Seeking Alpha
We cover over 5K calls/quarter
Profile| Send Message|
( followers)  

Red Hat (NYSE:RHT)

F4Q10 Earnings Call

March 24, 2010 5:00 pm ET

Executives

Tom McCallum - Vice President of Investor Relations

Jim Whitehurst - President & Chief Executive Officer

Charlie Peters - Executive Vice President & Chief Financial Officer

Analysts

Mark Murphy - Piper Jaffray

Kash Rangan - Merrill Lynch

Adam Holt - Morgan Stanley

Sarah Friar - Goldman Sachs

[Raul – Company Not Identified]

John Difucci - JP Morgan

Ed MacGuire – Merrill Lynch

Katherine Egbert - Jeffries

Nabil Elsheshai - Pacific Crest Securities

Richard Williams - Cross Research

Steve Ashley - Robert W. Baird

Brad Whitt - Broadpoint

Michael Turits - Raymond James

Heather Bellini - ISI

Brent Williams - The Benchmark Co.

Matt [Edberg] – Company Not Identified

Tim Klasell - Thomas Weisel

Operator

Welcome everyone to the Red Hat Q4 fiscal 2010 earnings conference call. (Operator instructions) I would now like to turn the call over to the Vice President of Investor Relations, Mr. Tom McCallum. Sir, you may begin.

Tom McCallum

Thank you. Hello everyone and welcome to Red Hat’s earnings call for the fourth quarter of fiscal 2010. Speakers for today’s call will be Jim Whitehurst, President and CEO; and Charlie Peters, Executive Vice President and CFO.

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

Various remarks that we may make about the company’s future expectations, plans and prospects including the statements containing the words believe, anticipate, plan, project, estimate, expect, intend or will constitute forward-looking statements for the purposes of the Safe Harbor provisions under the Private Securities Litigation Reform Act of 1995.

Actual results may differ materially from those indicated by these forward-looking statements as a result of various important factors including those discussed in the company’s most recent Quarterly Report on Form 10-Q filed with the SEC.

In addition, any forward-looking statements represent our view or estimates as of today, March 24, 2010 and these estimates or views may change. While the company may elect to update forward-looking statements at some point in the future, we specifically disclaim any obligation to do so, even if our estimates or views do change and therefore you should not rely on these forward-looking statements as representing our estimates or views as any date subsequent to today.

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

Jim Whitehurst

Thank you, Tom and let me add my welcome to all of you for joining us on today’s call. I am pleased to report we delivered strong results for both the quarter and the full fiscal year, exceeding our expectations and further demonstrating our market leadership position in this challenging global economy.

Here are just a few of the highlights from our financial results. Record billings of $243 million for the quarter was up 18% year-over-year. Double digit total revenue growth with subscription revenue up over 20% year-over-year for the second quarter in a row. 100 basis point improvement in operating margin for fiscal 2010 even while we continued to invest aggressively in our key growth areas. Record operating cash flow of $78 million even after the one-time litigation settlement of approximately $9 million which we reported last quarter. These results were driven by strong execution from our global team of Red Hat associates.

Let me now share a few of the business highlights from the fourth quarter. First, our platform business continued to perform well and ended the year on a high note with strength across our top verticals including a resurgent telecommunications segment which has lagged the performance we have recently experienced in our other segments. In addition we continue to see strong attach rates for management solutions, large embedded RHEL deals and further traction of our Merge products.

Of course the recent big news is IBM’s enterprise development and test cloud is being build on RHEL and on Red Hat enterprise virtualization or RHEV as the foundational virtualization technology, a major cloud win for Red Hat which I will discuss more in a few minutes. Our middleware business also had a solid quarter as more companies continued to standardize from JBoss rather than on more expensive proprietary solutions. With our flagship middleware product, JBoss EAP 5.0 shipping in the quarter we closed a large number of deals over $100,000 including our largest JBoss deal of the year, a multi-million dollar deal with a large bank.

Within the rest of the middleware portfolio our SOA products and business rules management systems notably had solid traction with customers in Q4. From a renewal perspective we continued to see strong renewals and growth from our top customers. For the quarter we renewed 24 of the top 25 deals scheduled to renew this quarter and those that renewed did so at approximately 130% of prior year value. Although we never like to lose a deal, in the case of the one who did not renew we are still well engaged with the customer and we have already signed an equivalent sized deal with another division of that customer in Q4.

Of interest in this quarter’s top deals we continue to see strong activity across the global financial services sector including global stock exchanges. When taking into account our existing customers plus new business won at the Tokyo Stock Exchange this quarter our footprint of stock exchange customers running mission critical applications on Red Hat solutions represents approximately half of the world’s equity trading volume.

Now let me discuss some of the key trends that we believe enabled Red Hat to outpace our competitors over the past fiscal year and which we believe position us well moving forward. First and foremost is customer satisfaction. Throughout the past year we have seen solid demand from both existing customers and new customers who are drawn to the innovation and high level of customer support we deliver. As I mentioned last quarter we are proud of regaining the top spot in the Independent Zip Data CIO Value Survey making us one of the top vendors for five straight years and positioned well ahead of our competitors. Customer satisfaction also is demonstrated by renewal metrics in which we have renewed close to 100% of our top customers up for renewal over the past three years.

Second, we are the first pure play open source company to be included in the S&P 500. This recognition further validates the commercial viability of open source development, our brand and the power of our subscription model. Third, government recognition and further adoption of open source. Over the past couple of years IT spending by global governments has created one of our fastest growing core segments. After some initial disruption due to the change in economic and political climate we saw additional recognition of open source solutions by both the U.S. and U.K. governments. We believe this trend will continue and lead to the modernization of data centers in government agencies around the globe which are seeking flexible, innovative and cost effective solutions based on open standards.

Finally, cloud computing clearly reached a tipping point in the past year. To illustrate the outlook for cloud computing, the 451 Group recently published a report showing a [kegger] of 70% in this market that will grow from $500 million to $4 billion over the next four years. We firmly believe our RHEL, JBoss and virtualization solutions will be key enablers for this rapid cloud adoption. Also in the 451 Group report they listed the top ten public clouds and nine of those 10 are built on open source and most of them are Red Hat customers.

IBM’s selection of Red Hat technology clearly underscores the significance of open source for cloud deployment. In addition to the wins in the public cloud segment we continue to see our large customers look to deploy private clouds including a recent win with the U.S. Department of Interior. Using Red Hat solutions as a foundation the Department of Interior’s national business server cloud platform has enabled up to 30% cost savings, improved server utilization, expanded security and enhanced customer service.

Whether it is public or private clouds, our approach to the cloud is different than other vendors. We recognize that customers have diverse infrastructure which unlike others in the market we are not trying to replace with monolithic, inflexible, expensive and closed technology stacks. Whatever our customers need to run, Linux or Windows, Red Hat enterprise virtualization or VMware or HyperV, Amazon’s EC2 cloud or IBM’s enterprise cloud, Dot net or Java, JBoss or Websphere, X86 or Mainframe if a customer deploys Red Hat technologies we believe they are laying the most scalable, reliable, secure and cost effective infrastructure available for both traditional IT deployments and for the cloud.

This flexibility is key to unlocking the value of the cloud and this is a key message we are conveying to our customers and partners; an investment in Red Hat today builds their cloud for tomorrow.

Before turning the call over to Charlie let me summarize some of the results of our key growth initiatives during the fiscal year. As a reminder, these multi-year strategic initiatives are designed to strengthen our long-term growth profile and market share gains and new product opportunities.

First, by expanding our marketing and commercial capabilities to drive mainstream adoption we sought significant growth outside of our core verticals. In an industries such as logistics, oil and gas, pharmaceuticals, transportation, travel services, retail and energy. For example we experienced over 150% growth within these mainstream verticals in our top deals compared with last fiscal year.

Second we saw good results of our free to fee paid conversion program in every quarter this year. In the fourth quarter we had several six figure deals that included a significant free to pay component. Our third strategic initiative is to further enhance our route to market distribution model with a focus on systems integrators and ISV’s and related process and system improvement to better scale this part of our business. This year we increased our commercial relationships with a number of key ISV’s and systems integrators including SAS, SAP, HP, CCS and Accenture.

At Summit we held a partner advisory council which included the top 12 strategic channel vendors. We also implemented a renewal portal and enhanced planning tools for our partners. The fourth and final initiative is to execute on our technology roadmap to enable us to maintain and extend our technology leadership position and drive future sales. This year we launched several new products and major releases including products based on the next generation KVM hyper visor technology.

Recently in E-Week, Red Hat enterprise Linux was named a Decade Changing Technology. These are the types of aspirations we have for our middleware, virtualization and cloud solutions in this current decade.

In summary we are pleased w2ith our fiscal 2010 results in which we clearly gained market share and wallet share in a very challenging global economy. As the macroeconomic environment improves we are excited about our market position. Heading into fiscal 2011 we believe we are well positioned at the center of several major technology trends at the data center including cloud computing, virtualization and open source software. Red Hat delivers innovative solutions that drive cost savings for our customers in each of these areas and we believe will continue to drive our growth.

Once again I want to thank the over 3,200 Red Hat associates for their hard work that delivered against these great results. I am confident they will remain focused on delivering for our customers and our stakeholders in the year ahead.

With that let me turn the call over to Charlie who will review our financial results and provide additional details on our outlook for fiscal 2011. Charlie?

Charlie Peters

Thanks Jim. These fourth quarter results once again demonstrate the strength of our subscription based business model and the increasing customer demand for our solutions. It is clear we are gaining market share and mind share. In the worst global economic conditions that any of us have faced in our lifetime, Red Hat has continued to grow and thrive.

We are looking forward in our new fiscal year to continued improvement in the economic environment and the positive effect it will have on our business. During this downturn we have stayed tightly focused on open source infrastructure software, services and our customers and we have executed relentlessly on engineering, sales and operational initiatives. These efforts have paid off.

Today we are reporting strong growth which exceeded our expectations for the quarter and the year. Jim mentioned a number of highlights including strong quarterly bookings and billings which led to 18% Q4 revenue growth and 21% Q4 subscription revenue growth, 100 basis points of annual operating margin improvement and record GAAP operating cash flow of $78 million for the quarter and $255 million for the year. Importantly we accomplished these quarterly and annual results while continuing to invest for the future.

For example, while other companies were cutting back this year, we added over 20% to engineering staffing, 13% to sales staffing and a few people in other functions, totaling over 350 new employees. We expanded 13 of our international offices and three U.S. offices. We commissioned a new data center. We continued to improve processes and systems and we launched a number of new products that expand our addressable markets. As a result we believe we are ready for more growth.

Once again we added thousands of new customers globally through our direct sales and multiple other routes to market. We have worked to further improve relationships with the global OEMs and have found that recent structural changes in this industry have brought most of them close to us. Likewise we have continued to develop our standing with major SI’s and ISV’s and have seen those relationships deepen.

Now let’s talk about the details. We are pleased to report another record quarter for both bookings and billing. We saw significant growth within our core verticals. As a reminder those are government, financials, telecom and tech/media as well as large deals in other mainstream segments as Jim mentioned. Let me share with you a few of the statistics on the top 30 deals in the quarter.

We had 18 deals at or over $1 million, one of which was free to pay. We had three deals over $5 million. Eight of these deals included a JBoss component. Two of them were more than $1 million in JBoss alone. Finally, more than 60% of the top 30 deals had a RHEL advanced platform component.

As I have done on other year-end calls I will add a few additional statistics about bookings. To be clear, similar to prior years we will not be updating these statistics on a quarterly basis. We had a solid year for bookings. We normally have a Q4 to Q1 decline but last year Q1 coincided with the worst of the economic cycle and therefore the Q1 dip of last year was deeper than normal. However, beginning with the second quarter bookings grew sequentially every quarter. Our off balance sheet backlog, that is the portion of customer contracts to be billed in the future, behaved in a similar fashion. The drop in Q1 was exacerbated by contract duration for that quarter but off balance sheet backlog built up sequentially every quarter thereafter and ended the year with a very healthy balance which is still in excess of $190 million.

Our billings proxy for Q4 set a new record at $243 million, up 18% year-over-year. As a reminder, our billings proxy is calculated by adding revenue to the change in deferred revenue on the cash flow statement which excludes any impact of foreign exchange rates on deferred revenue.

Moving onto bookings by channel and geography, our Q4 bookings mix was 56% from the channel and 44% from direct sales versus a 62/38% split in Q3. Our direct sales team had an impressive Q4 with a number of large deals. Our geographic split remains little changed with 59% from the Americas, 26% from EMEA and 15% from APAC, essentially in line with Q3’s split of 59%, 25% and 16% respectively.

Now let’s talk about our financial performance for the quarter starting with revenue. Fourth quarter revenue was $196 million, up 18% from the prior year and well above the high end of our guidance range. Good sales execution overall including better than expected linearity of bookings and billings were important factors. Subscription revenue for the quarter was $169 million, up 21% from the prior year. Subscription revenue which is a renewable revenue stream constituted 86% of total revenue in Q4. Training and services revenue was $27 million, essentially flat with the year-ago quarter and down $3 million sequentially as a result of holiday down time at customer sites around the globe. This performance is consistent with our guidance from the third quarter earnings call.

Now I will discuss the rest of our results on a non-GAAP basis excluding stock compensation expense, amortization expense and a charge for our previously announced litigation settlement. Overall, gross margin was 86% for Q4, up 20 basis points both sequentially and from the prior year. Subscription gross margin remained consistent at 94%. Q4 non-GAAP operating expense came in at $122 million, up 1% sequentially and up 19% from the prior year. Q4 non-GAAP operating income increased 17% from last year resulting in a Q4 non-GAAP operating margin of 23.8%, essentially in line sequentially and with the prior year quarter.

Net interest income which is net of interest expense was $2 million, down from $6 million in the prior year principally due to lower interest rates. Other income, which was primarily net investment gains, was $4 million up from $3 million in Q3 and a loss of $1 million last year. Our annual effective tax rate exclusive of the $7 million discrete tax benefits which were recognized in Q2 was 34% for both GAAP and non-GAAP results rather than the 35% rate we had been estimating in earlier quarters. As a result, when you adjust to this annual rate the Q4 tax rate is slightly lower.

Our non-GAAP diluted earnings per share was $0.19, approximately $0.02 of which relates to the investment gains and lower tax rate. Non-GAAP diluted EPS last year was $0.15.

Now let’s turn to the balance sheet and the cash flow statement. We ended the year with $970 million in cash and investments. We continue to be debt free and for the year we repurchased over 10 million shares of Red Hat common stock, contributing to the 8.4% reduction in our diluted share count. In addition as you may have seen our press release from earlier this evening where we announced that our board has authorized a repurchase plan for another $300 million of Red Hat common stock. The final $10 million of the previous $250 million repurchase plan was completed this month.

We continue to be pleased with the consistency of our day sales outstanding which was 56 days for Q4 versus 57 days last year. As a reminder, since day sales outstanding is traditionally a measure of receivables versus billing our DSO calculation includes revenue plus the change in deferred revenue.

Total deferred revenue at quarter end was $646 million, an increase of $103 million or 19% over the prior year. The increase was $99 million in current deferred revenue and $4 million in long-term deferred revenue. Excluding foreign currency exchange rates, year-over-year change in deferred revenue as shown on the statement of cash flow was $83 million all of which relates to current deferred revenue.

Just to briefly recap and make it clear to some reports I have seen out there, if you start with the Q3 deferred revenue of $619 million we added $47 million in billings and the currency change was a negative 20 to come to the $646 million at the end of the quarter. The primary reason for the change is the € which at the end of Q3 the spot rate was $1.50 and at the end of Q4 the spot rate was $1.36. Other currencies also come into play.

Moving to the statement of cash flows. It is simplest to just say cash flow was strong. As I mentioned on the prior earnings call we are anticipating good collections in the quarter based on the strong billings in Q3 but it got better due to stronger than expected collections and better than normal linearity in our monthly bookings. We exceeded our own expectations with over 30% year-over-year growth in Q4 operating cash flow with a record $78 million even after the payment of $8.8 million related to the previously announced litigation settlement.

For the full year GAAP operating cash flow was $255 million, up 8% year-over-year and above the high end of our guidance range, net of the one-time litigation payment. Excluding the one-time litigation payment operating cash flow would have been $264 million, up 12%.

Because of the substantial reduction in net interest income for the year and its negative effect on operating cash flow, some of you have asked about the growth of operating cash flow without any tax affected net interest income which some refer to as unleveraged operating cash flow. Unlevered operating cash flow before the one-time litigation payment was up 19% year-over-year. Due to the reduction in our diluted share count those growth rates would be even higher if viewed on a per share basis.

Now to briefly recap and summarize the highlights for the full fiscal year. Revenue grew to $748 million, up 15% year-over-year and well above the high end of the guidance provided at the beginning of the year. Subscription revenue grew to $639 million, an increase of 18%. Non-GAAP operating income grew by 19% and non-GAAP operating margins expanded by 100 basis points. Non-GAAP EPS hit the high end of the guidance which I provided at the start of the year before an additional $0.09 per share which was added by the better than expected investment gains and lower taxes. All in we ended at $0.71 per share. Overall it was clearly a good year.

Now I want to shift to fiscal year 2011 guidance. First, until we see greater stability in foreign exchange rates you can expect I will continue to discuss them. For example, the spot rate on the € on February was almost 10% weaker than it was on November 30th, as I have already mentioned, while the average rates in Q4 weakened about 4%. For my guidance I am assuming foreign exchange rates approximately where they were yesterday. I can tell you they are lower today. To be clear, I am not trying to forecast foreign exchange rates. I am simply building my guidance based upon foreign exchange rates at a point in time much like I did last year.

Many of you built your fiscal year 2011 models 3-4 months ago when the € was stronger. Your models generally reflect higher revenues than would be shown if your models were translated at today’s foreign exchange rates. Having said that, as for guidance we are forecasting total revenue in a range of $835-850 million for fiscal 2011, representing an annual growth rate of between 12-14% in U.S. dollars. We believe we can again expand our full year non-GAAP operating margin by approximately 100 basis points while also investing in future growth opportunities. I am estimating net investment income of approximately $8 million or $2 million a quarter which is a very modest reduction from fiscal year 2010.

However, please note I am not expecting any net investment gains in other income compared to almost $11 million in investment gains in fiscal year 2010. Some of you probably need to adjust your models here. Keep in mind that while investment gain helps the P&L and earnings per share, it is not included in operating cash flow where the change has no impact on operating cash flow.

Our estimated annual effective tax rate for fiscal year 2011 is 35% consistent with my earlier guidance. We will continue to report non-GAAP net income and EPS using our expected GAAP tax rate. There is good news on the cash tax front. That is, we still expect our cash tax rate to be about 5% throughout fiscal year 2011 as a result of stock compensation deductions and approximately $40 million of remaining tax credit carry forwards. Assuming a 35% tax rate and approximately 193 million diluted shares one would estimate diluted non-GAAP EPS in a range of $0.71 to $0.74 per share. As you work through your models keep in mind the differences in other income and taxes between fiscal year 2010 and 2011.

On a GAAP basis, we estimate quarterly stock compensation expense of approximately $15 million and quarterly amortization expense of approximately $4.5 million. From a cash flow perspective we anticipate operating cash flow for the full year of between $280-290 million. Again, this year I would expect we would produce $30-40 million of additional cash not included in operating cash flow which is related to tax savings from excess tax benefits from stock compensation. This will be recorded in our cash from financing activities line item as it has been for the past few years. However, depending upon actual stock option exercises that take place in fiscal year 2011 this amount could vary widely.

CapEx is still expected to be relatively modest in the $30-35 million range. Finally, looking at Q1 we offer the following guidance; Revenue is estimat3ed to be $202-204 million. Non-GAAP operating margin is estimated to be over 24.6%. Using my earlier estimates of quarterly interest income of $2 million and a 35% tax rate non-GAAP EPS is estimated to be approximately $0.17 to $0.18. Consistent with my past practice I do not guide quarterly cash flow because it can be quite variable depending upon the individual large payments or receipts.

To conclude, we are pleased with our results for fiscal year 2010 and we believe we are well positioned as we gain market share and grow. We are continuing to invest in areas such as virtualization, cloud computing and middleware but we are also prudently managing costs. We are optimistic about this fiscal year and the forward-looking pipeline continues to look strong. Before turning the call over to the operator I would like to remind our financial community to register for your exclusive VIP pass for the 2010 Red Hat Summit and JBoss [world] where we will host a financial analyst meeting on June 23rd.

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

Question and Answer Session

Operator

(Operator Instructions) The first question comes from the line of Mark Murphy - Piper Jaffray.

Mark Murphy - Piper Jaffray

I was wondering if you could comment on the relative importance of the server cycle and perhaps whether you sense possibly too much focus on service growth as the only indicator of the business? Perhaps could you talk about how meaningful server growth will be this year versus renewals and advanced platform adoption and perhaps some of the other drivers of the business?

Jim Whitehurst

Server growth does matter. As we have talked about if you actually look at what directly ships from OEMs it is a minority of our business. More important is to get servers out there especially in the Nehalem servers and higher end servers because they generally pull more advanced platforms. But most importantly is the servers are often going to because of their expanding capabilities to new projects. That is what really generates dollars for us. It is certainly important but the growth of advanced platform, the growth of JBoss and cloud infrastructures I think will be at least as large a driver of our revenue growth this year.

Mark Murphy - Piper Jaffray

As a follow-up a question on RHEV, what inning do you feel you are in just in terms of empowering your channel partners to be able to sell RHEV? Also where do you stand in terms of obtaining reference Lighthouse type of counts on RHEV?

Jim Whitehurst

I would say we are probably in the first inning. We just delivered the product in November. We are seeding the market now. That is our current strategy. We are basically getting it in a lot of people’s hands. We are training our partners to get out there and start selling it. In terms of Lighthouse customers, IBM running their cloud on RHEV, NTT running their public cloud on RHEV, neither of those companies are thought of as playing fast and loose with their technology so I think those will go a long way as we talk to customers about whether it is ready for primetime. So I do think those will help quite a bit. You will see some other references coming out in the not too distant future as we are starting to scale up that business.

Operator

The next question comes from the line of Kash Rangan - Merrill Lynch.

Kash Rangan - Merrill Lynch

With respect to the virtualization I was actually surprised to hear the statistic 30% of your top deals included advanced platform. I wonder if you could give us a comparable statistic for the previous quarter and also more strategically where do you think you are gaining market share from? Are these brand new deals that are not involving the competition or are you actually winning business at the expense of the competition in virtualization? Secondly, granted it is somewhat premature, when you look at the next upcoming release of RHEL, what are some of the key features you would expect that should give you a leg up in terms of the next phase of Linux [and options] in the enterprise?

Jim Whitehurst

That was a lot of questions in one. Let me start with the first part of the question about the percent of the advanced platform. What I actually said was about 60% of the top 30 deals had an advanced platform component and really for the last several quarters those percentages have been roughly in the same range. Somewhere between 60-70% every quarter for the last 3-4 quarters. So we are very pleased with the continual adoption of advanced platform and people moving from some of the older versions upward. The next part of your question?

Kash Rangan - Merrill Lynch

Are these virtualization deals competitive wins or captive within the customer base? I was looking to get some color there. Next [generation versions] of RHEL.

Charlie Peters

Obviously the wins like NTT and IBM are just clear wins for the technology. The wins we do with our customers is a mix. Some are competitive face offs. A lot of these are people running RHEL. RHEV is the logical choice to run it on and so a lot of them are starting to experiment buying small, very small numbers to start to experiment with an eye towards rolling it out going forward. Again, this quarter and really the next couple of quarters are really about seeding the market and getting our customer base familiar with the product and our partners familiar with the product. A lot of that is within our current core base of customers who obviously are familiar with Red Hat and our products and are generally running RHEL.

Operator

The next question comes from the line of Adam Holt - Morgan Stanley.

Adam Holt - Morgan Stanley

If you look at the last several quarters it looks like there has been a shift in total deferred between short-term deferred and long-term deferred. Can you talk about some of the puts and takes there that would be causing that mix shift and how do you think about those two elements as you start to get into a better spending environment?

Charlie Peters

One of the interesting things in fourth quarter was we had a very strong government business and in government business they typically do one-year deals because they don’t normally have a budget commitment beyond a year. So actually one of the largest deals we did in the fourth quarter was a government deal that was just like that and all of that was the current portion of deferred. You make a very good point. If you look at the year-over-year change in deferred virtually all of it is in the short-term portion. Earlier in the year back in Q1 we had some conversations about because of the economic climate some customers were not able to pay three years in advance which would be the only reason why the long-term deferred would go up. So to the extent they are paying one year at a time it is all going into current.

Jim Whitehurst

One other comment on that. We have talked about mainstream adoption and really branching out beyond our traditional telco, financial services type sectors. I talked a little bit about our success there. In a typical adoption model people start off with one-year subscriptions and as they get more familiar with the product and then they expand out beyond that. I am okay with the shorter deals as long as we are expanding our base of new customers.

Adam Holt - Morgan Stanley

If I could ask a quick follow-up on margins it sounds like you are comfortable with 100 basis points of expansion for the year. The first quarter guidance looks like it is up almost 100 basis points from what the fiscal 2010 number was. Does that imply we should expect margins to be roughly flat with Q1 going forward? How are you thinking about the rest of the year versus the Q1 guide?

Charlie Peters

Not necessarily. It sometimes depends on the timing of our expenditures. For example, Red Hat Summit whatever quarter that happens this year, it is going to be in June, that typically adds a bit more expense. In that particular last year it was in September so things like that can change it somewhat. Apart from that we see a pretty good revenue increase in Q1 based upon the strong billings and deferred revenue we put up in Q4 and so it is logical we would be able to have that kind of an increase.

Relative to the investments and the spending we will continue adding principally in our engineering and sales areas and that will be continuous throughout the year.

Operator

The next question comes from the line of Sarah Friar - Goldman Sachs.

Sarah Friar - Goldman Sachs

I want to go back to Kash’s question on the competitive environment in virtualization. What drives a customer to look to Red Hat if they are already with one of the bigger guys like a VMware or HyperV from Microsoft? Are you actually seeing some replacements going on or is it typically in new environments? Kind of part of that, what can you do to keep accelerating the adoption aside from these big wins with IBM? Is there something more tactical from a sales perspective that can help?

Jim Whitehurst

Again, we are three months into the GA of our product. We have another version of the management tools coming out. So take this as early day comments. What we are primarily hearing is most customers don’t want one platform. They want two. Frankly we don’t see Microsoft that often. That might be because of their customer base versus where we are normally strong. So we see a lot of interest from customers saying hey I have VMware but I don’t want to get stuck on one and I am just starting to really roll this stuff out. We want you to be the alternative.

So again I think it is a lot of customers, not necessarily that even dislike VMware. A lot of them are very high on VMware but most of them don’t want to get stuck with a single Hyper visor vendor for their entire environment primarily around cost reasons. So we have a very good, compelling story both on cost, on performance, certainly running RHEL on RHEV so it is not necessarily a replacement it is as people grow their platform we are taking part of those platforms.

Sarah Friar - Goldman Sachs

Tactically on the go to market?

Jim Whitehurst

Tactically on the go to market, clear marching orders to our sales teams about get it in people’s hands. Get it in customer’s hands. Get it in our partner’s hands. We are really seeding the market now. Let those seeds grow and harvest in the future. Right now most importantly we want to get trial. We want to get people using it. When the use it, when they see the performance themselves it sells itself. So a lot of activity on training our sales people and on training our distribution partners and value added resellers and really kind of getting it out in small quantities.

Operator

The next question comes from the line of [Raul – Company Not Identified].

[Raul – Company Not Identified]

A question related to virtualization. Have you given any thought to different pricing for virtualization like pricing via [different cores]? Also, what is your roadmap for the desktop virtualization product?

Charlie Peters

On the pricing question if your question is what happens when servers like Nehalem come up I think the question is more around operating system pricing. We are reviewing the pricing as we have said before and we will have something more to say about it probably at our summit in June. That is all on that one.

[Raul – Company Not Identified]

And the roadmap for your desktop virtualization products?

Jim Whitehurst

We have been very focused on getting the server product out in G8 and going. That will be out. You will see, kind of, I don’t think we have announced a date, but our management tools around the desktop coming out relatively soon here. I don’t think we have announced a date and so we will have more on the roadmap at the summit.

Operator

The next question comes from the line of John Difucci - JP Morgan.

John Difucci - JP Morgan

My question has to do with the macro environment. Last year you said you were positively affected by the macro environment along with gaining share and higher ASP. You sort of touched on them I think Charlie in your prepared remarks but if you could talk a little bit more about that especially the macro environment, your results in the past look like things are getting better. It may just be from gaining share and higher ASP’s. Has the macro continued to improve somewhat?

Charlie Peters

I think our view on the macro is we are seeing some improvement. As I have said before it has kind of taken on the shape of one vertical at a time. The first vertical was pretty much the financial vertical. We pretty much saw that 4-6 months ago. I would say the government vertical particularly in the fourth quarter was strong. Generally the overall tone is a little bit better and the discussion about the server refresh cycle we believe there is something to that. I think as Jim was saying that certainly will help us in a broad sort of way but we have many other things that we are doing that aren’t tied to the server refresh cycle.

Jim Whitehurst

One other comment there. In an up economy people are looking to do new projects and it positions Red Hat in a more strategic position to talk about how we can help you innovate faster, how we operate more modern architecture. So you have to go sell on value and innovation rather than just on cost helps kind of just raise our profile within an organization. The likelihood someone is going to do a new project on our technology is a lot higher and frankly a lot easier sell than trying to get people to re-platform something they are already doing. So obviously you saw clear acceleration in our subscription revenue and our billings obviously related to the economic improvement.

Operator

The next question comes from the line of Ed MacGuire – Merrill Lynch.

Ed MacGuire – Merrill Lynch

Could you comment about what the strategic implications as well as the financial implications as well as the IBM desk cloud deal as well as some of your other arrangements with public clouds?

Jim Whitehurst

Two things. Financial, we will see. Your guess is as good as ours at how fast clouds grow. So I wouldn’t expect anything in the real near-term that specifically stands out on the financial side. Strategically I think it is important for two reasons. One obviously continues to demonstrate that open source is going to be the technology that runs public cloud which helps us as we go to customers not only for the virtualization but more broadly to say if you write your internal applications on RHEL and on our virtualization it will be easier for you later on to move those to the cloud. That is a message that sells well.

Finally, it shows that KVM is staying together. I think one of the issues with them which has made it difficult to make progress in the enterprise is there are so many flavors of [zen] out there. So I think it is important IBM stood up and said we are standing behind Red Hat’s KVM. We are not spinning our own. We are keeping this thing together. We are keeping the ecosystem together. So there is kind of one enterprise implementation of KVM and I think that is important strategically long-term for us and for KVM.

Operator

The next question comes from the line of Katherine Egbert – Jeffries.

Katherine Egbert - Jeffries

Novell has effectively put itself up for sale. I think there is a lot of interest in the [lost] business. Any comments about that?

Jim Whitehurst

It seems like a reasonable question but we really don’t have any comments on that. It is not clear. They said they are looking at all sorts of alternatives. Until we hear otherwise we will assume that is the case.

Operator

The next question comes from the line of Nabil Elsheshai - Pacific Crest Securities.

Nabil Elsheshai - Pacific Crest Securities

I wanted to follow-up on JBoss. It seemed to me in your commentary the tone sounded a little bit better. I was wondering if you had seen an acceleration in growth in JBoss? I was wondering if the repackaging you did under the three different packages around Java development last year had improved the conversion rate of getting customers on a paid subscription?

Charlie Peters

We did see I would say the number of large deals around JBoss increase this quarter and the overall tone of the business around JBoss improved this quarter and the growth of the business was faster so overall yes, a much better tone.

Operator

The next question comes from the line of Richard Williams - Cross Research.

Richard Williams - Cross Research

Could you just go geographically and give us a sense of the tone of business and whether you are seeing the economy stabilize, improving or getting weaker?

Charlie Peters

For us, you could tell by the geographic splits I gave that Americas and EMEA were strong. APAC was a shade lighter. To try and describe it by region is actually kind of difficult. I would say we are clearly seeing strength in the western hemisphere, the Americas, country by country in Europe and as you read in the paper everyday it is a little bit different. Overall tone of business for us however for EMEA was good.

Operator

The next question comes from the line of Steve Ashley - Robert W. Baird.

Steve Ashley - Robert W. Baird

Maybe you could just comment on Windows to RHEL migrations. Is that something you continue to see in the marketplace?

Charlie Peters

We did continue to have some this quarter. We didn’t have any in the top 30 deals to the best of my knowledge as we did last quarter but we continue to see Windows to Linux migration. We hope to see more of that.

Jim Whitehurst

We certainly saw that and we expect to see more. In general the key for us is to catch people as they are moving from Unix to Linux rather than having them move to Windows. So while certainly actual migrations are important, the bigger strategic field of battle and part of our mainstream adoption effort is to make sure when people move mainstream customers from Unix they are moving to Linux and not to Windows.

Operator

The next question comes from the line of Brad Whitt – Broadpoint.

Brad Whitt - Broadpoint

Looking at the income statement, the G&A jumped up a bit this quarter. I just wonder if there is anything unusual? If you could, I think I heard you say you are going to withdraw some metrics. If you could review that real quick.

Charlie Peters

This has nothing terribly unusual in G&A. We had a little bit of higher professional fees in the quarter. That is basically it in G&A. In terms of the metrics, I am not withdrawing any metrics. My commentary was around the fact that once a year I talk about off-balance sheet backlog. Just at the end of the year. So my intention is to do it again next year at this time but just not each quarter.

Operator

The next question comes from the line of Michael Turits - Raymond James.

Michael Turits - Raymond James

You talked about the short-term deferred and implied that deal [inaudible]. First of all, what are we down to in terms of number of months of the average deal length? Do you expect it to stay that way and if so should we be concerned that will have an impact on cash flow?

Charlie Peters

Good question. The average deal duration was 22 months again this quarter so it has been consistent. Somewhere at 21-23 months I think that is very acceptable to where we have been all year except for in the fourth quarter of the year which I think by memory I think it was 19 months.

Operator

The next question comes from the line of Heather Bellini – ISI.

Heather Bellini - ISI

I was wondering if you could help billings growth is ending in the high teens yet your cash flow growth when you add back in the litigation settlement is only about 8% and it would seem like deferred trends this year even excluding FX would certainly be better than they were last year. I was wondering if you could help us think about the fact that your billings are ending on a higher note than obviously they started the year but your cash flow guidance is lagging by as much as it is?

Charlie Peters

Are you talking about the actual results for this year or for the guidance for next year? Sorry, you probably cut off. What I would suggest on the cash flow numbers is make sure you look carefully at the changes in interest income particularly from fiscal year 2009 to fiscal year 2010. It was a very large number which added to operating income in fiscal year 2009. As we look at the guidance ahead what I would say to you is if you go back and look at our cash flow statements over a number of years, if you add up all the items that comprised working capital starting with payables, prepaids, receivables, deferred revenue and accruals you are going to come to a number every year in a neighborhood of $75-100 million plus addition to cash flow.

So the primary move on cash flow you will find in the year ahead just like it has been in prior years is the change in the net income and operating income. I would be happy to follow-up with others later on if that is not clear.

Operator

The next question comes from the line of Brent Williams - The Benchmark Co.

Brent Williams - The Benchmark Co.

On the deal that didn’t renew could you give us a sense of what industry that might have been in and what was the motivation for that deal not coming in yet?

Jim Whitehurst

The industry was tech. The motivation was I think one of principally cost. So they found a free alternative they were going to try for awhile. As you may recall from our previous quarter results we have had over the last 3.5 or so years maybe 2-3 customers who have done the same. Usually in a period of a year and sometimes even less than that we are able to bring that customer back. So we are still hopeful this customer will come back.

Operator

The next question comes from the line of Matt [Edberg] – Company Not Identified.

Matt [Edberg] – Company Not Identified

My question is on the services line. It came in essentially in line with our estimate and how you talked about it last quarter. In terms of the strength, I know you have cited JBoss strength and in the past Charlie I know you have said JBoss usually translates into added service revenue. I am wondering on a sequential basis going forward and maybe throughout the year how should we think about the growth in services business? Last year it was down sequentially and you [key] one was obviously a unique time period. Just generically how should we think about the services revenue?

Jim Whitehurst

Excellent question. Obviously the one part of the business that was affected by macro economic factors last year was the services business year-over-year. I would say that we are expecting some improvement in services business this year. I would expect it to be slow improvement and maybe single digits kind of percentage growth year-over-year. We watch it quarter by quarter and will advise if something changes along the way this year.

Operator

The next question comes from the line of Tim Klasell - Thomas Weisel.

Tim Klasell - Thomas Weisel

I wanted to jump back to JBoss exposure. I think before we went into the downturn you were guiding to twice the growth of the core business. Do you think given the greater exposure to new projects you can get back to that level again or has the market grown and matured to a level of that not being possible?

Jim Whitehurst

Just to clarify I don’t think we ever actually guided to double the growth but we actually reported the actual results has been double the growth. For this quarter actually we are pretty close to being double the growth rate again. One of the questions I answered earlier, JBoss has improved during the year and it has come back quite nicely and I do think it certainly is feasible to get double the growth going forward over some period.

Operator

You have no further questions at this time.

Tom McCallum

Thank you everyone for joining us for our Q4 call. We look forward to talking with you in the future. Thank you very much.

Operator

This concludes today’s teleconference. You may now disconnect.

Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited.

THE INFORMATION CONTAINED HERE IS A TEXTUAL REPRESENTATION OF THE APPLICABLE COMPANY'S CONFERENCE CALL, CONFERENCE PRESENTATION OR OTHER AUDIO PRESENTATION, AND WHILE EFFORTS ARE MADE TO PROVIDE AN ACCURATE TRANSCRIPTION, THERE MAY BE MATERIAL ERRORS, OMISSIONS, OR INACCURACIES IN THE REPORTING OF THE SUBSTANCE OF THE AUDIO PRESENTATIONS. IN NO WAY DOES SEEKING ALPHA ASSUME ANY RESPONSIBILITY FOR ANY INVESTMENT OR OTHER DECISIONS MADE BASED UPON THE INFORMATION PROVIDED ON THIS WEB SITE OR IN ANY TRANSCRIPT. USERS ARE ADVISED TO REVIEW THE APPLICABLE COMPANY'S AUDIO PRESENTATION ITSELF AND THE APPLICABLE COMPANY'S SEC FILINGS BEFORE MAKING ANY INVESTMENT OR OTHER DECISIONS.

If you have any additional questions about our online transcripts, please contact us at: transcripts@seekingalpha.com. Thank you!

Source: Red Hat F4Q10 (Qtr End 02/28/10) Earnings Call Transcript
This Transcript
All Transcripts