well, one of the single biggest benefits we get with the very large customers is the ability to impact roadmap. I was with one of the very, very, very large financial services institutions recently. And one of the real benefits they see with our SOA suite, so I think one of the higher order of products, is that they have a full time developer on it. So they can drive the things that they need in a way they say they just can't with their other vendors. And so the open source story for large, sophisticated institutions who want involvement in roadmap really sells well. And then people who are less sophisticated, obviously, price sells well. So we basically kind of have that kind of two-pronged, depending on the customer need. But especially as you get higher order in the integration, you're selling that more into developer shops. The developers like the ability to be able to participate, and so it's a real feature of open source.

Operator

Next, we have Joel Fishbein with Lazard Capital Markets.

Joel P. Fishbein - Lazard Capital Markets LLC, Research Division

I just wanted to follow up on the Red Hat Storage. And I wanted to see if any -- if you could talk about any of your customers that have gone into production and the use cases that they're using before. It's our understanding that you have had some success in some deployments. It would be helpful to get just some color around that.

James M. Whitehurst

A couple of the examples that come to mind. Obviously, storage of music was a large provider there. Insurance companies have used it. Bank -- there's a couple of banks that are involved now. In various cases, mortgage loan applications and real estate information. In the insurance example, the use case is around automobile accidents and police reports and photos of accidents scenes and that kind of thing.

Joel P. Fishbein - Lazard Capital Markets LLC, Research Division

Can you just talk, Charlie, just about what it's replacing? Do you have any color around that?

Charles E. Peters

I think some of these are new sort of greenfield-type opportunities, not -- maybe replacing things that were old, or manual processes.

James M. Whitehurst

But yes, it's generally new applications. People aren't literally moving their data. But it's instead of more traditional data, net type storage architectures.

Operator

Next, we have Michael Turits with Raymond James.

Michael Turits - Raymond James & Associates, Inc., Research Division

Upside from services this quarter, you said it was due to training. But as you've moved to enabling the channel, more especially on JBoss, I think, are we at the point where your services line is starting to bottom in terms of growth rate, we could have it grow faster next year? And also, I was just wondering on RHEV, whether or not you're changing anything in terms of go-to-market to accelerate that?

Charles E. Peters

So on the service question, just as a reminder, the service line for us is about 50% consulting and about 50% training. And the partner enablement part of the discussion we've been having in previous quarters is really on the consulting side of it, trying to engage other partners to be able to deliver that consulting -- like those consulting services, and they would get that consulting revenue. So that part of it, we would expect to grow definitely to sort of moderate as it has all year long. On the training side, training tends to go in cycles of major new products. So for example, when RHEL 7 is introduced at some future date, as with what happened when RHEL 6 was introduced, I would expect to see a surge in the training business. Otherwise, it's pretty steady. I've been saying for some time that something in the either single digits to low double digits, a 10% kind of growth maybe if you're trying to model something might be appropriate for next year. As far as your question about RHEV, RHEV 3.1 is just out recently, and we continue to try to cross-sell and push it with our major accounts and are making some progress there.

Operator

Next, we have Abhey Lamba with Mizuho Securities.

Abhey Lamba - Mizuho Securities USA Inc., Research Division

Jim, you mentioned about longer POC cycle for storage. How does that compare with what you saw with middleware or what you're seeing with other technologies? And when, realistically, do you think we should expect the reasonable revenue contribution from the storage?

James M. Whitehurst

The sales cycle, itself, looks a lot like middleware. Less services-oriented, right? It's more of people want to get the stuff up and running. So there's a little special services, but nothing like the type of service that you see directly out of middleware. We'll see. We've been in the market for 6 months, GA-ed. We have had a couple of big deals close. So but I don't think, based on those couple, that I want to draw conclusions about the average sales cycle yet. Again, we're doing as many POCs as we can do, and I think in another quarter or 2, we can give a lot more color on the sales cycle there. I think the ones that we're doing, I think almost universally, people are very pleased with the technology, very, very excited about it. So all indications are positive, but let's get a few more of the bigger deals closed so that we can have a better sense of the average sales cycle.

Operator

Next, we have Brian Schwartz with Oppenheimer.

Brian J. Schwartz - Oppenheimer & Co. Inc., Research Division

Jim, I wanted to see -- I didn't hear Charlie mention public sector as a top vertical in the quarter in Q3. And you tend to have real good insight into that vertical with your strong positioning in that market. So I was wondering if you could just share with us, maybe qualitative, what you saw in the quarter and then maybe what you're seeing so far in December here in public sector. There's certainly some investor angst out there on what could happen to spending in that vertical subsequent to these budget talks. And just a real quick question for Charlie, if you could give us any sense of the size on how big ManageIQ's business was, what they were doing in revenue and if there were any verticals they happen to have a strong presence in.

James M. Whitehurst

Yes. I guess I hate to sound kind of like Goldilocks, but I would say kind of not too hot, not too cold with government. It's done fine. It certainly didn't have the blowout quarter that we saw in financial services as a vertical. But we also have -- I mean, it's still growing nicely. Again, we're a lousy indicator because we actually do well when budgets are tight because, obviously, people look at open source to save money. So we probably aren't the best indicator. But again, we haven't seen -- I mean, we saw a solid quarter, and pipeline in public sector continues to look pretty solid as well. So we haven't seen -- I mean, certainly, no strong inflection either way, so it's kind of not too hot, not too cold. And not only performance in Q3, but also outlook in Q4 in public sector.

Charles E. Peters

Just a quick comment on your -- first of all, the month of December. The month of December is off to a good start. It's really typical for us. A lot of companies have the December 31 quarter end, and so they tend to spend money in December, and December's looking fine. And that's broader than just government, I mean, overall. As regards ManageIQ, ManageIQ is an early-stage startup company. It has a few customers. It's got customers in the financial sector. It's got customers in a number of other sectors without going into all the detail. If you actually go to their website, you can actually see some of their customer names right there. In terms of revenue, it's not significant. And I think as we've disclosed in the press release, it has a burn rate of about $2 million a quarter, not including amortization and stock comp. That will add another $2 million a quarter. And those numbers are included in the guidance I gave for Q4.

Operator

Next, we have John DiFucci with JPMorgan.

John S. DiFucci - JP Morgan Chase & Co, Research Division

Charlie, can you just comment on sales and marketing? It continues to grow as a percentage of revenue. We realize you're investing in different regions and I guess different areas, too. But it's not just something we're used to seeing given the typical software model, whether it's a license and maintenance model or a subscription model. Usually, we see some leverage there. Can you just comment on that and whether we're going to start to see some?

Charles E. Peters

Sure. I think our sales and marketing spend, the team is doing great. They performed outstanding. The growth of the business has been great both in terms of what they've managed to do in terms of generating new customers and in terms of growing the existing base. We have been expanding into multiple countries. This year, we've added 4 new countries. We'll be having offices in Columbia, Poland, Turkey and Indonesia, brand new offices and presence there in sort of a startup mode. We've acquired 3 companies since October of last year, which has added some additional costs. We're still in expansion mode, John, and we're growing pretty well.

Operator

Next, we have Ross MacMillan with Jefferies.

Ross MacMillan - Jefferies & Company, Inc., Research Division

Two questions. Charlie, can you comment at all on Polymita and FuseSource in terms of revenue or billings contribution in the quarter? And then, Jim, as you start to look towards your commercial variant of OpenStack based on Folsom, can you just talk about what you're seeing in terms of kind of early customer interest and how you're gauging whether customers will be kind of biased towards one flavor of OpenStack versus another?

Charles E. Peters

Sure. In terms of -- first in terms of the contribution of Polymita and FuseSource in the quarter, it was not material. I'll just remind everybody, when you acquire a software company, and these were early-stage companies in any case, you'll revalue deferred revenue down to, generally, a fairly small number, and the subscription model, you kind of start from scratch. So since they were acquired one in the last week of August and one in the first week of September, very little layer of revenue this quarter.

James M. Whitehurst

In terms of OpenStack, I mean, obviously, there's just a massive amount of interest in it, very little production deployment because it isn't moving so rapidly. So we see tremendous interest in someone doing to OpenStack what we did for Linux, which is providing the point where vendors can certify in that long-term stability. As far as I know, others are talking about building clouds around OpenStack. I don't know anyone else looking to apply kind of a Red Hat-like enterprise model. So customers do -- not, obviously, not just any customers but cloud providers, as well, see a lot of potential value in that. Again, still early, early days.

Operator

Next, we have Scott Zeller with Needham & Company.

Scott Zeller - Needham & Company, LLC, Research Division

There were some comments earlier about hybrid cloud management. Just if you could, help us with where you think the spending is, what inning we're in for private cloud for open source versus hybrid cloud for open source, just to broadly frame it out.

Charles E. Peters

I just still think we're in batting practice.

James M. Whitehurst

Well, I mean, if you truly look at cloud as management, it depends on where virtualization management ends and cloud management begins. Obviously, it's a blurry, blurry line. But there is just very modest experimentation at this point with private cloud. You don't see tons of it. A lot of people will say they have a private cloud because they have a bunch of virtualized servers, but truly when you think about managing an application portfolio or an elastic infrastructure, that is still quite nascent. So that's a very large opportunity, we believe, in the future, but we are, again, we're in batting practice. We haven't started the first inning.

Operator

Next, we have Adam Holt with Morgan Stanley.

Adam H. Holt - Morgan Stanley, Research Division

I've got a question for Charlie, I guess, about margins. This year was an investment year, and you talked about ramping some of the infrastructure around cluster. We've obviously got a new acquisition to factor in. I guess a 2-part question. One, are you where you would like to be and think you need to be in terms of success on those initiatives around some of the new growth areas? And as we think about next year, I know you haven't given point guidance, but should we expect to see margins move up again as you start to harvest some of the benefits of the investments this year?

Charles E. Peters

So I mean, first of all, I mean, the guidance I gave for the full year was a 24.6% full year operating margin. It's very close to the operating margin I guided at the very start of the year, even before these incremental acquisitions added to it. So we believe that it's appropriate to invest in these areas because we see the market moving here, and we think there's a lot of growth to be had. Now in terms of what we'll be doing for margin for next year, it's too early to say. I will provide detailed guidance on the fourth quarter earnings call, as I always do. And I think you simply have to go back and look at our track record of providing guidance and our ability to achieve what we say we're going to do. But I'll leave it at that for now. We're going to provide detailed guidance on our fourth quarter earnings call.

Operator

Next, we have Brad Reback with Stifel, Nicolaus.

Brad R. Reback - Stifel, Nicolaus & Co., Inc., Research Division

So just going back real quickly, Charlie, on these public cloud deals that you're doing, are the economics there meaningfully different or pretty similar to what you see with a traditional corporate client?

Charles E. Peters

So there's a couple ways we get revenue from a public cloud. The ones I'm talking about here is in the top 30 of us actually selling infrastructure to the public cloud providers. And the economics are actually very similar to what we have in the rest of our customer base. Not mentioned in the top 30 is the fact there's a whole different revenue stream of customers using Red Hat in public clouds. And then there's a monthly, or quarterly revenue stream that's coming to us from that usage. And those numbers are also growing quite nicely at this time.

Tom McCallum

Thank you. Thank you, everyone. That's all the time we have this evening for the call. Happy holidays, and we look forward to catching up with you as the year progresses next year. Thank you, operator.

Operator

This concludes today's conference call. You may now disconnect.

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