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Executives

Tom McCallum

James M. Whitehurst - Chief Executive Officer, President and Director

Charles E. Peters - Chief Financial Officer and Executive Vice President

Analysts

Jason Maynard - Wells Fargo Securities, LLC, Research Division

Kash G. Rangan - BofA Merrill Lynch, Research Division

Heather Bellini - Goldman Sachs Group Inc., Research Division

Mark R. Murphy - Piper Jaffray Companies, Research Division

Raimo Lenschow - Barclays Capital, Research Division

Keith Weiss - Morgan Stanley, Research Division

Walter H. Pritchard - Citigroup Inc, Research Division

Stewart Materne - Evercore Partners Inc., Research Division

Edward Maguire - CLSA Limited, Research Division

Ross MacMillan - Jefferies LLC, Research Division

Matthew Hedberg - RBC Capital Markets, LLC, Research Division

Abhey Lamba - Mizuho Securities USA Inc., Research Division

Brent Thill - UBS Investment Bank, Research Division

Robert Scott Zeller - Needham & Company, LLC, Research Division

Gregg S. Moskowitz - Cowen and Company, LLC, Research Division

Tim Klasell - Northland Capital Markets, Research Division

Red Hat (RHT) Q3 2014 Earnings Call December 19, 2013 5:00 PM ET

Operator

Good evening. My name is Rachel, and I will be your conference operator today. At this time, I would like to welcome everyone to the Red Hat's Third Quarter Earnings Conference Call. [Operator Instructions] I would now like to turn the call over to Tom McCallum, Vice President of Investor Relations. Sir, you may begin your conference.

Tom McCallum

Thank you, Rachel. Hello, everyone. Welcome to Red Hat's earnings call for the third quarter of fiscal 2014. 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 redhat.com on the Investor Relations page. Also, on this page, you'll find a historic reconciliation schedule of GAAP to non-GAAP financial metrics, as well as a schedule of currency rates.

Various remarks that we may make about the company's future expectations, plans, 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 important -- various important factors, including those discussed in the company's most recent quarterly report on Form 10-Q filed with the SEC, as well as the Safe Harbor statement in today's press release.

In addition, any forward-looking statements represent our estimates or views only as of today, December 19, 2013, and these estimates or views may change. While the company may elect to update forward-looking statements at some point in the future, we specifically disclaim any obligation to do so even if our estimates or views do change. And therefore, you should not rely on these forward-looking statements as representing our estimates or views as of any date subsequent to today.

Before turning the call over to Jim, I'd like to remind everyone to save the date for our April 16 Analyst Day. It will be held in conjunction with Red Hat Summit, and we'll be providing the investment community VIP passes to attend the day. Please watch for registration details in January.

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

James M. Whitehurst

Thank you, Tom, and let me add my welcome to all of you joining us on today's call. Our team executed at a high level during the third quarter, and it led to strong growth in overall financial results that exceeded our guidance.

I'm pleased to share that we had the highest billings growth in 6 quarters, 19% on a reported basis and 21% in constant currency. From a revenue perspective, we generated 15% growth, which is consistent with our mid- to high-teens total revenue growth range over the past 6 quarters. We closed a record number of deals in excess of $1 million in the third quarter, exceeding the 30 deals we reported a year ago in the quarter.

I'm pleased to report that our European business and our U.S. federal business both delivered a solid performance in the third quarter and contributed to the acceleration in our billings growth, and we had good cross-selling of technologies, including middleware, virtualization and cloud management technologies and a number of initial OpenStack wins, including several 6-figure deals.

As I've traveled the globe, meeting with customers, it's clear that Red Hat is in an enviable position in the data center infrastructure space. Our innovative solutions address the needs to modernize existing IT infrastructure, which continues to be based largely on legacy proprietary software. We are able to do this by providing customers with a clear path to an open hybrid cloud.

Before Charlie reviews results for the quarter and guidance for FY '14, let me describe just a few of the business highlights we achieved recently that are resonating with and exciting our customers. First, last week, we announced the availability of the beta version of our award-winning Red Hat Enterprise Linux operating system.

RHEL 7 beta showcases hundreds of new features and enhancements, including Linux Containers, which enable applications to be created and deployed in isolated environments with allocated resources and permissions; performance management that uses built-in tools to enable optimized performance out of the box; enhanced virtualization, filesystems, networking and storage capabilities, as well as interoperability with Microsoft Active Directory domains. New features and capabilities like these should further entice customers to launch new workloads on RHEL and further migrate existing workloads.

Revenue for the server OS market is estimated to be about 10x the size of Red Hat. We believe we will continue to gain share in this market through innovation and superior TCO. In September, Red Hat released a study by a large industry analyst firm that concluded that RHEL today can lead to a 34% lower annual TOC [ph] savings compared to Windows.

Second, we launched the first version of RHEL OpenStack platform only a few months ago. And today, we released version 4.0, which is this based on the Havana release of OpenStack. We believe this will be the cloud OS of the future and is based on our integrated KVM, RHEV, RHEL and OpenStack distribution. We've been building additional proof-of-concepts with our customers. And as I mentioned earlier, we have already closed initial deployments with several early adopters.

Given the momentum in OpenStack, we have accelerated our efforts around private cloud solutions, including initiatives to train partners and customers, build out consulting services and expand our ecosystem. In fact, last week, we jointly announced a partnership with Dell to engineer enterprise-grade private cloud solutions based on OpenStack to help customers move to and deploy highly scalable cloud computing models.

As part of the expanded relationship, Dell becomes the first company to OEM RHEL OpenStack platform. The co-engineered solution will be built on Dell hardware and the RHEL OpenStack platform and will be delivered by RHEL OpenStack platform practice within Dell's cloud services. We highly value this endorsement from Dell, as well as the October endorsement from Intel, and we are looking forward to similar announcements with other partners in the future.

Third, our public cloud program continue to expand. In December, we welcomed Google to the approximately 50 cloud providers in the Red Hat Certified Cloud Provider program. Red Hat technologies that are certified available across public cloud providers allow our existing customers to expand as needed and enable us to attract new customers.

As evidence of this, in a recent survey, more than half of the respondents who are using RHEL on Amazon Web Services identified themselves as net new customers to Red Hat. Also, when asked what applications they're running on top of RHEL on AWS, many respondents indicated that the application workloads they are deploying use other open source software including LAMP, Python, Hadoop and JBoss.

Fourth, we launched OpenStack 2.0 with features developed directly in collaboration with some of our largest customers. These include web routing, team collaboration, OpenStack integration, new language support and more. As part of the launch, Cisco and Fair Isaac spoke of the benefits of OpenShift in their development environments. We're also expanding commercial availability of this technology to include new countries in Asia-Pacific and Latin America.

In addition to the increased number of large deals I discussed earlier, we continued to perform well within our top 25 renewal metric. This quarter, we once again renewed 100% of our top 25 deals and did so at a total value of approximately 120% of their previous value.

Important in these top renewals is the continued land and expand dynamic. Our largest deal this quarter was a renewal with a global investment bank, which has been a top RHEL customer for more than a decade. In the renewal, this banking customer purchased 35% more RHEL, as they continued to replace UNIX, consolidate on 1 Linux distribution and expand RHEL use for new applications.

In summary, I'm pleased with our execution in Q3. We continue to see strong demand for our core technologies, which is driven by customers' requirements for greater IT velocity, efficiency and scalability. We're also seeing strong interest in our new cloud technologies, and I'm grateful to our associates for their hard work on bringing the benefits of open hybrid cloud to our customers.

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

Charles E. Peters

Thanks, Jim. Happy holidays, everybody on the line, and I'm glad that we can share a strong financial report for the third quarter. In addition, as Jim mentioned earlier, we are also increasing our guidance for the year, which I will detail later.

Strong execution by our associates in Q3 led to the acceleration in billings that Jim highlighted earlier. In addition to results that exceeded guidance for revenue, operating income and virtually all other key financial metrics, our European and U.S. government business also both rebounded nicely from a slow second quarter.

Currency volatility is still a significant factor. Even though the euro appreciated against the U.S. dollar approximately 5% year-over-year, nearly all other currencies in which we do business weakened, including a decline of 20% for the yen. As I've done in previous quarters, I am going to discuss our results in both U.S. dollar terms and constant currency using last year's rates.

Here are just a few of the financial highlights for Q3: Year-over-year constant currency revenue growth was 17% and grew 15% in U.S. dollars; year-over-year constant currency subscription revenue growth of 18% and growth of 17% in U.S. dollars; year-over-year constant currency billings growth of 21% and growth of 19% in U.S. dollars; and year-over-year non-GAAP operating income growth of 22% in constant currency and 19% in U.S. dollars.

The top 30 deal metrics continued to show good cross-selling and expansion of our newer technologies in these major accounts, as well as growing deal sizes. The number of million-dollar deals was strong with more than 30 deals over $1 million. 4 of the top 30 deals were approximately $5 million or greater.

Cross-selling was strong with more than 50% of the top 30 deals, including a middleware component. Of these deals, 3 were stand-alone middleware deals. This cross-selling metric is significantly stronger than last year and is the result, we believe, of new sales initiatives which we began at the start of the year. We also saw a record number of deals with RHEV technology in the top deals, where 11 or 35% had a RHEV component. Within the top 30 deals, government and financial were the 2 top core verticals.

Now let's turn to our financial performance. In this quarter, 55% of bookings came from the Americas, 29% from EMEA and 16% from Asia-Pacific versus a 60%, 23%, 17% split in Q3 last year. As Jim mentioned earlier, Americas benefited from a strong federal business, and our European business rebounded well, helped by the euro foreign exchange tailwind.

While Europe experienced a multi-year low percentage of total bookings in Q2, it came back strongly and delivered a record 29% of our total bookings in Q3. APAC continues to grow modestly despite the uneven economic recovery there and significant currency headwinds in the region.

As predicted, our sales mix returned to a more normal split of 65% channel and 35% direct sales, consistent with the split in Q3 last year. However, we continue to target and invest toward a multi-year goal of 70% channel sales.

Sales execution led to the highest growth in our billings proxy metric in 6 quarters. The billings proxy, which we calculate by adding revenue plus the change in deferred revenue on the cash flow statement, was $453 million for the quarter, up 19% year-over-year. If one also factors in the year-over-year foreign exchange impact on revenue in this calculation, the FX-adjusted billings proxy was $458 million and grew by 21% on a constant currency basis for the third quarter.

As I discussed last quarter, the level of large deal activity, as well as the invoicing terms of such deals can have an impact on our reporting billings metric at any point in time. Our largest deal from the second quarter was a multi-year run-time deal, where the customer is embedding our technology with their application and hardware. In Q2, this deal had no long-term deferred revenue associated with it due to the production schedule of the customer and the billing terms.

With the customer's production schedule finalized in Q3, we were able to build a long-term portion, thereby adding to long-term deferred revenue and this added nearly 200 basis points of growth to the Q3 billings proxy.

Now let's shift to the income statement. Third quarter revenue was $397 million, an increase in constant currency of 17%. In U.S. dollars, the increase was 15% year-over-year and 6% sequentially. Both subscription revenue and services revenue contributed to the out-performance in the quarter.

The main driver of our total revenue growth was subscription revenue of $343 million. Subscription revenue was up 18% in constant currency and 17% in U.S. dollars year-over-year. Interestingly though, despite the strong top deal metrics which I've mentioned, the subscription revenue beat was largely driven by the very broad base of deals less than $1 million. In addition, public cloud revenue and compliance revenue both continued to grow and exceeded forecast.

The training and services component of revenue was $54 million and exceeded guidance. Services grew 10% year-over-year on a constant currency basis and 9% in U.S. dollars. Sequentially, services grew 13%, driven by both training and consulting services. Our European and Asian training business was particularly strong.

On the consulting side, we continue to work to enable our partners to deliver Red Hat-related services, which we expect to have a longer-term benefit in subscription growth. This remains our strategy. But in Q3, we had key accounts in both Asia and Europe that required additional middleware consulting services directly from us that also drove the services upside.

Now I'll discuss the rest of our results on a non-GAAP basis, excluding stock compensation and amortization expense starting with gross margin. [Audio Gap] 94%, unchanged from Q2 but 30 basis points better than last year.

Training and services gross margin was 36%, down 30 basis points from last quarter and down 200 basis points from last year, reflecting the investments that we've made in delivery capability for new products ahead of revenue. We see these investments paying off in the subscription stats. Overall gross margin was 86.1%, up 40 basis points from Q3 last year due to the growing proportion of subscription revenue in the mix. Subscriptions, which are renewable, now represent over 86% of total revenue.

Moving onto non-GAAP operating expenses. We continued to focus spending on long-term growth opportunities, including the commercialization of OpenStack and PaaS technologies. Q3 non-GAAP operating expense came in at $243 million, up 6% sequentially and 15% year-over-year. Spending was as expected with approximately 225 net new employees joining Red Hat this quarter.

R&D grew 21%, reflecting last year's acquisitions and our continued hiring of engineers for cloud technologies and core technologies. The 15% increase in sales and marketing reflects aggressive hiring for sales in all regions and new advertising expenses around Red Hat OpenStack, which we intend to pursue vigorously.

Q3 non-GAAP operating income was $98 million, producing on operating margin of 24.8%. This result is better than guidance and driven primarily by the out-performance in revenue.

The impact of foreign exchange changes on the P&L was as follows: Using currency rates from Q3 last year, this Q3 would have shown revenue $5 million higher, expenses $2.5 million higher and operating income $2.5 million higher. Using either currency rates from Q2 or from my guidance would not have produced materially different results than using the actual rates from Q3. Net interest income and other income was in line with Q3 last year.

Non-GAAP diluted earnings per share was $0.42, which is $0.07 above the high end of our guidance range. Good performance caused results to be higher than the guidance range. However, please note that tax benefits recognized in the quarter added $0.06 per share to our non-GAAP EPS. The significant tax benefits include a discrete benefit of $4.2 million and a cumulative reduction of the annual effective tax rate.

GAAP diluted earnings per share of $0.27 compares to $0.18 last year and includes tax benefits of $0.04 per share recognized in the quarter. I'll have more to say about the changes in taxes in the guidance section.

Now let's turn to the balance sheet and the cash flow statement. We ended the quarter with cash and investments of $1.3 billion. In Q3, we used $40 million to repurchase approximately 920,000 shares of Red Hat common stock. And for the fiscal year-to-date, we have repurchased $239 million or approximately 5 million shares of common stock. We have $240 million remaining on our stock repurchase program authorization.

Quarterly operating cash flow of $95 million was down 5% year-over-year, primarily due to the build in accounts receivable offsetting the benefit from increased net income and deferred revenue. The increase in accounts receivable is purely timing and was driven by higher billings in the back half of the quarter. Nevertheless, the foreign exchange adjusted DSOs will remain -- still remain in a reasonable range of 62 days compared to 61 days last year. As a reminder, since day sales outstanding is traditionally a measure of receivables compared to billings, our DSO is calculated using our billings proxy.

Total deferred revenue at quarter end was $1.12 billion, an increase of $136 million or 14% over the same quarter a year ago. In U.S. dollars, current deferred revenue grew 13% and long-term deferred revenue grew 15% from 1 year ago. Year-over-year growth in constant -- current and long-term deferred revenue in constant currency was 15% and 16%, respectively. Sequentially, deferred revenue increased 6% from last quarter in U.S. dollars.

To isolate the foreign exchange impact, let me break down the components of deferred revenue for you. Short-term deferred revenue, which ended Q2 at $796 million, had a real increase in Q3 of $33 million and increased $5 million more as a result of changes in the foreign exchange spot rates, ending Q3 at $834 million.

Long-term deferred revenue, which ended Q2 at $264 million, had a real increase in Q3 of approximately $23 million and increased $3 million more as a result of changes in foreign exchange spot rates, ending Q3 at $290 million. The total increase in deferred revenue, without the impact of currency changes, was $56 million and can be found on our statement of cash flows.

Now I'd like to turn to guidance. I don't forecast foreign exchange rates. But for purposes of this guidance, I have assumed that average FX rates for Q4 are as they were yesterday. So for example, the euro was $1.37 and the yen was JPY 103 to the dollar yesterday.

Let me start with the Q4 guidance first. Q4 revenue is estimated to be approximately $397 million to $400 million. Subscription revenue should grow $7 million to $10 million sequentially, even after taking into account 1 less day this Q4 compared to Q4 last year. 1 day of subscription revenue is just under $4 million.

As usual, we are forecasting a seasonal sequential decline in service revenue due to the reduced number of consulting and training days during the holidays. This year, we expect the sequential service revenue decline to be in the $5 million to $7 million range.

Operating margin is estimated to be in the 24.5% area, as we continue to hire for growth, such as increased investment in OpenStack consulting, training and support. Interest and other income should be around $1 million. And finally, non-GAAP EPS is estimated to be approximately $0.36 to $0.38, and that's assuming a 27.5% tax rate for the quarter.

Okay. So simply doing the math, full year guidance clearly needs to move up -- move higher after a substantial Q3 beat. We are raising the range of revenue guidance to $1.531 billion to $1.534 billion, which is up from our previous guidance of $1.51 billion to $1.52 billion.

We are raising our full year outlook for non-GAAP operating margin to around 24.6%. We are also raising our full year non-GAAP EPS guidance to $1.46 to $1.48. And finally, we are reaffirming our full year outlook for operating cash flow of $500 million to $520 million, despite the fact that we now expect our cash tax payments to be approximately $10 million higher than when we initially provided our guidance at the start of the year.

As we noted in our most recent 10-Q, we are expecting to be a full U.S. tax payer in the near term. Given the higher profitability outlook, we are forecasting that we will begin to pay higher taxes in Q4, as we begin to utilize the remainder of tax credits carryforward. From a modeling perspective, the tax headwind will be in the deferred tax line, not in the tax rate.

For fiscal year '15, cash taxes will likely increase an additional $20 million, which will impact the deferred tax line on the cash flow statement. It is important to point out that we are expecting a substantial reduction in CapEx next year due to the completion of major facilities projects, which, for free cash flow purposes, should fully offset the increase in cash taxes next year.

In summary, we're pleased with our strong performance in Q3, and we remain positive about Red Hat's outlook, which of course is reflected by the increased guidance. We believe our position in the data center is strengthening, as we continue to take market share and define the open hybrid cloud for enterprise customers.

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

Question-and-Answer Session

Operator

[Operator Instructions] And your first question is from Jason Maynard from Wells Fargo.

Jason Maynard - Wells Fargo Securities, LLC, Research Division

Jim, I have one question for you. There's a big debate in -- out there around how fast can Linux grow and whether you've hit the maturity phase of this product line. And I'd love for you to maybe talk a little bit about what your vision is there for the next legs of Linux growth. And specifically, you mentioned in your prepared remarks about taking share from Windows and the data center. I'd love to hear a little bit more about what you're thinking there and the plays you need to run to actually start to eat into that market.

James M. Whitehurst

Well, several things there. First off, we did highlight one of the deals, where our traditionally large, well-penetrated customers are continuing to grow their revenues with us in the Linux space. So that's still taking share from UNIX. We do think we are winning share from Windows purely by taking a larger percentage of net new workloads are going onto RHEL. And so, we're clearly winning share there. We think about the plays going forward, we continue to make a RHEL kind of more interoperable. We talked a little bit about Active Directory integration as well with RHEL 7, make it easier in mixed data centers and almost every data center is mixed to some extent. In cloud, we think Linux has a substantially larger share than Windows in cloud, and we feel pretty good about our monetization rate relatively in that. We continue to add features as well into the operating system, which allows -- which people start to buy up into the higher levels of the RHEL product with higher price points. So all of those things have an impact. And then, obviously, we continue to add additional products with middleware growing rapidly within the cloud set of products. So RHEL, we seek to continue to grow it to really as far as the eye can see, and then we're augmenting additionally with the other products.

Operator

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

Kash G. Rangan - BofA Merrill Lynch, Research Division

Charlie, I know that you've said in the past that you look for the training and education line. It looks like it picked up very nicely sequentially. Is this potentially a precursor to interest levels in RHEL 7? And can you give us any progress on the off-balance sheet bookings, if you can?

Charles E. Peters

Okay. Thanks, Kash. In terms of training, the surge in training and consulting this quarter was really confined principally to Europe and Asia-Pacific. I don't think it's yet to do with RHEL 7, although you do know that we've announced the beta of RHEL 7. I think, relative to -- although we're not prepared to talk about a full plan for next year, I would say this. In years in which major new releases have gone GA of RHEL, what we typically see is a spike in training revenue. And so, it wouldn't surprise me one bit to have the training and consulting in mid-teens, the high teens kind of growth next year, which we'll more fully explain when we give the guidance on the fourth quarter call. And then, on the second part of the question, Kash, was on off-balance sheet backlog, I'm going to stick to my policy of describing the off-balance sheet backlog at the end of the year in a fair amount of detail, and we'll do that along with some other booking statistics at that point in time.

Operator

Your next question is from the line of Heather Bellini from Goldman Sachs.

Heather Bellini - Goldman Sachs Group Inc., Research Division

Charlie, I was wondering, your long-term deferred obviously had a great snapback from last quarter, which is great to see. But I also remembered you saying that your larger customers, as they get bigger, are probably more willing to pay you 1 year up front as they trade -- as they stop doing -- stop paying you multiple years at a time. And I know this was a kind of catch-up from last quarter, but when we're trying to think about how we should think about long-term deferred trends for you guys even if you just look out over the course of the next few quarters, what would you say is kind of a good guide for us, a good gauge?

Charles E. Peters

Okay. Good question. Let me start with some more clarification on this quarter's long-term deferred and just, again, to point out, in my prepared remarks, I talked about the fact that a Q2 deal delivered almost 200 basis points of long-term deferred this quarter. So do the math, $6 million, $7 million of that. The second thing is the other part of my commentary is a lot of the revenue growth this quarter actually came from the broad base of deals below $1 million. We had a much better-than-expected uptake this quarter -- or performance this quarter from OEMs. And when the OEMs do long-term deals, they're always paid up front. So that means the long-term portion of that deal is also paid, and that is reflected in the growth in the long-term deferred revenue. Frankly, on the direct deals, the large direct deals, I don't believe anything is probably fundamentally different than what I said in the second quarter. We tend to sort of customize the really large deals that work for us and work for the customer. And sometimes, they're paid 1 year at a time.

Operator

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

Mark R. Murphy - Piper Jaffray Companies, Research Division

Jim, we had spoken with 45 of Red Hat's resellers a couple of weeks ago, and we've really heard the strongest feedback that we've seen in about 8 quarters pretty much across the board in terms of trajectories and uptake. And one of the new comments was that Red Hat's OpenStack push is driving a big wave of interest and opportunity and opening a lot of new doors with new accounts that were previously inaccessible. So you've had a pretty spectacular quarter here. I'm wondering if the OpenStack buzz -- or maybe there's an OpenStack halo effect to that could be part of the explanation really even prior to mainstream OpenStack adoption getting going.

Charles E. Peters

Mark, this is Charlie. I think it's a good point, and I think there is something to it. We are working very hard to be a big player with OpenStack. You may all have seen the full-page ads that we ran in the Wall Street Journal and the New York Times in late November. We also placed advertising on more than half a dozen online properties. We are recruiting hard for -- to build our consulting practice. We're building a training and certification practice there, as you know, with RHEL a big early push with Linux was to have Red Hat certified engineers all over the world. To-date, there's more than 50,000 of them. We intend to do the same sort of thing with Red Hat certified OpenStack engineers. And so, we're investing in it, and I think the market knows that. All of the big customers are aware of it, and I think there could well be some carryover effect to some of the other products.

James M. Whitehurst

Yes. I'd say, overall, it helps with our branding. I don't think, in this quarter, this quickly, you would see new business because of it because it does take just normal pipeline sales cycle a little bit longer. But on the margin, it probably does help in some of the deals. And longer term, I think it will certainly help. It's just the overall Red Hat brand is better known because of the affiliation with OpenStack.

Operator

Your next question comes from line of Raimo Lenschow from Barclays.

Raimo Lenschow - Barclays Capital, Research Division

I just wanted to stay on that subject. So how do you think about OpenStack and its rollout from a kind of monetary perspective from you guys? So you obviously -- you're the #1 contributor to the OpenStack system. You kind of had a great deal with Dell. You kind of got the mind share. But how do you think that translates then into revenue? I'm just trying to make sure that we've kind of not over modeled you, or just kind of get the timing right in terms of when do we have to think about them hitting the numbers?

Charles E. Peters

I would say, again, that we're very positive about it. We've got a lot of investment we're making in it, but I would caution everyone to keep your revenue expectations for the next year low because it's -- first of all, it's a subscription revenue model, and it is moving from proof-of-concept to early adopters, eventually early adopters into reference accounts and reference accounts into broad-based. It will take a while. So in the guidance numbers that we provide at the end of fourth quarter for next year, I would still expect a relatively modest amount of subscription revenue coming from it. I would say this and to maybe clarify a little bit more about what I answered Kash about training, it's entirely possible that the -- an additional factor driving our training and consulting numbers higher next year will be OpenStack training and consulting, where we intend to be a big player. So maybe on the training side is probably if you're modeling the only area in which I would guide you higher, probably something in the mid to high teens for our services line for next year.

James M. Whitehurst

Just to add a little bit of color, we honestly just don't know even some of big POCs that we're doing, there for a couple of dozen sockets and there's the promise that they could be for thousands ultimately of sockets, but we don't know where these POCs be 3 months, 6 months, 18 months. So the good news is people are generally buying with the expectation that these footprints will grow. It's one of the reasons they look at using Red Hat because of just the power of our model and ecosystem when these things roll out into production. But whether that win is in the next 6 months, 18 months, it's just really hard to say at this point.

Operator

Your next question is from the line of Keith Weiss from Morgan Stanley.

Keith Weiss - Morgan Stanley, Research Division

Some of the positive feedback that we're getting from the channel this quarter was around the OpenShift and the storage platforms. You guys didn't talk about that, as much as you typically do on the conference calls. So I was wondering if you could give us a little color on that, how those initiatives are progressing, in particularly, the ecosystem around OpenShift.

Charles E. Peters

OpenShift is seeing very good uptake, and a number of our larger accounts are using it. We've got a very large base of developers that's on it. Cisco has stepped forward and indicated that they're a large customer. We had a major global telecom company that is standardizing on OpenShift. So it's beginning to make some good traction.

James M. Whitehurst

Yes. Fair Isaac also is a public user of OpenShift. I think one of the reasons you're seeing that is we are the only company at this point that's offering a commercial version of OpenShift. And so, it's probably more differentiated in a lot of customers' minds from our other products, right. We believe that we have a clearly differentiated product, whether it's RHEL or OpenStack. But OpenShift, in particular, is the only enterprise provider of that today. And because it really does meet a DevOps needs that a lot of customers have, I think we're getting kind of a lot of positive halo out of that. And again, good revenue traction. But as importantly, for the dev side of house, it's positioning Red Hat, I think, very positively.

Operator

Your next question comes from the line of Walter Pritchard from Citigroup.

Walter H. Pritchard - Citigroup Inc, Research Division

Jim, wondering if you could talk a little bit about -- I know it's anecdotal, but you had some early success with OpenStack. Were those deals with enterprises, service providers? And any color in terms of what sort of applications those -- that technology is being adopted to underlie?

James M. Whitehurst

It's really a mix. There are a couple of telcos in there. There are a couple of universities in there. There's a retailer, a large SaaS company. It really is kind of a mix of people who are using it. In terms of the specific use cases, again, these are typically POCs at this point, with the expectation that they will roll out more broadly. I don't have a lot of color into the details of the opportunities. Again, most of them we're kind of at the pilot stage with the likely rollout -- or hopeful rollouts in the future, as those get up and running. But it's a nice mix really across verticals at this point.

Operator

Your next question comes from the line of Kirk Materne from Evercore.

Stewart Materne - Evercore Partners Inc., Research Division

Charlie, I was wondering, I'm sure that -- I guess, Charlie, when you look at the quarter, I mean, you guys had strength -- or more broad-based strength. You saw some bigger deals, but you're also mentioning that the sort of trend line business was doing better. I guess, how much do you think was you guys executing better in the quarter, especially around bigger deals, getting more products into these deals versus the demand environment just shoring up a little bit when you look back at, say, the results from 2Q?

Charles E. Peters

I primarily have to say it's some of both. Clearly, in Q2, we had issues in the federal space and also there was weakness in Europe, and both of those rebounded nicely. It's a combination, I think. However, our sales teams did a good job. And it's also a factor of just the environment changed a little bit and therefore it was more positive. Overall, from an economic perspective, much of the world is still very slowly recovering, so nothing is terribly robust. I think people are buying from us because they like our technology and they see the value in it. Our sales guys are doing a good job. Really, the biggest changes were Europe and the federal space for us for Q3.

Operator

Your next question is from the line of Ed Maguire from CLSA.

Edward Maguire - CLSA Limited, Research Division

Charlie, you mentioned that your public cloud business revenues were tracking well this quarter. I wondered if you could comment on whether you have any visibility on whether customers are actually moving on-premise workloads to public clouds and whether that has an impact on your business? Or whether what you're seeing out of the public cloud providers is -- are new projects?

Charles E. Peters

Good question. And really, it's some of both. And we've got this information from our own customers and balanced out from the cloud providers. I mean, let's start by saying the revenue -- or the bookings, I guess, the bookings that we saw in the last month of Q3 was 35% higher annualized than it was 9 months earlier. So it's -- we're seeing very fast growth in the revenue coming from the public cloud providers, and this is our certified cloud provider program. In addition, we have a program called Cloud Access, which is existing customers that buy subscriptions from us have mobility with their subscriptions. They can move the subscriptions, if they wish, to a public cloud provider. And so, this is an example of existing customers running some workloads in a public cloud, but buying the subscription from us, and both seem to work quite well. I think Jim mentioned in his comments that, in some recent information we have in a survey that customers on Amazon, more than half of them, are net new customers for Red Hat. We've never seen them as a customer before, so that is really terrific and we're looking forward to more of that. That was our hypothesis all along, but you got a lot of generally smaller SMB accounts that are beginning to move there. And then, you also have, on the other end of the spectrum, some of the larger accounts that are simply looking for some capacity planning space.

James M. Whitehurst

So of the existing customers running on Amazon, we frankly don't know if those are net new workloads that decided to run on Amazon using their RHEL subscriptions, or if those are moving existing workloads. We just don't have that level of visibility as to specifically what customers are running. My bet is they're net new workloads even for our existing customers that they're deploying on Amazon, but we -- I don't have data on that.

Operator

And your next question is from the line of Ross MacMillan from Jefferies.

Ross MacMillan - Jefferies LLC, Research Division

Charlie, you made a comment that you saw a much better uptake from OEMs this quarter. And I wanted to ask first, is that specifically server OEMs rather than a broader description, which might include public cloud service providers? And I'm just curious as to what you think the implications of a better OEM quarter are. Do you think there's some fundamental improvement in server growth that we haven't seen earlier this year? How would you describe that strength in OEM?

Charles E. Peters

Okay. And just to clarify, my comment was specifically about server OEMs, not necessarily cloud providers. And I commented on that separately, where we saw -- we've seen significant growth in the royalty reporting coming from the cloud providers. But back to the OEMs, partly, it's a function of the fact, I believe, that OEMs were fairly weak in the second quarter. So at least, sequentially, it maybe -- it was an easy compare. But compared to the second quarter, it was a nice bounce-back for the OEMs. And I think it was Heather's question about the long-term deferred that when we get long-term deals coming through the OEM partners, they're always paid up front. And therefore, that does help the long-term deferred. But it was a better performance coming out of the server guys this quarter than in the second quarter.

Operator

Your next question is from Steve Ashley from Robert Baird.

Unknown Analyst

This is Titania Ramada [ph] sitting in for Steve Ashley. You pointed to middleware strength in your comments and suggested 50% of your large deals included middleware. I was just wondering if you could comment on how fast that overall business is growing and perhaps help us understand, which specific products are seeing more traction in there?

Charles E. Peters

So good question. So my comment was specifically on the middleware business in the top 30, and I'm glad you asked the question because the middleware business overall was very good. It was much broader than the top 30. It was throughout our business. And since the beginning, the largest part of that business has been the EAP and continues to be good. But over a period of time, we've expanded the portfolio by our own engineering guys building new products. We've also acquired a few things. And that middleware business really is coming into its own, so it had a very strong quarter overall.

Operator

Your next question is from Matt Hedberg from RBC Capital Markets.

Matthew Hedberg - RBC Capital Markets, LLC, Research Division

I had a question on the storage product. Last quarter, you had some nice success with some -- with a very large deal. I'm wondering, can you give us a sense for how you might think adding functionality there through time beyond just the -- even the unstructured component?

James M. Whitehurst

Yes. I mean -- you can almost think of -- to me, at least, the way we -- I think about storage is it's a little bit -- innovator's dilemma here, right? We have a core product that works in some specific use cases extremely well. So with the functionalities and features in today around scale-outs, unstructured data. Based on customer demand, we continue to add new features into the product. And over time, more of the storage market will become relevant. So today, we're playing in the unstructured market, which, I believe, we've said is probably $5 billion. The overall storage market is 5x or 6x that big. And so, as we add things like snapshotting, et cetera, et cetera, there's just a whole new set of use cases we can address. So the total addressable market there should expand along with the road map. It's just a matter of us driving the community, working with the community to add those features and functionality to expand the TAM.

Operator

Your next question is from Abhey Lamba from Mizuho Securities.

Abhey Lamba - Mizuho Securities USA Inc., Research Division

Jim, staying on the topic of storage, I think a year ago, you had provided us a $0.30 a gigabyte number for your storage kind of being able to deliver that, including hardware. Do you have any update on that? Is there a magical number below which we can see much stronger uptake of the solution and also some of the functionality that you just mentioned? Is that something being planned for the next year, or is that model for the longer-term road map?

James M. Whitehurst

Well, I don't think there's a magical lower number that if it's $0.20 and then all of a sudden, it makes a radical difference. I mean, you're already talking about order of magnitude-type lower prices. I think it's just depending on the workloads, when is the feature, functionality and/or performance there, right? And there are a lot of different uses for storage. So whether you're looking at VM storage or whether you're looking at integration with Windows or things like snapshotting, et cetera, et cetera. It's a whole bunch of things depending on the use case where we continue to add things to improve both performance of that features the people want. I don't think there's one -- believe me, if there were one particular feature that we could get there and all of a sudden it would explode, believe me, it would be all hands on deck. It's the 100 little things. The core major things are in there. It's the 100 little things. And each one, with each release, it increases the TAM a little more and a little more and a little more. So we'll continue to drive that forward in the same way. Frankly, it took us years on Linux. So it will take us years on storage before I'd call it something that addresses the majority of the storage market.

Operator

Your next question is from Brent Thill from UBS.

Brent Thill - UBS Investment Bank, Research Division

Charlie, in Q2, you mentioned that special deal that it got booked, but not billed. Did you have any deals like that in Q3, where you're able to book but you didn't see the billing come through?

Charles E. Peters

We always have deals like that, but...

Brent Thill - UBS Investment Bank, Research Division

I'm talking the size of Q2.

Charles E. Peters

No, we had nothing of the magnitude of the one in Q2.

Operator

Your next question is from Scott Zeller from Needham & Company.

Robert Scott Zeller - Needham & Company, LLC, Research Division

I wanted to ask again about the improved performance Q-to-Q in EMEA and federal. Obviously, better execution. But could you give us some color around whether or not there was a pent-up spending or comment on the budget flush in federal, please?

Charles E. Peters

I think, one thing I would just kind of clarify [indiscernible] say again, we have a recurring revenue model. 86% of our revenue is subscriptions. And as long as we are doing a great job for our customers, they come back and renew. So one of the things we said on the second quarter call is our view of the pipeline for Q3 and Q4 for that matter is a lot better, a lot clearer. There's a higher percentage of large renewal deals there. So these are customers that we've had for some time. A lot of them are customers we've had for some time, the larger ones, where we secure the renewal that we were expecting and generally grew the deployment in those accounts. So part of it was it's better visibility on existing accounts. Second thing, I think, there was some clarity once the government shutdown was over in October -- during the month of November about what people could spend, and I think the spending was a little bit better, a little bit maybe easier. I don't know if that's the right -- our sales guys wouldn't agree with that because it's never easy. But we did a good job in the federal space, let's put it that way. And in Europe, we did a lot of large deals with a broad base of customers.

Operator

Your next question is from Gregg Moskowitz from Cowen and Company.

Gregg S. Moskowitz - Cowen and Company, LLC, Research Division

Just following on that last question, you guys really did have a monster quarter in Europe. I believe bookings were up by about 50% sequentially. And so, I'm wondering, Charlie, because I know you don't normally provide this, but just by way of path to getting a little bit more context, would you be able to give us a rough idea of how much of that sequential growth in Q3 was due to government as opposed to commercial?

Charles E. Peters

I'm not sure where you got your metric from. You're trying to take the percentage by region that I gave and then convert that back into a 50% growth. I'm not sure I would necessarily get there.

James M. Whitehurst

No change. No change still.

Charles E. Peters

Yes. So part of the European strength, as I said, is -- there was a FX tailwinds. There was a 5% increase in the euro, which helped somewhat. But if your question is how much of the European business was government business. I can tell you most of the European business was commercial business. Some of our traditional telecom, financial institutions, retail, I think we even did some automotive, a lot of different verticals. I don't -- I'm not aware of any substantial government deals coming out of Europe in the quarter, if I understood the question.

Operator

And your last question comes from the line of Tim Klasell from Northland Securities.

Tim Klasell - Northland Capital Markets, Research Division

A quick question on OpenShift. How many of those customers you see that adopted are existing JBoss customers, and how many are just new to Red Hat?

James M. Whitehurst

I'm not sure on the JBoss side. I will say most are probably existing RHEL customers at this point. But 90-something percent of the Fortune 500 are RHEL customers, so it would be surprising if they weren't. I haven't necessarily seen the correlation with JBoss. Just the way it works, I mean, obviously, there's some affinity on the Java side, but it's not so tightly tied to the JBoss shop naturally kind of adopts that and other shops wouldn't. So certainly, there's, I'm sure, affinity around just RHEL because those are places where we have strong relationships and frankly most customers -- or most large enterprises are our customer in some way or another. But when we think about go-to-market motion, it's not strongly tied with the JBoss side really at all.

Operator, I think we're finished. I'd like to thank everybody for joining us on the call. Happy holidays, and we look forward to seeing many of you over the next quarter and definitely when we send out our registration for our Analyst Day. I hope you all can make it. Thank you very much.

Operator

And ladies and gentlemen, that does conclude today's conference call. You may now disconnect.

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