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Red Hat (NYSE:RHT)

F2Q10 Earnings Call

September 23, 2009 5:00 pm ET

Executives

Tom McCallum – Vice President, Investor Relations

Jim Whitehurst – President, Chief Executive Officer

Charlie Peters – Executive Vice President, Chief Financial Officer

Analysts

Sarah Friar – Goldman Sachs

Adam Holt – Morgan Stanley

Heather Bellini - ISI

Nabil Elsheshai – Pacific Crest

John DiFucci - J.P. Morgan

Katherine Egbert – Jeffries

Mark Murphy – Piper Jaffray

Brad Sills - Barclays Capital

Steve Ashley – Robert W. Baird

Tim Klasell – Thomas Weisel Partners

Robert Breza – RBC Capital

Michael Turits – Raymond James

Brent Williams – Benchmark

Brad Whitt – Broadpoint Amtech

Todd Raker – Deutsche Bank

Aaron Schwartz – Ladenburg Thalmann

David Bayer – Cantor Fitzgerald

Trip Chowdhry – Global Equities

Richard Williams – Cross Research

Kevin Buttigieg – FTN

Operator

Good afternoon. My name is Christian and I will be your conference operator today. At this time I would like to welcome everyone to the Red Hat Q2 earnings conference call. (Operator instructions) I will now turn the call over to our host, Mr. Tom McCallum, Vice President of Investor Relations. Sir, you may begin the conference.

Tom McCallum

Thank you. Hello, everyone and welcome to Red Hat's earnings call for the second 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 you will be able to find 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 quarterly report on Form 10-Q filed with the SEC.

In addition, any forward-looking statements represent our estimates or view only as of today, September 23, 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 am pleased to announce another quarter of solid execution resulting in strong growth and financial results. Many IT organizations continue to move ahead with purchases of high value solutions that reduce costs and improve performance, reliability, and scalability of their IT infrastructure. Red Hat is capitalizing on this demand as a result of our strong customer relationship and proven value proposition. These factors contributed to our better-than-expected total revenue in the second quarter and drove annual subscription revenue growth of 15% for both the quarter and the first half of FY10.

What makes Red Hat's growth all the more impressive is the fact that it comes during a period of time that one leading industry research firm has referred to as the worst server shipment environment since the data has been tracked.

Red Hat's value proposition is further evidenced by our strength of our renewals. I am pleased to report that for the sixth consecutive quarter, all of our top 25 deals that were up for renewals not only renewed but did so at a total of over 120% of the prior year’s value.

We are pleased by the loyalty and trust our top customers have placed in Red Hat and as Charlie will discuss in a moment, we are especially pleased to see a former financial services customer return to Red Hat with a sizable purchase during the second quarter.

Over the past three-and-a-half years since we began tracking the metric of renewals on the top 25 deals each quarter, only three out of the 350 deals did not reduce. In that same time, two of the three have since returned to Red Hat, including one during the second quarter.

In addition to the solid sales execution, we are also able to deliver margin expansion and strong cash flow during the quarter. We continue to focus on expense management; at the same time, we continue to invest in key initiatives to grow our market share of infrastructure software for the data center.

I would also like to discuss Red Hat's Summit and JBOSS World Conference recently held in Chicago where we announced a number of technology advances that will help our customers optimize their IT infrastructure, including our position in virtualization and in cloud computing. This year’s combined event drew a record attendance of over 1,500. I had the opportunity to speak with many customers and partners and it was clear to me that the co-located events were a resounding success that enhanced and amplified Red Hat's role as the trusted open source leader.

During the event, we announced new releases of our flagship products, spanning each of our major business lines. These significant releases further establish Red Hat as a leader not only in open source operating systems management and virtualization but also in virtualization and cloud computing solutions. These releases included JBOSS enterprise application platform 5.0, or EAP 5, which enables customers to benefit from easier application development and deployment, developer choice and programming models, protection against programming model changes, and an easier transition to newer application deployment models. The EAP 5 platform spans a growing number of operating models from traditional on-premise lightweight Java applications to newer internal and external cloud based deployments.

Second, we launched Red Hat Network Satellite 5.3, our on-premise systems management solution that provides updates provisioning, configuration management, and monitoring across physical and virtual Red Hat enterprise Linux servers. Customers can gain bottom line benefits through enhancements for faster and more flexible provisioning of servers in a repeatable centrally managed way. In addition, customers benefit from scale advantages as they can expand their investment in Red Hat and manage their IT environments with existing staff.

Third, we launched the latest version of our award-winning operating system, REL 5.4. As the foundation of our Red Hat enterprise virtualization portfolio of solutions, REL 5.4 delivers expanded virtualization capabilities with the inclusion of KVM, or kernel based virtual machine. The latest version has received strong support from a number of our key partners, including Intel, IBM, Cisco, and Dell.

At the Summit, we also provided an update on our beta program for our Red Hat enterprise virtualization, or REV product portfolio. The product portfolio includes a new standalone hypervisor as well as server and desktop virtualization management products.

REV is designed to be a cost-effective solution that also addresses performance, security, and scalability issues associated with many of today’s expensive virtualization offerings from other vendors. Importantly REV also allows customers to leverage the broad Red Hat enterprise Linux certified ecosystem. Our beta customers have been running REL and Windows guests across a variety of enterprise grade applications like the [inaudible], SAP, Oracle and Microsoft Exchange, and feedback from the beta customers has been favorable.

On a final note, at the Summit we also updated customers and partners on emerging cloud computing market opportunities. Today Red Hat is supplying technologies to IT organizations for internal cloud building as a public cloud provider. At the Summit we discussed how Red Hat is enabling cloud computing in an open way. We announced Delta Cloud, a project to address customers’ needs for interoperability in the cloud. Delta Cloud is an open-source effort to create a common rest-based ATI, such that developers can write once and manage anywhere. This is just a brief summary of some of the exciting new products we have released. We will use the upcoming analyst day on October 6th to discuss these solutions, as well as our progress around our key growth initiatives.

Before turning the call over to Charlie, I would like to note that the past quarter marked a couple of important milestones for Red Hat. First we celebrated our 10-year anniversary as a public company. We started off as a small company distributing Linux software and have grown rapidly into a strategic IT vendor, providing open source solutions that support mission critical infrastructure of major enterprises around the globe.

Secondly, we are also pleased to be recently recognized by our inclusion as a component of the S&P 500, joining a key group of industry leading firms in the U.S. This achievement is a direct result of the effort of our Red Hat associates around the world and I would like to thank them all for their hard work in the quarter and over the years.

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

Charlie Peters

Thank you, Jim. I am also pleased to report another strong quarter as good customer demand and focused execution drove double-digit growth across our key expansion metrics and exceeded our expectations. Highlights include subscription revenue, total revenue, and deferred revenue all growing double-digits. We are particularly pleased with greater than 20% growth of the current portion of our deferred revenue. Consistent with the commentary from our last call, the length of the average subscription duration expanded. Non-GAAP operating income was up 21%. Operating cash flow was up 14% overall, and up 31% on a per share basis. Non-GAAP EPS was $0.20, or $0.16 if one excludes the positive effects of net investment gains in the discrete tax benefit. Either way, EPS was above the high-end of our guidance.

As Jim mentioned, these better-than-expected results illustrate that IT organizations are continuing to select Red Hat as a strategic vendor to provide high value industry-leading open source solutions. As further evidence to this point, let me share with you some of the statistics regarding our larger deals.

Our top 30 deals in the quarter included two deals over $5 million, 10 deals over $1 million, and two sizable [inaudible] to pay deals. Importantly, 23 of the top 30 deals included REL advanced platform, our most capable operating system, and five included a JBOSS component.

As Jim mentioned earlier, one of the free-to-pay deals was a multi-million dollar deal with a financial services customer. This customer chose to migrate back to Red Hat after using a competitor’s Linux provided to them through free coupons. This customer returned because our technology roadmap was clear and our value proposition is strong.

The other free-to-paid win in the top 30 was a deal with a large technology company. This customer has attempted to support the software themselves but realized that they were incurring significant costs and risks to do so. They were able to achieve significant cost savings by buying Red Hat subscriptions and their CIO now sleeps more securely at night.

Now let’s talk about our financial performance, starting with bookings, billings, and revenue. The channel generated 59% of our Q2 bookings and 41% came from direct sales, versus a 61%-39% split in Q1. Geographically, 56% of bookings came from the Americas, 25% from EMEA, and 19% from Asia-Pacific. This is essentially in line with our historic geographic splits.

From a deal length perspective, Q2 average deal length increased to approximately 22 months from 19 months last quarter. Considering the current macro environment, we continue to anticipate that the average deal length will vary from quarter to quarter, but the important factor is that we continue to sign significant new and renewable business, which is a key driver of revenue and cash flow.

Our billings proxy for the quarter, which is revenue plus a change in deferred revenue from a cash flow statement, was $194 million, up 8% in U.S. dollars and in constant currencies, it was up 10% year over year to $198 million.

Second quarter revenue was $184 million, an increase of 12% year over year, and above our guidance range. On a constant currency basis, using Q2 last year average rates, our revenue would have been $4 million higher, representing 14% growth.

Subscription revenue was the driver of our total revenue growth. Subscription revenue increased a healthy 15% year over year to $156 million, and was up 17% in constant currencies. Subscription revenue, which is renewable, constituted 85% of total revenue. The training and services component of revenue was $27 million, down 5% in the prior year quarter. As we’ve noted previously, training and services revenue is most impacted by the macro environment, as customers reduced travel and discretionary spending.

On a non-GAAP basis excluding stock compensation and amortization expense, overall gross margin was 85.5% for Q2. It’s up 140 basis points year over year, primarily due to strong subscription sales. Subscription gross margin was 93.8%, up 20 basis points year over year.

Moving down the P&L, Q2 non-GAAP operating expenses came in at $113 million, up 11% year over year. While we continued to invest in sales and R&D, focused execution on expense management enabled us to grow our non-GAAP operating income by 21% year over year. Our non-GAAP operating margin of 23.7% improved 170 basis points year over year.

On a constant currency basis, operating expenses would have been approximately $4 million higher. Netted against the currency impact to revenue, the impact to our bottom line was very small as our natural hedge of offshore revenues and expenses worked as expected.

Other income was $5.8 million, which includes $2.5 million of interest income and $3.3 million principally related to gains on investments. A year ago, other income was $14.8 million, which included $10.4 million of interest income and $4.4 million of net investment gains.

Taxes require some additional explanation this quarter. This quarter we recorded a discrete tax benefit of $7.3 million related to research tax credits. Before inclusion of this tax benefit, the estimated annual effective tax rate was 35% for both GAAP and non-GAAP results. After inclusion of this tax benefit, GAAP tax rate for the quarter was 13% and the non-GAAP tax rate was 20%, as explained in the tables attached to the earnings release. For those of you building models, keep in mind that we continue to believe the estimated quarterly tax rate for Q3 and Q4 will be 35%.

Non-GAAP diluted earnings per share came to $0.20. Excluding the one-time benefit -- one-time tax benefit and the investment gain, non-GAAP EPS would have been $0.16, or $0.01 better than expected and up 14% year over year.

Now let’s turn to the balance sheet and the cash flow statement. We ended the quarter with cash and investments of $912 million, an increase of $27 million from last quarter, even after the repurchase of 2.3 million Red Hat shares for $47 million. Year-to-date, we have repurchased $5.1 million shares for $94 million.

Operating cash flow was $62 million. This is up 14% year over year. More importantly, due to the 12% reduction in diluted shares outstanding since last year, on a per share basis operating cash flow and free cash flow were up 31% and 27% year over year respectively.

DSOs continue to be in good shape at 54 days, the same as last quarter, and down from 60 days last year. As a reminder, 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 $581 million, an increase of $84 million, or 17% over the same quarter a year ago, and an increase of $14 million, or 2% over last quarter. Breaking it down further, $420 million was in current deferred revenue while $161 million was on long-term deferred revenue. Sequentially, short-term deferred revenue increased by $17 million, while long-term deferred revenue decreased by $4 million.

So let me reemphasize several points that I have already made -- we had solid big deal flow and the average contract duration lengthened to approximately 22 months. Billings were strong. The current portion of deferred revenue grew 21% year over year and long-term deferred revenue declined $4 million. This information provides insight to the strength of the business and to changes related to the billing of long-term deals which is largely related to the economy.

Now I would like to turn to guidance, which assumes currency rates approximately where they are now. For Q3, revenue is estimated to be approximately $187 million to $189 million; operating margin is estimated to be about the same as Q2, knowing that the cost of the Red Hat Summit will cause sales and marketing expense to plump up a bit; and non-GAAP EPS was estimated to be approximately $0.15 to $0.16, assuming a 35% tax rate.

I am not providing specific guidance for Q4 at this time but since I know that many of you will be adjusting your models in the next few days, I want to point out two things about revenue that are frequently overlooked. The first is that we recognize subscription revenue on a daily basis, which means the number of days in a quarter is important. Q1 and Q2 each had 92 days; Q3 has 91 days; and Q4 has 90 days. In Q2, we recognized approximately $1.7 million per day of subscription revenue. And the second point, of course, is that Q4 services revenue historically has declined from Q3 levels as a result of holiday seasonality globally.

Concerning the full year, based upon the strength of the second quarter and the guidance I have provided for the third quarter, it’s fair to say that we are confident that revenue, operating cash flow and earnings per share not including the extra $0.04 one-time benefit in Q2 are likely to be closer to the high-end of the ranges that I guided earlier in the year. Full-year operating margins are expected to be about 100 basis points better than last year.

In summary, we continue to execute well in the current environment, as evidenced by double-digit growth across each of our key metrics. We continue to manage costs while investing in growth opportunities such as virtualization, cloud computing, and middleware. And finally, we continue to be optimistic about Red Hat's future and believe the company is well-positioned when the economic and IT spending environment improves.

Before turning the call over to the operator, I would like to remind the financial community about our upcoming analyst day on October 6th in New York City. It will be a great opportunity to hear from the Red Hat executive team as we provide a deeper dive into our business. I hope to see you all there and please remember to register for the event if you haven’t already done so.

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

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from the line of Sarah Friar with Goldman Sachs.

Sarah Friar – Goldman Sachs

Good quarter. Jim, if I could just ask you a little bit on the demand environment, some extra color -- did you actually see customers beginning to pick up on server purchases again or do you think you were benefiting from again taking share from other operating systems like Solaris, for example?

Jim Whitehurst

At this point, it still looks like taking share from other operating systems vendors. I would say we are seeing some signs of life out there as customers are talking a bit more about new projects but I don’t think we actually saw that in new volume in the second quarter. I think it’s mainly taking share still at this point.

Sarah Friar – Goldman Sachs

Got it, and then if I could just one follow-up on the geographical split, did you see anything coming back in EMEA? I know that’s been one geography that’s appeared to have lagged most and yet we are seeing some early signs that GDP is picking up there.

Jim Whitehurst

I think they made some progress and one interesting fact is they booked the largest deal in the history of EMEA in Q2.

Sarah Friar – Goldman Sachs

Okay, great. Thank you very much. Good job.

Operator

Your next question comes from the line of Adam Holt with Morgan Stanley.

Adam Holt – Morgan Stanley

I’ll echo the congratulations. My first question is on JBOSS. It sounded like you had good success, particularly with larger deals in JBOSS. Does this mean that you think that business is reaccelerated to be growing faster than the core business? And maybe talk about the pipeline for the second half there.

Jim Whitehurst

On the JBOSS business, it does continue to grow faster than the core business, and as I said in talking about the top 30 deals, there still seems to be a good cross-sell going on and when we have a REL account, we’re able to sell JBOSS there. And the second part of your question was on pipeline?

Adam Holt – Morgan Stanley

Yes, just the pipeline for the back half of the year for the JBOSS business.

Jim Whitehurst

I would say our pipelines overall remain good.

Adam Holt – Morgan Stanley

Terrific. Thank you.

Operator

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

Heather Bellini - ISI

Thank you. Charlie, I was wondering if you could talk a little bit about the success you’ve had to date in migrating customers to the advanced platform SKU and give us an idea of what percentage of your customer base had made the move thus far and kind of where you see that penetration rate going.

And the follow-up to that would be a little similar to Sarah’s question -- would you be more optimistic about the opportunity of migrating your customers to the higher priced SKU versus a pick-up in server shipments over the next couple of quarters?

Charlie Peters

A lot of questions there but first about advanced platform, I think one of the statistics which I shared I believe for the first time ever was the number of customers in the top 30 that had advanced platform and what was very interesting, it was a very significant percentage, 23 out of 30 of the top 30 deals in the quarter had an advanced platform component. So that tells you that certainly the big customers are moving that way and I think new customers, assuming that’s what they need, are moving that way.

In terms of the second part of your question, where are we in the migration, I do think this is a migration that is going to continue to go on for some time. It still could be a couple more years to be honest with you before customers move but not all customers need to move at the same time. If they have systems running well for them, they may well stay where they are.

Heather Bellini - ISI

Okay, and then just the last part was just about are you more optimistic about being able to migrate your customers to the advanced platform versus a pick-up in server shipments over the next two quarters or so?

Charlie Peters

I think on the server shipments, I’ll leave that back to the folks who are forecasting what’s going to happen with IBM, HP, and Dell. I mean, certainly the server statistics we’ve seen recently for those folks show that they are down quite a bit and it’s clear from our numbers that we’re not down anywhere near that.

I am planning at analyst to share some additional information about our business with the OEMs, which may clarify some of that.

Heather Bellini - ISI

Okay. Thank you and congratulations.

Operator

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

Nabil Elsheshai – Pacific Crest

I was wondering if you could add a little more color on the virtualization release. I think that you’ve talked about the management tools being an incremental charge. Do you have any clarity yet on what the potential for that is next year or do you think it’s a longer term thing?

Jim Whitehurst

We are planning on spending a fair amount of time talking about that at analyst day so I highly recommend you come and we’ll have the full team there to talk about it.

Nabil Elsheshai – Pacific Crest

Okay, and then just real quick on the sales force expansion, are you continuing to expand that and at what rate, or have you slowed down given the economy?

Jim Whitehurst

We have added people every quarter this year and our -- most of our additions have been in sales and engineering and we are planning continued additions where and when needed.

Nabil Elsheshai – Pacific Crest

Do you think the rate will remain roughly consistent or what signs of a rebound are you planning to increase that rate?

Jim Whitehurst

That again, maybe we’ll share more at analyst day.

Nabil Elsheshai – Pacific Crest

Okay. I guess I’ll have to come. Thank you.

Operator

Your next question comes from the line of John DiFucci with J.P. Morgan.

John DiFucci - J.P. Morgan

Thanks. Nice job, guys. It looks like a real clean quarter here. But it sounds like your performance has more to do with Red Hat specific factors. You’ve really bucked a recent trend anyway with a couple of pretty large software companies, Oracle and Adobe reporting at least the corporate results that were sort of less than they expected, anyway, and we did too. I guess sort of a follow-up to Sarah, from your assessment, is the environment stable? I mean, you mentioned signs of life, or does it continue to get tougher and you just have other things happening that are more than offsetting that?

Jim Whitehurst

Well, first off I think for the results you are seeing in the second quarter, we are taking share and therefore our results have diverged from a lot of other vendors. I think the dislocation around Sun has certainly been helpful, [the fill] we are beginning to reap some benefits around JBOSS post the WebLogic deal last year, so that deal has taken a long time. That said, I would say from our sales force, I am hearing anecdotal evidence that there is finally discussion of new projects out there, which obviously we feel good about because we do -- generally do better on new projects than replacing things that already exist. But that’s still very early but I think we are at least starting to engage companies in dialog about new projects versus just basically holding down the fort, which is good news.

John DiFucci - J.P. Morgan

Okay. Thank you.

Operator

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

Katherine Egbert – Jeffries

Good afternoon. Just two quick questions -- the first one is on the operating margin. You’ve significantly exceeded the 23% that you said for the quarter. I mean, is 23% still the right bogey? And you said 100 basis points for the year -- is that 100 basis points every year now?

Charlie Peters

The first part of the question in terms of the guidance I gave at the start of the quarter, the guidance I gave last quarter was around 23% and I guess I regretted because all of you quickly assumed that meant down and to me, I meant around, so 23.7% is a good result. It reflects the hard work of all of our employees to get there. The second part of your question, whether it’s 100% -- excuse me, 100 basis points a year, I think that both Jim and I have said before that we believe operating margin improvement in that level is something that we can deliver while still investing for growth. So again, we don’t want to sound like a broken record -- we are also going to be addressing that at the analyst day.

Jim Whitehurst

Just to amplify on that, because we are a company in a growth phase, we can basically determine our operating margin, take it up or down depending on how much we are investing for growth and as we said, we think there’s a big opportunity in front of us so we want to continue to demonstrate that we can deliver improved operating margins but that will be somewhat geared based on the size of that operating margin growth will be geared on how big we think the growth opportunities are in front of us.

Katherine Egbert – Jeffries

Sure, and then quickly that combination of operating margin expansion along with recovery in the server OEM shipments, I mean, I believe the bulk of your cash flow does come from server OEM payments. Can you tell us in a normal environment with server shipments flat, what would your cash flow have been? It seems like this is a depressed level right now and it can only go up from here.

Charlie Peters

I think that your presumption about the level of cash flows from the big OEMs is not accurate and I will provide more detail and it will be the first time I shared this information at analyst day about where we are with the OEM. If you went back four or five years ago, that might have been accurate but today we have a very diverse customer base globally and we do a lot of business with others other than OEMs.

Katherine Egbert – Jeffries

Okay, thanks. Good job.

Operator

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

Mark Murphy – Piper Jaffray

Are you seeing instances where REV will be displacing VMWare in a customer’s deployment or generally speaking, is that kind of activity not necessary for you to reach the growth trajectory that you are looking for with REV?

Jim Whitehurst

I think there are a number of opportunities for potential replacement but that said, we are at the very early stages of virtualization so there’s so much to do with just greenfield that that’s going to be our primary focus.

Mark Murphy – Piper Jaffray

Jim, as a follow-up, the Oracle and Sun microtransaction is being held up by the EU and we are seeing that it is causing a very dramatic drop in revenue for Sun. From what you can tell, are those Sun customers just deferring their spending temporarily and then presumably it will come back to Sun when the transaction closes? Or do you think that they are instead migrating faster off of Solaris and on to Red Hat? So any insight into the recent rate of Unix to Linux migration would be helpful.

Jim Whitehurst

Just to comment on that, I think that any time there’s change in a company like what’s going on at Sun, it creates opportunity and clearly the OEMs that Katherine was just talking about, HP, IBM, and Dell are squarely focused on that opportunity and when there are replacements like that in many, if not most cases, Red Hat software is involved, so I would say that we are seeing some opportunity there but I don’t want to expand any further on that.

Mark Murphy – Piper Jaffray

Thank you.

Operator

Your next question comes from the line of Brad Sills with Barclays.

Brad Sills - Barclays Capital

Just a question on the improvement you saw this quarter on the average contract length going up to 22 months. Could you just comment a little bit on was that execution, were there certain measures you took or was it more just customers more willing now to sign longer term agreements?

Jim Whitehurst

Frankly I think that Q1 was actually a little bit of an aberration, as we tried to explain on the Q1 conference call but until you see the rebound, it’s hard to be sure of that and what I would say at this time is I think that some people now view the economy, the economic prospects a little bit better. Maybe people are more inclined to sign up for longer term deals. Our sales guys clearly were more focused on going after longer term deals. I think a combination of things caused it to rebound so Q2 was more back to where we’ve been for every quarter for the last seven or eight, except for Q1.

Brad Sills - Barclays Capital

Got it. Okay, thanks and then just a question on JBOSS -- are you seeing, you know with the wins that you are seeing this quarter, it sounds like an improvement, would you classify that more as pilot and departmental type wins, where there’s room for growth going forward? Or would you say these are more some larger migrations?

Jim Whitehurst

I’m sorry, I don’t know if I can classify it one or the other because we definitely have some of both of those categories. We have some large migrations going on and we have many situations where there’s just small departmental initiatives, which we hope over time will grow into much larger migration.

Brad Sills - Barclays Capital

Got it. That’s helpful. Thanks.

Operator

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

Steve Ashley – Robert W. Baird

I guess first of all in terms of virtualization, is there any commentary metrics you could give us around what kind of adoption and how active your customers are in using REL to do virtualization?

Charlie Peters

Probably the best thing, Steve, I think is how they are using REL advanced platform, which has unlimited virtualization, allowed unlimited virtualization, so going back to 23 out of 30 of the top deals use advance platform, it is my assumption that one of the reasons why they are making that move is because they are using the virtualization capabilities in it.

Jim Whitehurst

But again, because it’s built in, we don’t actually track specifically usage.

Steve Ashley – Robert W. Baird

Okay, great. And then JBOSS, you introduced the new kind of JBOSS enterprise web platform. Any comment on the early response to that lighter weight offering?

Jim Whitehurst

Well, the offering just came out in June. We had very good -- a lot of interest and response from customers around it. I don’t really have any update specifically on the numbers around that but generally it’s been very well-received in the market. Basically giving a whole set of different kind of weights around how heavy a platform do you want but a consistent run-time environment. It’s been very well-received.

Steve Ashley – Robert W. Baird

Thank you.

Operator

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

Tim Klasell – Thomas Weisel Partners

Congratulations, everybody. Just two quick questions here -- one on the new 5.4, you are obviously changing the architecture of your virtualization strategy -- where have you been hearing initial interest? Is it the hosting providers or does this break you into new ground?

Jim Whitehurst

Well, the very first initial interest is obviously people who are large users of REL today because without having to lift up the operating system and put something underneath, they can get the benefit of virtualization. So especially some of our large customers who are running mission critical or performance critical applications, we don’t want to virtualize those but when those applications aren’t running at full steam, we want to take advantage of the benefits of virtualization, you can do that by having virtualization built into the kernel. So those are obviously the customers who have immediately jumped.

But more broadly, we are seeing interest from customers and really non-customers alike who have just had a chance to assess and see the technology.

Clearly what I would say is more technically sophisticated companies who spent the time to understand the relative benefits are particularly interest in KVM as a long-term virtualization solution.

Tim Klasell – Thomas Weisel Partners

Great, and as a follow-up --

Jim Whitehurst

-- companies and cloud providers are -- would fall in that category.

Tim Klasell – Thomas Weisel Partners

Okay, great and then a quick one -- how was your government business and what does your government pipeline look like?

Charlie Peters

Government business was good in the quarter -- 15% of the business was through the government vertical. And the pipeline is good.

Tim Klasell – Thomas Weisel Partners

Thank you.

Operator

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

Robert Breza – RBC Capital

Thanks for taking my questions. Jim, I just wanted to dig into the large deal you talked about in Europe. I was curious if you could talk about it relative to what they took from a product perspective and maybe just curious what kind of tipped them over to purchase this quarter -- any insight I think would be helpful. Thanks.

Charlie Peters

The large deal in Europe was principally around REL but there was also JBOSS involved and I think what caused them to buy this quarter just needs -- they need what we have and we had a good solution.

Robert Breza – RBC Capital

Thank you.

Operator

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

Michael Turits – Raymond James

I have a couple of questions. One, in billings growth, it looks like both on a nominal and constant currency, it seems to have reaccelerated. Does that feel like we’ve got a bottom there and we should see billings growth accelerate at this point?

Charlie Peters

I think on billings growth, the reason I went through some of the factors like strong growth in current deferred revenue, we actually have a reduction in long-term deferred revenue was to indicate that billing terms, just the way we bill long-term deals is a factor which influences the total billing metric and it’s not necessarily indicative of the strength of the business. The business was quite good, as indicated by a number of metrics that I’ve laid out. The fact that we have increased the duration of the deals and you have a reduction in long-term deferred revenue should lead one to conclude that there was some addition to the off-balance sheet backlog. I think -- I’ve been trying to tell people for some time, don’t get overly focused on the billings metric -- I know, although it is one metric of interest.

Michael Turits – Raymond James

And then another metric that you did give last quarter was current booking as a percentage of total which had ticked up to 80% but typically I think it said it was closer around two-thirds. Where did that go this quarter?

Charlie Peters

That was 70% of a single year bookings, which gets you to roughly the 22 month average duration.

Michael Turits – Raymond James

Okay, and the last one, just a longer kind of bigger picture question, REL is a well-deployed operating system for public cloud computing companies. Are there -- have you seen any pressure on pricing that we should be concerned with as an increasing amount of sales go to public cloud providers?

Jim Whitehurst

I think I’ve been saying for five years now that we are very price competitive. We compete every day with [inaudible]. We have our own free version of the operating system call [Tudor]. We have [inaudible] free version of middleware called JBOSS.org. There are other free versions out there. We win because of the value we add and as a result, we have been very consistent in our pricing over a five-year period of time and I think our growth, the consistency of our gross margin clearly demonstrates that.

Tom McCallum

We have a lot of people in line. If you can limit yourself to one question, that would be really helpful so we can get through to everybody’s questions. You can come back in the end if we still have some time. Thanks. Next question, Operator.

Operator

Your next question comes from the line of Brent Williams with Benchmark.

Brent Williams – Benchmark

A lot of the detailed oriented questions that I wanted to post have been asked, so something very philosophical. I saw an interview with [Linus Torvalds] the other day and he was suggesting the idea that in some respects, the core Linux kernel is getting a little bit bloated and that there’s just so much stuff going in there and I think of course Linus speaks his mind at any given moment and doesn’t bother himself with consistency from day to day in his thoughts, but is this reflective of any maturity in the evolution of the kernel technologically? Is this suggesting maybe that a lot more focus is going to surrounding capabilities? I mean, is this indicative of a change in the focus of the kernel development community and can we look at any sort of hints there about where Linux might evolve and how that might end up helping Linux attack new markets, or anything like that?

Jim Whitehurst

I guess my simple answer to that is as Linux has continued to grow and its applicability continues to expand, there’s just more feature functionality that people are looking for to be built into the operating system.

I have not had a conversation with him about the comment. I don’t think of that as bloat. Certainly bloat is when you start adding feature functionalities that people don’t want, and certainly the nature of Linux where users are the key contributors, I do think Linux is growing but I think it is much more indicative of the fact that its’ continued added features that people do want and the key differentiator is it can continue to do that in a very modular way, so I actually look at the growth as much more of a reflection that it continues to add features that people do want, and that’s a good thing.

Operator

Your next question comes from the line of Adam Holt with Morgan Stanley.

Adam Holt – Morgan Stanley

I didn’t mean to get back in the queue this quickly. I apologize, I just had one more question on cash flow, which was there were a few moving pieces in the balance sheet that had a particularly large impact on cash flow, prepays in particular and some of the payables. Could you just walk through if there was anything unusual in the quarter? Thanks.

Charlie Peters

Sure. There’s nothing particularly unusual that I am aware of in the quarter. For us, various working capital elements move around whether it’s increase or decrease in receivables, payables, or prepaid and there was nothing else really unusual about the cash flows this quarter.

Adam Holt – Morgan Stanley

Great, and again --

Operator

Your next question comes from the line of Brad Whitt with Broadpoint.

Brad Whitt – Broadpoint Amtech

Charlie, just along those same lines, I noticed that the negative impact from excess tax benefits was less than we had projected and less than it’s been in quite a while. I was just curious as to how we should think about that going forward.

Charlie Peters

One of the things you might think about in terms of looking at that line is look at the net impact of the excess tax benefits and the deferred tax item. If you put those two together, you get $4.5 million this year, you get $4 million a year ago for the same quarter. More specifically to your question, what to think about going forward, I think for the next at least couple of quarters, for the excess tax benefit, my guess is it’s probably going to be somewhere in the $4 million range, maybe $5 million dollar range, and much will depend upon what additional excess tax benefits are generated through current period stock option exercises and stock option deduction. Something in the $4 million to $5 million range would seem appropriate if you are trying to build a model for Q3 and Q4 for that number.

Operator

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

Todd Raker – Deutsche Bank

Nice quarter -- two quick questions for you; first, from a tax perspective, when do you guys anticipate becoming a full cash tax paying entity? When will the NOLs run out? And then secondly, if you look at the top 25 deals, for the last two quarters you have kind of grown that value over 120%. Can you give us some sense for what is driving that metric? Is it cross-selling incremental products? Is it just more units or up-selling the incremental functionality? That would be very useful if you can give us some insight.

Charlie Peters

On the first part of the question, when we will be a full taxpayer, we have -- we still have remaining, a small amount of remaining NOLs. We have in addition to that R&D tax credit carry-forward and we have foreign tax credit carry-forward, enough so that we will make it all the way through this year paying very limited taxes in the U.S. and maybe some into next year, so sometime in the next year probably.

The answer to the question is once again linked to what additional stock option deductions are available from current exercises, so that could change and it could go for a longer period of time before we become a full taxpayer. And just so it’s clear, I think everyone knows that our operating cash flow is already fully taxed, so it should not have any impact on operating cash flow.

And the second part of the question --

Jim Whitehurst

It was regarding what is driving the 120% on the renewal -- it really is a mix. Most customers continue to expand their footprint of REL in their environment, so there’s some just unit volume growth but we actually are seeing increases in the cross-sell at JBOSS, which is good, and especially AP. As a lot of customers move into more mission critical applications, the additional functionality with AP becomes more important. So it’s really a combination. I don’t think one particularly outweighs the others. It’s really a healthy mix of both.

Operator

Your next question comes from the line of Aaron Schwartz with Ladenburg.

Aaron Schwartz – Ladenburg Thalmann

Good afternoon. I was just wondering if you could update us on the growth reinvestment balance specifically within the JBOSS division. I know you’ve been reinvesting heavily there. Does that continue into next year or do you pull off a little bit? And when do you hit the revenue scale to where margins in JBOSS start to materially move higher?

Charlie Peters

I think that the key thing with the JBOSS, we’re still investing more in R&D in JBOSS than we are in -- on the operating system side of the business as a percentage of revenue. I guess that should be obvious given the relative size. Starting at the top line, the gross margins are about the same and it will simply be a matter of time until revenues grow to a sufficient size on a percentage basis. It might look more like REL. I think that is still some time to go. That will not happen in the next year or two, I don’t believe. REL is a much more mature product line.

Aaron Schwartz – Ladenburg Thalmann

Okay, that’s helpful, thank you and a quick follow-up on the cash flow, was that -- the at benefit you recorded in the quarter, was that fully reflective in the cash flow? I know it’s on the net income but was there an offset somewhere else in operating cash flow?

Charlie Peters

It will be in the deferred taxes so that tax credit does not flow all the way through the cash flow this quarter. It’s probably spread over Q2, Q3, and Q4.

Operator

Your next question comes from the line of David Bayer with Cantor.

David Bayer – Cantor Fitzgerald

Thank you for taking the question. Clearly virtualization is beginning to be more widely adopted, or at least licensed by the customers. And yet we still see a phenomenon in the trade press where it seems like solutions from Citrix, Microsoft, and VMWare seem to get more press. What efforts is the company making to sort of increase the awareness of your solution set?

Charlie Peters

I would say we made a significant effort at the Red Hat Summit to highlight it. We’ll make significant effort at analyst day to highlight it. We are working with various press outlets and our marketing group to find ways to get the message out.

It’s not unlike where we were seven or eight years ago from an operating system perspective. We clearly are the underdog but we think we’ve got a very good solution that is going to have a very compelling cost benefit type of relationship that will make good headway but we are working on it from marketing and a PR perspective.

Jim Whitehurst

Let me also emphasize -- Red Hat, our heritage is enterprise class software, right? Linux is freely available and the reason we are by far the market leader in enterprise Linux is because we deliver and we deliver for the most mission critical applications out there, so we are not believers in hyping vapor ware until we can deliver. We just delivered REL 5.4 with KVM, so the core foundation, we talked a lot about that at the Summit and obviously when we release the REV M or the management tools, you will see a significant effort in communicating not only via our sales force but in marketing, the messages around that and why we think it’s a superior solution. But that’s to come when we deliver the product, not before.

Operator

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

Trip Chowdhry – Global Equities

Two quick questions -- first, very good execution. Two questions, first on the cloud computing -- I was wondering, where do you see your sweet spot? Is it at the edge or at the core? And the second question I have is regarding appliances -- increasingly, more appliances are using Red Hat as an embedded operating system and I was wondering if an enterprise has an option rather to install the software on the server or buy an appliance, is the revenue stream the same or is it different in the two situations? Thanks.

Jim Whitehurst

Let me start off on the cloud -- I think we found ourselves in the middle of most of the major cloud discussions with customers and certainly with potential cloud operators and I think the reason we’ve ended up there is because we’ve built key components to building a cloud. At the same time, we haven’t proscribed all the pieces so one leading cloud provider specifically chose our virtualization technology because it wasn’t linked to the management tools and they saw their source of differentiation management tools and their ability to write their own and differentiate that with their customers.

Another key cloud provider yet to announce [one out soon], very specifically chose it because they had a different suite of management tools already in place that they want to apply to it. Others are actually looking at using our tools.

The flexibility of our platform to take components that you want and not others that you don’t want, combined with the ability or with the lack of concern that we can lock customers in long-term after they have built a large business on this has put us in a fairly central role -- when I say central role, we are central to the debate, we are central to the direction of many of the trends around cloud computing but again, I think we are in that role because we are not trying to drive a single solution and we are actually working with different people with different needs and different wants as they build their own business models around cloud.

Your second question around the embedded space, embedded is such a significant area. It’s hard to give you a blanket answer there. Perhaps we can spend a little more time at analyst day addressing that for you.

Operator

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

Richard Williams – Cross Research

Could you give us some color on the geographies, what kind of conditions you are hearing from the customers in each?

Charlie Peters

I think based upon the geographic split, the numbers that I mentioned, I think what you can conclude is our business came back to I’d say near normal in each of the regions. It’s not -- a near normal split, not to say that business is easy because it clearly isn’t. Europe and Asia and America still have an economic slump going on. We’ve -- our guys have made very good progress, in particular as I said, Europe booked the largest deal in their history so in a period of a real economic downturn there, that’s very good news for us.

Tom McCallum

Operator, I think we have time for one more question.

Operator

Our final question comes from the line of Kevin Buttigieg with FTN Equity Capital.

Kevin Buttigieg – FTN

Back to REL 5.4, just wondering to what extent you think customers may have been waiting for KVM in order to go to virtualization and do you think that it influences the decision to go to virtualization with KVM relative to how people have been moving to virtualization with ZEN support? And I know that you haven’t been pre-selling 5.4, but with its availability so close to the end of the quarter, do you think it was a factor at all in the return of large deals in 2Q?

Jim Whitehurst

A couple of things there -- I do think some customers have waited around virtualization until KVM comes out. One of the benefits is any hardware certified for REL is certified for KVM, our KVM REV M because it’s the same code base. So I think for customers who are currently running REL or customers who want the largest possible choice in terms of certified hardware, KVM is the only -- is that virtualization solution, so certainly I think some customers have waited to adopt it.

I don’t think it had any effect on the quarter because we didn’t announce the GA REL 5.4 until the beginning of Q3, so clearly no impact in Q2 associated with it.

Tom McCallum

Thanks, everyone and thank you for joining us for the call today. This concludes our second quarter earnings call and we look forward to seeing many of you at our analyst day in October. Thank you.

Operator

Ladies and gentlemen, that does conclude today’s Red Hat Q2 earnings conference call. You may now disconnect.

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Source: Red Hat F2Q10 (Qtr End 8/31/09) Earnings Call Transcript
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