Red Hat F2Q07 (Qtr End 8/31/06) Earnings Call Transcript (SeekingAlpha)

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Red Hat, Inc. (RHAT)

F2Q07 Earnings Conference Call

September 26, 2006 5:00 pm ET

Executives

Dion Cornett - VP, IR

Matthew Szulik - Chairman, President, CEO

Charlie Peters - EVP, CFO

Analysts

Steven Ashley - Robert W. Baird

Chris Kwak - SIG

Heather Bellini - UBS

Katherine Egbert - Jefferies & Co

Kash Rangan - Merrill Lynch

John McPeake - Prudential Equity Group

Rick Sherlund - Goldman Sachs

Mark Murphy - First Albany

Todd Raker - Deutsche Bank

Terry Tillman - SunTrust Robinson Humphrey & Co

Trip Chowdhry - Global Equity Research

Brendan Barnicle - Pacific Crest Securities

Brent Williams – Hapoalim Securities

Tim Klasell - Thomas Weisel Partners

Brent Thill - Citigroup

Presentation

Operator

At this time, I would like to welcome everyone to the Red Hat second-quarter 2007 conference call. (Operator Instructions). I would now like to introduce Mr. Dion Cornett, Vice President of Investor Relations. Mr. Cornett, you may begin.

Dion Cornett

Thank you, Richard. Welcome to Red Hat's second quarter fiscal year 2007 earnings call. Speakers for today's call will be Matthew Szulik, Chairman, President and Chief Executive Officer; Charlie Peters, Executive Vice President and Chief Financial Officer; and myself.

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

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

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

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

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Matthew Szulik

Thanks, Dion and good afternoon to everyone on the call. The second quarter was a positive quarter for Red Hat with a number of important highlights. We released our Red Hat Enterprise Linux Version 5 beta.

We have made rapid progress integrating our June 2nd JBoss acquisition, expanding the Red Hat footprint into the multi-billion dollar middleware market. In August, JBoss closed its largest sales transaction since its founding. In our first full quarter of ownership, our entities in India, Argentina and Brazil all improved their productivity as we expanded our reach into new geographies.

Red Hat completed its 18th consecutive quarter of sequential revenue growth.

This afternoon, my remarks will focus on three areas:

  1. The advancement of the RHEL JBoss platform in the global enterprise market.
  2. The increasingly complex customer environment which we sell and deliver technology.
  3. Geographic and industry trends that management of the Company observes.

First, Red Hat launched the first-certified Enterprise Linux platform, Red Hat Enterprise Linux, or RHEL as we call it, in our second fiscal quarter of 2002. And in just four short years, the platform now enjoys support from thousands of independent hardware and software vendors worldwide. This creation of a certified Linux standard into a single point of accountability for global service and support continues to expand the development ecosystem and drive global penetration. Today, RHEL supports 19 foreign languages and runs on nine different computing architectures. These developments helped Red Hat achieve its sixth straight quarter of 10,000-plus net new customer additions and highlights the superior economic returns delivered to global IT organizations.

Moreover, our upcoming release of RHEL 5 following the Beta 1 release this past quarter will include virtualization, improved system management capabilities, storage and security capabilities. It will be the most comprehensive release of enterprise software that Red Hat has delivered to the marketplace. Even more exciting, when the RHEL platform is combined with JBoss suite of offerings, it creates what Marc Fleury likes to call the open source foundation for the enterprise.

In the quarter, we were pleased to see customers expand their relationship with Red Hat to include JBoss as a part of their open source foundation. A major publishing company signed and plans to make the Red Hat/JBoss combination their corporate infrastructure standard. A major security firm, driven by JBoss' technically-superior performance and reassured by Red Hat's acquisition, signed an agreement in August to migrate away from its proprietary solution. And finally, a major media and entertainment company transaction closed within the quarter due to the ease of transacting with a single worldwide provider for the RHEL/JBoss stack.

These are a few examples that confirm for us the importance of accelerating sales integration. This integration was accomplished during the August quarter and the early indicators are favorable. As importantly, in my individual meetings with numerous customers within the quarter, I did not meet one customer that was not running JBoss. Most have plans to pursue a more strategic dialogue with Red Hat as a result of the merger.

The second item I would to discuss is the increasingly complex technical environment where Red Hat and JBoss is deployed. Currently, more than a third of our deployments worldwide are in mission-critical 7X24 environments. Let me describe a few examples. An Asian cargo, logistics and aviation company relies on continuous uptime operation from a Red Hat Linux-based environment that includes hundred of Red Hat systems, an Oracle database, Lotus Notes, and application server and network file system infrastructure components. A leading media and entertainment company uses thousands of Red Hat systems in a highly-clustered, high-performance database environment for content delivery to broadcast TV networks. And a major European corporate investment bank deployed over 1,000 Red Hat Enterprise Linux systems in multiple geographic locations to perform core banking applications and financial market simulations.

Today, Red Hat customers tell me that they place more workload on their infrastructure and have higher uptime and performance demands than at any other time since the development of the network-based computing model. As a core competency, Red Hat has built systems, processes, and expertise to meet the needs of an ever increasingly demanding customer base.

To give perspective, Red Hat handles over 1 million service requests annually, a testament to our growth and the increasingly complex environments where RHEL and JBoss are deployed. This customer success has created new and differentiated relationships for Red Hat. In Q2, JP Morgan Chase, Cisco and Red Hat created an open source project called AMQP, focused on innovation in the area of high speed, low latency messaging. This is a highly strategic component of the enterprise middleware in the investment banking industry.

Similarly, JBoss and one of its customers, a large insurance company, collaborated to bring to the open source community an Enterprise Service Bus project, JBoss ESB, to extend the value of the JBoss stack, the transparency of open source and the trust Red Hat and JBoss have earned by making customers partners in advancing open source solutions.

Finally, we see continued global growth and momentum amongst government, education, and business. During Q2, the State of Kerala, India announced its intention to migrate all government computers to open source; Malaysia adopted the open document format; and the Philippines mandated government computers be capable of running Linux. Red Hat enjoyed sales success in Japan and Russia, driven by a U.S. federal standard called Evaluation Assurance Level, which is being adopted by certain international governments. In the United States, a Department of Defense report urged the adoption of open source to improve the military's fighting capabilities.

Beyond governmental adoption, I can't overstate the enthusiasm with which the educational community views collaborative and open developments. Last week, I attended the One Laptop Per Child Board meeting where I saw a prototype for the OLPC and was very impressed by the design and the utility of the device. The power of the collaborative development process, in this instance involving MIT, AMD, Google, News Corp., Quanta and Red Hat has resulted in a compelling new usability form factor and functionality including enterprise applicable enhancements, such as advanced power management. Stay tuned.

In closing, I would like to share two relevant predictions from the industry analysts. In servers, IDC estimates that Linux market share based on unit sales will rise from 24% today to 33% in 2007. And in a survey of business users by Forrester Research, 52% said they are replacing at least some of their Windows units with Linux. Amidst this growing demand, Red Hat remains the open source leader, continuing to outpace the growth of the industry and our nearest competitors.

Charlie will now address specific financial performance.

Charlie Peters

Thank you, Matthew. We're pleased to report that we have once again delivered strong operating performance for our shareholders. Let me begin by pointing out that we have included in the press release, in addition to GAAP financial tables, non-GAAP financial information for the first time. We heard clearly from investors and analysts following the Q1 conference call that this will provide better comparability to the prior year. I would also point out that the majority of analysts following Red Hat reporting to First Call are reporting non-GAAP adjusted numbers. We believe that comparability is important to investors, and will provide them a better understanding of operating results in relation to the prior year.

In addition, we use these non-GAAP measures to manage the business. There are only two non-GAAP adjustments in that table, so it's relatively simple. We have the exclusion of stock option expense under FAS 123 R and adjusting the tax rate to reflect taxes actually expected to be paid. I will briefly explain each.

Red Hat, like most companies, adopted FAS 123 R on a prospective basis, meaning that substantial non-cash stock option compensation expenses are included in the fiscal year 2007 quarterly P&L but not in the prior year. Nothing operationally has changed, just the accounting. However, since the GAAP P&L are on two different accounting bases, they are not comparable. The non-GAAP table excludes the incremental stock compensation expense related to FAS 123 R in the fiscal year 2007 Q2 and first-half numbers, so they are comparable to the last year.

The adjustment to taxes may be unique to Red, Hat but it is also helpful for comparability. We have approximately $450 million of tax NOLs available to offset future taxable income. Although the cash taxes that we pay this year and for the foreseeable future are likely to be approximately 5%, also similar to recent past years, the GAAP tax expense this year has changed to 37% based solely on the source of the historical NOL. The non-GAAP financial table assumes an estimated annual cash tax rate of 5% for the fiscal year 2006 and fiscal year 2007 periods. This table is not meant to replace the GAAP financial statements that's being provided at the request of investors for better comparability to last year and to supplement the GAAP financial statements.

Now, let's talk about Q2. I will comment on non-GAAP adjusted results because I believe they provide a better comparison of performance with the prior year. Total second quarter revenue of $99.7 million represents an increase of 19% from last quarter and 52% from the same quarter and fiscal year 2006 and includes approximately $7 million in JBoss revenue. It also includes in-quarter revenue of approximately $1 million, which was not originally planned and is not likely to repeat in Q3. Even with this $1 million, we beat the high end of our previous guidance.

Subscription revenue was $84.9 million; it grew 19% sequentially and 56% year-over-year. Training and services revenue came in at $14.7 million, an 18% sequentially increase and 29% year-over-year. This quarter, 54% of our business came from the channel and 46% from direct sales versus a respective 61%, 39% split last quarter. This shift back towards direct sales is primarily the result of including JBoss' relatively higher direct bookings mix. Our expectation is that over time the indirect contribution will grow from these levels as we leverage our existing channel relationships to promote the JBoss offerings. Last week's introduction of the Red Hat application stack and our ability to rapidly introduce a joint Red Hat/JBoss offering to channels is illustrative of this point.

From a geographic perspective, 61% of bookings came from the Americas, 23% from EMEA, and 16% from Asia Pacific. Due to the inclusion of JBoss' results, this mix is more heavily tilted towards Americas than the recent prior quarters, as JBoss bookings have historically been small in EMEA and almost nonexistent in APAC. Of course, the exciting aspect of JBoss' previously-limited ability to serve users globally is the opportunity we have to leverage our existing worldwide sales and support structure to grow the business in the future.

Our billings, which we define as revenue plus change in deferred revenue, was $113 million, up 23% year-over-year and up 3% sequentially after adjusting for currency swings in each quarter. We have, of course, excluded from the change in deferred revenue the additional increase of approximately $16.8 million which came with the acquisition of JBoss. Q2 billings were affected this quarter by three specific Red Hat-related issues which are temporary and which we believe will rebound quickly.

First, sales productivity was impacted by integration activities related to the recently-acquired businesses. For example, we invested selling time of the entire global Red Hat sales force, including sales engineers, to train them on the basics of JBoss offerings. Although this training came at the expense of valuable selling time in Q2, we believe it was necessary and will produce returns in coming quarters.

Secondly, Asia-Pacific billings were impacted due to changes in sales structure in that region. The changes are complete and the outlook for the region remains strong, so we expect substantial Q3 improvement there.

Finally, we did a higher proportion of three-year deals billed one year at a time than last year, resulting in growth in unbilled backlog but not billings.

These items impacted billings during Q2. But the good news is the pipeline is strong and the outlook remains solid.

For the quarter, we achieved an overall gross margin of 84%, up from 82% in the year-ago period and only 50 basis points lower than Q1. That is 25 basis points better than my own expectations, which I communicated to you last quarter. This improvement is primarily attributable to faster and better JBoss integration progress than originally planned.

Operating expenses came in at $66 million, excluding stock compensation expense of $7.8 million. Operating expenses were slightly lower than expected as we continue to manage tightly. Non-GAAP operating income was $16.9 million for the quarter, resulting in non-GAAP operating margin of 16.9%. This is almost 200 basis points better than originally expected due to higher revenues and lower operating expenses than planned. Nevertheless, it should be obvious that by comparing each line of operating expenses as a percentage of revenue to prior quarters that we have room for rapid improvement as revenue continues to grow.

Moving on, other income net, attributable primarily to investment income, was $9.6 million versus $10.7 million last quarter. The smaller contribution is primarily attributable to differences in foreign exchange and lower interest rates on smaller cash balances after funding recent acquisitions.

Our estimated effective GAAP tax rate is 37% for the year, unchanged from our previous estimate. However, to reiterate, regardless of the GAAP tax rate, it's important for investors to understand that due to tax NOLs of approximately $450 million, we continue to estimate cash taxes of 5% for this year and for the foreseeable future. Therefore, 5% is a rate we use for the non-GAAP adjusted results.

Non-GAAP adjusted net income was $23.7 million versus $17.7 million in Q2 of last year. Based on 220 million fully diluted shares in Q2, fully diluted non-GAAP adjusted earnings per share was $0.11 per share versus $0.07 per share last quarter.

Now, let's turn to the balance sheet and cash flow statement. Quarter end, we had $1 billion in cash and investment, a decrease of $104 million from the end of Q1 after paying out $148 million related to acquisitions. At the end of Q2, total receivables were $70.3 million, which translates to an adjusted DSO of 58 days versus 52 days at the end of Q1 and 60 days last year. As a reminder, DSOs are traditionally a measure of receivables versus billings so our DSO calculation includes the change in deferred revenue related to billings. Deferred revenue at the end of the quarter was $284 million, an increase of $29 million or 12% from the prior quarter.

Moving to the statement of cash flows, cash flow from operations was $44 million for the second quarter, reflecting somewhat slower growth in billings as discussed and the previously-anticipated negative cash flow impact related to JBoss.

Now, I'd like to turn to guidance. As we discussed last quarter, we believe that the second quarter will be the low point for the year for cash flow and profitability, both of which were impacted by the inclusion of JBoss results integration activity. With this quarter now behind us, we remain comfortable with our prior margin guidance and expect an improvement of approximately 200 basis points in operating margins for each of the next two quarters.

Specifically for the third quarter, we anticipate revenue in the range of $103.5 million to $105 million. We will continue to invest in people and systems in response to continuing global demand, resulting in approximately a $1 million to $2 million sequential increase in operating expenses, excluding stock compensation expense.

Other income should be relatively flat and share count approximately the same, producing non-GAAP adjusted earnings per share, assuming a 5% cash tax rate, of $0.12 to $0.13 per share.

I realize that there may be people interested in the GAAP results. For that, I would estimate FAS 123R stock compensation expense of approximately $9 million and a 37% estimated GAAP tax rate, which would produce GAAP earnings of approximately $0.05 to $0.06 per share.

As has been our practice for the last couple of years, we usually provide quarterly guidance. However, given specific investor interest in the performance of our JBoss operations, in this instance, we believe it is appropriate to reiterate our prior JBoss revenue guidance of $22 million to $27 million for the three quarters ending February 2007. We are making good progress in integration activities across many areas. In light of the fact that cash flow from operations year to date is $96 million, it seems prudent to reset guidance for full year cash flow between $210 million and $215 million.

Due to the classification changes mandated by FAS 123 R, some of this cash flow which are related to tax savings from option deductions will ultimately be shown as cash flow from financing activities. By way of illustration, in the first half of our current fiscal year, approximately $3 million of Red Hat's cash flow that would have been classified as cash flow from operations; under the previous accounting treatment was classified instead as cash flow from financing under the new rules of FAS 123 R. Approximately $400 million of our NOLs relates to historical tax deductions from stock options. While the same cash flow will occur, it will appear on different lines of the statement of cash flows. For the full year, we estimate the effect of this classification could be the range of $10 million to $20 million.

I will now turn it over to Dion to discuss some additional investor considerations.

Dion Cornett

Charlie, thank you. I would like to make some observations related to our presentation for the first time of non-GAAP results. As Charlie stated, the 5% estimated annual tax rate utilized for our adjusted results reflects our expectation for actual cash taxes to be paid for the foreseeable future given our large NOL position. What may not be appreciated is the likelihood of Red Hat enjoying this low tax rate for many years, represents a significant structural advantage in that more cash is available for investment, acquisitions and buybacks. I'd also like to point out that our Q2 adjusted diluted EPS of $0.11 is calculated consistent with and is a $0.01 better than the mean analyst estimates reported by First Call.

Finally, as we have done in prior quarters, we are providing several metrics to help investors evaluate our business. For the second quarter, the percentage of full bookings value beyond one year was 22%, up 10% sequentially. As we have observed in past quarters, an increase in this metric can have a short-term negative impact on billings while at the same time improving our long-term visibility.

In Q2, we renewed 24 of our top 25 deals up for renewal from the prior year second quarter. While all 25 remain Red Hat customers today and we suffered no competitive losses, we did see one of our customers scale back their overall business resulting in fewer than expected IT assets for RHEL to run on. Nonetheless, we expect future revenue from this customer under separate contracts, and this loss was more than offset by our expanding relationships with customers that are performing better in their respective end markets. As an indication of the remaining 24 of our top 25 customers, the renewal rate was 114% of the original deal value.

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

Matthew Szulik

Thanks, Dion. Fortune Magazine last week named Red Hat one of its 100 fastest-growing companies and the fastest-growing information technology company on its list. I would remind listeners that one quarter ago Business 2.0 made a similar acknowledgement. I am proud of this accomplishment, which is a direct result of the collaborative effect of open source software development and of the team's aggregate worldwide execution.

I would also like to thank and acknowledge the efforts around the JBoss integration. I'm very pleased to see the good news bestowed by the media and customers on Red Hat aggressively introducing a unified stack offering roughly 90 days after closing the acquisition. Our ability to do so speaks to solid execution and to the very benefit that open source, open standard-based technologies provide.

Our business appears strong and the pipeline looks good. Customer reception remains outstanding. We need to continue our focus on day-to-day execution, complete integration activities with JBoss and leverage our global distribution network and move the division to profitability and positive cash flow and continue to deliver value to our customers with unsurpassed quality of support. We have earned a reputation as the trusted provider, high-value open source solutions. We are working hard to build upon that every day.

Let me turn it over for Dion for questions.

Dion Cornett

Operator, please poll the audience for questions.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question is from Steve Ashley - Robert W. Baird.

Steven Ashley - Robert W. Baird

A couple of questions on JBoss. First of all, Charlie, are you able to tell us what the billings amount might have been in the period for JBoss?

Charlie Peters

Steve, we are going to stay away from individual disclosures on JBoss. It is not a separate segment. The only reason for providing the reaffirmation of the previous guidance was to give comfort that things are basically on track.

Steven Ashley - Robert W. Baird

Maybe, could you tell us the status of the foreign language versions of JBoss, where they stand today?

Charlie Peters

Sure, there are a number of integration activities going on and that happens to be one of them. As I described last quarter, JBoss really only had an English version. We now have in progress six different languages, two Asian languages and three European languages, and then Brazilian Portuguese. So those activities are in process now. Various parts of materials will be available within the next two months. So we would hope that that is going to be very positively received.

Steven Ashley - Robert W. Baird

Was there any revenue from the new stacks, the LAMP stack and the other stacks that were introduced in the period?

Dion Cornett

We announced those after the quarter ended, Steve.

Steven Ashley - Robert W. Baird

Thank you.

Operator

Our next question comes from Chris Kwak - SIG.

Chris Kwak - SIG

Charlie, just a couple of questions. On this deferred revenue balance, just looking at the balance sheet, the change is obviously close to $30 million. But looking at the cash flow statement, the deferred revenue cash generated component was about 13 million. How much of that was FX related and how much of it was invoice related that wasn't collected in terms of cash?

Charlie Peters

I think that the biggest change is to help you reconcile that was the opening balance of deferred revenue for JBoss was about $16.8 million. And the rest of the change that's showing is going to be organic growth. You should be aware that there were significant currency differences at the end of last quarter and this quarter. So in my remarks, I tried to factor those out of the equation.

Chris Kwak - SIG

So almost all of the delta between the balance sheet and the cash flows for deferred revenue you are saying is from the $16.8 million that was brought over from JBoss?

Charlie Peters

Yes, that is correct.

Chris Kwak - SIG

And then secondly, just looking at organic bookings growth, we're getting to roughly a 15% kind of number for organic bookings growth. Other than the disruptions, what gives you the confidence that you could actually re-accelerate that going forward?

Dion Cornett

Just to clarify on the numbers, we don't specifically break out details around bookings. If you're looking at billings, the answer to the foreign exchange question, we had about a $5 million benefit to our billings proxy last quarter because of changes in foreign exchange and how those reflect on the balance sheet. It was about a negative $400,000 impact this quarter. Beyond that, we just haven't provided anymore details on bookings.

Charlie Peters

But specifically about the strength of the business, what gives us confidence, I would say that a lot of interaction with our sales force, Matthew and I have monthly and sometimes weekly update from the sales forecast. Matthew travels extensively and visits with customers. I think we've got a very good sense of the pipeline, and the business does look healthy. As I tried to explain, there were some Red Hat related items that impacted our business this quarter. We think for the most part that is behind us. I talked a little bit about the JBoss integration activities and the fact that we took time out of the entire worldwide Red Hat sales force including SEs to train them on JBoss.

I didn't elaborate a lot but in addition, we were integrating three other companies: Argentina, Brazil, and India. So we did spend a lot of time of many employees and probably money in Q2 to move these integrations along in a proper way. As I said, I think it is the right investment to make and will pay off as we go forward here.

Matthew Szulik

Chris, let me just add a couple of observations to your question. First and foremost, we have a rich product pipeline. We talked about RHEL 5 beta. So far, the early public comments are positive. It contains strategic technology to the enterprise in and around virtualization that we think will be very positively received by continued net new customers.

The JBoss activity and the success that it had previously with its customers and now the stack is going to provide a very good, low-cost, high-value option for the channel globally, keeping in mind that JBoss historically had no sales presence in key markets like India, China, Japan, Brazil, South America, where we continue to see strong interest for their middleware offerings.

Thirdly is the continued reference ability that we create within our enterprise and strategic customer sets. That is now balanced positively, we see, by the expanding net new customer growth in the small to medium-sized business segment. So it is for those reasons that we are positive on our forward outlook.

Operator

Our next question comes from Heather Bellini - UBS.

Heather Bellini - UBS

My question was really related to what Chris was just asking. The people looking at your business right now, the primary thing that I think people are thinking is if you look, you could still do the math and figure out what the core billings number might have looked like ex the JBoss acquisition. It looks like billings declined sequentially.

So again, it goes to the fact that what are your customers specifically saying to you? Has there been any change in the pace of deployments that you are seeing? Is there any commentary that you can give us with almost a month into this quarter, kind of what you're seeing from a sales pipeline perspective?

The follow-up to that would be, could you rank the impact of each of those three factors that you cited that were the reasons for the billings weakness on your deferred growth?

Matthew Szulik

I continue to speak to a significant number of customers on a week-to-week basis. As I mentioned in my remarks, what is surprising to me -- positively surprising -- is the increased complexity that Red Hat is now engaged with our customers.

Secondly, I don't see the deployment slowing down. In fact, we see it expanding. I described some of those instances on the call. We were very pleased to see some of the interesting rates of net new large strategic enterprise customers adopt both directly and with our partners like IBM, IGS within the quarter. We're also starting to see strong uptake for 64-bit environments both in dual and quad-core processing as customers begin to experiment with the RHEL 5 beta on a selected basis,

And certainly the opportunity to have the integrated JBoss RHEL stack I believe, really my experience with these customers, they are running JBoss currently. I was pleased to see over the course of the quarter how many customers actually had JBoss deployed. We see those opportunities now expanding through a combination of RHEL 5 and the upcoming JBoss technology releases.

So I believe that the deployment level has not slowed down. I think the complexity is increasing. The expectations of performance on Red Hat continue to go up from a technical and serviceability standpoint. But I did not see as recently as last week in my travels with customers, I did not see any slowdown in deployment.

Charlie Peters

Heather, on the second part of your question relative to the priority ranking of the three items I mentioned relative to impacting billings in Q2, I would say I ranked them in order. The first was the productivity impact around the integration activities and the time we took out for training people. The second was organizational changes in Asia. The third was a higher proportion of three-year deals billed one year at a time. The last item, we've been trying to do that more and more really over about the last year-and-a-half. So we have been continuing to make further progress on that.

Dion Cornett

Heather, just to elaborate on Charlie's comment, I would not try to draw too much of a correlation between bookings and billings. If you will recall, the third quarter of last year we had a sequentially down billings quarter but very strong sequential bookings growth. As we talked about at that time, the reasons for this are just volatility we see in the mix of one to three-year deals mix, how multi-year deals are billed, foreign exchange, the mix of direct/indirect. So all these things factor in that do cause volatility quarter-to-quarter.

Heather Bellini - UBS

So do you not agree with the assumption that the core billings actually would have declined sequentially? So are you saying core bookings actually would have gone up?

Dion Cornett

Core bookings did grow.

Heather Bellini - UBS

On a sequential basis?

Dion Cornett

That is correct.

Heather Bellini - UBS

Great, thank you.

Matthew Szulik

Heather, let me just add an additional comment. If I see activity that is interesting for me to note, it is the continued amount of education that CIOs, CTOs and other strategic decision makers on a worldwide basis require to become informed about open source software in its implementation. As one of the old rats in the barn here at Red Hat, it still surprises me that a large number of especially international CIOs require continued education on the merits of open source.

Heather Bellini - UBS

Great, thank you.

Operator

Our next question comes from Katherine Egbert - Jefferies & Co.

Katherine Egbert - Jefferies

Thanks. I'm going to follow-up a little bit. I don't mean to beat a dead horse. But if I look at these numbers, it looks like the trailing indicators are all up, meaning revenues, earnings, and margin. But all the leading indicators including organic cash flow number, your organic billings and your cash flow guidance of 15% year-on-year all seem to be headed down, meaning they are decelerating in terms of growth. I think that's what we're are all trying to reconcile here.

Is there anything you could offer us in terms of what your bookings look like this quarter to sort of counteract what we can see in these numbers?

Charlie Peters

Let me speak first about cash flow. As you know, we don't comment about total bookings levels. But on cash flow, let me just say this: we don't provide quarterly cash flow guidance for a reason because quarterly cash flows can be volatile. I would point out that for the six months, our cash flow was up about 20% year-over-year and that includes the quarter we just finished, which we have said is probably the low point for the year. We acknowledged that last quarter. It came in where it came in. But what I would say is that we still expect to show significant growth in our cash flow run rate over the course of the year and expect to enter the next fiscal year very strong.

Katherine Egbert - Jefferies

Maybe then to address another concern that investors have. IDC, although it shows that Linux is still gaining share, it actually shows Windows is also gaining share and that the rate of Linux share of the overall server market is growing at a decelerating rate. Can you address that?

Dion Cornett

Heather, I think it is important for investors to appreciate that less than 20% of our business in any given quarter including this past quarter comes through sales via the OEM hardware partners. Our business is extremely diversified. It never has really correlated well with the IDT server results, given that those are geared around a single metric, what the suppliers report to them.

We have a number of customers that build boxes in-house that don't count. We have a number of customers that will deploy workstations or desktop solutions in server-based environments. So, I wouldn't put too much credence into fluctuations in that number and how they fair against our results.

Then also to remind you of Matthew's commentary during the prepared remarks, a more recent IDC study does estimate that we're going to see an increase in Linux market share from 24% to 33% over the next couple of years.

Operator

Our next question comes from Kash Rangan - Merrill Lynch.

Kash Rangan - Merrill Lynch

Thank you very much. Having gone into the cash flows and billings, I had a couple of quick follow-up questions if I could on ASPs. I know you don't talk about ASPs, but how should we think about your pricing for the core operating system and JBoss combined stack, if you will?

The second part of the question, how would you characterize the integration of JBoss support into the overall Red Hat core --

Charlie Peters

The second part of your question broke up a bit. Could you just restate the second part?

Kash Rangan - Merrill Lynch

Yes, how is the integration of the support organization for JBoss coming along as it relates to the core Red Hat operating system support organization? Are you keeping these two entities separate? Or are you trying to get some economies of scale in integrating these two divisions?

Charlie Peters

Starting first with ASPs. As you said, we don't discuss ASPs. But we can kind of give you just a general feel about pricing.

Dion Cornett

If you saw the announcement about Red Hat applications stack, you saw that the pricing around that offering is extremely compelling. Again, this is the high value, low-cost solution that we have provided in the operating system space now for four years. In the applications stack, that pricing ranges from $2,900 to $8,500 depending on your service level. And this is a level again, it is unprecedented for the industry relative to the proprietary solutions that are out there.

Charlie Peters

On the second part of your question, we have merged the support organizations of JBoss and Red Hat and we did it very early on in the quarter. We have a senior JBoss individual here who reports to the head of our global support organization. We will be continuing to build out the support capabilities of JBoss both here and elsewhere.

They have some resources in India. We have a much bigger platform of support in India, and it will allow us to serve our customers jointly from there. So that is one part of the integration that happened very quickly and is essentially done.

Kash Rangan - Merrill Lynch

Charlie, on the three factors you talked to contributing to the slower than expecting expected billings, where do you stand with this current quarter with that one month done? Are the sales engineers fully ramped up and trained? Are they on the field productive for all of the one month in the quarter that was concluded? How would you characterize that?

Charlie Peters

Just so everyone's expectations are right, the entire Red Hat sales force and sales engineers have received some training. But the guys at JBoss are experts in this. They've had much greater training. Whereas every Red Hat salesperson and SE have some degree of capability, we still may use the investment banking model where the sales rep, the guy with the relationship may go in and over time may bring in the experts from JBoss. But we raised the awareness. We believe we have them to the level where we can at least have a good conversation with the customer. We will continue to have that training over time.

Operator

Our next question comes from John McPeake - Prudential Equity Group.

John McPeake - Prudential Equity Group

I have a few questions. When you gave the guidance for this quarter, did you know you were going to be training people for the JBoss product? If you could share with us maybe what you thought deferreds could be up sequentially? Then I just have a follow-up, so what you thought going into the quarter.

Charlie Peters

Obviously, virtually on every metric that we provided guidance on last quarter, we have exceeded the guidance that we have provided. We certainly knew at the start of the quarter that we had integration of four different companies ahead of us and a lot of planning underway. So yes, it was contemplated and it was expected as part of the guidance.

John McPeake - Prudential Equity Group

Dion, you said that billings were up sequentially because you had some longer-term contracts signed that don't show up on the balance sheet. Could you quantify?

Dion Cornett

I specifically addressed Katherine's questions about bookings. And again, it was a qualitative statement and we do not quantify bookings. And just so people understand, if there is a specific bookings goal that we're trying to hit, some companies can drive bad behavior where you find yourself a day before the quarter ends and you are $1 million short. Some customer comes to you with a $2 million proposal and says, "Hey, I will do it today if you give me $1 million off."

So I think it is to our shareholders' long-term advantage if we don't get in on sort of that rat deal of chasing bookings number each quarter, which is why we are not more specific in quantifying that.

Charlie Peters

Again, just to be clear, on a subscription revenue model, the deal that comes on the last day of the quarter means very little. So we are far better off waiting for the following week or two to bring it in.

Operator

Our next question comes from Rick Sherlund - Goldman Sachs.

Rick Sherlund - Goldman Sachs

Thanks. First, Matthew, could you talk a little bit about the JBoss business? I know a lot of JBoss was available for no charge if you didn't have the service component. I'm curious how you are approaching that in the market. Is it going to be required that you have a license agreement and you're paying on a subscription basis in order to get that? And then I have a follow-up for Charlie.

Matthew Szulik

Rick, it is clear that we want to move the customer to an integrated subscription, which is incorporating both JBoss and once again the multitude of products that are contained within the umbrella of JBoss: App Server, Hibernate, etc. We intend to move that to a subscription. I think customers that have spoken to us now that they have a single point of global service and support were very receptive with the examples that I highlighted in the prepared remarks of some very large enterprises that said well this is good. We know that there is a global single source of accountability behind the offering.

The other interesting thing is the JBoss product line continues to expand. So within that subscription, customers would receive those enhancements and receive those levels of entitlement. But I think it goes back to the investment that we are making to up-fit and to provide consistent levels of support for JBoss that we have provided with RHEL. I believe that will provide a very good opportunity for us to monetize in the future.

Rick Sherlund - Goldman Sachs

Is the market being as receptive as you would hope to the paid JBoss and license?

Matthew Szulik

You know, Rick, I think there were two things. JBoss has a very strong footprint in the developer space. One of the opportunities that we see is in the production space, which heretofore to my earlier comments of not having a single point of accountability globally. I think customers had some reluctance to put the JBoss environment on top of RHEL or on top of Windows or on top of SuSE in their production space. That objection has now been removed. I like what I have been hearing from our customers about moving to production and being able to monetize that relationship with us.

Operator

Our next question comes from Mark Murphy - First Albany.

Mark Murphy - First Albany

Charlie, there was an 8-K filed in August showing that JBoss had revenue of $6.5 million for the March '06 quarter. So just looking at the JBoss revenue of $7 million this quarter, two questions: is that a gross revenue number or is that net of the writedown? Then is it possible to actually get another decimal point in terms of is that $6.5 million rounding up or possibly $7.4 million rounding down or is it right in the middle?

Charlie Peters

The first part of your question relative to the 8-K that you saw that the revenue we report this quarter is after or is taking into account the fact that some of the deferred revenue, as we discussed on last call, was written down as part of the purchase accounting. It was about $2 million write-down of the deferred revenue.

Then the second part of the question is relative to trying to be more specific. I think $7 million is specific enough.

Mark Murphy - First Albany

Okay, as a follow-up, Matthew, where do you stand on the possibility of creating a Fedora-like environment for the JBoss products? Are the dynamics sufficiently different in the middleware market that you would not consider re-creating that for JBoss?

Matthew Szulik

You know, Mark, we've had discussions internally about that. I think that Marc Fleury is taking a leadership role within the Company of going through the pros and cons with that. No, I don't think that it would work any differently than the RHEL subscription model. I think that the technology continues to innovate. I think performance is still a key issue. I think that there are very exciting activities in the ESB space for example, the rules engine. All of these I think would continue to deliver value to the customer in a certified, compliant way with the stack and other operating environments. So I think we examined that but I think so far, so good with what we see.

Operator

Our next question comes from Todd Raker - Deutsche Bank.

Todd Raker - Deutsche Bank

Two questions for you. One, can you just talk about the one deal in the top 25 that did not renew? What the rationale for not renewing was? How do renewal rates look across the rest of the customer base? I have a follow-up question.

Dion Cornett

That one company, it was due to their business struggling. So, we actually had multiple contracts with this organization. Because of a pullback they saw in their business unrelated to Red Hat, just the competitive environment they were in, they did not renew one of those contracts. Just did not need the additional boxes. And the other contracts remain in force; we would expect those to renew.

Todd Raker - Deutsche Bank

Second question, last quarter I believe you guys acquired three local partners in foreign countries. Can you talk about the impact that had in terms of how material were they from a revenue perspective or a headcount perspective?

Charlie Peters

Sure. In the last two weeks of May, we acquired distribution companies in Argentina and Brazil. In the first or second week of June, we acquired the minority interest that we did not previously own in a joint venture in India. So relative to headcount in total between those three entities, we've probably added as many as 150 people.

Relative to other impacts, the joint venture because it was majority owned, it was 60% owned, was previously consolidated. The businesses in Argentina and Brazil were not. They were just an independent distributor. So by acquiring them, we have taken on their operating costs. Our revenues would be higher to the extent of the fact that we're now showing revenues through to end customers as opposed to revenues to a distributor.

Operator

Our next question comes from Terry Tillman - SunTrust Robinson Humphrey & Co.

Terry Tillman - SunTrust Robinson Humphrey

Charlie, in terms of the bookings, I guess Dion talked about it being up sequentially. So you had a book-to-bill I am assuming greater than 1. So does this just translate to more of this, it's just hitting off the balance sheet? And where are we at in that process in terms of these three-year deals, more just once-a-year upfront cash payments? Where are we at in that cycle?

Charlie Peters

Yes. I think it's clear from the comments I made about the fact that we had more three-year deals billed one year at a time. Just so everyone else's up to speed with us, we only recognize deferred revenue when we issue a bill or we have a receivable. So to the extent you have a three-year contract that you've only billed one year, you have one year of deferred revenue and you have two years which are the so-called sort of off-balance sheet backlog. It doesn't have any financial implications currently, but it does create greater visibility for the future performance because we kind of know what we are going to be billing a year from now and two years from now.

So yes, that did increase the off-balance sheet backlog. We have typically talked about that once a year, usually at the year end. So I would expect that maybe we will give you a more thorough update on where we currently stand with that at the end of this fiscal year.

Terry Tillman - SunTrust Robinson Humphrey

Why not feel comfortable with just talking about the sequential change without giving the base number?

Charlie Peters

I think you can assume that the sequential change was an increase.

Terry Tillman - SunTrust Robinson Humphrey

I guess the other question --

Dion Cornett

Terry, I'm sorry; we really have to limit it to one question, one follow-up just given the number of people still to ask questions.

Operator

Our next question comes from Trip Chowdhry - Global Equity Research.

Trip Chowdhry - Global Equity Research

Congratulations on good execution on integrating these previous companies across the world. Two questions : I will ask different questions. Regarding RHEL 5, when is it shipping? And have you thought about pricing on it yet?

Matthew Szulik

A lot of work has been going on investigating different pricing to service the global market. Nothing final has been communicated. Secondly, the shipment will be Q1 of calendar '07.

Trip Chowdhry - Global Equity Research

Do you think you may have a computational-based pricing or user-based pricing? Because there are some upside to probably a user-based pricing for your customer base. Any thoughts on that?

Matthew Szulik

Yes, Trip, would be the answer. We are considering all of those right now.

Operator

Our next question comes from Brendan Barnicle - Pacific Crest Securities.

Brendan Barnicle - Pacific Crest Securities

Two quick questions. First, why the move to three-year deals? Is that something the customers want more of now? Second, Matthew, you had said that this increase in transitions from Windows to Linux, what are the circumstances in which you are seeing that? Where are customers interested in making that transition? Thank you.

Charlie Peters

First on the three-year deals, there's nothing new about having three-year deals. We have always offered a three-year contract. I think what we have explained over the past year or so is we have moved more and more towards the multi-year contracts billed one year at a time than multi-year contracts billed all upfront. The only real exception to that is when those deals are done by an OEM partner. In which case, they are typically billed for three years upfront.

Matthew Szulik

Let me just share a couple of observations with you. Customers, now especially the large enterprise customers, the transactional-based businesses, have had a number of years of experience with open source software. It's clear whether it is Linux, whether it is GCC in the compiler in the tool space, all the way up to things like open Ajax and PHP on the client side, there is a labor force that is growing. It's qualified and adept at working with open source technology.

Secondly, I think customers now are recognizing the issues and the benefits of delivering open source software in terms of quality of software, performance and once again the expanded ecosystem that I referred to. So as customers globally are either sitting on Windows 95 or they're sitting on Windows 98, they may be reevaluating their investment they made a number of years ago to the SAA licensing and pricing scheme. They are now stepping back and hearing from their labor pool, the integration with the chip manufacturers, whether it be Intel or AMD, the availability of the ecosystem. I think open source specifically and Red Hat specifically is providing a compelling set of alternatives.

If you look at some of the function that is going to inside of RHEL 5 as an example, stateless Linux, it will significantly, positively impact the reduction in cost and the boost in performance of managing large distributed Intel/AMD environments. So customers are experiencing this, and they are seeing not only the cost benefit of reducing the amount of manpower to manage these systems as an example, but they're also seeing tremendous improvements in performance and reliability. So that is where we are starting to kick in, especially outside the United States, in Europe and Asia.

Operator

Our next question comes from Brent Williams – Hapoalim Securities.

Brent Williams – Hapoalim Securities

That is Hapoalim Securities, guys. On the integration now that you have announced the stack and you've got a message and an identity for that separately then just we sell RHEL and we sell JBoss. How much incremental value-added engineering are you doing going forward sort other than just tidying it all up in one box or one license agreement?

Matthew Szulik

As you know, there's a lot of incremental engineering and development in terms of certification and testing of the stack, systems performance and tuning, workload measurement and enhancement. So it goes way beyond just cobbling together the components.

Brent Williams – Hapoalim Securities

So that is kind of the part of the iceberg below the water line which I would assume. Anything in terms of other features? New, different and exciting management tools or anything like that?

Matthew Szulik

Absolutely. I think there's a very talented guy that came with the acquisition named Rich V. Friedman, who is well underway of working with Marc and the engineers on integrating JBoss with RHN, which is a very positive set of systems management system utilities on the management side. Hibernate continues to grow and function and market penetration. You have the whole BPM rules engine that we're very pleased to see. There's a very large international telecom provider that is rolling out the JBoss Portal. So these are all good news and upside activities that I think are a part of the integration between the two companies.

Operator

Our next question comes from Tim Klasell - Thomas Weisel Partners.

Tim Klasell - Thomas Weisel Partners

Of the sales force you took off line, the traditional Red Hat sales force, how much of those JBoss revenues came from that group after they got trained?

Charlie Peters

I would say very little in quarter. They are trained. They now all have a JBoss quota beginning in Q3 and they are all driving. But in terms of how much they actually produced, the traditional Red Hat sales guys in Q2?

Dion Cornett

Very little.

Charlie Peters

It was an educational time for them.

Tim Klasell - Thomas Weisel Partners

You mentioned you had your largest deal in the quarter. I didn't catch if you gave some color on how large that deal was.

Matthew Szulik

Tim, it was a multi-million dollar transaction. It was a global technology company.

Tim Klasell - Thomas Weisel Partners

What vertical?

Matthew Szulik

Telecommunications.

Dion Cornett

Operator, we have time for one more question.

Operator

Our final question comes from Brent Thill - Citigroup.

Brent Thill - Citigroup

You mention the channel is shifting a little bit back to more of a direct sale and you mentioned that that should shift back over time. I think one of the bigger concerns out there right now is that the sales cycles will lengthen as this becomes a more complicated sale, expanding the cycles and potentially impacting the margin structure. If you can just talk about why you think that won't happen going forward.

Matthew Szulik

A couple of things that Charlie highlighted. One is that the JBoss business was virtually 100% direct. So when you look at that 60% to 54%, keep in mind that that JBoss business really was the driver for that number going from 60% to 54%. Our channel activity continues to be positive and growing on a worldwide basis.

Secondly, I would like you to keep in mind and the investors to keep in mind that as I said in my remarks, every customer that I have visited this quarter is running JBoss, whether it was downloaded for free or whether it came from another source. So for Red Hat's selling efforts, they are going in there presenting a capabilities presentation, not a prototype, not a proof of concept. So I think once we establish the technical capability and the reference ability because of our service organization, I believe that provides a short-term opportunity to monetize and then move into the more sophisticated areas like the production environments or the business processing or the rules engine, etc.

Brent Thill - Citigroup

Just a follow-up on JBoss, there's obviously been some forced attrition. Can you give us a sense of how much of that is completed now and how stable now is the business unit going forward?

Charlie Peters

Just to clarify the restructuring as we talked about basically it was in G&A, the finance function was eliminated really from day one. For more than any other reason for purposes of Sarbanes-Oxley and good control, we felt very comfortable about our finance group here in Raleigh and therefore, all the transactions have been coming through this group since that time. I think whatever transition in that regard that was to be done is already behind us.

Dion Cornett

We would like to thank everyone for their participation today. We look forward to talking to you in the coming weeks and months. Thank you.

Operator

That concludes today's Red Hat second-quarter 2007 conference call.

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