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Red Hat, Inc. (NYSE:RHT)

F3Q07 Earnings Call

December 21, 2006 5:00 pm ET

Executives

Dion Cornett - VP, IR

Matthew Szulik - Chairman, President and CEO

Charlie Peters - EVP and CFO

Analysts

Kash Rangan - Merrill Lynch

John McPeake - Prudential Equity Group

Steve Ashley - Robert Baird

Todd Raker - Deutsche Bank

Jason Maynard - Credit Suisse

Brent Thill - Citigroup

Mark Murphy - First Albany

Katherine Egbert - Jefferies

Brent Williams - Hapoalim Securities

Chris Kwak - SIG

Kirk Materne - Banc of America

Heather Bellini - UBS

Tim Klasell - Thomas Weisel Partners

Denny Fish - JMP Securities

Brad Reback - CIBC World Markets

Brendan Barnicle - Pacific Crest

Terry Tillman - SunTrust Robinson-Humphrey

James Gilman - Cross Research

Presentation

Operator

Good afternoon. My name is May, and I will be your conference facilitator today. At this time, I would like to welcome everyone to the Red Hat Third Quarter 2007 Conference Call. All lines have been placed on mute to prevent any background noise. After the speaker's remark, there will be a question-and-answer period. (Operator Instructions). As a reminder, ladies and gentlemen, this conference is being recorded today, December 21, 2006.

Thank you. I would now like to introduce Mr. Dion Cornett, Vice President of Investor Relations. Mr. Cornett, you may begin your conference.

Dion Cornett

Thank you, May. Welcome to Red Hat's third quarter fiscal year 2007 earnings call. Speakers for today's call will be Matthew Szulik, Chairman, President and Chief Executive Officer, and Charlie Peters, Executive Vice President and Chief Financial Officer. Our earnings press release was issued after the market closed today and may be downloaded from redhat.com or requested by calling Linda Brewton, Manager, Investor Relations, at 919-754-4476.

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

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

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

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Matthew Szulik

Thanks, Dion. We are pleased with the company's continued strong year-over-year growth and solid execution exhibited during the third quarter. The quarter included a number of important highlights. Billings, revenue, earnings and cash flow all exceeded our expectations. We released our Red Hat Enterprise Linux Version 5, second beta, helping set up what we expect to be the most productive product cycle since the company entered the enterprise market in 2002.

We saw an acceleration in the addition of net new customers this quarter, signing in excess of 12,000 net new customers for a total of 32,000 plus net new customers year-to-date. And shortly after the quarter closed, Red Hat was recognized in the CIO Insight survey of over 1,000 IT executives for an unprecedented third consecutive year as the number one enterprise software vendor for creating and delivering value.

The continued loyalty shown by our customer base, particularly during a period of increased competitive activity, was resonant in Q3. We believe that our customer loyalty is in no small part attributable to the power, flexibility and choice that the open source software development model provides, specifically the power to build, test, integrate and deploy customized applications in an environment that frees customers from the proprietary vendor lock-in and interoperability issues of the past.

My visits to large strategic enterprises around the world over the past 90 days have revealed customer interests, investment and deployment that exceeded my expectations. The common theme amongst these customers is that open source software delivers tangible business value, and Red Hat is the open source leader. Macroeconomic drivers of our strong quarterly performance included growing demand from global enterprise and government customers in the form of both net new wins and successful renewals with renewing customers frequently expanding their installations.

The continued hardware re-platforming as customers replace UNIX with Linux and move older mainframes to higher performing, lower-cost, grid like computing infrastructures. In next-generation software architectures, we are beginning to see mid-market Fortune 3000 firms move infrastructure and applications from client server models to Web-based environments. We believe the drivers specific to Red Hat included the expanding and positive reference ability of Red Hat to the Corporation and our service capabilities across all key verticals, an improved and enhanced ecosystem globally of independent hardware vendors and independent software vendors, including our recently announced relationship with Satyam, a leading Indian service provider that will be building centers of excellence around Red Hat Enterprise Linux and JBoss Technologies.

Three, the growing availability globally of an increasingly well-trained technical talent base. At the end of the third quarter, there were approximately 40,000 Red Hat certified engineers and Red Hat certified technicians distributed across 110 countries. And fourth, management's continued strong focus on the global integration and execution of the JBoss acquisition.

During the quarter, Red Hat rolled out JBoss in Latin America, the Middle East and Asia, scaling global service and production level support while introducing new functionality and core technologies, its Hibernate and Seam, two critical components of the JBoss spec. In addition, JBoss World Berlin proved to be an outstanding developer event with strong attendance keynoted by Marc Fleury while providing several new product introductions.

And finally, our performance continues to be driven by management's commitment to develop the internal capabilities of our organization through continued education. Our intro education investments include an initiative known as Red Hat University. It trains Red Hat managers in core leadership and customer facing skills.

In addition, our Red Hat Sales College has delivered and administered over 23,000 sales courses for both our direct sales organization and the growing and expanding third-party channel of third-party resellers.

Looking forward, for over 15 years, Red Hat has built in partnership within a growing global open source community, hurdles, compilers, installers, libraries, directory service and other core functionality comprising the over 1,500 independent software packages that make up what we call Red Hat Enterprise Linux, a platform that we today, combined with the JBoss middleware suite, delivering to users the capability to build comprehensive Web 2.0 applications.

Moreover, Red Hat and the open source community, which today includes private enterprises, governments, national labs, students and technicians, have worked together to create the debate around intellectual property and copyrights to advance the ecosystem of open source entrepreneurs and to leverage open source software to improve access to information. We are a pure open source play building upon a successful 15-year history with the open source community. We have learned that collaboration-proven value are characteristics which have shaped the relationship with Red Hat in this community. The greatest beneficiary of this model is the customer. Because of the transparency and the ability to make modifications, the customer is an active part in the innovation process. The customer receives a more secure and more reliable and a higher performance software solution.

In closing, we're pleased with our performance during the third quarter. We believe recent competitive announcements are expanding the market for open source software. And based on this quarter's strong bookings, billings and revenue, we are optimistic that our long-term competitive positioning is being enhanced by the market participation of larger entrants. We continue to emphasize the biggest benefit of our growing open source portfolio versus the technology focus traditionally touted by proprietary vendors. We focus on and deliver what customers in open source community have come to expect from Red Hat.

Charlie will now address specific financial performance.

Charlie Peters

Thank you, Matthew. Again, as Matthew stated, our third-quarter results were strong across virtually every metric. Our efforts directed at customers were intense, and our results suggest this customer-focused response served us well. While we don't specifically disclose bookings, we have from time to time provided qualitative commentary. On that basis, I'm happy to share that bookings were particularly strong, leading to the largest ever dollar increase in off-balance sheet backlog, and our pipeline entering the fourth quarter remains strong.

Our billings proxy, which we define as revenue plus change in deferred revenue, was $133.4 million, up from $112.2 million last quarter and $88.8 million last year representing increases of 19% sequentially and 50% year-over-year.

Total third quarter revenue was $105.8 million, and it topped our prior guidance, represents an increase of 6% from last quarter and 45% from the year-ago quarter. Both GAAP and non-GAAP diluted earnings per share for the third quarter exceeded our prior guidance and mean analysts' expectations at $0.07 and $0.14 respectively.

Our Q3 non-GAAP cash flow from operations adjusting for the $2.4 million impact of FAS 123R was $62 million, up 39% sequentially and 15% year-over-year, putting us in good shape to hit our full-year guidance.

Breaking down our Q3 bookings mix, 50% of the business came from the channel and 50% from direct sales versus a respective 40 -- excuse me, 54%, 46% last quarter. Our expectation is that over time, the indirect contribution will grow from these levels as we expand our routes to market and leverage existing channels to promote our middleware offerings.

From a geographic perspective, 60% of bookings came from the Americas, 24% from EMEA and 16% from Asia-Pacific, nearly unchanged from the respective 61%, 23%, 16% split last quarter. For Q3, the percentage of quarterly bookings valued beyond one year was 28%, up from 22% in Q2 and the highest we have ever reported. For the quarter, we have achieved an overall gross margin of 84% consistent with last quarter. Increased efficiency and delivery of subscriptions and growing scale helped us improve subscription gross margin by 110 basis points sequentially, while strong services revenue at lower margins left the overall blended gross margin nearly unchanged from last quarter.

Operating expenses came in at $66.9 million, excluding stock compensation expense. Versus Q2, operating expenses were lower as a percentage of sales as we started to see operating synergies related to the JBoss integration. I also note that operating expenses included approximately $1.5 million of amortization expense related to JBoss intangibles.

Non-GAAP operating income, excluding only FAS 123R stock-based compensation expense, was $21.5 million for the quarter, up 26% from the prior quarter and resulting in a non-GAAP operating margin of 20%.

Moving on, other income net attributable primarily to investment income was $11.1 million versus $9.6 million last quarter, driven primarily by higher interest rates on larger investment balances. Again, our non-GAAP tax rate, which reflects actual cash taxes that we expect to pay for the foreseeable future, is still estimated to be 5%, resulting in non-GAAP net income of $29.6 million versus $23.9 million last quarter. Our remaining US NOL carry-forward is approximately 100 -- excuse me, is approximately $411 million. Based on $219 million fully diluted shares in Q3, our fully diluted non-GAAP adjusted earnings per share was $0.14 versus $0.11 last quarter. Note that on a GAAP basis, we still anticipate a tax rate of 37% consistent with our prior estimate.

Now let's turn to the balance sheet and the cash flow statement. At quarter end, we had $1.1 billion in cash and investments, an increase of $63 million from the end of Q2, driven primarily by cash flow from operations. At the end of Q3, total receivables were $81.3 million, which translates to an adjusted DSO of 55 days versus 58 days at the end of Q2 and 57 days for the third quarter of last year.

As a reminder, the DSOs are traditionally a measure of receivables versus billings. So, as a result, our DSO calculation includes the change in deferred revenue. Total deferred revenue for the quarter was $311.7 million, an increase of $27.6 million or 10% from the prior quarter.

Moving to the statement of cash flows, third quarter non-GAAP operating cash flow reported on a basis consistent with the year-ago period was $62 million. Cash flow from operations on a GAAP basis, including changes required by FAS 123R, was $59.7 million. You will find a reconciliation of our non-GAAP measures in the press release, and so now I would like to turn to guidance.

Notwithstanding the changing dynamics of our market, we are cautiously optimistic that competitive efforts by some of the largest technology companies in the world are actually expanding our opportunity. Early results suggest that as buyers investigate their open source options, they naturally consider Red Hat the clear market leader. This appears to be creating opportunities including those customers currently running RHEL in conjunction with proprietary stock offerings more seriously considering open source stack alternatives.

It is our policy not to update cash flow guidance on a quarterly basis, but the combination of Q3 results and a solid outlook for the fourth quarter provides us a relatively high degree of confidence in our prior full year estimates, including $210 million to $215 million non-GAAP cash flow from operating activities. The reconciliation between GAAP and non-GAAP cash flow is provided in the press release and consists of only one item that relates to FAS 123R, which is excluded for historical comparison purposes.

Specific to the fourth quarter, we anticipate revenue in the range of $112 million to $113 million. Our Q4 non-GAAP operating margin should again improve by approximately 200 basis points sequentially after increasing operating expenses approximately $3 million to $4 million, primarily in sales and engineering. I would suggest that you model other income and share count for Q4 approximately the same as that that we have reflected in the results for Q3. I expect this will produce a non-GAAP adjusted earnings per share assuming a 5% cash tax rate of between $0.14 and $0.15 per share. For GAAP results I would estimate FAS 123R expense of approximately $9 million and a 37% estimated GAAP tax rate, which would produce Q4 GAAP earnings of approximately $0.07 to $0.08 per share. With that, let's turn it back now to Matthew for closing remarks.

Matthew Szulik

Thank you, Charlie. As our results have communicated, the growing demand for open source software, Red Hat's established leadership within the open source community and our continued global investment and innovation and the ability to respond to customers' needs continues to grow. We are entering the richest product cycles in Red Hat's history, commensurate with expanding customer expectations of Red Hat that transcend the operating system. These expectations include support for massively scaled compute clusters, innovative middleware, advanced management services and tools -- what our CTO likes to call service-oriented infrastructure. Customers already familiar with the benefits of Linux today approach Red Hat for information management and assurance, workflow and storage solutions. UNIX to Linux migration does not end with a simple hardware replatforming and operating system migration. Instead it extends to the development, testing, deployment and management of content-based services.

We remain grateful to our shareholders, customers and almost 2000 Red Hat associates for their continued support as we build the defining technology company of the 21st century.

Dion Cornett

For the question and answer period today, we ask the callers limit themselves to one question and one brief follow-up. Operator, please poll the audience for questions.

Question-and-Answer Session

Operator

(Operator Instructions). Your first question comes from Kash Rangan with Merrill Lynch.

Kash Rangan - Merrill Lynch

It looks like the world is not coming to an end after all. Nice quarter. A couple of questions for you guys. One is, on the pricing side, what are you seeing in terms of pricing on renewal? You do not give us exact ASP, but directionally how is pricing looking in the market especially as you have more competition come to the market? I guess my follow-up question is on a technical level what are the barriers to exit for our customers that have installed the RHEL 3.0 or the 4.0? What makes it tougher for them to extricate from the commitment that they have made to you and go to the competitor? That is it. Congratulations.

Matthew Szulik

How about Charlie and I both answer your question?

Kash Rangan - Merrill Lynch

Sure.

Matthew Szulik

I just this past week I was at one of our largest customers, which is in the financial services business, and by his statements he made it very clear that saving $5 to $10 on an operating system on a per server basis was not very motivating to him. And as more and more customers move from analog-based models to digital-based businesses, their expectations for the performance and the strategic value of their computing infrastructure rises in importance. And most importantly, as evidenced by our continued strong growth in renewals on a year-over-year basis, they feel that they are getting very strong value from our business as it relates to the pricing question. Certainly, of course, in the enterprise and in the volume that we are selling there is a certain level of discount. But I will defer to Charlie to provide you the specifics.

Charlie Peters

I think cash -- in pricing we have always been competing against free Linux as one alternative and we have our own, Fedora. There have been other very price competitive distributions in the market. So, I don't think there has been anything new in that regard. And what we have done for at least the last two and a half years was very disciplined pricing approach with our sales guys. I believe, we have stuck to that sort of a pricing model. As regards renewals, in the last 12 months, we have renewed 98 out of 100 of the largest deal up for renewal, including 24 of 25 this quarter.

Matthew Szulik

And to answer your question regarding the upgrade challenges, Kash, one of the good things about our model for our customers is that when RHEL 5 is shipped into February that the customers will receive all that value as a part of their subscription. So, we have worked with these customers that have renewed and that are up for renewal on their planned migrations to go both with their hardware re-architectures, as well as their migration to a virtualized environment and their continued commitment to open source infrastructure.

Kash Rangan - Merrill Lynch

So I guess is that the barrier to exit then, Matthew? How should we think about the technical barrier to exit for a customer? Arguably, if open source is really free, then what strengthens their commitment to RHEL 3.0, 4.0 and not unwind from them going with the competitor?

Matthew Szulik

In our core markets, Kash, I think the customers have bought into the concept that we vandalized our customers-driven innovation. This isn't a matter of simply providing a standard set of requirements, but they are actively involved in the evolution of the platform to meet their specific needs in their business value, whether it is at the operating system in kernel-level that helped drive virtualization or whether it seems hibernate the JBoss portal technology. So, I think as long as we continue to deliver value to these enterprise as evidenced by the strong numbers, that we have not given them a reason to exit to save a couple of thousand dollars.

Kash Rangan - Merrill Lynch

Got it.

Dion Cornett

Thank you very much Kash.

Operator

Your next question comes from the line of John McPeake with Prudential Equity Group.

John McPeake - Prudential Equity Group

Thank you. I have a sort of easy one I think and then a longer-term question. Can you talk a little bit about JBoss and the contribution at least qualitatively to grow sequentially in the quarter or how should I think about how much JBoss you guys had in the quarter?

Matthew Szulik

On JBoss I would be happy to reiterate the guidance that we gave previously that -- which was for the nine months from June 2 through the end of our fiscal year, our estimate still is that we will have revenue in the $22 million to $27 million range, and we're making good progress. An awful lot was written and said about integration, and I can tell you that an awful lot of hard work has gone into making the integration successful, and we have come a long way this quarter. Sales is -- has improved quite a bit relative to the -- some of the training activities that we talk about in the Q2 conference call. We have done a lot of work to build out the support infrastructure and enterprise production type quality support, and we have made real progress there.

John McPeake - Prudential Equity Group

So considering the integration behind you?

Charlie Peters

I would not say it is behind us, but I would say the bulk of it is behind us. Because integration is something that typically takes a fair amount of time, but we have made very good progress.

John McPeake - Prudential Equity Group

And then I was hoping you could take a stab at trying to help us understand maybe what's some of the -- what's your view as to what you think the larger players are up to with their, if you want to, with their moves in the Linux market, trying to undercut you on price or partner with someone of less market share?

Matthew Szulik

John, they are probably similar to your perceptions. I think that the marketplace for Linux and open source software globally is continuing to grow, and it is an irrevocable force of how people and individuals will want to use and create content and make it available as an innovative way to create value either for their end-user customers or for their own internal infrastructure. As customers are thinking about building what some people call Enterprise 2.0 level apps, the whole opportunity for component reuse that has been evangelized for 20 years in the tech business, the opportunity to leverage a massively scaled horizontal grid to create new business models whether they be in the financial services industry or whether they be in Telco, this whole opportunity that we see today is a really once in a generation opportunity as these enterprises migrate from older architectures to really 21st century based architectures to move to digital economies.

But I think these large imprints see that happening, and in one case we believe that they are certainly trying to continue to protect their proprietary franchise, and another as it relates to the intellectual property issue is simply trying to bang on a drum that was banged on almost three years ago in the SDO case. So, I think that we have anticipated this degree of competition, but the marketplace has grown exponentially, and certainly they would like to participate in that growth.

John McPeake - Prudential Equity Group

Okay. Thanks.

Dion Cornett

Thanks, John.

Operator

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

Steve Ashley - Robert Baird

Hi. My congrats on the solid quarter as well. I was just wondering if you could talk first or maybe about the layered products and what kind of growth and traction you were seeing in that product group?

Matthew Szulik

Steve, we saw a very good growth within the layered products within the quarter, as customers now starting to deploy RHEL outside of perhaps some smaller areas and getting into the multiple hundreds and thousands. The role of Red Hat Network becomes all the more strategic to them. Within the quarter, we released a significant upgrade to GFS. We are very positive about the performance within the quarter and also as it relates to virtualization of having a standard Linux file system in a virtualized environment and eventually touching on the storage opportunity. And, of course, in the JBoss perspective, we're very pleased with the progress and the adoption rate that we see as how to be integrated into it.

Steve Ashley - Robert Baird

And if we could talk about JBoss, what percentage of the billings today are coming from the core app server, and which of the products outside of the core app server are starting to get traction in the market? Thank you.

Dion Cornett

This is Dion. I did a little analysis on that, and I think you might be surprised just how diversified the JBoss business is, that whole suite componentry, in looking at sort of on a subscription basis seeing strong contributions out of things like Hibernate and Seams. We've had some early success email things like portal and BPM. So, I think the broad message there is we have a complete suite of middleware solutions that are starting to gain adoption in the enterprise.

Steve Ashley - Robert Baird

Great. Thank you.

Operator

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

Todd Raker - Deutsche Bank

Hey guys, again, nice quarter. My question actually relates to if you look at the billings proxy, if you can just discuss why it looks like contract length is extending so dramatically versus what we saw last quarter? Is this something we should continue to see? Is there anything that particularly drove this quarter, a large deal or anything along those lines?

Charlie Peters

That measure changes from quarter to quarter. So, for example, if you went back to Q1 of this year or Q4 of last year and you looked at those measures between Q4 and Q1, the long-term deferred revenue grew by $11 million. In Q2, for all the reasons we talked about on the Q2 call, the long-term deferred revenue number only grew by about $1.5 million. This quarter that number grew by about $11 million again. Actually the quarter that had a little bit of a deviation was actually Q2, not this quarter. It is normal for us to see long-term deferred revenue. We have -- a lot of our customers like to do longer-term deals, and this quarter was no exception.

Todd Raker - Deutsche Bank

And can you just talk about customer concentration? Were there any large deals in the quarter?

Charlie Peters

Every quarter we have seven-figure deals, and we had a number of seven-figure deals this quarter that were important. And those deals, when we get seven-figure deals, for the most part they typically are long-term deals. Generally three years. We actually had one this quarter that was a two-year deal.

Todd Raker - Deutsche Bank

And then one last question, just talking about the market, can you guys give us a sense for expectations in terms of unit growth versus pricing if you looked at the market more generally just from a higher level perspective two or three years out?

Matthew Szulik

It would be very difficult perhaps for us to forecast that because of the potential impact that virtualization will have on what was historically a per unit basis. Certainly the channels of distribution will change, and the value-add that we're looking to build into that customer experience will look different than the historical per unit tracking.

Todd Raker - Deutsche Bank

Thanks guys.

Operator

Your next question comes from the line of Jason Maynard with Credit Suisse.

Jason Maynard - Credit Suisse

Hey good afternoon guys. I just wanted to follow-up on that last question regarding long--term deferred revenue. I understand the quarter by quarter volatility, but this was a record quarter with I think 28% on multiyear contracts. Do you think then we should expect to see that that contribution pare back next quarter and assume those sort of normal trends, or will we see this kind of continue to creep up enough?

Charlie Peters

That is hard to know. As you pointed out, this is -- the 28% was a record quarter. It typically is around 20, 21%. It's been sometimes 22%. My guess is it could be back into the low to mid 20s.

Matthew Szulik

A couple of thoughts to you on this. One is that some of the renewals we saw are a portion of customers that were early RHEL 2.1 or RHEL 3.0 customers that had a successful experience with us and have now improved and extended their renewal with us, number one. Number two was the continued growth in net new customers that were signing up for the first time in multiyear agreements. And, as I highlighted in my remarks, the referenceability also brought us I think renewed expansion within some sizable currently installed customers within key verticals.

Jason Maynard - Credit Suisse

Well, that is what throws me for a loop a little bit. Because net new customers I would think more than likely are going to sign maybe shorter term contracts and then get success and go to multiyear. So to see the percentage on the multiyear expand so much, I'm just wondering if in some of these renewals, perhaps there isn't maybe some discounting on price and, therefore, in exchange there's a longer-term commitment. And --

Charlie Peters

I would just say again, Jason, what I said to an earlier question, that our pricing philosophy this quarter and our approach has been no different than it has been for the past two and a half years. As I have said in previous quarters, for large strategic accounts that have multiyear deals, sometimes we have different arrangements. But what is very clear is for the third year in a row CIO Insight has ranked us the number one enterprise software company for value. It is a very compelling argument for me to be talking to the sales guys about let's sell value. You don't have to worry about trying to sell price. We were helping the customers in many ways create value. But the short answer is our pricing approach this quarter has been no different than it has been for the last two and a half years. But, as we have said, the longer the deal, the bigger the deal. The discount levels can be different, but that's the same that has been.

Next question?

Operator

Your next question comes from the line of Brent Thill with Citigroup.

Brent Thill - Citigroup

Thanks, good afternoon. The last two years you have given guidance, at least a snapshot of guidance, for what you think operating cash flow looks like for the next fiscal year. And correct me if I am wrong, I don't think we got any update on that. Is there any reason why this year that metric was withdrawn?

Matthew Szulik

Just to clarify, we have not withdrawn the metric, but I typically do provide guidance on the fourth-quarter call for the coming year. So it is just one quarter early. I'm expecting to say something about that on the fourth quarter call, which is exactly what I did last year.

Brent Thill - Citigroup

Okay. Matthew, you mentioned RHEL 5 was a pretty big release for you. How would you characterize the important drivers of that release, and if you could just update us in terms of when that is going to be available our next fiscal year?

Matthew Szulik

Well, starting with Fedora Core 5 and Fedora Core 6, customers have had a chance to experiment and be able to see the functionality for almost at least six months now. And that led to the success of reducing RHEL 5 Beta 2 in the last 30 days, and I was with the number of the beta customers in the last 30 days, and people I think are impressed by the stability of the release. I think they are anticipatory of the virtualization capabilities, the inclusion of the Xen hypervisor, and I think the importance of what it may mean to be able to drive down very, very large costs of their hardware computing infrastructure as, of course, they deliver on the benefits of virtualization. There are good capabilities in the product as well, improvement to the cashing environment, the ability to drive towards a stateless environment for client side computing. So, I think in concert with the continued success of the hardware platforms in AMD and Intel, we think that this will really provide customers with a lot of flexibility in driving out costs.

Brent Thill - Citigroup

Thanks.

Operator

Your next question comes from the line of Mark Murphy with First Albany.

Mark Murphy - First Albany

Thank you. You are saying that competitive actions are actually expanding your opportunity. You were not saying that in early November. What did you see happening toward quarter close that has emboldened you here to make a longer-term statement like that?

Charlie Peters

I think probably the difference is in early November, although there is an incredible amount of press -- in fact, all of you guys wrote an awful lot, and so there was an awful lot of noise. And we were still working with the customers trying to understand their positions and understand the competitive offerings. I think as the quarter, particularly within the month of November went along, it become much clearer. The open source community contributed very heavily in blogs and other things trying to shed light on competitive offerings, which were helpful to us and helpful to customers to understand what was really been offered. So, it certainly did become clearer as the quarter went along. There is lots of talk about open source software. Lots of talk about Linux and middleware, and invariably when that kind of talk happens, when people talk about Red Hat and there's an awful lot of advertising went on about open source software so that people think about Red Hat.

Matthew Szulik

Mark, let me just add to that. Management in the last 90 days has traveled around the world and has expected both the current installations that our leading customers have spoken with OEMs and third parties, as well as participated actively with prospect case. I think just to reaffirm Charlie's comments, although the marketplace is certainly competitive, customers continue to reinforce the value that they get from doing business with Red Hat and open source software.

Mark Murphy - First Albany

Then Matthew, just as a follow-up, our own survey of Red Hat customers showed that Oracle's Linux is essentially irrelevant to your customers in a lot of ways and we have also spoken to Oracle's own resellers, and they have actually been unable to figure out where to order the product from. And there is other feedback showing that Oracle's Linux is extremely buggy, and it keeps crashing, and Oracle has generated quite a bit of backlash and animosity from the broader open source community towards Oracle. So, I guess the question is, is it realistic to think that Oracle is just going to ride this experiment into the ground, or would you expect them to possibly withdraw their offering from the marketplace?

Matthew Szulik

Mark, I like the famous basketball coach at UCLA, John Wooden, used to say, we're focused on the success of our customers. We are focused on expanding the opportunity for open source software through initiatives like OLPC with RHEL 5, RHN 2.0, the expanding JBoss middleware stack, and I have to be frank with you, I don't spend a whole lot of time thinking about the operational issues and the Oracle operating system product. We are focused on making our customers tremendously successful with open source software.

Mark Murphy - First Albany

Thank you.

Charlie Peters

Thank you, Mark.

Operator

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

Katherine Egbert - Jefferies

Hi, good afternoon. I will put my two questions upfront. First, pricing aside, did you guys put any incentives in place during the month of November to encourage your reps to sign multiyear deals? And second, were organic RHEL billings up quarter on quarter? Thanks.

Charlie Peters

This is the first part of the question, Katherine. There were no special incentives to sales people to sign multiyear deals in the quarter. And then the second part of your question is the organic growth of RHEL up? Is that what you said on a quarter-to-quarter basis?

Katherine Egbert - Jefferies

Right. Were RHEL billings organic, or were they up quarter-on-quarter?

Charlie Peters

Substantially, yes.

Katherine Egbert - Jefferies

Okay. Thank you.

Operator

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

Brent Williams - Hapoalim Securities

Hi. So, Mark Murphy there had a good question about Oracle. Well, let's move over to Novell. I have heard a number of staff engineering defections from Novell, including today the leader of the Samba project, Jeremy Allison. Are you -- do you have any statistics or visibility in the number of people who are actually leaving Novell either employees or resellers or anything like that that suggests -- that can give us some clarity on the tension level within the Novell SUSE community over the Microsoft deal?

Matthew Szulik

Brent, all that we are aware of is exactly what you have read as well.

Brent Williams - Hapoalim Securities

Okay. And then a technical question on the move to a little bit more direct revenue in the quarter. I think if I read the number right, is that just JBoss with more direct sales force?

Charlie Peters

Is your question specifically on the services revenue?

Brent Williams - Hapoalim Securities

Yeah.

Charlie Peters

The services component of JBoss' revenue was higher than the traditional Red Hat services percentage, and so the addition of JBoss in Q2 did increase that number. In Q3, we put a great effort on increasing the resources available to offer training to our customers and also consulting. So, you can see a couple of things. There was a nice acceleration in services revenue in the quarter. In fact, a larger growth than we have seen in quite a long time in services revenue in percentage terms. And you can also see on the cost of services revenue that that grew quite a bit. In fact, the gross margin went down a little bit there, and the reason is because we staffed up ahead of the business. But we see a good opportunity for both JBoss training and the traditional Red Hat training and we will keep pushing that as we will in the consulting side.

Brent Williams - Hapoalim Securities

Great. Okay. Thank you.

Operator

The next question comes from the line of Chris Kwak with SIG.

Chris Kwak - SIG

Great. I would like to ask both questions upfront as well. Just on the accrued expenses, it looked like that was actually a significant cash inflow item this quarter. Was there something unusual there that actually helped boost the cash flow number? And then secondly, Charlie, it sounds like the JBoss billings contribution, which you're not talking about, but would it be safe to assume that because you had a carryover from deferred revenue from the last -- in the last quarter, that is in Q2, that it was likely to be less of a contributor at this quarter, that is JBoss to the overall business?

Charlie Peters

Well, I will answer your second question first. I think that would not be I think a correct assumption. Revenue has grown. It really has nothing to do with carryover deferred revenue. When we acquired them, there was some deferred revenue as we discussed in the second quarter call. And that -- the deferred revenue that came with it at the time is there and amortizes over a period of time. But the revenue, in fact, did grow as we expected.

The second part of your question on the accrued expenses and the contributions to cash flow, I think a better way of looking at that is the total working capital impact for the quarter. And what you can see is that receivables grew substantially because of nice billings, almost a $10.5 million increase in receivables, which is a consumption of cash; accruals, which includes both some tax accruals and some interest accruals on a debenture, as well as the normal increase in accruals primarily on employee-related and accounts payable, the net of all that is only $3 million working capital change.

Chris Kwak - SIG

You wouldn’t expect something like that again from the accrued expenses just specifically that line for the next quarter?

Charlie Peters

I would think probably not. So keep in mind that the interest and the debenture is paid semiannually. So by the time we get to the end of February, I think that number goes back down to zero, the accrued interest. We also have accrued vacation in that number, and we typically see a lot of use of employee vacation time around this time between now and the New Year. So, some of the employee accruals go down as well.

Chris Kwak - SIG

Right. Just so I'm clear on the JBoss issue, you're saying that the revenue contribution obviously went up, but you're not saying that there was deferred revenue generated in the quarter somehow outpaced the deferred revenue contribution from the carryover from the acquisition last quarter? You're not making a comment on that?

Charlie Peters

To be clear, deferred revenue from JBoss grew in the quarter nicely.

Chris Kwak - SIG

In excess of the amount that you brought over? I'm trying to get a sense for the billings here.

Charlie Peters

That is correct.

Chris Kwak - SIG

Okay. Great. Thank you.

Operator

Your next question comes from the line of Kirk Materne with Banc of America.

Kirk Materne - Banc of America

Yeah. Thanks very much. Charlie, just two quick questions. First just, the first one is on linearity. Given the Oracle announcements, we are two-thirds of the way through the quarter. Can you just talk on linearity maybe this quarter versus last quarter? And then secondly, you all mentioned a number of large seven-figure deals this quarter. What was -- I guess can you give us an idea either quantitatively or qualitatively how many of those JBoss may have been involved in? Thanks.

Charlie Peters

Okay. Sure. On the linearity, as we've had said before, linearity typically is going to be something like up by month, 25%, 25%, 50%, occasionally it is 20%, 20%, 60%. And I would say, this quarter the linearity was more, it was similar to the second quarter, but it was more 20, 20, 60. So kind of a back-end loaded quarter. On the question about JBoss and whether or not there any seven-figure deals in JBoss this quarter, they had -- they were close.

Kirk Materne - Banc of America

Actually just to clarify, of the seven-figure deals you had, I guess how many of those deals was JBoss a part of, maybe not the full driver of the seven-figure allotment. But were they involved in a number of your bigger deals this quarter? I guess is what I am trying to get at?

Matthew Szulik

Yeah. They were involved in two-thirds of them.

Kirk Materne - Banc of America

Great. Thanks very much.

Operator

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

Heather Bellini - UBS

Hi, good evening. I was -- two questions actually. I was wondering, Charlie, given you had just such a strong cash flow quarter and what you have just recently reported, why not increase your full-year range seeing there is only one quarter left? It seems to me that that is what you did this time last year. And also could you comment a little bit Matthew on virtualization with RHEL 5 and how you expect your pricing to change as that comes out? Thank you.

Charlie Peters

Well, the first part about the cash flow, we have talked about this before, but predicting quarterly cash flow can be difficult, and so we have avoided quarterly cash flow estimates. So for me to change the estimate for the full year, it would obviously change my estimate or give you a specific estimate for Q4. I guess all I would say is that because of the strong Q3 and what we think is a pretty good outlook for Q4 that we have high confidence in the prior estimate. But I really don't want to get into trying to forecast quarterly cash flow. It is very difficult.

Matthew Szulik

Regarding pricing, I literally two hours ago was in a RHEL 5 pricing meeting, and we're not in a position to comment publicly on that.

Heather Bellini - UBS

Okay. When should we expect more details on that deal with RHEL 5?

Matthew Szulik

In terms of the pricing of RHEL 5, Heather?

Heather Bellini - UBS

Well, just more information about when it's launching and pricing and more on the feature set.

Matthew Szulik

If you download the Fedora Core 6 over the weekend, you will see RHEL 5 in an uncertified and non-tested environment. I think you will have a great experience with it if you would be willing to do that. So, the feature set is all there. In terms of more public exposure, you should expect that happening around the end of January timeframe.

Heather Bellini - UBS

Okay. Great. Thanks you.

Operator

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

Tim Klasell - Thomas Weisel Partners

Just a quick question on the 24 of the top 25 deals that closed in the quarter, last time when somebody did not renew, you sort of gave the circumstances around that. Could you provide that now? And then one follow-up.

Matthew Szulik

What circumstances would you like. Tim?

Tim Klasell - Thomas Weisel Partners

Why didn't the customer renew?

Matthew Szulik

It became a competitor during the quarter.

Tim Klasell - Thomas Weisel Partners

Okay. Good enough. And then the second one is the pricing uplift on those remaining 24, you sometimes have given us a number of how that has moved. Can you give us an idea of how that happened this quarter?

Charlie Peters

Yes. On the renewals this quarter the uplift was 103% of what it was last year.

Tim Klasell - Thomas Weisel Partners

Okay. That is a little bit less. Are you seeing any competition in those large deals, or was that a non-issue there?

Charlie Peters

The numbers have ranged from 100% up to about as much as 114, 115% from quarter to quarter. There was a lot of competitive noise as we have talked about. But, as I said, the renewal amount depends on what they are doing with the product and how each individual customer has expanded or not expanded in their business. So it is more than just pricing.

Tim Klasell - Thomas Weisel Partners

Okay. Good enough. Thanks

Operator

Your next question comes from the line of Denny Fish with JMP Securities.

Denny Fish - JMP Securities

Two quick questions. First, I will just ask them both upfront. First, since Oracle's announcement, have you made any structural changes to the way that Red Hat source code is distributed publicly, number one? And then number two, any update on the Hibernate lawsuit? Thank you.

Matthew Szulik

No, structural changes, Denny. And secondly, regarding the Hibernate, it's still going through examination and discussion and no events to publicly disclose.

Denny Fish - JMP Securities

Okay. Thank you.

Operator

Your next question comes from the line of Brad Reback with CIBC World Markets.

Brad Reback - CIBC World Markets

Great. Just a couple of quick questions here. Matthew, maybe you could address how much faster you think Red Hat can grow than the overall market here is going forward as you take share? And number two, real quickly obviously Novell and Microsoft had a couple of announcements yesterday about financial institutions. Were you involved in any of those deals on a competitive basis? Thanks.

Matthew Szulik

Thanks. I would not be so bold to forecast how fast we can outgrow the current market. As I said in my remarks, I have been very pleased in my travels around the world in the last 90 days to see broadening adoption from even some of the most conservative customers. This past week and a half when we launched on the New York Stock Exchange, I was really pleased to see the very customers that I spoke to in 1999 that told me they would never deploy Linux where there to support our launch and these are some very demanding Wall Street customers. So, I think once again that our focus on value and our focus on to continuing to take cost out of the enterprise through innovation and better support services, I think that we can continue to scale and grow the business globally. I highlight that in markets like South America, Latin America, Russia, the developing nation China. We are just beginning to really get deeper into some very strategic accounts that is giving us good knowledge to build upon and go forward. So, I wouldn’t want to be so bold as to comment on that. I think virtualization will open up a whole new frontier, and we're excited about that opportunity. The second question was, if you will just repeat that for me please?

Brad Reback - CIBC World Markets

Sure. Novell and Microsoft yesterday had a joint announcement about some wins at some various European financial institutions. Were you guys involved there at all?

Matthew Szulik

Those were existing accounts, and at least there was at least one of them that I can speak definitely that is out to a Red Hat account. So we would -- those were older engagements and we were not involved in competitive situations with those two to three years ago when they became Novell accounts.

Brad Reback - CIBC World Markets

So, if one was a Red Hat account, as it stood, is there any reason why you did not have an opportunity to take some share there as opposed to have Novell re-up?

Matthew Szulik

I don't think that they have opened it up for competition at this time.

Brad Reback - CIBC World Markets

Great. Thank you very much.

Operator

Your next question comes from the line of Brendan Barnicle with Pacific Crest.

Brendan Barnicle - Pacific Crest

Thanks. I just wanted to ask a follow-up question on virtualization. There has been some concern with virtualization and fewer units of service sold that that may mean fewer software OSs sold. What is your view on what virtualization is going to do to demand for operating systems?

Charlie Peters

Well, I think it is going to increase demand for operating systems. I think it is going to create increased demand for Linux operating systems. I think it is going to increase demand for the management tools and the management services and advanced open files systems. And I think it is going to be a tremendous boom for the customer. It is not without its risks. Virtualization has become the new honeymoon topic of the industry. I think customers certainly will be cautious in their deployment, but I believe the leadership that we have within our engineering organization, and I think the fantastic work that our marketing organization has done to understand the customer requirement, I think puts us in a good position to deliver that in a responsible way to the customer.

Brendan Barnicle - Pacific Crest

And what do you think the timing is on when we will finally get some kind of resolution around that?

Matthew Szulik

Around virtualization?

Brendan Barnicle - Pacific Crest

Around the impact virtualization will have on to the OS sales?

Matthew Szulik

I think the next five to seven years.

Brendan Barnicle - Pacific Crest

Thank you.

Operator

Your next question comes from the line of Terry Tillman with SunTrust Robinson-Humphrey.

Terry Tillman - SunTrust Robinson-Humphrey

Yeah. Thanks guys. First question just relates to hardware OEM performance. Could you maybe update us on how the hardware OEMs performed in the quarter at least qualitatively? And then as it relates to that, how are those relationships evolving post hardware vendors very public pronouncements around Oracle's initiatives? That would be the first question.

Matthew Szulik

Well, I think that our relationships with the OEMs continue to be very good, and we have relationships with multiple hardware OEMs. It is not totally unusual if they have relationships with multiple software providers. But they are going to sell what the customer demands at the end of the day.

Dion Cornett

Terry, we saw a pretty good productivity based on all three of the major American partners. We saw good positive up-tick from one of the West Coast hardware manufacturers, especially around blade in memory databases. We saw that as positive activity. And in Japan, Fujitsu did a good job within the quarter for us as well. So, although we read the same press that you read, they were on track.

Terry Tillman - SunTrust Robinson-Humphrey

Thanks, Matthew. And then the follow-up question, Charlie, just relates to you talked about a lot of the heavy lifting being done. Still some more left on the integration of JBoss, but can you update us on where you are at in cost synergies? Have you worked through a lot of that, or are there still some cost synergies that can be reaped? Thanks.

Charlie Peters

I would not anticipate any additional significant cost synergies. It is really kind of the end for us. We're in investment mode with JBoss. We will be adding personnel to some of the existing projects. We will be adding additional support people around the globe, adding additional trainers around the globe. We keep investing and training of our existing sales people. So, I think it is still a business that needs investment, and it is our intention to keep investing there. I would not expect additional cost reductions or cost synergies there.

Operator

Your next question comes from the line of James Gilman with Cross Research.

James Gilman - Cross Research

Good day, gentlemen. A couple of follow-up questions. In reference to the hiring and JBoss personnel, per your site you have I think 60 postings. Is that for backfill and/or organic? And then the next question would be in reference to virtualization and pricing. I believe you charge per box. Will you be charging for OS, or how would that be going forward? Thank you.

Charlie Peters

On the first question about the JBoss postings, we are looking for people with those types of skills on a global basis and I suspect what you're looking at could be just a US posting because we are looking for people in EMEA. We just launched JBoss Japan last week. It was a very successful launch. Almost 120 customers attended the launch. So, we need trainers there. We need support people there. I would say it is organic growth. And then the second part of the question?

Matthew Szulik

Hey, James, I think we have talked about that earlier. I just left a RHEL 5 pricing meeting. We did not publicly disclosed the pricing for that yet.

James Gilman - Cross Research

Okay. Thank you.

Charlie Peters

This is Charlie. Let me just get back to earlier question and get it out in public. Our OEM revenue was up 25% sequentially.

Operator

At this time there are no questions.

Dion Cornett

Well, we thank everyone for their participation today and look forward to talking to you in coming days. Thank you again.

Operator

This concludes today's conference. You may now disconnect.

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Source: Red Hat F3Q07 (Qtr End 11/30/06) Earnings Call Transcript
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