Red Hat, Inc. F3Q09 (Qtr End 11/30/08) Earnings Call Transcript

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 |  About: Red Hat, Inc. (RHT)
by: SA Transcripts

Operator

At this time I would like to welcome everyone to the Red Hat third quarter 2009 fiscal year earnings call. (Operator Instructions) I would now like to turn the call over to Tom McCallum, Vice President of Investor Relations; sir, you may begin your conference.

Tom McCallum

Hello and welcome to Red Hat's fiscal third quarter 2009 earnings call. The speakers for today’s call will be James Whitehurst, President and CEO; and Charles Peters, Executive Vice President and CFO.

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

Various remarks that 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 or 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.

In addition, any forward-looking statements represent our estimates or views only as of today, December 22, 2008 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 as of any date subsequent to today.

With that, I’d like to turn the call over to James.

James Whitehurst

Thank you Tom and let me add my welcome to all of you joining us on today’s call. I’m pleased to announce another quarter highlighted by strong execution and financial results. Although the current economic crisis has created a challenging business environment for Red Hat our performance was strong and our outlook remains positive.

Our value message continues to resonate with customers who recognize Red Hat as the low cost high value supplier of data center infrastructure solutions and this is driving strong renewals and new sales.

Customers must carve out costs in their infrastructures and we can show them how. Although movements in foreign exchange rates reduced our reported revenues, when measured in local currency or market share or new customers attained, our growth remained strong.

In addition we have balanced our revenues and expenses well to minimize the impact on profitability resulting from foreign exchange rates. Combined with carefully managed costs we delivered better then expected operating margins, net income, operating cash flow, free cash flow, and earnings per share.

Before Charles provides you additional financial details and our outlook for the remainder of fiscal 2009 I would like to touch on two topics. First I’ll review some key accomplishments from the quarter and finally I’ll describe why Red Hat is particularly well positioned to perform in the current economic environment.

Starting with a few highlights from fiscal Q3, we continued to see strong renewals and up sells. We renewed all of the top 25 deals that were scheduled to renew this quarter and they were renewed at approximately 106% of prior year’s value.

This included multi year renewals with three large financial services firms. This type of commitment from customers in an industry that has been heavily impacted by the financial crisis illustrates the high level of value we continue to deliver to our customers and the power of collaborative open source model.

We also continued to develop our capabilities and offerings. Early in the quarter we acquired Qumranet which accelerates our time to market to deliver an expanded virtualization solutions portfolio.

The integration of Qumranet’s capability has been going very well and is nearly complete. The VDI solution, Solid Ice, is now available for customers as part of an early adopter program. You will see additional announcements around new virtualization products and tools in the near future.

Also this quarter we signed an agreement with Fujitsu to provide new Linux support services that are designed to provide quicker response times over extended support periods for mission critical systems through our Red Hat Advanced Mission Critical Program.

The program combines the mainframe expertise of Fujitsu with the enterprise Linux expertise of Red Hat.

Our middleware solutions continue to gain traction with customers. Not only does it exhibit the same type of cost saving characteristics as our platform business but customers are also enticed by the high performance and flexibility of our offering.

At a recent conference one of our largest middleware customers, a national communications provider, discussed how they were replacing their proprietary middleware software with Red Hat offerings. The proprietary software was not only costly to run and maintain but it suffered from many of the same attributes other proprietary vendor solutions; declining innovation and lack of collaborative customer participation.

They said their use of proprietary middleware was literally holding them back from launching new revenue generating services across a growing number of devices that consumers and businesses use to access data and communication services.

Our middleware solutions directly address these issues for the customer and they are now ripping and replacing the proprietary solution and deploying JBoss across their enterprise. They are not alone. More and more I hear similar stories as budgets get tighter.

And finally we continue to make good progress on our strategic initiatives including our free to pay initiative. As a proof point our top deals for the quarter included a six-figure deal with a customer who moved from free Linux to a paid subscription.

Going forward Red Hat is well positioned to perform in the current climate. As our history has shown difficult economic environments provide a catalyst for attracting customers who previously did not deploy open source solutions on a broad basis.

These customers can no longer afford the status quo of proprietary solutions. They must search for low cost more flexible alternatives which favors open source and Red Hat. CIOs have to go beyond mere cost containment, they must aggressively cut costs while helping their companies transform the economic model for the current conditions.

Legacy proprietary software and proprietary license models work against that kind of change the companies must make today in order to survive. If we take a step back and look at the recession of 2001 Red Hat was a relatively small company with a limited geographic footprint.

At that time we were gaining stature with early adopters enterprise customers based on the cost savings of UNIX to Linux migration. However the dot com bust helped move us beyond the mainstream as tight budgets forced a growing number of IT managers to embrace the value of UNIX to Linux migration.

What they found was substantial savings, improved performance, and faster innovation. This trend of UNIX to Linux has continued forward to this day.

This past quarter we held 17 events in cities attended by more then 1,400 CIOs and IT professionals. It is clear that our cost savings and quick ROIs are back on the top of their agendas. While the UNIX to Linux ROI story still holds true today, Red Hat now has a much larger global footprint, a broader portfolio of solutions, products and services, and a stronger well recognized reputation for helping IT managers carve out costs.

In terms of footprint Red Hat now has 65 offices in 28 countries providing customers global sales and support. We are now doing business in every major geography including emerging markets that industry analysts predict will continue to have IT spending rates that are well above the global average.

A Red Hat enterprise Linux platform now has more then 2.5 million subscriptions and a comprehensive eco system of over 4,200 hardware certifications and 2,100 [ISP] partners with over 3,000 certified applications which gives RHEL the largest eco system of any Linux distribution by far.

In terms of products we have expanded beyond the OS and now offer a broad array of open source enterprise infrastructure solutions. We have built out a complete managed middleware solutions offering including our EAP, SOA suite, portal and data solutions.

We continue to push the performance boundaries with our Red Hat enterprise MRG, or merge platform which integrates messaging, real time, and grid technology. MRG is the next generation IT infrastructure that makes enterprise computing faster, defines new levels of interoperability and gives customers competitive advantage by running applications and transactions with greater performance and reliability.

We have key wins for MRG in the financial and government verticals in Q 3 and expect to release the 1.1 version of MRG early next year.

And finally with the addition of Qumranet we now have a virtualization portfolio that enables us to deliver solutions to one of the fastest growing segments of the IT infrastructure. All of this gives us an opportunity to address the approximately $50 billion enterprise infrastructure market.

We believe that our business proposition remains compelling even in recessionary times and we will continue to grow our market share.

Finally the reputation of Red Hat [inaudible] open source more broadly to reduce costs and deliver value is clearly recognized across the industry. A number of our recent top industry analyst reports and surveys conclude that open source will be a winner in this economic environment even as IT spending slows.

In fact Business Week recently published results from a Gartner survey of enterprises that found that approximately 45% of respondents who are not currently using open source plan on doing so in the next 12 months.

Reinforcing this CIO insights 2008 customer value survey was published in November. This survey measures how US based IT executives perceive the value of their vendor product and service offerings along with overall satisfaction with the support of these vendors.

Red Hat ranked among the very top vendors for meeting expectations for lowering costs. Red Hat has consistently sustained high levels in this survey over the past several years and our responsiveness to customer needs was recognized again this year by those who matter the most to us, our customers.

In summary Q3 was a strong proof point of Red Hat’s ability to execute at a high level during challenging times. Our proven ability to lower cost while improving performance continues to resonate with customers.

We believe this position will allow us to continue to gain market share and deliver solid results. With that let me turn the call over to Charles.

Charles Peters

Thank you James, the combination of good execution and cost management enabled us to deliver another solid quarter for Red Hat, this time in a very difficult economic environment.

There are a number of important financial highlights for the quarter, 23% operating margin, an improvement of 120 basis points from last quarter, tax efficiencies that reduced our GAAP annual effective tax rate 35%, capital structure adjustments which reduced the diluted shares outstanding by 6% to 208 million and reduced our outstanding debt by 50%, better then expected earnings per share, and strong operating cash flow and free cash flow per share.

Our results demonstrate the strength and predictability of our business and the continued demand for open source solutions. We believe our business and our value proposition are key reasons for our resiliency.

Keep in mind that 82% of our revenue is recurring and subscription based. Some of the most mission critical trading systems in the world run on Red Hat and more mission critical work is moved our way every quarter.

Our renewal rate in these situations and with our largest accounts is extremely high for two reasons. First the high performance and reliability of our products and support and second the low cost and high value of our offerings.

Before taking you through the financial details let me describe the impact of foreign exchange movements on our reported Q3 results.

As James mentioned Red Hat has offices in 28 countries and does business in many more than that. Approximately 45% of our revenue is non-US and approximately 50% of our employees are non-US. In historically significant ways currencies in virtually all of these countries except Japan devalued against the US dollar during the third quarter.

As you can see from the foreign exchange rate schedule provided on our Investor Relations section of our website, more then half of the 20 countries listed experienced currency devaluation of 10% or more compared to the prior quarter.

As one would expect this unusual currency environment materially impacted our reported revenue in US dollar terms. However as we said at Analyst Day on October 7, the global location of our sales and engineering resources creates somewhat of a natural currency offset on the operating expense line.

As a result the net negative foreign exchange impact on operating income was significantly moderated. The devaluation in average Q3 exchange rates compared to average exchange rates in effect during the prior quarter had the following rough impact on our Q3 non-GAAP P&L.

Revenue was reduced by $7 million, cost of revenue was reduced by $1 million, and therefore gross margin was reduced by $6 million. Operating expense was reduced by $4 million and therefore operating income was lower by $2 million or about $0.01 a share.

Since our Q3 non-GAAP operating income actually improved approximately $2 million over Q2, even after the negative currency impact and inclusion of the acquisition of Qumranet, the significant performance improvement relates to operational efficiency and prudent cost management actions which we aggressively pursued during the quarter.

In Q3 customer demand and sales execution remained consistent. The channel continued the gradual rise we have seen over the past few quarters and generated 55% of our Q3 bookings. Direct sales were 45% versus a 52-48% split in Q2.

The geographical split is unchanged from last quarter at 58% from the Americas, 25% from EMEA, and 17% from APAC as we continued to experience consistent demand for our solutions around the globe.

Using our billings proxy of adding revenue to the change in deferred revenue shown on the cash flow statement which excludes the impact of foreign exchange rates on deferred revenue, billings for the quarter were $193 million.

They would have been $200 million if one added back the $7 million of FX impact on revenue which I just mentioned. Our rolling four-quarter average billings for Q3 using our proxy was $183 million, up 24% year-over-year.

Our top deals help drive these results. Let me give you some highlights of the top 30. We had 14 deals at $1 million or more. We had four deals equal to or over $5 million. In addition to the strength in the financial sector that James mentioned earlier, media, technology and government made up the largest percentages of our top deals.

Over 20% of the top deals had a middleware component including two $1 million plus deals that were middleware only. And finally as James mentioned, one of the top 30 deals was a free to paid conversion.

Now let me turn to the full P&L, total revenue for Q3 was $165 million, an increase of 22% from the year ago quarter and up 27% year-to-date. As already described revenue would have been $7 million higher in Q3 if average FOREX rates were the same as they were in Q2.

Also reported revenue would have been within our guidance range if the Q3 rates had remained at the levels in place at the time we provided our guidance. The currency impact primarily relates to subscription revenue since most of our services business is in the United States.

Subscription revenue was $135 million or 82% of total revenue and up 17% year-over-year. The training and services component of revenue was $30 million, up 52% from last year largely due to the acquisition of [Ementra] and increased demand for training and consulting services.

As I mentioned at our Analyst Day for better comparability with the vast majority of other software companies, our non-GAAP disclosures now exclude amortization of intangible assets as well as stock based compensation expense, therefore the non-GAAP income statement calculations that I will refer to exclude these items for both the current quarter calculations and historical quarter comparisons and as appropriate make adjustments for our effective cash tax rate.

On a non-GAAP basis overall gross margin was 85%, was 90 basis points above Q2 but slightly lower then last year. The improvement compared to last quarter is due to continual small improvement in subscription margin as we scale and better utilization rates in services.

The primary factor in the year-to-year comparison is the higher services mix this year. As regards our subscriptions gross margins our overall pricing and discounting policy remains consistent as evidenced by our steady subscription margins of 93% to 94% for the past several years.

For Q3 non-GAAP subscription margin was 94% and was 80 basis points better then last quarter due in part to the geographic positioning of our support resources and the reduction in US dollar expenses caused by the change in foreign exchange rates which I’ve already discussed.

The Q3 services margin was 42%, up from 39% in Q2 and 36% in the year ago quarter primarily due to better utilization of our staff and facilities. Operating expenses for the quarter were virtually unchanged from Q2 despite the acquisition of Qumranet which added approximately $3.8 million principally in R&D expense during the quarter.

Currency impacts as discussed earlier reduced US dollar expenses in both sales and marketing and R&D. Other costs savings in almost all functions allowed us room for continued investment in key growth initiatives.

Our Q3 non-GAAP operating income was $38 million and it produced a 23.2% margin which was well above our guidance and up $2.3 million or 120 basis points over the previous quarter. Continuing on down the P&L, other income net was $12.5 million and included a gain of $4.1 million from our convertible debt repurchases.

The non-GAAP tax rate reflecting actual cash taxes that we expect to pay remained at approximately 5% resulting in non-GAAP net income of $48 million, up 13% year-over-year or 3% sequentially. Non-GAAP diluted EPS was $0.24 a share, up 9% sequentially and 20% year-over-year and significantly better then our guidance.

A simple reconciliation to my previous guidance is as follows, I’ll start with $0.17 which was the high end of the guidance range that I provided on September 24, so starting with the high end of that range $0.17, you need to exclude amortization of intangibles, so add $0.02.

There was a gain on repurchase of convertible bonds, so add $0.02 more. Foreign exchange rate impact, you need to subtract $0.01. And we reduced the diluted share count, add $0.01. And finally performance improvement which we are particularly pleased about, add $0.03.

That results in a net non-GAAP EPS of $0.24. EPS in both Q2 and Q3 included $0.02 per share from other items. The $0.02 in Q3 was from the gain on the repurchases of a portion of the convertible debt that I described and will say more about in a moment, and the $0.02 in the second quarter was from gain on the sale of an investment.

Now let’s turn to the balance sheet and the cash flow statement, cash and investments at the end of the quarter were over $1.1 billion. During the quarter we used cash to repurchase $315 million in convertible debt and stock as well as a little over $100 million to acquire Qumranet, partially offsetting this uses was healthy cash generation from operations.

We continued to see strength in our cash collections as DSOs declined slightly to 56 days compared to 60 days in the second quarter. As I’ve mentioned on previous calls our DSO calculation includes revenue plus the change in deferred revenue which I have adjusted for FX this quarter since all DSO is traditionally a measure of receivables.

Our deferred revenue at quarter end was $505 million consisting of short-term deferred revenue of $353 million and long-term deferred revenue of $152 million. Deferred revenue was reduced by approximately $19 million related to FX at November 30 compared to August 31.

Excluding the foreign exchange impact total deferred revenue increased by $27 million which can be seen on the cash flow statement. Moving now to the statement of cash flows, our GAAP cash flow from operations was $59 million, up $5 million from last quarter and in line with the prior year quarter.

Year-to-date cash flow from operations is $177 million up 19% over the prior year-to-date amount. In addition to operating cash flows in Q3 we also produced $15 million in cash from tax benefits relating to NOLs which is included in cash flows from financing activities on the cash flow statement.

We have approximately $111 million of NOLs remaining to offset future taxable income. CapEx was only $4 million this quarter resulting in free cash flow of $55 million. We appreciate that many investors analyze cash flow of companies including Red Hat on a per share basis.

For those of you who do this calculation please note that 6% reduction in the diluted share count this quarter which increases cash flow on a per share basis. As a reminder starting in fiscal 2010 we will be reporting non-GAAP income statement results at our GAAP tax rate.

It is important to note that this reporting change will have virtually no impact on our GAAP operating cash.

Now I’d like to turn to guidance for the fourth quarter, keep in mind that changes in foreign currencies continue to be significant even in the last several days.

For purposes of guidance I am assuming the same average exchange rate as in effect in Q3 and you can find these on our website. If you have different foreign exchange assumptions, please adjust your estimates accordingly.

It is apparent to me by reviewing first call that at this point most [inaudible] analysts have not adjusted for foreign currency their estimates for Q4 or their estimates for the coming year so I would assume that they will all do that.

Revenue for Q4 is estimated to be $166 million to $167.5 million. Consistent with prior years Q4 services revenue, that’s training and consulting, is expected to decline sequentially by $1 million to $2 million as a result of downtime at customer sites around various year-end holidays.

This will partially offset a continued growth in subscription revenue. Our non-GAAP operating expenses are expected to increase principally related to employee compensation. Non-GAAP operating margin is expected to be in the range of 21% to 23%.

Other income will be approximately $5 million. Interest income will be lower as a result of lower cash balances and lower interest rates and we will not repeat the $4.1 million gain on the convertible bonds that occurred in Q3.

The non-GAAP tax rate will remain at 5% and non-GAAP EPS will be approximately $0.19 to $0.20.

You should also anticipate that we will redeem the remaining convertible debt on January 15 for $285 million which will reduce the Q4 diluted share count to approximately 200 million shares.

In summary we continue to manage through a very challenging macro environment and remain focused on delivering solid results across our key financial metrics. We are not immune to the broad economic slowdown and we cannot change currency rates, but we believe that we are better situated then most.

We have a significant amount of control over our business model and a value proposition that is compelling for customers in good times and bad. We have a recurring revenue model with good visibility to subscriptions, a globally strong pipeline, solid cash flow, and a large addressable market.

We will continue to invest for growth but we will also control expenses responsibly in light of market conditions. We remain optimistic about our outlook and our long-term opportunities.

We are now ready to take your questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from the line of Mark Murphy – Piper Jaffray

Mark Murphy – Piper Jaffray

If you look several years into the future where you do see JBoss going as a percentage of revenue. Do you think that that will ultimately hit a point where its contributing 25 or 30% or more and also have you seen an uptick in the large JBoss transactions since Oracle raised prices on BEA customers?

James Whitehurst

Certainly JBoss is growing and we expect it to continue to grow substantially faster then the current core business. We’re not going to give long-term forecast around that. I’ll let you do math there but in general we see, its still earlier in the game, it’s a bit UNIX to Linux of a few years ago so the growth rates are substantially faster and we expect it to stay that way for a while.

In terms of large deals, absolutely. Both in terms of large deals closed and the other thing is middleware is a long sale cycle and so post the price increases and really the price post closing the acquisitions a lot of people starting asking so we’re in a lot of trials with a lot of people. We’re getting a lot of traction so the pipeline there remains strong.

Mark Murphy – Piper Jaffray

Investors are bracing themselves for a likelihood of license revenue declines next year from Oracle and SAP and seeing the possibility of revenue decline for Microsoft next year, how confident are you in achieving a reasonable rate of revenue growth next year with the understanding that you haven’t provided guidance yet but if the environment is going to be that challenging how confident are you.

James Whitehurst

Reasonable is in the eye of the beholder. We’ll provide guidance in Q4. What I would say is obviously a lot of our revenue sits on the balance sheet so a lot of it you can calculate but we won’t provide any real guidance on next year until Q4.

Operator

Your next question comes from the line of Brent Thill – Citigroup

Brent Thill – Citigroup

You mentioned you were particularly pleased with the performance improvement, could you just characterize going forward on the operating margin side in a poor environment are you willing to hold margins where they’re at now or do you think we can now assume some slight margin improvement from you’ve seen over the last year.

Charles Peters

The margins improved 120 basis points in Q3 compared to Q2, our guidance for Q4 was 21 to 23% operating margins and it will vary a bit by quarter but I think James has said depending upon how fast the growth is we’ll moderate the operating margin up and down. I think we have very good control of the business. We are continuing to invest in longer-term projects for the business and we don’t want to sacrifice that but I think there probably is room for margin growth over time.

James Whitehurst

Putting it very simply, growth slows margins will improve. It really is the balance of the two. We do have a lot of positive ROI projects and we’re in a situation where we have a rich set of opportunities to grow. That said we will continue to deliver bottom line results.

I think this quarter you saw that and we were worried about the environment so we were diligent in cost and you can see we can do that and so we’ll play it quarter by quarter as we go forward depending on what growth opportunities there are out there.

You won’t see significant wild variations I don’t think from where we are now but it really depends on what’s out there and what opportunities arise given the times we’re in.

Brent Thill – Citigroup

The euro exchange rate that you’re assuming for the Q4 guidance is?

Charles Peters

The euro exchange rate for Q4 guidance is the same as the average rate for Q2 which was about 135 and just as point of reference the euro has moved rapidly in the last two weeks. A week and a half ago we were at 127, last week it got as high as 147, today it closed at I think around 139 to 140. I’m trying to pick a peg. You can find the exchange rates we use on our website. Just use the same average exchange rates as in effect and for Q3 in terms of how I estimated Q4.

Operator

Your next question comes from the line of Tim Klasell - Thomas Weisel Partners

Tim Klasell - Thomas Weisel Partners

Regarding customer behavior what are you seeing around advance platform adoption and some of the higher price SKUs out there, are you seeing customers stay with the lower priced SKUs or are you seeing any sort of change in behavior given the macro backdrop.

Charles Peters

It really depends upon what their need is and we have continued to see movement of existing customers to advanced platform and certainly some of the new customers go straight to advance platform but it really is depending upon their need what they choose.

Tim Klasell - Thomas Weisel Partners

Did you give the percentage of revenue sold through the channel versus direct?

Charles Peters

It was 55% for the channel and 45% direct this quarter versus 52, 48 last quarter.

Tim Klasell - Thomas Weisel Partners

And how have the large OEMs, how have their contributions been trending.

Charles Peters

I think our business across the board was pretty solid and pretty consistent and the OEMs were big contributors to that.

Operator

Your next question comes from the line of Sarah Friar – Goldman Sachs

Sarah Friar – Goldman Sachs

Can I just come back to the margin point, I know you’re talking about the ability to show improvement over time, but just thinking about the guidance for next quarter, the 21 to 23% operating margin, what would change between a November and a February quarter that would bring margins down. Is there just more heavier weighting into sales and marketing because of fiscal year end comp, is that the way we should think about it.

Charles Peters

Its not just on the expense side, you need also to be thinking on the gross margin side. As I said from a revenue perspective what typically happens in our Q4 is that services revenue declines and the guidance I gave was $1 to $2 million but the personnel that deliver that type of revenue don’t go away simply because they’re on holiday so the services gross margin probably will decline somewhat which falls right to the operating margin line.

And then on the expense side of things, as I said from just an employee compensation, we continue to add people responsibly but our employee compensation will be higher in Q4 then it was in Q3.

James Whitehurst

We’re in budget time right now and so as we look at budget for next year and we look at what we think the revenue out there and the bookings can be, sales people can handle a certain amount of revenue and so we have to hire in advance of the demand that we see out there because it takes a while to get people trained up.

So frankly a little bit depending on what we see going into next year from our regional general managers determines to some extent the headcount they need next year, in order to do that we have to hire them in Q4 so they’re at least a little bit ramped up. So because of that lag as well depending on the speed that we find people and the like will also impact the level of spending this quarter. It might not be directly impacting revenue.

Sarah Friar – Goldman Sachs

On some of the geo trends, I need to work out the model on a real constant currency basis year-over-year but it looks like EMEA slowed most, which I assume a lot of that is the FX impact coming through but just as you did business did you find that EMEA was catching up with the Americas in terms of more scrutiny on budgets and so on or is that still a lagging the US indicator.

Charles Peters

I think if you take the FX into account and you go back to the [inaudible] I gave which was basically unchanged geographic splits from a quarter ago and given the fact that the euro depreciated, I think you would conclude that Europe was actually pretty strong in Q3.

James Whitehurst

Maybe a little better then the UK but in general EMEA is holding up well.

Sarah Friar – Goldman Sachs

Do you think that’s a penetration issue or what do you put that down to as you talk to customers.

Charles Peters

I think its just the willingness to adopt open source and our traction overall. We’ve got a very capable sales force over there that has had good coverage and good acceptance over a long period of time. They’re just doing a good job.

Operator

Your next question comes from the line of Larry Patrone – WR Hambrecht & Co.

Larry Patrone – WR Hambrecht & Co.

Could you talk a bit about the pipeline. I know at Analyst Day you mentioned that the pipeline was fairly strong. It sounds like its still relatively healthy considering the larger environment, just wondering if there’s been much change in that pipeline on a geographic basis.

James Whitehurst

I would still characterize the pipeline as strong. The pipeline obviously would [inaudible] around, along with the exchange rate so when we’re looking at the absolute numbers they obviously move with the exchange rate but generally across regions we just had all of our general managers from around the system together last week as we planned into next year and no significant areas of weakness.

I think the concern everyone has is we see a strong pipeline. At the same time existing customers are all pushing as hard as you would expect but the net net still is a strong pipeline across all regions.

Larry Patrone – WR Hambrecht & Co.

Have you seen any slowdown at all on the government vertical at all or would you characterize that as also pretty healthy at this point.

Charles Peters

I think its healthy and the reason why is because governments across the globe at this point need to cut IT costs and so they are looking more, they’ve always been reasonable open source buyers but even now I think its accelerating somewhat. I think still quite healthy.

James Whitehurst

I was at one European country not too long ago and their desperate to find some ways to carve out some costs because some of the [bank] they allow, those are hitting government budgets pretty hard and so if anything I’ve seen some acceleration in a lot of areas of government. Of course government and financial verticals seem to be mixing a little bit with the number of bailouts going on.

Operator

Your next question comes from the line of Steve Ashley - Robert W. Baird

Steve Ashley - Robert W. Baird

You hear a lot about cloud computing and you get into a little bit of semantics but if I were to throw that into two buckets with one being the public ISP type software as a service people like salesforce.com and then the second bucket being these internal private clouds, are you seeing either of those architecture changes impacting the demand for your product today.

James Whitehurst

Certainly we are engaging with a number of customers, I’d say much more on the internal cloud side at this point. Obviously a lot of the external clouds providers are large customers and large users of open source. So certainly we see continuing demand there but I would say in terms of just conversations really pushing the limit on the technology and looking for more its still more internal demand then external demand. I think that’s just because of the raw numbers.

There are a lot of enterprises out there who have literally thousands of computers in data centers that they’re looking to run more effectively as a grid or a cloud or whatever you want to call the marketing word de jeur.

But we have a lot of traction there and that’s certainly helping our business.

Steve Ashley - Robert W. Baird

You talked about a number of large deals, there were four $5 million deals and 14 $1 million deals, were any of those or some of those not billed in the quarter.

Charles Peters

There were certainly some of them certainly on the large, the $5 million deals, most of those would be one year at a time and its possible that even in the $1 million some of those may not have been totally billed in the quarter. There was a sizable off balance sheet backlog increase in the quarter which when we come to the end of Q4 I’ll provide some additional clarity on as I usually do once a year in Q4.

I’d also add this because some may be thinking about the change in deferred revenue there was a $19 million change on the balance sheet on deferred revenue and so of that $19 million about $15 million of that effects the current portion of deferred revenue and $4 million effects the long-term portion of deferred revenue so in order words the increase in current deferred revenue was substantial on [inaudible] the impact of currency, almost $21 million and the increase in the long-term deferred revenue was about $6 million after adjusting for the currency.

Operator

Your next question comes from the line of Heather Bellini – UBS Investment Research

Heather Bellini – UBS Investment Research

You made a comment at the beginning that I think you renewed all of your large deals and that you renewed at an average rate of 106% of the contract value, that’s a little bit lower then what we’ve been seeing from you, its been more like 120, how does that impact your revenue growth outlook for next year and then you had a good cash flow quarter this quarter, you haven’t guided or updated your guidance to cash flow. If you do the puts and takes of what you’ve been saying over the last few quarters and after you lowered it last quarter due to Qumranet, it stood at about $228 to $235 million, I’m wondering if that’s still a good level considering there’s only one quarter left in the fiscal year.

Charles Peters

On the top 25 deals they renewed at 106% of the prior year. We’ve had a couple of quarters where we’ve done as much as 120%, we actually had one quarter because of one usual deal we got as high as something like 150%, we kind of put that one out of the mix to come to 120.

I think you could do the same this quarter with 106, you could take one or two of those financial services deals out of the mix and it definitely comes to a higher percent. Clearly we’re very pleased to have these renewals but because of the circumstances of the market environment we did a couple of them that were a little less then the normal 120% number.

James Whitehurst

A couple of those are just large so they skew the results.

Heather Bellini – UBS Investment Research

But what does that mean for your outlook for revenue growth, is that growth rate decelerating and if over the next few quarters, people are talking about a challenging environment for the next few quarters, when we’re building our models out for the next fiscal year how should we be thinking that type of renewal. Do you expect it to bounce back next quarter if we’re there for the next few quarters at that level, how should we adjust our revenue forecast.

Charles Peters

The short answer is I think, one quarter doesn’t make a trend. This is, we had a couple of items here that probably took us down a little bit. I wouldn’t adjust your model at all for that. I think more importantly and as I said in my remarks I think every analyst needs to look at the currency numbers for next year because very few have already adjusted or had adjusted before today the FOREX impact in Q4 or for next year.

Heather Bellini – UBS Investment Research

Do you think currency is a bigger issue then the macro, is that how I should take it.

Charles Peters

I think so yes. About cash flow forecast as you know, I have not provided quarterly cash flow forecasts for the last several years. Having said that there’s one quarter to go. The primary items I think you should be thinking about in terms of what the cash flow forecast should be is first of all whatever assumptions you had on interest income or other income of the items in other income the only item that is included in operating cash flow is interest income and interest expense.

So for example, the $4 million gain this quarter and the gain the prior quarter none of that is in operating income. You need to be assuming interest income is going down and therefore that does have an impact on operating cash flow. Beyond that I don’t have any further guidance to provide on cash flow. We’ll see the number when it comes to the end of Q4. I think there’s some historical data that you could look at that might be helpful though.

If you look at operating cash flow the previous two our three years for Q4 as compared to Q3 that might provide you some guidance.

Operator

Your next question comes from the line of Trip Chowdhry – Global Equities Research

Trip Chowdhry – Global Equities Research

Many companies in Silicon Valley are thinking that probably March to September timeframe of next year will be very challenging from a global macro picture, and they are thinking of doing four-day weeks to cut costs that is particularly getting 20% current cost of the company. Is Red Hat thinking in same ways, or its probably too early for you to think on those terms yet.

Charles Peters

We don’t have any plans for anything like that at this point in time. I think our business is still solid. Our pipeline looks good. As I said we’re still looking to hire but to do so judiciously. We’re not contemplating four-day weeks.

Trip Chowdhry – Global Equities Research

Regarding Fedora do you think you can start charging some money for Fedora because again what we are hearing is there are so many competitors to you who are just taking advantage of Fedora, for example [inaudible], and to some extent I would say Red Flag which has changed its name right now, do you think even if you charged $10.00 a month subscription you could get about $20 million a quarter just out of Fedora, any thoughts on that.

James Whitehurst

Fedora is our R&D release. It is unsupported. It is not something that we look to or would expect to directly monetize. I think in terms of Oracle or [Zintas] those are forks of RHEL not of Fedora and they are without support and without certified eco systems. So but no, specifically on Fedora, no plans to directly monetize.

Operator

Your next question comes from the line of Brent Williams - The Benchmark Company

Brent Williams - The Benchmark Company

Looking at the middleware and incremental product opportunities beyond JBoss, how would we think qualitatively about how the MRG pipeline looks in calendar 2009 and what is the deal size for MRG versus other stuff, because it’s a re-architecture to implement does that become less of a factor as things get turbulent or is it still just going along a pace here.

James Whitehurst

Typically the deal sizes of those are quite large because these are things like trading platforms, or stock exchanges, so they’re generally typically large implementations and so by nature the deal sizes are larger on average.

I think even as you look going forward though if you look at the typical technology that a MRG implementation would replace, they are substantially more expensive and cost is a key thing driving people to MRG so I would not expect the turbulence in the economic environment to be a negative at all for MRG, it anything it can actually help accelerate adoption.

Brent Williams - The Benchmark Company

And also in deals that you sell yourself as opposed to hardware OEM deals, is there any change either in deals closed in the quarter or in pipeline that people are talking about towards one-year deals and away from three year deals?

Charles Peters

There hasn’t been any real meaningful change in the last year in that statistic, no.

Operator

Your next question comes from the line of Nabil Elsheshai - Pacific Crest Securities

Nabil Elsheshai - Pacific Crest Securities

I wanted to focus on the JBoss channel a bit, obviously it will never get as big a channel as the OS, but how do you feel like you’re progressing both in terms of developing OEM channel for JBoss as well as working with system integrators to potentially develop practices or something like that around JBoss.

Charles Peters

I think we’ve made a lot of good progress there, adding additional channel partners every quarter, qualifying them, training them, and as you say its probably never going to be as large as the operating systems. But we’ve made very good progress.

James Whitehurst

Especially with the integrators. There’s a lot of end user pull from customers asking more about JBoss and the potential to use JBoss and so we see a lot more interest from systems integrators coming to us saying help us think about building practices around that so hopefully we’ll have some announcements in the not too distant future but we feel pretty good about the progress we’re making with partners in that eco system around it.

Nabil Elsheshai - Pacific Crest Securities

The JBoss progress that you’ve made in the direct channel, how much of that is co-selling with RHEL versus selling independently.

Charles Peters

We’ve talked about that on previous quarters, and in most of our large deals there’s at least some component of JBoss. This quarter there were a couple of deals over $1 million were nothing but JBoss. I don’t have the number of other deals but there was some component, but we do have a good portion of cross selling that happened.

Operator

Your next question comes from the line of Katherine Egbert - Jefferies and Company

Katherine Egbert - Jefferies and Company

Did you say what JBoss did this quarter?

Charles Peters

We only talked about the number of large deals, we had of the top 30 deals two of them were nothing but JBoss and I now have the answer to the previous question, we had four of the top 30 deals had a JBoss component. We continue to make very good progress there, the growth rate continues to be faster, then the OS side of the business.

Katherine Egbert - Jefferies and Company

Are you ever going to break that out?

Charles Peters

Not sure that we will ever break it out unless it becomes a reportable segment.

Katherine Egbert - Jefferies and Company

One of the key things whether or not you buyback stock is whether this down economic environment favors a migration to low cost Linux can you comment on that because in 2002, 2003 you were quite a different company and if you’re seeking the market come to you as a low cost provider, can you give us an example.

Charles Peters

One of the comments that you may have missed early in the call James said that of our top deals this quarter one of our top deals we did was a free to paid Linux conversion so that’s an excellent example of what is no incremental servers sold, no new hardware, we simply moved someone from free to paid.

Katherine Egbert - Jefferies and Company

But that’s not an example of someone migrating to a low cost infrastructure, do you have an example for that?

Charles Peters

Many of our other accounts are going to be people moving off of UNIX or other sorts of proprietary software whether its on the OS side or the middleware side, moving over to what we have. James did give an example of a very large telecommunications supplier that is moving off of their proprietary middleware to JBoss.

James Whitehurst

But to be clear the UNIX to Linux migration continues. There’s still a lot of UNIX out there and a lot of our growth is replacement of very high cost UNIX platforms.

Katherine Egbert - Jefferies and Company

Do you feel like its accelerating, staying the same, decelerating.

Charles Peters

I think what’s happening is we’re hearing from a lot of additional customers that might now have called us before that at this point they must find ways to lower their cost and so they’re reexamining what they’re doing.

James Whitehurst

I’d say at this point really we’re about four months in to the new economic realities so there’s a lot of talk and a lot of interest that I’ve met with a lot of CIOs who were not interested in talking before. All that still has to turn into orders and so as I said the pipeline is strong but obviously we need to turn some of that new found interest into real orders and real cash.

Katherine Egbert - Jefferies and Company

What was the FX impact on cash flow in the November quarter?

Charles Peters

Probably the best way to think about that I think is the FX impact on the operating income was a negative $2 million, so if you add that to the reported cash flow that would probably be the primary difference.

Operator

Your next question comes from the line of Todd Raker – Deutsche Bank

Todd Raker – Deutsche Bank

When you’re thinking about the next quarter I understand that a lot of the revenue visibility comes off the balance sheet but have you changed your expectations in terms of close rates for the pipeline or scrub the pipeline any more severely then you normally would and I want to go back to this top 25 deals renewing at 106%, why shouldn’t we think that’s a worrisome data point that things could start to decelerate here given the economy.

Charles Peters

I think that like everyone else is reporting everyone is examining purchases whether its operating expense commitments or whether its CapEx closely, CFOs like me are holding people very closely accountable. So it probably makes some of the selling time a bit longer but we’re not making any different assumptions about our close rates. Our pipeline still looks strong.

About the 106%, I think the key statistic that you’re missing is we renewed 100% of the top 25 deals, that’s the statistic people should focus on. The second point that I made is that each quarter we have some deals that may be a little bit out of the ordinary. This quarter we renewed three multi year deals with financial services customers who are having their own difficulties that probably impacted that statistic a little bit.

I don’t believe that that is indicative of trend. That statistic has been as low as 103% and as high as 120% so we’re still right in the ballpark.

Todd Raker – Deutsche Bank

If you look at those top 25 deals roughly what was the breakout in terms of financial services representing what percentage.

Charles Peters

Three of the top 25 were financial services, all of those would have been in the large deal, very large deal category.

Todd Raker – Deutsche Bank

And if you look at the top 100 deals that we annualize, is that a fair representation of your exposure in terms of large deals in the financial services?

Charles Peters

That would be a higher percentage then normal and I would say at this point that—

James Whitehurst

The dollar volume is higher then normal.

Charles Peters

I would say at this point the good news is we have renewed pretty much all the significant financial services business out there. There’s always going to be something each quarter but the big ones are done.

Operator

Your next question comes from the line of James Gillman – Cross Research

James Gillman – Cross Research

I wanted to follow-up on the free to paid, was that due to a, from a unpaid RHEL after going in [inaudible] account or was it from another type of free such as [Zintas]?

James Whitehurst

This was not a compliance related initiative. This was purely a getting the customer to understand the value of a paid subscription.

Charles Peters

The customer needed support and wanted a certified operating system.

James Gillman – Cross Research

When you closed the deal was it just for a year or did it have a long-term component associated with it.

Charles Peters

That was just a one-year deal. So it’s a sizable win to make a one-year deal to be in that category.

Operator

Your final question comes from the line of Kash Rangan – Merrill Lynch

Kash Rangan – Merrill Lynch

I heard you talk about the UNIX to Linux migration, when you look at some of the server data coming out of [IDC] it does look like that was a pronounced trend in the past, but it is starting to slow down a little bit and also coupled with that you’ve got server unit growth also slowing down due to the tough macroeconomic environment, just wondering how you look at your business fiscal 2009 and if server unit growth rate does slow down, how do you handicap the impact to your business and how you go about managing that. In particular there is a metric that the company used to give out in the past which was I believe the paid attached rate to Linux servers which I think at one point used to be as low as 20-25%, I think it got to as high as 40-45%, I’m wondering if you can give us an update on where the paid portion on a quarterly basis of the Linux server market is. Maybe that gives you some room to grow against a tough server unit shipment backlog.

Charles Peters

In terms of growth, in terms of total revenue growth, one thing to think about is this, first of all there’s the Linux server statistic that you mentioned, there’s also the other types of hardware that we run on including the Fujitsu deal that James talked about, the IBM [D] Series machines and other sorts of mainframe, there’s the free to paid growth where we have customers that already have computers, there’s no new hardware at all come over to us.

This one by the way this quarter that James mentioned is not the first one. We have another top 25 deal about two or three quarters ago from free to paid. In addition we’ve got the growth in JBoss. There’s a whole lot of things going on other then just Linux servers.

Kash Rangan – Merrill Lynch

Maybe another way to look at it is if you look at the Linux server market, maybe there’s about 21% of the server market that’s Linux and the server market grew down to a 3% growth rate according to IDC, maybe is there another way to quantify what percentage of the Linux market is paid currently versus unpaid so that we can make some rough estimations as to how much could move to paid and how much share gain you could get from that relatively slower growth market.

James Whitehurst

I will tell you, I think IDC publishes the numbers which you can certainly get. I think, we look at this on a deal by deal, country-by-country perspective and the numbers are kind of different. There’s a lot of free RHEL out there. There’s a lot of free [fork] versions of RHEL, the RHEL derivatives out there so again as we build it up, we do a bottoms-up build every year from what our sales force is seeing and what we think we can go get.

And we do think there’s a lot of opportunity out there. I know that’s a bottom-up versus a top-down. Its hard for us to ever get those numbers synced back up with the top down view other then to say that its, there’s a substantial amount out there.

Charles Peters

I wouldn’t say cash but free Linux out there probably substantially is in excess of any paid.

Kash Rangan – Merrill Lynch

Any final commentary on the credit crisis, I know the company has been able to invoice customers several months ahead of time and still be able to collect, do you see any changes at all to that invoicing and payment pattern based on the credit crisis or you’re not seeing any but are in tuned to what could be going on.

Charles Peters

I think probably the most telling statistic in the quarter is the 56-day DSO which is an improvement. We’ve consistently been in the 52 to 62 days over the last four years. I think it would probably be naïve to say that over the next year or so assuming this goes on at least that long which I think it will that we may not see a little bit of change in DSO but we’ve done a very good job collecting and our business model is one where we have some leverage to collect. I think we’re in pretty good shape there. Our bad debt expense has been very low and we manage it carefully.

Thank you very much, I think that’s all for tonight.

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