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Red Hat, Inc. F1Q07 (Qtr Ending May 31, 2006) Earnings Conference Call Transcript (RHAT)

June 28, 2006 | about: RHT

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Red Hat, Inc. (RHAT)
F1Q07 Earnings Conference Call
June 28, 2006 5:00 pm ET

Executives

Matthew J. Szulik - Chairman, Chief Executive Officer and President
Charlie Peters - Executive Vice President and Chief Financial Officer
Dion Cornett - Vice President Investor Relations

Analysts

Steven Ashley - Robert W. Baird & Co., Inc.
Jason Maynard - Credit Suisse
Kash Rangan - Merrill Lynch
Chris Kwak - SIG
Tim Klasell - Thomas Weisel Partners
Terry Tillman - SunTrust Robinson Humphrey
Brendan Barnicle - Pacific Crest Securities
John Stewart - UBS Investment Research
Brent Thill - Citigroup
Katherine Egbert - Jefferies and Company
Todd May - Deutsche Bank
Todd Weller - Stifel Nicolaus
Trip Chowdhry - Global Equities Research
Rick G Sherlund - Goldman Sachs & Co
James N. Gilman - Cross Research/Soleil Securities

Presentation

Operator

Good afternoon. My name is Carol, and I will be your conference operator today. At this time, I would like to welcome everyone to the Red Hat conference call. All lines have been place on mute to prevent any background noise. After the speaker’s remarks, there will be a question-and-answer period.

(Operator Instructions)

As a reminder, ladies and gentlemen, this conference is being recorded today, Wednesday, June 28, 2006. Thank you.

I would now like to introduce Mr. Dion Cornett, Vice-President of Investor Relations. Mr. Cornett, you may begin your conference.

Dion Cornett

Thank you, Carol. Good afternoon, and welcome to Red Hat's first quarter fiscal year 2007 earnings call. Speakers for today's call will be: Matthew Szulik, Chairman, President, and Chief Executive Officer; Charlie Peters, Executive Vice-President and Chief Financial Officer; and myself.

Our earnings press release was issued after the market close today, and if anyone has not yet obtained a copy, it may be downloaded from redhat.com, or requested by calling Linda Brewton, Manager, Investor Relations, at 919-754-4476.

Various remarks that we may make about the company's future expectations, plans and prospects, including statements containing the words "believe", "anticipate", "plan", "expect", or "will", constitute forward-looking statements for purposes of the Safe Harbor provision 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 annual report on Form 10-Q filed with the SEC.

In addition, any forward-looking statements represent our views only as of today, and should not be relied upon as representing our views as of any subsequent date. While we 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 change and therefore, you should not rely on these forward-looking statements as representing our views as of any date subsequent to today.

I would now like to turn the call over to Matthew.

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Matthew Szulik

Thank you, Dion. Red Hat is pleased to report strong results during a very productive quarter for Red Hat and our shareholders. We continue to execute on a multi-dimensional opportunity, which includes deeper penetration of our installed base, creating value for new customers around the globe, and enriching our solution set beyond the core operating systems into the middleware market.

In Q1, our deepening relationships and ability to continuously provide value to our Enterprise customers were rewarded by the renewal of 25 of our top 25 deals up for renewal. This marks 99 out of our 100 largest customers renewing during the past four quarters.

During the quarter, Red Hat added 10,000+ net new customers, reflecting the continued expansion of our global market opportunity. Moreover, Q1 was marked by several key initiatives focused on our geographic expansion and growing our solution portfolio.

Since we last reported, we completed four acquisitions, one being JBoss, which I will talk about later in the conversation, and the other three related to fortifying our leading open-source position in the increasingly important geographies of India and South America.

On June 8, we acquired the remaining portion of our Indian joint venture, reinforcing the Red Hat brand, which already enjoys a leading Linux share amongst businesses, government, and education, and validating a framework by which we enter emerging markets.

Similarly, on May 16, we completed the acquisitions of our distribution partners in Brazil and in Argentina. These transactions were driven by growing demand in a region that is demonstrably pro-open source. Not only have several governments passed laws encouraging the use of open-source technologies in the region, but the largest free-software conference in the world, the Forum Internacional Software Livre (FIFL) took place in Brazil last month with Alex Pinchev, our EVP of Worldwide Sales, as its keynote.

The acquisition of JBoss, which was completed on June 2, serves as a foundation for a broader developer strategy. We brought a strategy to focus on what we consider to be the important distributed software development market. We believe that this developer market wants a true open-source, open standards-based platform for implementing open-service architectures.

For those who attended the successful Red Hat Summit in Nashville, Tennessee last month, it should be clear that we intend to extend the benefits of our collaborative and transparent development process well beyond the operating system.

Complementing the suite of developer solutions made available to Red Hat customers through the acquisition of JBoss, we also announced a portal called 108, where developers and engineers can mentor, learn, communicate, and collaborate. Similarly, we announced Red Hat's test and certification service, which we believe will accelerate the validation and certification of code developed on the Red Hat platform. We believe these initiatives, along with our certified Web Application Stack, which shipped in beta in April, will help fortify RHEL as the platform of choice for software development.

It is by creating value for our customers that we achieve the financial success and the hallmark of that value creation is providing choice. In an open-source, open standards-based environment, customers are free to choose when and if they upgrade applications, free to choose what applications they run on what software and on what hardware. As such, we will continue to support the JBoss platform on Microsoft Windows operating systems, recognizing that most IT environments are heterogeneous, and understanding that if JBoss technology can abstract the application from the operating system, then it is simpler to move to the Red Hat Enterprise Linux platform.

Along these lines, during the Red Hat Summit we announced the launch of a platform designed to bring the benefits of open collaborative development to the world's non-technical Windows desktop users. This project, called Mugshot, is designed to create a live social experience around entertainment and introduces open-source software to a non-enterprise marketplace.

We recognize the trend away from the fat, isolated, monolithic client of a decade ago and during the Red Hat Summit, we also provided an update of the One Laptop Per Child Project, an initiative to empower individuals in emerging geographies.

In aggregate, these four initiatives -- 108, testing and certification, Mugshot, and One Laptop Per Child -- will help extend the benefits of Red Hat's low-cost, high-value proposition to a broader group of beneficiaries. We are thankful that our market leadership position affords us the chance to drive this adoption, and we recognize our responsibility to properly execute against this unique opportunity.

Finally, in terms of execution, I believe that it is important for investors to appreciate the people advantage Red Hat continues to drive in this human-capital-intensive business. Recently, we were recognized by Business 2.0 as the fastest-growing information technology company based on a combination of measures, which include revenue, profit, and operating cash flow growth. Being part of such a dynamic environment has meant that we are able to recruit and retain top-notch talent that again produced excellent results.

Charlie will now address the specific financial performance.

Charles Peters

Thank you, Matthew. We are pleased to report that we once again delivered strong operating performance for our shareholders. Total first quarter revenue was $84 million, and represents an increase of 7% from last quarter and 38% from the same quarter in fiscal year 2006. Driven by strong bookings, subscription revenue of $71.5 million grew 7% sequentially and 45% year over year. Training and services revenue came in at $12.5 million.

Breaking down bookings, we generated 61% of our bookings from the channel, and 39% from direct sales, unchanged from last quarter. From a geographic perspective, 57% of bookings came from the Americas, 22% from EMEA, and 21% from Asia-Pacific, which is also very similar to last quarter.

Our billings proxy, which we define as revenue plus change in deferred revenue, was $115.3 million, up 42% year over year and 12% sequentially.

Before I begin a discussion of the rest of the P&L, let me remind listeners that this is the first quarter of adoption of FAS123R accounting for stock option expense for Red Hat. We have adopted this statement prospectively, meaning that prior periods have not been adjusted. In order to help investors and others understand the impact of FAS123R, we have included a table in the press release on the bottom of the P&L which details the non-cash stock compensation expense included in each line of the P&L for each period presented. If you have not looked for that, you should look at it; it should help you understand the numbers much better.

Let me now begin with gross margins. As a result of FAS123R, cost of revenue in the first quarter included $500,000 of stock compensation expense as compared to zero last year. Nevertheless, we still achieved an overall gross margin of 84% for the quarter, up from 79% a year ago period. The continuing growth of subscription revenue and efficient operations made the improvement in gross margin possible.

Operating expenses came in at $57.9 million, which include stock compensation expense of $7.1 million under FAS 123R, as compared to stock compensation expense of $1.2 million in the first quarter of last year.

As discussed in our fourth quarter conference call, we continue to build out the business and invest in people and systems. The primary driver of higher first quarter operating expenses, other than the accounting change related to stock option expense, was increased sales, marketing, and engineering costs as we added people and programs on a global basis in response to growing demand.

Our GAAP operating income was $12.6 million for the quarter after deducting FAS 123R stock compensation expense of $7.6 million, resulting in an operating margin of 15%. Comparisons to operating income and operating margin percent of prior quarters are not appropriate given that those prior quarters did not include FAS 123R expense.

Moving on, other income net attributable primarily to investment income was $10.7 million versus $7.7 million in the year ago period. The larger contribution is primarily attributable to higher investment income due to higher interest rates and larger cash balances.

Our estimated effective GAAP tax rate is 37% for the year, slightly higher than our previous estimate. Regardless of the GAAP tax rate, it is important for investors to understand that due to operating loss carried forward in excess of $450 million, we continue to estimate cash taxes of 5% for this year and for the foreseeable future.

GAAP net income was $13.8 million. Growth calculations based upon comparisons of this figure to prior quarters are not appropriate also, given the different accounting treatment of option expense and taxes between this quarter and prior periods. These figures translate into fully diluted GAAP earnings per share of $0.07.

Now let’s turn to the balance sheet on cash flow statements. We ended the quarter with $1.1 billion in cash and investments, an increase of $60 million from the end of the fourth quarter, driven by strong cash flow from operations. At the end of Q1, total receivables were $65.4 million, which translates to an adjusted base sales outstanding of 52 days, unchanged from 52 days at the end of Q4.

We believe that our low DSO’s not only indicate effective collection efforts, but also satisfaction in our overall customer base. As a reminder, as DSO’s are historically a measure of receivables versus billings, our DSO calculations include the change in differed revenue. Total differed revenue ended the quarter at $255 million, an increase of $32 million or 14% from the prior quarter.

Moving to the statement of cash flows, cash flow from operations increased 43% year-over-year to $52.4 million for Q1.

Now I would like to turn to guidance. Although I do not normally update annual guidance on a quarterly basis, I will this quarter so that the impact of the JBoss acquisition can be better understood.

As I mentioned at Analyst Day on April 11, JBoss has been in a rapid expansion mode, growing much faster on a percentage basis than even Red Hat’s fast-growing core business, but JBoss is not yet profitable.

For synergies that fully realize the combination of JBoss fast growth revenue of negative operating margins, and Red Hat’s own rapidly growing revenue and good profitability, we expect it to result in slightly lower margins, but even faster sales growth for Red Hat’s shareholders.

For the full fiscal year of 2007, we are raising our prior revenue guidance, which was $370 million to $375 million, and now anticipate revenues in the range of $400 million to $405 million, with the inclusion of three quarters of JBoss results. This reflects our expectation that the Red Hat piece will exceed the high end of previous guidance, and that JBoss will add $22 million to $27 million of revenue for the nine months.

The inclusion of JBoss will reduce the gross margin percentage by approximately 75 basis points, primarily due to their mix of subscription services revenue, which is more weighted toward service than Red Hat.

Operating income, excluding FAS 123R stock compensation expense, should be in the range of 19% to 20% for the year. For those of you who are tracking the results on a GAAP basis, JBoss will add approximately $1.5 million per quarter in stock compensation expense. Again, we anticipate a 37% GAAP tax rate for the full year, but only 5% cash taxes for many years.

We will clearly work to make JBoss profitable as rapidly as possible, but not at the expense of under-investing in what we view as a very large market opportunity.

Beyond the accelerated top-line growth, one of the clear benefits of the JBoss transaction is that Red Hat has infrastructure, meaning people and systems, priority built out in 22 countries and can potentially accelerate JBoss’ move to profitability.

Integration activities are underway in sales, support, customer training, systems, finance, HR and other areas. Progress is already being made in localizing JBoss offerings in a number of languages beyond the English-only version that’s available today.

For the second quarter, we anticipate revenue, including the nearly full quarter impact of JBoss’ $6 million to $7 million, to be in the range of $96 million to $98 million, up from $65.7 million in the prior year, representing year-over-year growth of 46% to 49%.

In Q2, the inclusion of JBoss will reduce gross margin percent by approximately 75 basis points, both with and without the stock compensation expense. The same is anticipated for the full fiscal year.

Operating expenses in Q2 will be approximately $74 million to $76 million, hitting planned organic expense growth of approximately $4 million for Red Hat and the addition of approximately $12 million for JBoss.

Total stock compensation expense is expected to be approximately $9 million, and amortization of JBoss intangibles is likely to be at least $1 million.

As a result, we estimate that Q2 operating margins, before stock compensation expense, will be in the range of 15% to 16%. It is my expectation that operating margin percentage can improve approximately 200 basis points in each of Q3 and Q4 as JBoss moves towards profitability. This should result in a full year operating margins before stock compensation expense being in the range of 19% to 20%, as I stated earlier.

Cash flow from operations for the full year is expected to be in the range of $225 to $235 million, consistent with earlier estimates. As we stated on April 11, we are not expecting any significant cash flow related to JBoss for several quarters.

Let me now address FAS 123R. My current estimate for the full year of fiscal 2007 for non-cash stock compensation expense, under FAS 123R, is approximately $36.5 million pre-tax, which includes $4.5 million for JBoss, or approximately $23 million after tax. For Q2, FAS 123R expense is estimated to be approximately $9 million pre-tax, as I stated before.

I’d now like to turn it over to Dion to discuss some additional investor considerations.

Dion Cornett

Charlie, thank you. Feedback from the investment community suggests that there exists confusion as it relates to Red Hat’s analyst estimates. This uncertainty is a result of widely ranging views as what information should be reported to First Call and other estimate aggregation services. We believe investors are better served when estimates are reported in consistent fashion, allowing the company’s performance to be evaluated against well-understood benchmarks.

In examining analyst’s estimates submitted to First Call, roughly two-thirds of Red Hat’s analysts currently report earnings per share estimate on an adjusted basis that excludes stock compensation expense. Applying this approach to current quarter’s results, we would expect the majority of our analyst’s to add back our reported $7.6 million in non-cash, stock compensation expense to arrive at an adjusted pre-tax income of $29.5 million.

Also, there is some discrepancy around reported EPS estimates related to analysts using differing tax rates. We believe that earnings per share comparisons tax at our effective annual cash tax rate of 5% not only provide more relevant comparisons to prior periods but also better reflect the actual dollars generated by the business that may be reinvested on the behalf of shareholders.

As we have mentioned in prior calls, we still do not anticipate any significant corporate taxes for many years. Analysts using the effective estimated cash tax rate might identify this 5% rate to our adjusted net income of $29.5 million to arrive at basic adjusted net income of $28.0 million, or fully diluted net income of $29.4 million. This equates to adjusted, fully diluted earnings per share of $0.14. This is significantly higher than the prior year’s earnings per share of $0.07, which did not include FAS 123R expense and was taxed at lower effective cash tax rate, and a couple cents higher than estimates submitted by analysts using this approach for the past quarter.

Again, we believe that the interests in the investing public are better served if analysts use a common methodology when reporting estimates in various aggregation services.

Finally, as we’ve done in prior quarters, we are applying several metrics to help investors better evaluate our business. For Q1, the percentage of quarterly bookings valued beyond one year was 20%, the same as last quarter. Our average contract length remained in the 18-to-21 month range and again, the vast majority of our long-term deals continue to be three-year contracts.

With that, I’d like to turn it back over to Matthew Szulik for closing remarks.

Matthew Szulik

Thanks, Dion. We are excited to have entered fiscal ’07 with a strong and consistent results to report to our shareholders. Red Hat continues to grow its customer base and its global market share. This growing market presence in return means even higher value for Red Hat users, as we see our partners in ecosystem improve their capabilities to service a Red Hat-based environment.

Simultaneously, we continue to improve our global capabilities to educate, service and retain customers and business partners. We continue to build our online model with the goal of a complete customer-partner, self-service paradigm.

In closing, I’d like to thank our customers, partners and shareholders for their continued commitment to Red Hat. I especially want to thank our associates worldwide whose hard work, team spirit and innovation all contributed to a great quarter.

Dion Cornett

Operator, we will now take questions.

Question-and-Answer-Session

Operator

Thank you.

(Operator Instructions)

Your first question comes from the line of Steve Ashley with Robert W. Baird.

Steven Ashley - Robert W. Baird & Co., Inc.

Good afternoon. I guess I just have a question regarding what the JBoss impact is going to be at the EBIT line for the full year. I’m kind of sketching the map out here, but Charlie, what kind of EBIT impact are you expecting?

Charlie Peters

Steve, the guidance I gave was in various pieces, which is probably enough so that you would be able to put that together. It certainly is going to be a loss from the full year at the operating level. It’s at least $10 million, or maybe higher.

Steven Ashley - Robert W. Baird & Co., Inc.

Great. Do you know how much deferred revenue that JBoss will be adding to current quarter?

Charlie Peters

I have a rough estimate. My assumption is that the deferred revenue that will come over with the JBoss acquisition is going to be in the range of about $15 million.

Steven Ashley - Robert W. Baird & Co., Inc.

Perfect, thank you.

Operator

Your next question comes from the line of Jason Maynard with Credit Suisse.

Jason Maynard - Credit Suisse

Good afternoon, guys. I just have a follow-up question on JBoss. It looks like the revenue number that you are guiding to here, $22 million to $27 million, is lower than what we were talking about in April. I’m trying to see if that’s just my calculations or if you guys have down-ticked it a little bit, and maybe what the rationale is for that?

Charlie Peters

Just a couple things, Jason. First of all, as you know, we were talking full-year numbers before, so this is three quarters. In the purchase accounting, there is a slight discount on deferred revenue, which is a piece which gets to the question Steve Ashley was talking about. Then beyond that, we’re still in the process of building out the sales force on a global basis and trying to make sure we get to the numbers.

Jason Maynard - Credit Suisse

So it does sound like there is a little bit more of subscription revenue write-down than you had anticipated a couple of months ago?

Charlie Peters

I’d say a slight one, but not much.

Jason Maynard - Credit Suisse

Then one follow-up just on currency. If we look at the net change in deferred on the cash flow statement, I think it was $25 million and change versus the balance sheet was $31 million -- is that primarily due to the swing in currency during the quarter?

Charlie Peters

It is, yes. You can assume that’s basically the currency impact on the quarter.

Jason Maynard - Credit Suisse

Great, thanks.

Operator

Your next question comes from the line of Kash Rangan with Merrill Lynch.

Kash Rangan - Merrill Lynch

Hi, thank you very much, just a quick clarification. Your operating income targets post-guidance relative -- actually post this quarterly report that you talk about -- relative to the guidance that was provided at the Analyst Day. Any change at all? I’m still trying to reconcile what you had said about operating income for fiscal ’07 at the Analyst Day versus what you are telling us right now. Can you help us out there? That would be great.

Charlie Peters

I think that operating income, the guidance is somewhat lower today then it was at Analyst Day for operating income, primarily due to the guidance I’d given you on JBoss.

Kash Rangan - Merrill Lynch

By how much? I thought you had quantified the EPS impact on fiscal ’07 due to JBoss at the Analyst Day, right?

Charlie Peters

Just to recap what I said on April 11 is the dilution I expected at that point was about $0.01 a share. You go through the math there, I think it’s closer to $0.04 a share.

Kash Rangan - Merrill Lynch

For the August quarter?

Charlie Peters

No, for the year.

Kash Rangan - Merrill Lynch

For the year. That’s useful. Also, qualitatively, can you talk about, since the JBoss deal is closed, what are the merger integration steps that you have taken -- sales force, product perspective -- can you just give us just a little more clarity as to how you managed through what seems to be a fairly sizeable transaction for you guys?

Charlie Peters

What I’d say is that there are integration teams that have been assembled on both sides for multiple function support -- training, sales, DNA, HR, going through a lot of different organizational things, product related things, and HR payroll-type things. The things that have been accomplished thus far is that, particularly on the G&A side relative to the people, the financial functions at this point have been transitioned over for the most part to Red Hat. Support functions are working together. The training functions are working together. The sales groups have had conversations and are still working on some of that transition.

I would say that from a planning standpoint, you should be thinking about a couple of quarters for the integration to be completed. From an international perspective it’s probably a lot cleaner, because as I mentioned I think on April 11, JBoss had only a handful of international locations, all of which were in EMEA. So they are already working together with our European group in EMEA across many functions.

Kash Rangan - Merrill Lynch

Got it. You are expecting JBoss to be cleared of the EPS and free cash flow for fiscal ’08. Is that something you said the last time around, right, so no change to that?

Charlie Peters

That is correct in both cases.

Kash Rangan - Merrill Lynch

Thank you very much.

Operator

Your next question comes from the line of Chris Kwak with SIG.

Chris Kwak - SIG

Great, thanks. Charlie, a couple of follow-ups on the JBoss question. I think Jason was asking about the revenues, and you indicated a deferred revenue write down was a little bit more than you expected. Can you just tell us roughly what the deferred revenue write down was, or give us a sense of how much was written down?

Charlie Peters

It was a little bit more than 10%.

Chris Kwak - SIG

Okay, so it wasn’t very significant if you are looking at a $15 million number coming from JBoss’ balance sheet.

Charlie Peters

That is correct.

Chris Kwak - SIG

The other thing I wanted to make sure I understood was you said that the deferred revenue off on the cash flow line, most of that was currency. Was some of that from just collection issues and being balanced on the receivable side at all, or was it almost all currency?

Charlie Peters

Let me just clarify. The question that Jason, I believe it was Jason Maynard, asked was of the change in deferred revenue on the cash flow, it shows as $25 million, or thereabouts…

Chris Kwak - SIG

Versus the change on the balance sheet.

Charlie Peters

Right, so the difference is all currency.

Chris Kwak - SIG

Then lastly, I know the revenue guidance that you guys gave for JBoss was in excess of $40 million for the calendar year ’06, and in excess of $80 million in calendar ’07. Those were rough estimates and those are obviously subject to change, given the deferred revenue write down, which doesn’t seem large to begin with, but the bookings numbers that you indicated a couple of months ago, are those still in line with your expectations today?

Charlie Peters

I think for fiscal year ’06 -- excuse me, fiscal year ’07, the current year -- yes, it is, and I have not at this point tried to go back and re-estimate next year. We’ll certainly have plenty of time to do that as this year progresses.

Chris Kwak - SIG

Great, thank you.

Operator

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

Tim Klasell - Thomas Weisel Partners

Good afternoon, everybody. Also some questions on JBoss. Can you walk us through what impact JBoss will have on the metrics that you normally give as far as contracts, you know, average life of the contracts and that sort of a thing?

Charlie Peters

Some of the metrics we get, and just to reiterate some of the things I said on April 11th, where, starting with some of the P&L things, on a gross margin percentage, the gross margins on their subscriptions tend to be similar to ours. The gross margins on their services tend to be similar to ours, but the overall gross margin is lower because they have more services than they do subscriptions. You will see that change, and that is the reason why the 75 basis point drop is what I am expecting in our gross margins for a while.

In some of the other metrics, like the average length of contract, at this point, the average length of their contracts are somewhat shorter. They have fewer long-term contracts than we do, but because of the total size of our business relative to theirs, I do not think you are going to see any measurable change in the overall blended metric in terms of the average length of contract.

Tim Klasell - Thomas Weisel Partners

Okay, and then just one on current operations, it looks like your sales and marketing came in a bit high in your G&A, about an equal portion lower than what we were anticipating. Is that actual headcount moves or is that just an accounting move in reallocating expenses?

Charlie Peters

Well, I think there’s a couple things. It’s not an accounting move, obviously, on the GAAP financial statement, the stock compensation expense changes things. If you take that out, you look at things without that in there, you are going to see increases in personnel in sales on a global basis, but you are also going to see some fairly substantial marketing programs, including the Red Hat Summit that we ran in Q1 to continue to boost sales in future periods.

Tim Klasell - Thomas Weisel Partners

And the reduction in G&A is sustainable?

Charlie Peters

I guess as I said for some time, I believe we have a G&A structure here that is capable of supporting a much larger business. We’ve got the people we need to do it and the systems we need to do it. I think the reduction this quarter, you are looking at primarily the reduction in professional fees, where over time we have also gotten rid of some professional assistance by doing it internally.

If you look at it on a GAAP basis, it’s about 12.9% in G&A percentage. If you take out the stock compensation expense, it’s even substantially lower -- sorry, as a percentage of revenue, it’s 16.2% on a GAAP basis and it’s 12% on a non-GAAP basis, excluding that stock compensation expense.

I believe that we can see those percents for G&A continue to come down as the revenues grow.

Tim Klasell - Thomas Weisel Partners

Okay, good. Thank you.

Operator

Your next question comes from the line of Terry Tillman with SunTrust Robinson Humphrey.

Terry Tillman - SunTrust Robinson Humphrey

Hey, guys. Charlie, I had a question, just another point of clarification in terms of the operating income assumption for the full year. You said it’s a little bit lower than before, related to JBoss. Is that simply the mechanics of the fair value write-down of deferred revenue, or is there also a greater assumption around the expenses from JBoss?

Charlie Peters

I think it’s both. We’ve also realized that we need to do more work in terms of building up a support infrastructure and some of the other parts of JBoss than we originally anticipated, so expenses are probably a little bit higher and a little bit of a cut on the deferred revenue.

Terry Tillman - SunTrust Robinson Humphrey

Okay, but in terms of FY08, I mean, I know that’s further out, but you are going to start having this fair value go the other way, I would think, so I think I’m right on that, but also, should we expect 200 bip’s kind of margin improvement that you are anticipating throughout the year, that same type of trajectory for full year ’08? I mean, how should we look at margins for ’08?

Charlie Peters

I don’t want to provide any guidance on ’08 yet, I guess for the same reason. I think that our first objective here is to quickly integrate JBoss and to drive the sales as fast as we can and when we get closer to the end of the year, we’ll start talking about fiscal year ’08.

I do think, however, that we should see about 200 basis points improvement in operating margin in Q3 and in Q4 as we get past this quarter we are now in.

Terry Tillman - SunTrust Robinson Humphrey

Okay, and just my final question relates to, I don’t know if this is something, Dion, you could help with, but you know, the idea of the top 25 accounts, strong renewal rate of 100%, any data on the actual contract value, the percentage increase, or did it not increase, in terms of when those customers were renewing, at what value?

Dion Cornett

It increased by 6% this quarter, and I recognize that’s a few percent below what we’ve seen in prior quarters, but we had one deal in excess of $5 million that was static in size -- they tend to skew that metric a bit more this quarter than what we’ve seen in the past.

Terry, let me add on JBoss as well, a lot of questions so far focusing on the expenses around JBoss. You know, please keep in mind that we have perfect control over what we spend in building out their sales marketing, operating support infrastructure, and that the growth that we’ve baked into our model here is directly attributable to the opportunity that we see. You look at where JBoss is and where Red Hat was a few years ago, we see the same opportunity to build on the excellent job that the JBoss team has done. If you look at Charlie’s guidance, Red Hat is clearly outperforming prior expectations. You know, we are very optimistic that we can, working with the JBoss team, drive the same performance of JBoss that we have been able to do out of our RHEL business.

Operator

Your next question comes from the line of Brendan Barnicle with Pacific Crest Securities.

Brendan Barnicle - Pacific Crest Securities

Thanks, and following up on the JBoss, just in terms of an operational question, there’s been some discussion about some channel conflict now with some of your partners because you know that some others have application servers. How are you planning on addressing that? What kind of push-back have you had so far?

Matthew J. Szulik

Brendan, this is Matthew Szulik. I think we have been in discussion with all of our significant channel partners. Certainly I think we have made our position clear about our view of the importance of the developer space and so far, the field-based activity continues to be positive in our interaction with all of these channel partners -- Oracle, IBM, BEA, and others.

Brendan Barnicle - Pacific Crest Securities

So you haven’t seen any decline in referrals from any of those folks as a result of this?

Matthew J. Szulik

Not that I’m aware of.

Brendan Barnicle - Pacific Crest Securities

Perfect. Just quickly over on the Microsoft side, you mentioned them, has anything changed there competitively? Are you seeing any more sort of Windows-Linux migration activity?

Matthew J. Szulik

No, as we’ve seen in prior situations, we see continued strong demand for the client-side implementation, and now certainly through the introduction of the JBoss technology into the mix running on RHEL, greater access to the developer’s space than we had access to prior to.

I do not think the situation competitively has changed with Microsoft than prior quarters.

Brendan Barnicle - Pacific Crest Securities

Great, thank you.

Operator

Your next question comes from the line of Heather Bellini with UBS.

John Stewart - UBS Investment Research

Hi, this is John Stewart here for Heather. Can you talk a little bit about, now that the JBoss deal is closed, can you talk a little bit about your go-to-market strategy, maybe direct pricing a little bit, and also your thoughts on how you are going to improve the ratio of downloads to paying customers?

Matthew J. Szulik

You know, the good news about this, John, is that I think that we have global channels of distribution. We have a global service and support infrastructure that many of our large enterprise accounts I think had been requesting of JBoss in their selling interaction that as an early-stage company, JBoss was not able to fulfill. We have consistent global channels of distribution, with certainly companies like Hewlett Packard and IBM and Dell and others. So that is the good news.

In terms of pricing, I think that customers, we continue to hear it and it was in evidence at the JBoss World, their equivalent to the Red Hat Summit, that I think customers continue to get very high value from their relationship with both the JBoss technology and the service arm.

I think we feel good about the existing pricing model that JBoss has in place. Of course, we are thinking about other ways to add value to that combined stack, and we’ll disclose those as appropriate, but I think we feel pretty good about our go-to-market, both within channel and with the pricing as it exists.

John Stewart - UBS Investment Research

Okay, thank you.

Operator

Your next question comes from the line of Brent Thill with Citigroup.

Brent Thill - Citigroup

Thanks. Regarding the margins, obviously it’s understandable that they are going to take a hit this year relative to JBoss, but as you look out, is there any reason to believe that next year won’t be back at least at the run-rate you saw in ’06 on the core Red Hat business at 22%? How should we think about the longer-term margin structure now, considering the acquisition?

Charlie Peters

The very first word you said, we didn’t get. You were talking about operating margins?

Brent Thill - Citigroup

Right.

Charlie Peters

Is it unreasonable to assume that next year they might get back to where they were? I don’t think that’s an unreasonable assumption. I think that obviously JBoss is growing rapidly. They’re starting from a much smaller size. We are still in investment mode with JBoss, but the demand is high, so there is no particular reason at all with good management and taking advantage of the growth opportunity that we shouldn’t see the operating margins back to where they were.

Brent Thill - Citigroup

In longer term, is there a range that we should expect that to fall into as we’re building our models out a couple years out?

Charlie Peters

I think the guidance I would give you on that is probably the same as I have, having consistently given for almost the last year-and-a-half or two, which is we still see a very large growth opportunity, so we still think we should be investing. You saw us put up operating margins of 25%, 26% on a quarterly basis for several quarters in a row. You know, looking to get above that number, assuming the growth opportunity is still what it is, probably wouldn’t be the right assumption, at least for the next year or the year after.

Brent Thill - Citigroup

Okay, and a follow-up for Matthew. There’s been a lot of concern in the market relative to a more macro-economic slowdown hurting the technology sector. Obviously your results don’t show that, but any evidence, any commentary from customers that you’re seeing would be helpful?

Matthew J. Szulik

You know, I think certainly, Brent, to your point, customers who, going all the way back to 2000 and 2001, have been looking to drive down their cost of software acquisition, and you certainly have seen that since that period of time. I think what we are also witnessing, of course, is the improvement in system performance and hardware at lower cost, one-way, two-way, four-way machines, which that, in combination with Linux and now the JBoss implementation, really continues to advance the low cost and the high-value proposition that we talked so many years about.

So we’re really fitting in, I think, to that sweet spot of customers paying for value that I think customers, as recognized by the CIO surveys that we have been, certainly that we talk about and communicate, the enterprise is getting enormous value from this open-source solution, in fact, that I think -- I don’t want to say is resistant to some of the macro economic factors, but I think is a key driver of why customers are increasingly moving away from their proprietary, whether it be Unix or Windows implementations, and moving to a flexible, more higher-value, open-source stack, which I think accrues to our benefit in the long term.

Operator

Your next question comes from the line of Katherine Egbert with Jefferies.

Katherine Egbert - Jefferies and Company

Hi, good afternoon. So if I’m right, you’re writing off about $15 million in JBoss deferred. You’re also guiding your operating margins down for the year, effectively, but yet you’ve reiterated your cash flow, previous cash flow guidance. So is that cash flow guidance reiterated because Red Hat organic is having stronger cash flow, or do you expect these deferred’s to start to flow back on some time in the next 9 months?

Charlie Peters

Just to be clear what I said about JBoss deferred revenue, was that our expectation is on the opening balance sheet, we will bring over about $15 million of deferred revenue, which is only about a 10% [inaudible] cut from their [book value]. You heard that piece wrong.

Katherine Egbert - Jefferies and Company

Okay, but still the question is you are having to write off a piece of the deferred, and you’re guiding your operating margin down, yet you’ve reiterated your cash flow guidance for the year, so is that cash flow guidance then reflective of further strength in Red Hat organic cash flow, or are you bringing back the deferred sometime within the 9 month period?

Charlie Peters

Okay, thanks for that clarification. I think that the Red Hat cash flow remains strong and pretty much just where it was. What I think what I’m seeing is I see negative cash flow out of JBoss for the next two quarters, and probably positive cash flow in the last quarter on the overall. My hope is and my expectation is that the JBoss cash flow will have a negligible impact, either up or down a little bit, on the total Red Hat number. The total Red Hat cash flow still looks very healthy.

Katherine Egbert - Jefferies and Company

Okay, and then I have a question. You had a $6 million to $7 million deal last quarter. Was that deposited in both deferred revenue and in cash flow this May?

Charlie Peters

You’re referring to a deal that happened in Q4?

Katherine Egbert - Jefferies and Company

Right, in February.

Charlie Peters

What we said was that there was a mid-7-figure deal that was booked last quarter with no billings, and so the billings on that, and that was an annual deal, the billings on that deal begin this quarter, billed one quarter at a time.

Katherine Egbert - Jefferies and Company

Okay, so what’s the term of the contract?

Charlie Peters

One year.

Katherine Egbert - Jefferies and Company

One year. Okay, and then I have another question. Are you going to continue to support JBoss on [Cisco] Linux?

Matthew J. Szulik

We continue to do that on all of the Linux platforms as well as the Microsoft platforms, Katherine.

Katherine Egbert - Jefferies and Company

Okay, thanks, Matthew.

Operator

Your next question comes from the line of Todd May with Deutsche Bank.

Todd May - Deutsche Bank

Could you guys talk about deals from non-OS products? I believe in the last last year’s quarter, you guys reported 14% of bookings from non-OS products. What do they look like this quarter?

Dion Cornett

This is Dion. Honestly, I don’t know what the number is this quarter. I’ll have to get back to you on that.

Todd May - Deutsche Bank

Okay, and then there was a larger deal in the year-ago quarter that was related to the Defense Department and the certificate server, and I was just wondering if that was something that renewed this quarter or not up for renewal.

Matthew J. Szulik

It did.

Todd May - Deutsche Bank

I’m sorry, it did?

Matthew J. Szulik

It did renew this quarter, yes.

Todd May - Deutsche Bank

Last question just around virtualization. I was wondering if you guys have any commentary around what you expect for pricing when you add virtualization into the next version of RHEL.

Dion Cornett

Todd, we haven’t publicly announced our virtualization pricing yet. I still wouldn’t expect that offering until the very end of this calendar year, but expect it to be simple, as our current pricing is, and it’s likely that you’ll find a different skew for virtualized servers that will allow us to capture the additional value that virtualization provides.

Todd May - Deutsche Bank

Okay, good, thank you.

Operator

Your next question comes from the line of Todd Weller with Stifel Nicolaus.

Todd Weller - Stifel Nicolaus

Thanks, just a question on JBoss relative to the Red Hat. Could you contrast the sale of those products from a complexity perspective and then from a kind of direct/indirect perspective? Thanks.

Matthew J. Szulik

You know, Todd, right now, the JBoss organization was largely driven by an inside sales organization with a very small channels team, so the bulk of their sales to date has been inside-driven, where the lead volume I think has been, and very positive and very high, supported by that inside selling effort. Clearly they’re selling to a different subset, meaning the development community and the production community, where Red Hat has historically been selling to the infrastructure buyer.

I think that our hiring in our selling channels over the last 24 months has been increasingly technical. We see complementary synergies between our inside selling function, which has increased in size over the last two years, and the JBoss inside selling channel. I think we’re enthusiastic about our ability to move the integrated solution of RHEL and JBoss into the volume channels of distribution globally, where we have historically had strong success.

Todd Weller - Stifel Nicolaus

Do you think on a near-term basis, to penetrate your larger enterprise customers, that it’s going to require more of a direct touch from the Red Hat sales force?

Matthew J. Szulik

You know, Todd, in the beginning of this fiscal year, we moved to a tiered, direct-selling model. We moved an executive by the name of Kate Johnson into a strategic, focused, what I would describe as a Fortune 50 selling relationship, which includes a small professional services enablement team. So they have the technical competency and the professional, direct, high-touch skills to service that exclusive market place and to meet their needs of relationship management that they would have expected from a larger company, IBM, etc.

I think what we are seeing also is really the investment that we’ve made in the Fortune 3000 segment, both direct as well as the value-added channel, are starting to show very good traction. I think building on the success of the existing RHEL enterprise sale, which is providing door-opening into other segments within that organization.

Also, I think we are starting to see very positive overlap between where JBoss was successful within the enterprise and where Red Hat is successful.

So I think we’re in a good position to solve the technical issue and the technical complexity. I think we’re in a good position to build on the strong customer value that we have historically been noted for. There will certainly be failed education issues that we’re very sensitive too, but I believe that we factored those integration issues in pre-closing.

Operator

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

Trip Chowdhry - Global Equities Research

Congratulations, I would say you executed very well in the Asia-Pac region. Matthew, can you tell us a little bit of the details -- our research did indicate a very major shift in the market share, both in China and Japan, especially against Red Flag and [Medical] Linux. Can you tell us what technically have you been doing there?

Secondly, I had a question on JBoss. Our research is indicating that I would say Charlie’s guidance is a little on the conservative side, because over the last 15 days, we have seen some major shifts, at least in the open-source community, where JBoss’ SOA architecture is at least having top-of-mind awareness and at least top-of-mind share against another alternative which was mushrooming in the open-source community called Zope. I was wondering, what are your thoughts on it? Again, I would say congratulations on very good execution.

Matthew J. Szulik

Thank you, Trip, for noticing that. I think that what you are seeing is that the continued investment in the growing and important international part of our business in Asia-Pacific is starting to bear some fruit, and so a lot of credit should go to Alex Pinchev and his team over in Asia-Pacific and the services organization there. Michael Chen in China -- as you know, it’s been almost 24 months -- less than 24 months since we established a direct presence in China, and once again, I think we are starting to see some benefit from that investment. Similarly in Japan. I think customers in the channel partners that we’re working with in those markets are now finally getting up to speed and getting productive through the direct Red Hat presence.

In terms of the open-source community embracing the SOA model approach, I think that’s once again just building on the good success that the JBoss development organization and Marc Fleury have had of articulating a very strategic and valuable SOA architecture and messaging-based solution.

Trip Chowdhry - Global Equities Research

Okay, thank you.

Operator

Your next question comes from the line of Rick Sherlund with Goldman Sachs.