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Red Hat (NYSE:RHT)

Q2 2012 Earnings Call

September 21, 2011 5:00 pm ET

Executives

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

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

Tom McCallum - Investor Relations

Analysts

Gregg Moskowitz - Cowen and Company, LLC, Research Division

Reid Menge - UBS Investment Bank, Research Division

Nabil Elsheshai - Pacific Crest Securities, Inc., Research Division

Keith Weiss - Morgan Stanley, Research Division

Mark R. Murphy - Piper Jaffray Companies, Research Division

Tim Klasell - Stifel, Nicolaus & Co., Inc., Research Division

Steven M. Ashley - Robert W. Baird & Co. Incorporated, Research Division

Kash G. Rangan - BofA Merrill Lynch, Research Division

Edward Maguire - Credit Agricole Securities (NYSE:USA) Inc., Research Division

Heather Bellini - Goldman Sachs Group Inc., Research Division

John S. DiFucci - JP Morgan Chase & Co, Research Division

Brad Reback - Oppenheimer & Co. Inc., Research Division

Michael Turits - Raymond James & Associates, Inc., Research Division

S. Kirk Materne - Evercore Partners Inc., Research Division

Walter H. Pritchard - Citigroup Inc, Research Division

Operator

Good afternoon. My name is David and I will be your conference operator today. At this time, I would like to welcome everyone to Red Hat's Q2 Earnings Call Fiscal 2012. [Operator Instructions] I would now like to turn the call over to Mr. Tom McCallum, Vice President of Investor Relations. Sir, you may begin your conference.

Tom McCallum

Hi, everyone, and welcome to Red Hat's Earnings Call for the second quarter of fiscal 2012. Speakers for today's call will be Jim Whitehurst, President and CEO; and Charlie Peters, Executive Vice President, CFO. Our press release was issued after the market closed today and may be downloaded from redhat.com on the Investor Relations page. Also, on this page, you'll be able to find a historic reconciliation schedule of GAAP to non-GAAP financial metric 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 harbors provision under the Private Securities Litigation Reform Act of 1995. Actual results may differ materially from those indicated by these forward-looking statements as a result of various important factors, including those discussed in the company's most recent annual report on Form 10-Q filed with the SEC as well as the safe harbor statement in today's press release. In addition, any forward-looking statements represent our estimates or views only as of today, September 21, 2011, and these estimates and 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 at any day subsequent to today.

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

James M. Whitehurst

Thank you, Tom, and let me add my welcome to all of you joining us on today's call. Red Hat Associates around the globe executed extremely well and delivered outstanding results. While the macroeconomic environment remained volatile, we continue to experience broad demand for our open source solutions in every major geography during the second quarter. We drove significant upselling within our top deals and we added a number of large wins from customers who migrated away from proprietary products and other Linux distributions. Customers are increasingly turning to Red Hat as they look to modernize their data center infrastructure and fundamentally change the way they deliver IT services.

Let me review some of the highlights for our second quarter, which combined with strong demand heading into the second half of this year, provides us with confidence to again raise our full year growth outlook, as Charlie will explain later.

First, sales execution was once again strong in Q2 and we delivered accelerating year-over-year organic revenue growth for the fourth consecutive quarter. Our 27% revenue growth to the first half of this year had significantly outpaced last year's 20% first half growth, given our investments in sales and marketing and R&D are clearly paying off.

Second, even with this focused investment for growth, we continue to deliver leverage, which enabled our operating income to significantly outpace revenue. Our operating income is up 41% in Q2 and up 35% in the first half of this year.

Third, we continue to drive strong cash flow growth with operating cash flow up 20% for the quarter and 34% for the first half of the year. I'm also pleased to report that all of our top 25 deals that were up for renewal in the second quarter, not only renewed, but they did sell at a total value of over 150% of the original value. This was our strongest upsell percentage since we started tracking this metric, which is usually in the 120% to 130% range. Customers across a variety of segments and geographies contributed to this record.

The value and innovation that customers receive from a Red Hat subscription is a key demand driver for us in both good times and in challenging ones. For instance, this quarter, one of our largest renewals and upsell came from a technology firm that has been a staunch proponent of UNIX for several decades. Given the value, performance and capabilities of RHEL, they have now -- have a substantial deployment in their internal infrastructure.

From a demand perspective, it is clear from our results that there's a fundamental shift happening in the way IT is being delivered. Recently, the former U.S. CIO, Vivek Kundra, wrote an article that demonstrates this need for change. His article spells out the issues government agencies face when purchasing, deploying and maintaining inefficient software and hardware. To combat these issues, government agencies are now shifting away from the older model of customized, deeply integrated IT purchases, which often came with heavy maintenance fees and the need for specialized IT staff and expensive customization. Rather, they choose a new model that relies on modularity, reuse, flexibility and the interoperability of systems that they control and are not locked into.

Open source is in the sweet spot and the U.S. government's IT reform effort and cloud-first policy are examples [indiscernible]. Open source and Red Hat can enable that change. It is not just the U.S. government that's embracing open source solutions. We're seeing governments around the world choosing open source to solve the issues associated with traditional IT deployments. Our research indicates that more than 40 countries have adopted policies that promote a fair playing field for open source or emphasize technology neutrality for open source when compared to proprietary software, notably in the U.K., India, Brazil and Australia. This type of validation enables Red Hat to win and strengthen relationships with a government stamp of approval.

The issues in Kundra's article are not isolated to governments but are very similar to discussions I've had with enterprise customers around the world. This change in IT decision-making is also bolstered by the increasingly younger generation of IT leaders who are not leaded to the old model of enterprise software purchases. These customers want to partner with Red Hat to reduce costs while modernizing their IT infrastructure to enable applications to run on bare metal, virtualized and in the cloud.

Now let me provide an update on some of our virtualization and cloud computing highlights and initiatives. This quarter, Telstra, Australia's leading telecommunications and information services company, joined our expanding ecosystem of cloud computing providers who have partnered with Red Hat to provide a choice for enterprise customers in the cloud. Telstra has joined our Red Hat certified cloud provider program that provides a reliable, scalable, supported and consistent environment for enterprise cloud deployments.

In Q2, we announced the next generation of Red Hat's virtualization management product, RHEV 3 in Beta. RHEV 3 adds new features and important capabilities focused on performance, memory and scalability for managing virtual guests. RHEV 3 now runs as a Java application on our JBoss Middleware and on our RHEL platform with an updated KVM hypervisor. We've also built a partner ecosystem with top ISPs to provide an excellent solutions for customers who are seeking choice, interoperability and integrated management solutions. We expect to release the GA version of RHEV 3 later this year. We also announced that OpenShift, our platform-as-a-service offering, now supports Java EE 6. OpenShift was the first pad in the industry to deliver JEE 6, simplifying how developers build and deploy applications in the cloud.

At Red Hat Summit, we jointly announced the creation of the Open Virtualization Alliance or OVA with a number of industry partners. The consortium is committed to fostering the adoption of open source virtualization technologies, primarily the KVM hypervisor, in driving industrywide adoption. The OVA membership has now grown to over 200 technology companies, including some of the largest technology companies in the world. This broad membership of technology leaders to cloud startups is backing KVM as an enterprise class hypervisor for both on-premise and cloud deployments. We are pleased with the solid progress on these important initiatives as we continue to build out our cloud offerings and ecosystems.

On a final note, last month, Linux celebrated its 20th anniversary, and I want to recognize the contribution of Linus Torvalds, Richard Stallman and the other early trailblazers of open source. Without open source and the collaborative development model, many of the key technologies that make our lives more productive and interesting would not exist. This year, Red Hat will be the first open source company to surpass $1 billion in revenue. With cloud computing still in its early stages and new disruptive shifts in data center architecture, we believe that the open source movement and Red Hat are well-positioned for future growth.

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

Charles E. Peters

Thank you, Jim. We have a number of financial highlights in what was overall a very strong quarter. On a year-over-year basis, we experienced billings growth of 30%, our highest Q2 billings growth rate in 6 years. At that time, Red Hat was 1/4 of its current size; revenue growth of 28%, non-GAAP operating income growth of 41%, non-GAAP earnings per share growth of 53%, total deferred revenue growth of 25% and operating cash flow growth of 20% for the quarter and 34% year-to-date.

As Jim mentioned earlier, we remain well-positioned to capitalize on the modernization of enterprise data centers. Our strong and accelerating growth, particularly when compared to our competitors, shows a market share shift to Red Hat. Our top 30 deal metrics provide further evidence of Red Hat's market share gains where we saw significant increases from existing customers and new wins. The top 30 deals set a Q2 record for deals over $1 million. For only the second time in our history, all the top deals in the quarter exceeded $1 million and 3 exceeded $5 million.

Approximately 40% of the top 30 deals include a Middleware component with 2 being stand-alone Middleware deals. The 2 largest industry verticals represented within the top 30 deals were financial services and local, state and federal governments from around the world. While investors have been concerned about IT spending in these sectors, the strength of our value proposition is further reinforced by the fact that these 2 sectors were important contributors to our accelerated and better-than-expected growth. It's probably not surprising since both of these verticals are actively trying to reduce costs and we help them do that.

Now let's turn to our financial performance. Bookings from the channel generated 57% of our Q2 volume and 43% came from direct sales versus a 63%-37% split in Q1, directed up somewhat from last quarter because a couple of the largest deals were closed by the direct sales team. In terms of geography, 58% of bookings came from the Americas, 25% from EMEA and 17% from Asia Pacific with 20-plus percent growth across all geographies.

Our billings proxy for the quarter was $304 million, up 30% year-over-year, reflecting strong market demand, market share gains and a slight lengthening of average contract duration to greater than 21 months. Our billings proxy is calculated by adding revenue plus the change in deferred revenue on the cash flow statement, which eliminates most foreign exchange impact.

Now let's shift to the income statement. Second quarter revenue was $281 million, an increase of 28% year-over-year and 6% sequentially, also well above our guidance. For the first time, on a trailing 12-month basis, our billings and revenue each exceeded $1 billion. Revenue growth was driven by both subscription revenue and service revenue. Subscription revenue was up 28% year-over-year and 6% sequentially to $238 million. Subscription revenue, which is renewable, constitute 85% of total revenue. The training and services component of revenue was $43 million, up 28% from last year and up 10% sequentially. We continued to see good demand for services, which generally leads to additional future subscriptions. On a non-GAAP basis, excluding stock compensation and amortization expense, overall gross margin was 85% for Q2. Subscription gross margin was 94% and training and services gross margin was 33%, in line with the second quarter of a year ago.

Moving on to non-GAAP operating expenses. We continued to increase investments in the business, principally in sales, marketing and engineering, leading to Q2 non-GAAP operating expense of $161 million, up 2% sequentially and 22% year-over-year. At the same time, the operating leverage continues to improve. Q2 non-GAAP operating income was $76 million, producing an operating margin of 27%, up 210 basis points sequentially and 250 basis points year-over-year and better than our guidance. Net interest and other income of $2.5 million is in line with guidance on Q2 of last year. Non-GAAP diluted earnings per share came to $0.29, which is $0.04 higher than our guidance, up 53% compared to last year. Our estimated annual effective tax rate before discrete items is 31% for both GAAP and non-GAAP results. In Q2, there was a discrete tax benefit of $2 million, which contributed $0.01 to our earnings per share. Excluding the discrete tax benefit, the non-GAAP earnings per share would've been $0.28 a share.

Looking at the foreign exchange impact to our income statement. The average euro and yen rates for the second quarter were in line with the foreign exchange rates we use for guidance and very close to the first quarter rates for that matter. However, if the second quarter had then the same foreign exchange rates as Q2 last year, revenue would've been $13 million lower and expenses $9 million lower than we reported, which would have resulted in about $4 million lower operating income.

Now let's turn to the balance sheet and the cash flow statement. We ended the quarter with cash investments of $1.3 billion. In the second quarter, we used cash to repurchase approximately 890,000 shares of common stock for $38 million. The remaining balance of our stock repurchase authorization is now $163 million. Operating cash flow of $77 million was up 20% from Q2 of last year. Strong sales execution, good linearity in the quarter and strong collections contributed to the strong cash flow performance. Foreign exchange adjusted DSOs continued to be in good shape of 53 days, consistent with last quarter and compared to 49 days from the year ago quarter. As a reminder, since days sales outstanding is traditionally a measure of receivables compared to billings, our DSO is calculated using our billings proxy.

Total deferred revenue at quarter end was $813 million, an increase of $163 million or 25% over the same quarter a year ago. Current deferred revenue grew 24% in U.S. dollar terms, while long-term deferred revenue grew 27% from 1 year ago. Sequentially, deferred revenue increased approximately $27 million from last quarter.

Let me break down the components of deferred revenue for you. Short-term deferred revenue, which ended Q1 at $584 million, had real growth in Q2 of $14 million and increased an additional $3 million as a result of changes in foreign exchange spot rates, ending Q2 at $601 million. Long-term deferred revenue, which ended Q1 at $202 million, had a real increase in Q2 of approximately $9 million and benefited by changes in foreign exchange spot rates by $1 million, ending Q2 at $212 million. The total increase in deferred revenue without the impact of currency changes was $23 million and can be found on our statement of cash flows.

Now I'd like to turn to guidance. Since I do not forecast foreign exchange rates, for purposes of guidance, I simply put a stake in the ground and assume that foreign exchange rates for Q3 and Q4 will be where they were yesterday, that is the euro about $1.36 and the yen about JPY 77 to the dollar. That means the assumed euro rate is about 5% weaker than the Q2 average rate, while the yen rate is about 1% stronger.

From a fundamental perspective, we are mindful of the global economic turmoil and that stock market volatility remains high. Despite these conditions, we are significantly raising our full year guidance based on our strong first-half results, combined with the ongoing momentum of our global sales pipeline. We have demonstrated in the past that we can see -- succeed in up and down markets because of the value we deliver to customers and the cost savings we help them achieve. We are raising our full year revenue guidance by about $45 million to a range of $1.12 billion to $1.13 billion and our non-GAAP EPS range to $1.03 to $1.05 a share.

From a dollar perspective, operating income is cruelly expected to exceed our original estimates based upon the significant increase on revenue projected. While there is potential to exceed our original full year non-GAAP operating margin target of approximately 25.7%, we are sticking to that target at this time as it continues to be our intention to invest for growth. As you know, from the past, we do not typically adjust our cash flow guidance into a year. However, based upon the strong performance in the first half of fiscal year and our current outlook, we are raising our operating cash flow estimate for the fiscal year by $20 million to a range of $350 million to $360 million. Keep in mind that we will also produce approximately $35 million of additional cash from excess tax benefits from stock compensation deductions, which is included in cash flow from financing activities. For Q3, revenue is estimated to be approximately $288 million to $290 million, operating margin is estimated to be in the 25% area and non-GAAP EPS is estimated to be approximately $0.25 to $0.26 a share, assuming a 31% tax rate.

In summary, our associates and partners continue to execute well in delivering value and innovation for customers. This is a primary contributor to our market share gains and exceptional financial results.

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

Question-and-Answer Session

Operator

[Operator Instructions] Your first question comes from the line of John DiFucci of JPMorgan.

John S. DiFucci - JP Morgan Chase & Co, Research Division

Just a quick question. Charlie, you've mentioned that the contract period was up a little bit to a little over 21 months. If you could just, I guess, first remind us what the period has, and I think it's been like 18 to 21. And has the billing period changed much over the last few quarters? And 2 out of the last 3 quarters, we saw sort of a little bit of a pop in long-term deferred revenue and I was curious if -- not only the contract period, but the average billing period, if that's changed much.

Charles E. Peters

The average contract duration for the last 6 quarters or so has been in the 20- to 21-month range. In the first quarter, we're at about 20 months, and for roughly 5 quarters before that, it was about 21 months. So it's come back this quarter to a little bit closer to where it has been in at least the 4 quarters prior to Q1 of this year. This is the average contract duration. In terms of the billing duration, it typically follows fairly close to the contract duration. Just a reminder, when we do long-term deals through partners, they typically build the entire thing in advance. And when we do deals direct, sometimes they're billed in advance and they're sometimes billed over a longer period. But the change in long-term deferred revenue, you can see for the quarter, we added $9 million in real increase and $1 million in foreign exchange. It's fairly consistent with what we saw from the bookings change and duration.

Operator

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

Kash G. Rangan - BofA Merrill Lynch, Research Division

I was really reserved to get a little bit more color on what seems to be pretty impressive, 150% original value being renewed. Can you talk about what exactly is driving that? I think perhaps some of that could be due to the RHEL 6 levers. I think you had some pricing enhancement. We also had the free-to-fee leverage as you embark on this transition. I'm just wondering if you could talk to how sustainable this pick up in same-store sales could be as you embark on the RHEL 6 cycle going forward. If I could indulge you on a growth versus margin expansion question, a lot of SaaS companies going through extra record revenue growth would seem to be willing to sacrifice their margins in return for higher revenue growth. How do you look at that trade-off as you have these opportunities being presented to you? That's it for me.

Charles E. Peters

Kash, I'll take the first part, which is of the top deals, the fact that we had more than 150% upsell this quarter, Jim commented, is a little bit out of the norm for us. We typically have been in the 120%, 130%, but what I saw in the deals this quarter, much larger deals, as you saw, that all of them in the top 30 were over $1 million, much greater amount of cross-selling. 40% of those deals had a JBoss component, so they're buying multiple products. And there's a significant expansion even within the existing products today that they have. And you asked a little bit about the pricing change, RHEL pricing change. Really, at this point, it still does not have much impact on these numbers. It's almost all volume related, so really good cross-selling and strong demand. Many of the large accounts continued to deploy significantly in excess of the original contracted amounts, which then result in, which in true ups in growth for those customers. The second part of the question about the growth versus margin expansion, I have my views opportunity consistent with Jim, but I'll let Jim talk about that.

James M. Whitehurst

Well, let me -- first off on the -- just one more thing to note is, as we built our portfolio, our sales force has more products in their bag to sell. And we often see customers in a number of these deals, as Charlie said, have a Middleware component. What's happening is companies start with RHEL, sees its value and start adding additional products. Some of that's virtualization. A lot of that's Middleware as well. And as we've added additional Middleware products, that certainly allowed those accounts to continue to grow. So we were seeing absolute volumes of core Linux growing, but a lot of it is -- a lot of these big accounts are expanding the breadth of the products that they're buying from us. In terms of the margin versus growth, certainly, we're focused on growth. At the same time, we continue to be comfortable that we can, especially as we continue to accelerate our growth rate, we can continue to invest heavily in the business and still return reasonable margins. So obviously, it depends on the opportunities in front of us. I think as you can see the mix in our line items, we've been able to deliver margin improvement by reducing G&A and actually as a percentage of revenue and actually maintaining or often increasing sales and marketing and R&D as a percent of revenue over the last couple of years. So we'll continue to make those trade-offs going forward. But obviously, the best of both worlds is take it out of the back office and drop it to the bottom line and reinvest. And I think we've been very effective in doing that.

Charles E. Peters

And just to finish the last bit of that that we did not raise the operating margin guidance, so we're basically saying, "Although it's certainly possible that we could, the intention is to continue investing for growth from a margin perspective."

Operator

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

Mark R. Murphy - Piper Jaffray Companies, Research Division

I wanted to ask a question about the composition of the deal pipeline. You've had this huge number of companies sign up for the Open Virtualization Alliance. There's been a lot of positive buzz on the upcoming RHEV 3.0 in the community, and I think you've had our competitors suffer from some pushback on some licensing changes. So just wondering, when you look at the pipeline, do you see an appreciable increase in the RHEV mix that would indicating that it's potentially building toward some type of an inflection point in the future?

James M. Whitehurst

Well, I will say, if I look in the pipeline and kind of set a number to deals, it has a very immaterial impact on the pipeline because RHEV 3.0 is still in Beta. What I will say is, we have an exploding number of POCs. In fact, one of the biggest pushbacks I'm getting from our sales force now is getting enough resources to do POCs on RHEV 3.0. Sensible GA until towards end of year were subtle, a ways away before we'll see that turn into revenue. So actual numbers in sales force that we see in the pipeline, yet a little far out from that. But what I'd say is, anecdotally, we're just seeing a massive number of requests for POCs as people got a chance to see RHEV 3. As you said, there are some large customers who are upset with that other virtualization player. There are pricing changes. There are a number of Linux shops who really want a Linux-based management tool. So whole bunch of different reasons, but certainly with RHEV 3.0, we're seeing significant pick up in traction on the commercial side.

Operator

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

Keith Weiss - Morgan Stanley, Research Division

Actually, Keith Weiss calling in for Adam Holt. I was hoping maybe you could go into some of the sort of the initial reaction that you guys have received, some of the new cloud initiatives that you guys really wanted to detail with in your recent user conference, OpenShift and in CloudForms. Maybe some of the feedback on how on track do you guys think you are with those initiatives. How well have you hit the target? And what's your current thinking on sort of how those are going to ramp on a go-forward basis?

James M. Whitehurst

Well, look, I will tell you what we hear and then I'll also be a little bit cynical. We're getting great feedback on the technologies, just the structure of OpenShift, the simplicity especially, I mean, just massive interest from the broader JBoss community with having AS 7 there, which is JEE 6. It's just been extraordinary. So we're hearing a lot of really, really, really good feedback. I would say, though, cloud shift is -- I'm sorry, OpenShift, it is much a R&D effort on business model as it is on the technology. And so obviously, because it is not for sale, I'll really believe all the kudos when people start writing these checks, right? So again, I think we have a great position. We got a lot of momentum. If it's a language that runs in a Java virtual machine, we have, by far, the best alternative out there. And we're having some great pick up in usage. But again, right now it's free, so we'll see how that goes. CloudForms, I think at least the customers that I have talked to and the feedback we've gotten has been positive in the sense of we're not trying to compete with, say, EC2 or other lower-level management platforms, right? So cloud forms will help manage it at slightly higher level and it's compatible with EC2, obviously RHEV and others. And so getting good feedback on continuing to push a truly layered modular architecture. But again, that's not out yet and I'll believe it when I see the real revenue numbers once it's out in GA.

Operator

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

Nabil Elsheshai - Pacific Crest Securities, Inc., Research Division

First, on the spending side, from a sequential increase perspective, the operating expenses went up far less than normal in the Q1 to Q2. So if you guys slow investing given the uncertainty and now are comfortable in releasing it. Or what's the reason for the lower sequential increase?

Charles E. Peters

Good question. Now, in fact, we hired more people in the quarter than we have in any quarter in our history. So we're still investing aggressively in sales and engineering. As Jim commented, if you look at the P&L, you'll see where it's coming from, and it's mostly reduction in G&A. Partly, that is reduction of professional fees and it's also the benefits of some of the systems enhancements we made a couple years ago. And on sequential basis, Jim is also pointing out Q1 we had expenses of the Red Hat Summit and obviously did not have that in Q2.

James M. Whitehurst

Historically, that has been in Q2. And so if you look at the relative years, that's a significant expense that moved from Q2 to Q1 relative those prior years.

Nabil Elsheshai - Pacific Crest Securities, Inc., Research Division

Okay. Fair enough. And then real quick on the RHEV side. Would it be fair to say that your initial focus on RHEV has been through the direct channel? And if so, at what point do you want to accelerate pushing it through your channel or through a larger ecosystem?

James M. Whitehurst

Yes. I think with, obviously, any brand new product, you have to go generate demand and you generate demand yourself. And so certainly, our focus has been on direct thus far. We have partner programs. We have a ton of partner interest, because obviously, virtualization pulls through a fair amount of professional services that our partners provide. So we've been primarily focused internally on our own direct sales force generating demand. Now especially with having so much of the industry stepping up behind KVM, with OVA, as we get 3.0 out the door and effectively erode that into 3.1, it will be much easier for us to enable our partners. We have a whole partner enabler program up and ready, is pulled up and we'll be rolling that out as well. So a lot of interest from partners in it because of the professional services component that goes along with virtualization. And so we've just been really getting the product out and generating initial demand.

Operator

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

Michael Turits - Raymond James & Associates, Inc., Research Division

A few questions. First, just wanted to get any more granularity on the questions asked earlier regarding the upsell. More specifically, what additional products led to that broadening? And then I have a follow-up question about UNIX migration.

Charles E. Peters

I think the clear volume leader is still RHEL. There's no doubt about it. The significant deployment of RHEL and expansion of RHEL is in those large accounts. And then the second largest one clearly is the JBoss commentary, where 40% of them added a JBoss component, some of them sizable, 2 of them, and of course all of them were over $1 million. So at least 2 of them were nothing but JBoss in over $1 million.

James M. Whitehurst

It's a standard adoption pattern that we see and so it's hard for me to comment specifically on the 25 deals and the renewal. But most of them work this way. You start off with EAP. So it's a classic application server. You get comfortable with that. And the other products, I think, we're seeing a lot of interest in now are SOA [ph] and BRMS. Our BRMS product, almost every customer I've talked to is very interested in that. So it's the product, it's -- from the feedback I'm getting from customers, it's just an excellent product. The only competitor or the strongest competitor out there is very, very high priced. And so since several of our larger deals starting to add more on the BRMS side as well. But I would still say, if you will get absolutely dollars EAP is just a huge vision.

Michael Turits - Raymond James & Associates, Inc., Research Division

And then my question on UNIX migration, actually called it out. I don't remember if you've done that before, but you called out, Jim, in your prepared remarks that that is a driver. I think migration off of UNIX. Obviously, that's always been the theme. But what's been the trend? Has there been, in the last one quarter, several quarters, an increase in the rate of UNIX migration? And also, is there any risk of that easing up? Oracle last night actually said that it was showing growth in its UNIX business. I think they are probably for the first time. So any risk that that slows then?

James M. Whitehurst

I think, obviously, we're in the take share gain and we certainly continue to take share from UNIX. We continue to take share from free Linux and other paid Linux's and we take share from Windows. I haven't noticed anything in particular any difference this quarter than in prior quarters. Yes, I do think there is a little bit of a pick up as economy gets a little tighter as people look to move to lower platforms maybe a little bit faster. But I don't think there's anything kind of out of the ordinary. It's a pretty consistent trend.

Operator

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

Steven M. Ashley - Robert W. Baird & Co. Incorporated, Research Division

On the JBoss, if you could give us some maybe commentary. The pace of bookings growth versus if we look at the overall company growing 30%, what can you tell us about the pace of growth of the JBoss business?

Charles E. Peters

Steve, the pace of growth is still faster than the base business. It's come off a smaller base but grew faster than the overall businesses.

Steven M. Ashley - Robert W. Baird & Co. Incorporated, Research Division

And just, we look at your business accelerating in the last 3 quarters. One thing that we just haven't talked about much is the ecosystem that supports you, the ISV ecosystem, the number of SKUs they have. Has there been any dynamic an increase in just ecosystem support here in recent times that has contributed to some of this growth?

Charles E. Peters

We have thousands of software applications and thousands of hardware devices that are certified as part of our ecosystem. That is a very significant selling point when we talk to our customers. The numbers are close to about 4,000 each I think, about 4,000 each. But ecosystem is a very important part of the value proposition to the customer.

James M. Whitehurst

And just 2 additional observations on that. We've always had thousands and thousands of ISV relationships of certified ISV vendors. It seems over the last year, and this is more anecdotal, but seeing how strategic we are becoming to some ISVs, I think ISVs are going from just certifying on RHEL to actually wanting to go to market and work together, if there's kind of this view among many ISVs that Windows and RHEL will be the 2 winning operating systems. And so I do think we're starting to get more commercial attention from ISVs and I think on the margin that helps. Secondly, we've actually worked to start build out a much broader, deeper, richer set of certifications around JBoss. And that was an investment we started making about 18 months ago, which I do think is paying off as we have much better both kind of attention and a set of certifications on the JBoss side from ISVs.

Operator

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

Heather Bellini - Goldman Sachs Group Inc., Research Division

I was just wondering, a little bit following up on one of the last questions, the 30% billings growth that you were able to do and that's an uptick slightly from last quarter. Just wondering, given the product momentum that you guys are talking about and looking out to the RHEL 6 adoption curve, how do we think about kind of what your target is, like a reasonable range for billings growth if you look out over the next few years?

Charles E. Peters

Heather, we don't project past this fiscal year, so I don't have anything to help you with that at this point. I think if you go back and try to look at our history, we have shown that the up-and-down markets that we have outperformed others in the market but...

Heather Bellini - Goldman Sachs Group Inc., Research Division

Well, I guess the other way to ask it then is, is it fair to say that given the product momentum that it sounds like you guys think you have, do you think that versus the prior few years that you're feeling more comfortable that that growth, without giving a level, that you like you feel comfortable it's accelerated versus -- your potential has accelerated versus what it was a few years ago?

Charles E. Peters

Well, we clearly feel through the end of our fourth quarter that it's accelerated, and we will provide guidance at the end of the fourth quarter relative to next year. We have just put up really solid numbers, increased our guidance significantly for the year. We've got a broadened portfolio. There's a lot of things that would indicate that we feel pretty good about our business right now.

Operator

The next question is from the line of Brent Thill of UBS.

Reid Menge - UBS Investment Bank, Research Division

This is Reid on for Brent. Just had a question on the -- given how sensitive your services businesses is to the macro conditions whether you're seeing any early signs in that business of a potential slowdown.

James M. Whitehurst

I put some screws to my head of services yesterday because I agree with you. Services is often the canary in the coal mine. He continues to be very bullish, and so we say the pipeline remains strong. Obviously, our check on that is the services pipeline continues to be strong. Obviously, we've had very solid growth there and we still feel comfortable saying, "Overall, including services, our pipeline is strong."

Operator

Your next question is from the line of Gregg Moskowitz of Cowen.

Gregg Moskowitz - Cowen and Company, LLC, Research Division

I was just wondering, Charlie, on the SMB front, what you're seeing broadly speaking as well as if there's any change in renewal rates with the rest of the customers this quarter versus where things were 3, 6 months ago?

Charles E. Peters

It's a good question. So we have talked before that we have done a number of things to continually improve our renewal rates. And I guess what I said pretty much every time is we see incremental improvement. We've never seen a step function change. But things, different activities like cleaning the data, different approaches with our sales force, employing third-parties to help with renewals over the long tail of the small customers, particularly in the SMB market, those things are producing results. From a dollar perspective, the results probably are still relatively small. But from a customer retention on the real small account, it's important because these small accounts will grow to be medium-sized accounts and large accounts in the years ahead. Like I said, the short answer is, we believe we'll continue to make incremental improvements in our renewal rates on the SMB end of the spectrum.

James M. Whitehurst

And just one note on that, as Charlie said, I would say it's incremental improvement, it's a little better every quarter. We're watching it carefully, especially on the small deals and how it makes up the base. Not only can those become larger customers, but the impact long term in our business is multiplicative. By renewing something this year that would not have renewed before, that's something next year we have that we can go renew, right? So you can imagine the multiplicative effect over the year or so. But based on our analysis, a few points change in the renewal rates in those small deals. Five years from now is a very material impact on revenue. So as Charlie said, yes, these are newer initiatives, they're going well, seeing steady improvement and feeling really good about it.

Operator

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

Edward Maguire - Credit Agricole Securities (USA) Inc., Research Division

Earlier this year, you had mentioned that you're focusing on hiring in a lot of new countries, some in emerging markets and would appreciate any update on how the progress in ramping up in some of these new geos is tracking versus your expectations.

Charles E. Peters

Good question. That continues to be the case. We talked about opening new sales offices within 4 countries this year. Chile is open. New Zealand is open. Denmark, we now have a number of employees and office in Russia. So those were these 4 new offices this year. All we've established entities in each location and begun operation. Probably, the broader picture just around the employment, we continue to hire globally. So I would say in the last 2 quarters, more than 50% of our hires probably were outside of the U.S. But it's very close, so maybe 48% U.S. and 52% outside the U.S. We hire sales resources wherever we need them globally. We hire engineering resources wherever we can find them globally.

James M. Whitehurst

And in general, we're seeing, especially in Asia, kind of where we were 5 years ago in the U.S., a lot of massive, really massive, UNIX installation. And CIO was asking the same question he asked here 5 years ago. Is this really safe? Can it really run mission-critical? And obviously, we know that playbook, so we're ramping up in those areas. But there's such a huge amount opportunity globally in a whole lot of markets where there's a lot of UNIX.

Operator

Your next question is from the line of Tim Klasell of Stifel, Nicolaus.

Tim Klasell - Stifel, Nicolaus & Co., Inc., Research Division

So you're going to keep operating margins where you guided them. So you're going to have extra money to invest into the business, like, I think you guys said in the prepared remarks. Can you sort of tell us where? Is it more distribution? Or is it in R&D? And if in R&D, in the Middleware side, in the virtualization side, in core RHEL? Can you give us an idea of where you're seeing the most opportunity?

James M. Whitehurst

I was seeing the details of the numbers, but in the discussions around the number of people, we're significantly increasing our hiring in a series of areas around what I'll call cloud and management around cloud. So that's around CloudForms, it's around OpenShift. It's around storage and network and all the components to make all of that work. So we have some fairly significant hiring targets in those areas. Those are not actually the easiest people to find. One of the reasons, I think, you saw less growth in that area is we're out recruiting. So if anybody on the call needs jobs and it's included in those areas, let us know. But in all seriousness, it's more on that side. Certainly, we're continuing to hire on RHEL in that. But RHEL is kind of the cash cow, where certainly we continue to invest in that. But it's what's just generating significant dollars for us to invest in the newer growth areas.

Edward Maguire - Credit Agricole Securities (USA) Inc., Research Division

Okay. And then a quick follow-up on that inorganic growth. You've got about $1 million on your balance sheet. Could you start to see putting some of that to work to help all of those initiatives? Or are there just not enough quality targets? And if not, why not buy -- get a little bit more aggressive in buying back shares?

Charles E. Peters

It's a good question and it's -- the answer is still the same. The first use of cash is in the organic growth of the business. The second use of cash is M&A. And we've done a couple, the last one being Makara not long ago, which really was a key contributor to the whole OpenShift development. I think -- and before that, quarter than that at a series of others, we continue to be interested in M&A. It's a matter of finding the right type of company that is an open source infrastructure software and is an appropriate target. So I think you can expect more from us in over time. And the last thing is share buyback. We haven't consistently been active in our buying back around shares. We bought back $38 million worth this quarter and have bought back shares in most quarters. And we still have, I think, there was $168 million left authorized to go.

Operator

Your next question is from the line of Walter Pritchard of Citi.

Walter H. Pritchard - Citigroup Inc, Research Division

You guys talked about strengths in the RHEL businesses first and foremost in terms of driving the performance. And I'm wondering, you did say that pricing around RHEL 6 didn't really drive anything. I'm wondering, Bill, what you're seeing in some of those contracts that are top 30 or large ones that may have renewed with new RHEL 6 pricing and what sort of average type uplift do you see in there?

Charles E. Peters

So just first of all, just to clarify, the RHEL pricing change that came about, was first introduced last November, is about -- is around all RHEL, it's not just RHEL 6. It has to do with a number of stock appears in the computers that the customers have. 70% of our installed base has a sort of the basic machines with 2 sockets. And as a result, for that group, there is no change when they renew. No pricing change when they renew. For those that have the larger machines, there are definitely some pricing changes. I guess what we've said thus far is of the various factors that influence the growth and so far in this fiscal year, pricing has a small incremental impact. But the big impact is simply volume, lots more volume.

Walter H. Pritchard - Citigroup Inc, Research Division

Got it. And then, Jim -- just a question for Jim on acquisitions, I guess, we have seen a lot of sort of changes around the data models and the way data's stored, and there's a number of open source initiatives and otherwise in that area. And you said traditionally, database -- traditional database is not an area you're interested. I'm wondering if just the shifts around data have caused you to rethink getting into the database-like business, not necessarily a traditional RDBMS?

James M. Whitehurst

Well, look, I think that most of the big data innovation going on is happening in open source. I think that as enterprises look to adopt this, they're going to look for a trusted partner to do that with. And third, I think all of the tools that they're going to ultimately sell on top of some of these paradigms are going to once have a standard reference architecture. Obviously, all of that are things that we think that we are good at and know how to do. The issue for us is finding the right people who want to join Red Hat and will stay with Red Hat. Because when you buy open source, you're not buying intellectual property. So those are certainly areas that we have looked at and are looking at and would be interested in because we think that we can be the right enterprise partner in a lot of those categories. But it's really a matter of finding the right people at the right time who want to be part of Red Hat. So we'll continue to watch that space.

Operator

Your next question is from the line of Brad Reback of Oppenheimer.

Brad Reback - Oppenheimer & Co. Inc., Research Division

Jim, on the UNIX migration, this has been a comment you [indiscernible] sort of questions around how much is really left out there. Could you give us any sense how much opportunity is in front of you there?

James M. Whitehurst

Yes. I got to tell you, we just kicked off an internal initiative to figure this out. Because you go read the IDC report and you'd scratch your head and you say, "It doesn't look like there's that much out there." But when we go talk to our customers and we talk to our sales force about what's out there in the size of the opportunities, it would suggest we're nowhere near halfway through that. We're in the fourth inning on that. We're going to the IDC data, say, seventh or eighth. And just to give you an example, I was with a couple of our very large banking customers and where -- they have very large deployments of RHEL in the investment banking side. Most of the customers I was talking to this week also have large commercial banking operations. And they had barely started on Linux on the commercial banking side. But what they wanted to talk about is how they do that and how they deploy that faster. And if you look at the infrastructures I'm talking about, they had as much on 4 on the commercial side available on the investment banking side. We barely even touched those. If you look at telcos, there's a set of telco workloads that we have moved over to Linux. But there is so much in the core operating systems and building systems I know that we have yet to get. And so at least when I talked to our sales force and they look at the kind of multi-year pipeline, it's huge. You have whole markets, like Korea, that has barely even started on Linux, right? So -- and you look forward. There's a lot out there. And I can't think those numbers with you with IDC, but we are working very hard to understand why our sales force is still positive relative to IDC or Gartner.

Operator

And the question is from the line of Kirk Materne of Evercore Partners.

S. Kirk Materne - Evercore Partners Inc., Research Division

Just real quickly, as Charlie seems to know, that's the question on Europe. I guess I'll ask it and maybe catch in this way. Obviously, the rest of your business has seen a fairly substantial amount of acceleration thus far this year. I guess are you seeing the same kind of trends in Europe? I guess is there any sort of difference in terms of what you're seeing in Europe versus the U.S. and Asia Pac and either from a product standpoint or just from an overall sort of demand standpoint? That'd be helpful.

Charles E. Peters

Yes, sure. Europe for us was also strong. And as I said, all geographies were 25-plus percent growth. I would say we had company-specific growth in Europe, which maybe is different than what others are experiencing but not only do the growth but really the pipeline looks good.

S. Kirk Materne - Evercore Partners Inc., Research Division

And maybe just to elaborate on that a little bit, when you talk about company-specific growth, is it JBoss catching up to sort of where JBoss was in the U.S. given that obviously JBoss for a long time was well ahead of -- the U.S. JBoss operation is well ahead of Europe? Is it just more UNIX is now shifting over in Europe whereas maybe it happened a little quicker in the U.S.? I guess is there any other sort of details you can offer around sort of why there's some company-specific momentum over there?

Charles E. Peters

Yes. I think that first of all, on the company specific, I do think it's around our value proposition. The fact that the open source -- quality open source offerings that we have is really the key to it. But in your specific question about what products are selling, I think the behavior we're seeing in Europe is very similar to what we're seeing in U.S. now. We have good sales force training and overlay sales force for the various products. And so the cross-selling is going on in Europe just the same way it is over here.

James M. Whitehurst

Yes. And just a general comment, I think there's a sweet spot for us when times are tough but not completely shut down where we do well. Yes, I'd say the one place that there might be a little bit of weakness in the pipeline would be southern Europe government. And obviously, we know where the position of those governments that are in there are literally doing nothing. But even the rest of southern Europe, and certainly Europe more broadly, is feeling cost pressure. But cost pressure is actually the real sweet spot for us. There's enough budget to invest to save money in the short run. And that really is a mix. It's continuing UNIX or Windows to Linux and certainly the proprietary application server vendors to RHEL.

Tom McCallum

Operator, let's now conclude our second quarter call, and thank you, everyone, for joining us.

Operator

Ladies and gentlemen, this does conclude today's conference. Thank you for your participation. You may now disconnect.

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