Red Hat, Inc. F1Q10 (Qtr End 05/31/09) Earnings Call Transcript

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

Red Hat, Inc. (NYSE:RHT)

Q1 2010 Earnings Call

June 24, 2009 5:00 pm ET

Executives

Jim Whitehurst – President & CEO

Charlie Peters – EVP & CFO

Tom McCallum – VP IR

Analysts

Adam Holt – Morgan Stanley

Sarah Friar – Goldman Sachs

Kash Rangan – Merrill Lynch

Tim Klasell – Thomas Weisel Partners

Katherine Egbert – Jeffries

Steve Ashley – Robert W. Baird

Aaron Schwartz – Ladenburg Thalmann

Michael Turits – Raymond James

Brent Williams – Benchmark

Richard Williams – Cross Research

Todd Raker – Deutsche Bank

David Bayer – Cantor Fitzgerald

Trip Chowdhry – Global Equities

Robert Breza – RBC Capital

Kevin Buttigieg – FTN

Brad Whitt – Broadpoint Amtech

Brent Thill – Citigroup

Mark Murphy – Piper Jaffray

Nabil Elsheshai – Pacific Crest

Operator

Good afternoon. At this time I would like to welcome everyone to the Red Hat first quarter 2010 earnings conference call. (Operator instructions) I would now like to turn the call over to Mr. Tom McCallum, Vice President of Investor Relations; you may begin your conference.

Tom McCallum

Hello everyone. Welcome to Red Hat's earnings call for the first quarter of fiscal 2010. Speakers for today's call will be Jim Whitehurst, President and CEO and Charlie Peters, Executive Vice President and CFO.

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

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 Annual Report on Form 10-K filed with the SEC.

In addition, any forward-looking statements represent our estimates or view only as of today, June 24, 2009 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 any date subsequent to today.

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

Jim Whitehurst

Thank you Tom and let me add my welcome to all of you joining us on the call today. I’m pleased to announce a strong start to fiscal 2010 as we reported better than expected revenue and EPS in the face of a challenging global economy.

A key driver of our continued growth and success is the fact that we deliver a pure value proposition helping our enterprise customers carve out costs, while driving innovation in their IT infrastructure.

A reflection of the value we deliver is the strength of our renewals. I’m pleased to report that for the fifth consecutive quarter all of our top 25 deals that were up for renewals not only renewed, but did so at a total value of over 120% of their original value.

With overall IT spending down on a year over year basis our largest customers continue to renew and spend more with Red Hat as we increasingly become one of their most strategic IT vendors.

Like most companies we remain focused on closely managing our costs in this environment, however we are also investing in R&D and sales to expand our market share and deliver innovation to our customers.

Even in this economic environment, CIOs continue to reevaluate their overall IT architectures in order to better take advantage of state of the art solutions such as virtualization, cloud computing and middleware.

Importantly over the past few weeks Red Hat has announced several key technology milestones and integrated solutions that further strengthen our unique ability to address each of these strategic IT areas.

In virtualization last week we released the Beta versions of our Red Hat Enterprise Virtualization or REV, product portfolio, including a new stand alone hypervisor as well as server and desktop virtualization management products.

The REV Beta release will involve a collaborative effort where we have engaged several strategic enterprise customers and ecosystem partners across geographies and industry segments.

There has been strong interest in the Beta program and it is well over subscribed which I view as a very positive long-term indicator and a reflection of Red Hat’s unique approach in offerings. This is also a clear indication that the market is looking for an alternative to today’s expenses solutions.

The REV portfolio is designed to help customers overcome these cost barriers and address performance, security, and scalability. Importantly it also allows customers to leverage the broad Red Hat Enterprise Linux Certified ecosystem. Our ecosystem will be a key enabler to permit customers to deploy virtualization more broadly.

REV builds upon our widely adopted Red Hat Enterprise Linux operation system foundation which has featured integrated virtualization since 2007 as well as KVM, which is part of the Linux kernel and is expected to be generally available later this year.

And now let me outline why I believe we are well positioned to capitalize on the emerging cloud computing market opportunity. If you look at the top cloud providers today, you’ll find that most of the major ones are running open source, a good number of which are based on Red Hat technology.

As the leader in open source technologies, we are focused on breaking barriers, providing wider adoption of the cloud and being a provider of the enabling technologies to our IT customers and to cloud providers.

Open source technologies are key to being competitive in the cloud environment. We are excited to embrace a model that can enable both CapEx and OpEx cost reductions this low cost, high value offerings have always been a core focus for Red Hat.

We are pleased with the growing interest from end user customers evaluating how to leverage Red Hat’s suite of solutions in cloud models. We are seeing interest from end user customers who want us to help them architect and build private cloud. The vast majority wants to test the model out internally and position themselves for the ability to use external and public clouds in the future.

Regarding cloud providers, we are looking to expand upon the success we have had with early cloud providers to new emerging ones. Since 2007 we have had a partnership with Amazon web services that continues to grow. Last month we announced a new partnership with Verizon around their recently launched computing as a service solution.

Red Hat Enterprise Linux is one of the two operating system environments offered by Verizon. We are hosting an online event called the open source cloud forum on Wednesday, July 22. Red Hat and other cloud vendors will discuss how open source technologies are uniquely enabling the cloud in an open way.

We will update you further on our progress in this fast growing space the industry analysts have predicted will grow to $8 billion in infrastructure software spend by 2012. Finally I want to update you on our growing middleware business.

In middleware we unveiled the JBoss Open Choice application platform strategy. With the expanding and rapidly changing landscape of Java for the enterprise Red Hat’s open choice strategy aims to provide application developers with the ability to choose the framework, language, and programming technologies that best fit the application requirements they are trying to achieve without sacrificing reliability, availability, scalability, or manageability across their projects.

Along with the announcement of JBoss Open Choice strategy, the JBoss Enterprise Middleware portfolio expanded its products to three application server solutions that address common Java application workloads from simple web based applications, to light enriched Java applications, to Java Enterprise addition based applications.

Moreover, JBoss platforms now support a variety of popular programming models including the spring framework, theme, and Google web toolkit.

In addition in May we had launched JBoss Enterprise Business Rules Management system which is an open source business rule solution that allows customers to reduce development time as to update applications and processes with the latest business rules and policies.

With this expansion of our middleware products and capabilities, Red Hat is now one of the most comprehensive Java application server portfolios in the industry which we believe positions us well to continue to gain share in this important segment of the overall IT infrastructure market.

In summary our business model enables us to deliver solid results in challenging times while continuing to invest in future opportunities. We believe the trends in virtualization, cloud computing, and middleware clearly align with our technology roadmap and extent our technology leadership in the datacenter.

Our progress in these key areas is also strengthening Red Hat’s market position by creating additional long-term growth opportunities. Before turning this call over to Charlie, I’d like to thank our associates around the globe. Their hard work to deliver value to our customers is the driver of our continued success.

With that let me turn the call over to Charlie.

Charlie Peters

Thanks Jim, I’m pleased to report solid financial results in Q1 highlighted by double-digit revenue growth, in both US dollars and constant currencies. In light of the economic environment we also remained focused on managing costs and improving efficiencies, while investing in important new opportunities.

Combined with Red Hat’s strong market position and high level of execution, this focus enabled us to grow first quarter revenue in constant dollars by 17% on a year over year basis assuming Q1 fiscal year 2009 average rates.

We spanned the non-GAAP operating margin by 160 basis points year over year, grow earnings per share by 25%, and a view to generate strong operating cash flow and reduce our diluted shares outstanding by 11% on a year over year basis including an additional 2.7 million shares repurchased in the first quarter.

In addition to the strength within the renewals that Jim talked about, here are the stats concerning [our] 30 deals overall. In the first quarter they included five deals of a million dollars or more with one deal in excess of $5 million. Approximately 30% of these deals included a middleware component with two being stand alone middleware deals.

Enterprise customers continue to make significant commitments to Red Hat to optimize the performance and efficiency of their IT infrastructure. In the current challenging IT spending environment the ability to save money compared to existing and alternative solutions is particularly appealing.

Now let’s talk about our financial performance, first quarter revenue was $174 million, an increase of 11% year over year, 5% sequentially, above our guidance range. On a constant currency basis, using Q1 2009 average rates, our revenue would have been $8 million higher representing 17% growth as I already mentioned.

We believe is more indicative of the underlying growth of the business. The driver of our total revenue growth was subscription revenue, which was up 14% year over year and 7% sequentially, $149 million. Subscription revenue which is renewable constituted 85% of total revenue.

Training and services component of revenue was $26 million, consistent with the prior year quarter and down 5% sequentially. Services continues to be the [inaudible] of our business but has been most impacted by the current economic environment as a result of customers cutting travel, and discretionary training spending.

Regarding bookings the channel generated 61% of our Q1 bookings, 39% came from direct sales versus a 56%/44% split in Q4. This in part reflects the progress that we are making on our key initiatives to build out our channel business.

In terms of geography, 53% of bookings came from the Americas, 25% from EMEA, and 22% from Asia Pacific. Our billings proxy for the quarter was $177 million, up 3% in US dollars for $185 million, up 8% in constant currency, when compared to the prior year quarter.

As I’ve noted on previous calls, billings can vary quarter to quarter. In addition to seeing the typical decline from Q4 to Q1, our billings proxy was influenced by the fact that the percentage of one year deals increased 80% and the average deal length was 19 months as compared to 24 months of recent quarters.

Within this mix there were a small number of large deals in which the customer opted to be billed for one year instead of multiple years. It’s not overly surprising considering the current economic environment.

Most important is the fact that we continue to sign a significant level of new and renewal based business. Our renewal rates on the larger deals remains very high which are the drivers to reiterating our full year revenue guidance for fiscal 2010; [however] it does impact the presentation of our billings proxy.

So let me now shift back to the income statement, non-GAAP basis, including stock compensation and amortization expense, overall gross margin was 85.8% for Q1, in line sequentially and up 180 basis points year over year primarily due to the strong subscription sales.

Subscription gross margin was 94.1%, up 20 basis points both sequentially and year over year. Moving on to non-GAAP operating expenses, we remain focused on managing discretionary costs while continuing to invest in growth opportunities such as middleware, virtualization, and cloud computing.

Q1 non-GAAP operating expense came in at $109 million, up 6% sequentially, 12% year over year. On a constant currency basis using Q1 2009 average rates, our non-GAAP operating expenses would have been $8 million higher resulting in no change in constant currency operating income.

Q1 non-GAAP operating income was $41 million producing an operating margin of 23.4%, up 160 basis points year over year and down 50 basis points sequentially, slightly better than our guidance.

Other income net which is primarily attributable to investment income was $3 million, in line with our guidance, lower than last year, due mainly to lower interest rates and lower investment balances.

Our estimated annual effective tax rate is 35% for both GAAP and non-GAAP results. Non-GAAP diluted earnings per share came to $0.15 which is $0.01 above the high end of our guidance, up 25% from the adjusted non-GAAP result of $0.12 a share last year, in line with the prior quarter.

Now let’s turn to the balance sheet and the cash flow statement, we ended the quarter with cash and investments of $885 million, which is an increase of $38 million after the repurchase of 2.7 million shares.

Quarterly operating cash flow of $61 million was essentially consistent with the previous year ago quarters. We appreciate that many investors analyzed cash flow of companies including Red Hat by per share basis. For those that do as a result the company’s use of its cash substantially reduced the [inaudible] share count.

On a per share basis, operating cash flow and free cash flow was up 9%, 15% respectively year over year. Strong collections led to a foreign exchange adjusted DSO of 54 days, down slightly from 56 days in Q4 and 60 days in Q1 last year.

As a reminder since days’ sales outstanding is traditionally a measure of receivables versus billings, our DSO calculation includes revenue plus the change in deferred revenue from the cash flow statement.

Total deferred revenue at quarter end was $567 million, an increase of $76 million, or 15% over the same quarter a year ago and an increase of $24 million, 5% over last quarter. Breaking it down further, $403 million was in current deferred revenue while $164 million was in long-term deferred revenue.

I would like to turn to guidance; revenue is estimated to be approximately $178 to $180 million. Operating margin is estimated to be around 23%, non-GAAP EPS is estimated to be in the $0.14 to $0.15 per share range, assuming the same 35% tax rate. Full year guidance remains unchanged.

In summary the company continues to execute well in this difficult economic environment. We are managing costs and improving efficiencies which enables us to continue investing in long-term growth opportunities. We believe Red Hat remains well positioned from a short and long-term perspective as a result of our unique and industry leading suite of open source solutions to help our customers save money.

Our customer satisfaction and top renewals remain at very high levels and we continue to distance ourselves from the competition. Before turning the call over for your questions, I would like to extend an invitation to the financial community to attend our fiscal year 2010 Analyst Day on October 7 in New York City.

Invitations with further details will be forthcoming. We are now ready for questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from the line of Adam Holt – Morgan Stanley

Adam Holt – Morgan Stanley

My first question is can you talk, you talked a little bit about the success with the largest customers that came up for renewal, can you talk a little bit about the customers outside of the top 25 or 30, what renewal rates were like and maybe a little bit for the total billings, what the mix between new billings and renewals was like in the quarter.

Charlie Peters

First on renewal rates, the only renewal rates statistics that we share are those in the largest, but I would add this color that we have had recently been working on various efforts to incrementally improve renewal rates overall. What we know we have shared previously is that where we have direct deals regardless of the size, our renewal rates are quite high.

When we have indirect deals and through possibly multiple layers of distribution, renewal rates historically have not been, so over the last couple of years we’ve engaged in multiple efforts to gather the data about the end customer, economically and [incense] the partners to help with renewals and various other things to improve that renewal rate.

I’m happy to say we’ve seen improvement there and those efforts are continuing.

Adam Holt – Morgan Stanley

You also have another initiative to get folks to move from free to pay on a number of different levels, can you update on your progress there as well.

Charlie Peters

This quarter we did not have any deals in the top 30 deals that were free to pay. We did have a number of smaller deals that moved from free to pay and that effort continues as well. I’m also happy to report that although it happened in the month of June so therefore not in, there was a sizable free to pay that we have managed to land this month which I’ll expand more about when we come to the Q2 call.

Operator

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

Sarah Friar – Goldman Sachs

Could you talk a little bit about the differences you saw between large enterprise spending versus the more SMB type spending. Was there any shifting around in the quarter and I guess what I’m asking is SME’s I feel have been more heavily hurt by this downturn, so are you starting to see them recover at all.

Charlie Peters

At this point I would say we have not seen any recovery and we’re not trying to call the timing of the recovery, the timing on the basis that the economic environment is going to stay fairly similar to what it is for the balance of the year. I would say this, like others that have recently reported, we see a longer sales cycle and in some cases additional levels of approval in sale cycle.

But that’s kind of the way it’s been for the last couple quarters. Our expectation is that’s going to continue for at least a few more quarters.

Sarah Friar – Goldman Sachs

The financials vertical, I’m kind of not asking the same question but I’m not asking you to say its recovering, but clearly that was a vertical very hurt where you have a lot of, it’s a big vertical for you. So do you see at least financials beginning to sound a bit more optimistic. And then just on the numbers, the difference between the change in cash flow on, change in deferred revenue on the cash flow statement versus what we can see on the balance sheet, is that all just a currency difference.

Charlie Peters

On the financial vertical, even in, when it was most dire, probably three months, six months ago, our renewals of important financial customers continued pretty much nonstop. And we’ve done very well. We’ve recently also in the month of June picked up another very important financial customer, a new financial customer.

So it has been good for us. I’m hopeful that the business of the financials will pick up so they will have even greater demand. The last part of the question on the deferred revenue, let me just add a little bit. The question is, the change in the deferred revenue, if you [take it] up the balance sheet its about $24 million. The change in deferred revenue if you look at the cash flow statement it’s about $3, and part of it is currency, part of it is US dollar.

I would break it down this way, in the short-term section there’s a positive change of $6 million and additional $14 million change from currency for roughly a $20 million change in short-term. And long-term consistent with what I said about the changing of the average life of the contract from 24 months historically last two quarters to 19 months this quarter, we have a US dollar reduction in long-term deferred of about $3 million.

Which is more than offset with a currency improvement of $7 million for a net change in long-term of $4 million. Hope that provides everyone better clarification.

Operator

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

Kash Rangan – Merrill Lynch

First when I look at the cash flow guidance for the year, I think your assumptions may have not incorporated the change in the billings patterns that you’re seeing in this quarter so obviously when you look at the cash flow statement, the delta in deferred revenue is lower then what it has been in the last few quarters, so are you able to still hang onto the cash flow forecast in light of some of the changes of the margin you’re seeing where the average contract length is going down by five months and also the one year billing component is a greater percentage of your mix. So is it time for us to fine tune our cash flows for this year and for Jim, do you have any commentary at all on Oracle’s proposed acquisition of Sun. I know the last time you were not able to comment because the RDM proposal had not gone through. But I’m wondering with more clarity on that deal, I was wondering if you could give us your take on how you see Red Hat positioned in light of that big change that’s happening in the industry.

Charlie Peters

On the cash, I’m reiterating the full year guidance. I would also say that the average life of the deals in Q1 is not necessarily indicative of a longer-term trend or change and we will monitor that situation as the year progresses.

Jim Whitehurst

I think there’s still a lot up in the air. What happens to the hardware, what happens with [inaudible], so at this point a lot of it is speculation, but I will say is we’ve seen a lot of interest from customers in post the deal being announced where customers were concerned about having too much spend concentrated with a single vendor.

So certainly in the I call it short to medium term, i.e. over the next couple of years, it will be a positive as customers look for ways to diversify some of their risk. In the longer-term, I don’t see why it would be a negative, whether it’s a positive or not, we’ll have to wait and see as we see what really happens to the hardware and what Oracle does with the various technologies.

Operator

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

Tim Klasell – Thomas Weisel Partners

I wanted to talk a little bit about what’s changing with the larger deals, are customers taking just one year contracts, or are they just taking the three year contracts and just paying on an annual basis.

Charlie Peters

First of all let me reiterate what I just said at the very end of my comment about the cash flow, I wouldn’t draw any longer-term conclusions from the Q1 result. We’ve already seen activity in the month of June which indicates that we may have some movement back in the other direction.

But specifically what happened in the first quarter is we did have a couple of the longer-term deals that decided to pay one year at a time instead of three years up front as I said. It doesn’t seem terribly surprising in this economic environment.

Tim Klasell – Thomas Weisel Partners

And then maybe you could give us a little color then directionally maybe just on the off balance sheet component then. I know you don’t like to give details midyear, but maybe in light of what happened this quarter you can give us maybe some directional color.

Charlie Peters

No, as you said, my history going back three or four years, I only really talk about that one time of the year in fourth quarter, so I don’t have anything to add at this point.

Operator

Your next question comes from the line of Katherine Egbert – Jeffries

Katherine Egbert – Jeffries

Not to beat a dead horse, but just quickly are the multiyear deals renewing for multi years or are they renewing at either one year at a time, or are they renewing except they are paying one year at a time although they are committed to multi year.

Charlie Peters

When it comes to renewals, basically we’d almost always renew on very similar terms as the prior deal. So if it was a prior three year deal, it’s probably most likely very high probability it’s going to renew on a three year deal and I’m not aware of any particular situations where a large renewal deal changed the payment terms.

It’s just on some of the large newer deals.

Jim Whitehurst

You recognize we didn’t do a lot of three year deals three years ago so we don’t have a whole lot of experience this quarter with renewing three year old deals from three years ago.

Katherine Egbert – Jeffries

Your subscriptions are back over to 85% of total revenue, can you flesh out a little bit more why services is weaker in this economy.

Charlie Peters

I think particularly on the training side, travel is a discretionary item and just knowing what CFO’s are likely to look at, [inaudible] is certainly one thing that is fairly variable, and travel and training sometimes is the first to go.

I think if you look at other software results, released recently you’ll see fairly similar kind of results in services and training.

Operator

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

Steve Ashley – Robert W. Baird

Just getting back to the question regarding the Sun/Oracle deal, do you have any idea what percentage of the business you do in any given period would be related to Oracle and Oracle software at this point.

Charlie Peters

Not really.

Steve Ashley – Robert W. Baird

And then in your prepared remarks you talked about the cloud and cloud computing as being an important focus point, public and private clouds, is that impacting demand today and manifesting as bookings here today.

Jim Whitehurst

At this point I wouldn’t say it’s a significant component of business. There’s a lot of talk, there’s a lot of work going on and our customers have asked us to do a lot for them. In terms of actual incremental dollars today, I don’t think a lot of companies are there yet.

Operator

Your next question comes from the line of Aaron Schwartz – Ladenburg Thalmann

Aaron Schwartz – Ladenburg Thalmann

You spent a lot of time talking about the opportunity with the free to paid conversions, have you changed anything operationally to either incent your sales force or partners to more aggressively pursue those opportunities.

Charlie Peters

We have an internal team, a combination of folks in sales and in finance that work collaboratively to first of all identify opportunities and then determine the right course of action to help pursue the activities, whether it’s make a sales call, help educate an existing customer or a potential customers about the value of a subscription. The teams are working together and work with our sales people.

Yes, so we have done some things really in the last six months or so to focus on this.

Jim Whitehurst

And there are a myriad of small activities from pulling together packages which we’re sending out to customers, to the sales force training, to the follow-ups to selected audits. It’s a whole program that’s marching forward.

Aaron Schwartz – Ladenburg Thalmann

You talked a little bit about strategic partners and I was wondering if you could provide some color on sort of as you move more into the VDI opportunity what should we expect there. Are you doing to pursue more strategic partnerships to attack that opportunity.

Jim Whitehurst

In general one of the things I think Red Hat does well which positions us well, this is across all of our areas, is we work well with others in the ecosystem. Our job, or our key focus in open source is we commoditize computing at various layers of the stack and we work well with other partners who have other strategies around us. I think that’s no different in VDI then it is in most other areas of the stack.

Operator

Your next question comes from the line of Michael Turits – Raymond James

Michael Turits – Raymond James

First of all your constant currency billings rate was up 8%, I calculated organic about 9% last quarter, does it feel like that’s pretty much bottomed here.

Charlie Peters

In terms of the rate of change, I think your question is probably about economically, has the economy bottomed. I don’t have really any idea. I don’t want to try to make a call. In terms of billing it really has more to do with the type of deals that we do, the agreement about when a customer is to be billed then really anything else.

Michael Turits – Raymond James

And then so, on JBoss, you’ve made comments in the past that JBoss was growing somewhere around twice the rate of the REL business, is that still a pretty good rule of thumb, those trends still in place.

Charlie Peters

I think in Q1 it did not grow at twice the rate but it still grew at a faster pace than the rest of the business and I think we offered some color, Jim offered some color in the big deals. We’re still seeing big deals. They’d be leading indicators we had a number of large consulting assignments in the quarter and continuing which are helping customers move off more expensive proprietary middleware to JBoss so consulting goes first, [inaudible] follow.

Operator

Your next question comes from the line of Brent Williams – Benchmark

Brent Williams – Benchmark

I wanted to go back to the Oracle bid for Sun that’s out there, do you think that the odds are that they are going to change the Java community process or anything to favor their own products more. As you know, Sun never did a particularly good job taking any of the four application servers they were trying to bash together and really monetizing, but Oracle has got a much bigger revenue stream there and an incentive to really bend the process. Do you think that they might be able to do that and do you think that that ends up being an opportunity as partners throw up their hands and say, I need to get open source because I don’t need that kind of concern or do you think that it might be an issue that they’ll just stop talking to non-Oracle providers.

Jim Whitehurst

I think first off, we’ve obviously been involved in the JCP with Oracle for a long time and Oracle has over a long period of time continued to ask for more openness. I think given that Java is not a standalone world, there’s dot net out there as well and I think Oracle, I certainly think and hope understands the importance of keeping Java very, very open and moving forward, recognizing that it’s not a single world out there and Java has to compete with lightweight frameworks, has to compete with dot net and so it’s important to keep Java vibrant and thriving.

And I think they understand that. All that said I do think that developers in general are using lighter weight frameworks and other things and bypassing the heavyweight Java and so a combination of a little lack of clarity there as well as some of the other movements going on, certainly accrue to our benefit.

And as we talked about we made some significant announcements recently talking about our ability to support kind of any model a developer wants to use.

Brent Williams – Benchmark

And relatedly, they’re also going to get Solaris if they complete this deal including open Solaris, have you had any uptick in customer activity, people saying I wonder what this does to the future of that operating system and are you putting in place any programs to help particularly the open Solaris crowd, what there is of it, to move away and not look back.

Jim Whitehurst

No, frankly we haven’t seen a material open Solaris customer base in the enterprise. Most customers when they decide to make the jump from Solaris decide to go all the way to Linux versus taking an interim step at open Solaris.

So it’s not been a significant market factor to date, and we’ll obviously continue to watch it going forward but most of our customers are still focused on getting off of Solaris and going all the way to Linux and we’re quite good at helping customers do that.

Operator

Your next question comes from the line of Richard Williams – Cross Research

Richard Williams – Cross Research

I wonder if you can give some geographic color, customer sentiment, that sort of thing.

Charlie Peters

I can just reiterate I guess what I talked about in terms of the geographic split of the business with 53% in the Americas and 20% in APac. The customer sentiment in countries around the world is in many cases mostly linked to the economic situation in the countries in which they’re doing business because they’re limited by the budgets that are made available to them.

Apart from that we’re still seeing very high interest in open source software and finding ways to cut costs. But the common thing across every region I believe is that. Just to reiterate the numbers, it was 53% Americas, 25% EMEA, and 22% Asia Pac.

Operator

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

Todd Raker – Deutsche Bank

I just want to follow up on JBoss growth, clearly you’re starting to hit some tougher comps here, and if we look out from a longer-term perspective, how should we be thinking about the growth profile of JBoss versus the core business with a two to three year time horizon. Do you expect the growth profile to be maturely higher than the core business or should we start of it as about coming in line with the core business.

Jim Whitehurst

It’s still very early in its development by years versus what we’re, Red Hat Enterprise Linux is, so fundamentally it should grow faster and we’ll expect it to go faster than the core REL business. That said, it also is probably, it’s certainly more impacted by the economy then would be REL and for the simple standpoint of doing a migration from an expensive proprietary application server to JBoss saves a lot of money but there is often a large integration cost up front and so if you have a quarterly budget you’re trying to hit, migrating doesn’t necessarily work.

If you’re looking at an annual budget or over the next couple of years, then it’s a significant savings to move to JBoss. So depending on how the economic environment goes, and the amount of CapEx dollars companies have to spend, will determine JBoss’ relative growth rate. But no matter what we would expect it to be faster.

Operator

Your next question comes from the line of David Bayer – Cantor Fitzgerald

David Bayer – Cantor Fitzgerald

Congratulations on a fine quarter in a tough environment, I will not continue to pursue my original question which had to do with Sun and Oracle also but I would ask you to clarify a little bit, on the shorter contract lengths, does that imply anything about the overall pipelines or is it just more people being more conservative with what budgets they do have.

Charlie Peters

I’d like to clarify it, the pipelines remain strong. Its more indicative of just the nature of the deals that closed in that particular quarter. As I said we’ve already seen some deals in Q2, in this month, that will change that statistic at least so far this quarter and I don’t necessarily believe that what we saw in Q1 is a trend. It was just Q1.

Operator

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

Trip Chowdhry – Global Equities

Congratulations on a good quarter in a tough environment, first regarding the success of open source companies and here I am talking about [inaudible] CRN which had a lot of momentum, a lot of noise, and today its struggling quite a bit and I was trying to understand what is the reason that you as a company are doing very well and probably you’re the only open source offer company which is buckling that trend. Any key data points you can suggest like when we look at the open source companies, what should we be looking at in terms of financial end market success.

Charlie Peters

Clearly the very clear differentiator for us with Linux is the certified ecosystem, there is no other vendor out there today that has a certified ecosystem we have with 3,000 certified apps, more than 4,200 [inaudible] certified hardware. Even those distributions that claim to be clones of Red Hat, do not have the certifications and therefore if you’re running an enterprise you can’t take the risk of something not being supported.

So that’s certainly one thing. Very compelling value proposition is the second thing and that applies across everything we do. We have found a way to offer very good software and support at prices that bring a great deal of value to the customers and do it in the way that we’ve been able to scale by growing a partner, a distribution partner ecosystem as well as this partner that certify our software.

Jim Whitehurst

Just to add to that, I am not an expert in other open source business models at some of our competitors or some of the other open source companies use, we have a very disciplined business model that’s focused on commoditizing important layers in the stack that commoditize and improving performance.

So we’re not trying to differentiate in the application space functionality versus proprietary competitors. So as Charlie said that allows us to build large ecosystems of other commercial providers either hardware or software that want to work with us or above or below us at points in the stack.

And we’ve been laser like focused on that mission of commoditizing these key layers and working with other partners. I think open source is particularly good at that. I certainly hope for and we certainly like to work with other open source companies out there. But those are fundamentally different business then what we’re doing.

Trip Chowdhry – Global Equities

Regarding cloud computing and the two I would say camps that [inaudible] as we speak, one is a scale up model where we have virtualization as a key driver for providing cloud services and the other is what I call is a scale out model, also application clouds, in which companies like Google, and Microsoft Azure playing a role. It seems like Red Hat is gravitating towards the first camp and I was a little concerned that probably you may be missing an opportunity in application clouds where at least I know two projects, open source projects, which are having a lot of traction. One is [Twizzle] which is a spin-off from MySQL and the other one is [Eucalyptus] and of course [Hardoo]. So I was wondering who do you see the space and how do you make sure you don’t get blindsided if one takes over the other camp.

Jim Whitehurst

Our strategy again is we are the infrastructure provider to the cloud and regardless of whether that cloud providing infrastructure or providing platforms, we expect to be the infrastructure provider there. In our view it’s hard to imagine why anyone would build a cloud on a proprietary stack in this day and age and so we continue to work on adding functionality to our existing products as well as add additional virtualization products which are applicable in the cloud as well.

So we feel good about what we’re doing but we can only do so much and do it well with our model.

Operator

Your next question comes from the line of Robert Breza – RBC Capital

Robert Breza – RBC Capital

Just a quick follow up as you look at the billings, and the trends there towards more one year deals, did that differ by geography and can you also comment, you talked about the trend here in Q2, can you also maybe give us some color if there is any color to be given around the geography split amongst those trends.

Charlie Peters

First of all I don’t think it was a trend, we had multiple quarters in a row at roughly 24 months. We had one quarter at 19 months. It was partially driven by North America and I expect the second part of your question in terms of what may be happening, currently I’m expecting that North America may start going the other way in Q2. But that remains to be seen.

But it was principally North America.

Operator

Your next question comes from the line of Kevin Buttigieg – FTN

Kevin Buttigieg – FTN

I wanted to understand the reduction in the average term length is it influenced at all by when a customer decides to pay over time on their contract rather then up front, or is it purely influenced by the contract length that they choose.

Charlie Peters

It’s with the contract length that they choose. There’s two factors. One is the length and one is the payment.

Kevin Buttigieg – FTN

And then just any quick comments that you could make as far as the advanced platform trends particularly in light of some of the pricing actions by some of the competitors in recent months.

Charlie Peters

I think the advanced platform continues to make good progress and as we’ve been saying for a while now, as new customers come on and adopt REL 5, many of them are going to advanced platform and existing customers as they upgrade and many of them still are on older versions and will upgrade when the right time comes, will move some of their subscriptions to advanced platform.

It’s a continual trend I think more and more toward the higher price point but it’s sort of a gradual slope. I don’t see any step change in that.

Operator

Your next question comes from the line of Brad Whitt – Broadpoint Amtech

Brad Whitt – Broadpoint Amtech

Just looking at the channel contributions this quarter, 61% a little ahead of our expectations, how would you characterize that, did you see a little weakness from your internal sales organization, if you could just give some more color around that.

Jim Whitehurst

Typically the multiyear long-term deals are done by the direct sales force and as we said, some of those went to single year deals or single year payment and so that relatively impacted that balance.

Brad Whitt – Broadpoint Amtech

I wondered if you could share with us some of the things that you’re doing to try and enhance renewals from a channel, anything specific that you can share there.

Jim Whitehurst

We’ve been working hard and we have made a lot of progress in changing contract terms with a number of our distribution partners so we get access to the names. We’ve also put specific programs in place and actually hired a third party firm especially for some of our channel partners who don’t want to disclose the customers to us, to go after those renewals with our partners.

We’ve done a lot of work educating our partners. The cost to get a renewal, as several of our partners have agreed now, is about a third of the cost of getting new business. So they now see the value and we have processes in place to go after it.

So certainly our channel renewal rates are going up and going in the right direction.

Operator

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

Brent Thill – Citigroup

You got out of the gate pretty strong on the margins you already have your target for the year, it looks like you’re going to dial back a little bit on the margin in Q2, can you give us a sense are there additional expenses that are coming back in that are going to tone the margin expansion down from what we saw in Q1. How are you thinking about that metric.

Charlie Peters

I think you’re simply interpreting my guidance of the [use] around 23%. I didn’t mean necessarily at 23%, I mean around 23% so, but having said that, Jim did talk about continuing investments in various growth areas. I would expect that the mix of the services business would be a little bit greater in Q2 then it was in Q1.

But overall I think the performance down the line down to the operating margin line, still looks like it’s going to be on track with the numbers I talked about at the start of the year.

Operator

Your next question comes from the line of Mark Murphy – Piper Jaffray

Mark Murphy – Piper Jaffray

You’re making it clear here on the call that you’re not calling stabilization in the economy yet, but with the conversations you’re having with CIOs are you getting any sense that their budgets are loosening up for the second half of this calendar year or possibly looking at it from a metric standpoint, can you compare the growth in your pipeline or the number of RFPs received this past quarter to the previous quarter.

Jim Whitehurst

In talking to both CIOs as well as other large partners of ours, frankly we’re not seeing any, we’re not seeing a lot of signs that budgets are getting looser. Budgets are still tight. I think companies across the board are all waiting to see the bottom and so I would say budgets continue to be tight.

But emphasize again, though that in relative terms is pretty good for us. Our value proposition is strong in a tough economy so, I don’t want to say that in a negative way but certainly we see budgets continuing to be tight out there and without a clear end in sight right now.

Charlie Peters

I would just add I think there’s also a positive here in that at least budgets are known. For the most part they’re known. Whereas three, four months ago, many budgets were still be debated and were unknown and therefore it was, particularly in the government for example, it was much more difficult to even have the conversation about the budget that’s available.

Operator

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

Nabil Elsheshai – Pacific Crest

If you look at the virtualization release coming up later this year, do you look at that as kind of an incremental revenue opportunity either through driving greater AP sales or incremental revenue opportunity or is it too early in the virtualization story to make that call.

Jim Whitehurst

In terms of long-term strategically we see a revenue potential on the management tools as well as standalone hypervisor working with others. So there’s certainly revenue opportunity well beyond just what’s in the platform. In terms of revenue this year, I think it’s too early really to talk about impact for this fiscal year.

But certainly we’re not just doing this to enhance our current REL business.

Nabil Elsheshai – Pacific Crest

And then on the competitive front and in particular with Oracle now that they have potentially two operating systems, to the degree that you do compete with them on unbreakable Linux, did you see customers concerned about the future of that product line.

Jim Whitehurst

I think you’ve seen over the last couple of years customers have been concerned about it. We’ve yet to lose a major customer as we’ve talked about over the last year, all of our top 25 deals each quarter for the last five quarters have renewed. So I think the only one that didn’t in the last couple of years was Oracle itself.

So I think Oracle’s competing Linux is a fork of Red Hat Linux. Very few hardware or software certifications. They are not capable of guaranteeing that any changes they make their customers will make it in back up stream and therefore they’ve had very limited success in selling the product.

I think with the addition of Solaris I think it would be an even harder sell of something that’s already proven pretty unsuccessful for them. So, yes, I wouldn’t want to be the sales guy comped on selling Oracle unbreakable.

Operator

There are no additional questions at this time; I would like to turn it back over to management for any additional or closing comments.

Tom McCallum

Everyone, this concludes our call today and we look forward to any follow-up questions you may have. Thank you very much.

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