Red Hat F1Q08 (Qtr End 5/31/07) Earnings Call Transcript

TRANSCRIPT SPONSOR

Red Hat, Inc. (RHT)
F1Q08 Earnings Call
June 27, 2007 5:00 pm ET

Executives

Katrinka McCallum - VP, IR
Matthew Szulik - Chairman, President and CEO
Charlie Peters - CFO and EVP

Analysts

Derek Bingham - Goldman Sachs
Mark Murphy - First Albany
Trip Chowdhry - Global Equities Research
Todd Raker - Deutsche Bank
Brendan Barnicle - Pacific Crest Securities
Heather Bellini - UBS
Kash Rangan - Merrill Lynch
Jason Maynard - Credit Suisse
Steve Ashley - Robert W. Baird
Adam Holt - JP Morgan
Kirk Materne - Banc of America Securities
Brent Williams - The Benchmark Company
Katherine Egbert - Jefferies
Brent Thill - Citigroup
Tim Klasell - Thomas Weisel Partners
James Gilman - Cross Research

Presentation

Operator

Good afternoon. My name is Jason and I will be your conference facilitator for today. At this time, I would now like to welcome everyone to the Red Hat First Quarter Fiscal Year 2008 Earnings Call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks there will be a question-and-answer period. (Operator Instructions). As a reminder ladies and gentlemen, this conference is being recorded today Wednesday June 27, 2007. Thank you.

I would now like to introduce Ms. Katrinka McCallum, Vice President of Investor Relations. Ms. McCallum, you may begin your conference.

Katrinka McCallum

Thanks, Jason, and welcome to Red Hat's first quarter fiscal year 2008 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 Investor Relations.

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

In addition, any forward-looking statements represent our estimates or views only as of today June 27, 2007 and these estimates or views may change. While the company may elect to update forward-looking statements at some point in the future, we specifically disclaim any obligations to do so. Even if our estimates or views do change and therefore you should not rely on these forward-looking statements as if representing our estimates or views as of any date subsequent to today.

Now I will turn the call over to Mathew.

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Matthew Szulik

Thank you, Katrinka. And thank you everyone for joining Red Hat's management this evening for our first fiscal quarter earnings call. Q1 was a productive quarter for the company and I am pleased to report continued strong financial results. Our revenue of $118.9 million was above the high end of our guidance and our billings proxy for this quarter of $143 million was also strong. These demonstrate to me the solid momentum in our business, as well as the consistent performance of our global organization.

In Q1 we released Red Hat Enterprise Linux 5 on a global basis. With Red Hat Enterprise Linux 5 we have delivered an Enterprise Operating System which tightly integrates high availability and virtualization, two critical pieces of functionality in a computer architecture that was requested by enterprise customers who seek improved data reliability and more flexible compute capabilities through virtualization.

The tighter coordination with the Linux kernel, real-time compute function and virtualization, simplifies the systems management requirements for our customers, while accelerating the ease for RISV and IHV adoption of the REL platform.

The global ecosystem of independent software providers and hardware vendors are certifying to the Red Hat Enterprise Linux 5 platform at a faster rate than any prior releases of the Red Hat Enterprise Linux product line, highlighting the interest and demand within the global market. And the application providers like Oracle are seeing 30% to 40% plus performance improvements in their databases and applications running on Red Hat Enterprise Linux 5.

In April we communicated our first installment of the JBoss middleware strategy. A highly tested and certified production version of the enterprise class JBoss platform was rolled out. The JBoss middleware platform has been translated and localized into six languages. Global 7-by-24 production services have been built and enabled. And within the quarter we announced we have closed on the acquisition of MetaMatrix, capabilities that compliment core JBoss functions like hibernate, to enable customers to access, federate and analyze data stored across numerous databases within their enterprises. Simplifying and reducing the cost of application development through a common set of open source components and standard interfaces.

And in an addition, within the quarter we held our third annual Red Hat Summit in May to a sold-out audience. At the summit we communicated our global desktop and client computing road map announcing new partnership with Intel to build next generation virtualized desktop management tools in an expanded partnership with IBM to further the development and deployment of Red Hat Enterprise Linux on System zSeries mainframe.

Also during the summit Red Hat announced a sales and technical collaboration with Sybase to develop its first database software plans utilizing Red Hat Enterprise Linux 5, virtualization functionality and high availability features.

And on May 10, Red Hat announced the Red Hat Exchange, our contemporary online value added model of delivering certified and integrated open source software solutions.

The RHX leadership team is carefully building an ecosystem of partners and satisfied customers, and customers trials are progressing. To be clear, RHX is in an investment period. And while we are encouraged by the global response and interest from leading IHVs and ISVs, I have communicated to investors not to expect material economic contribution from RHX within the fiscal year.

One quarter ago on the Q4 earnings call, I described for investors three core themes for Red Hat during fiscal '08 campaign. And to recall these were, deepening customer relationships, expanding global channels of distribution, and investing in innovative technical and service capabilities to continue our subscription growth and renewal strategy.

Let me review the company's performance toward achieving these objectives within the quarter. In Q1 the company continued to make advances in growing existing customer relationships through renewals and expansion of our implementations.
In the quarter, Red Hat renewed 24 out of its top 25 leading renewal opportunities. But one renewal which did not close is a federal government customer. We expect the renewal to occur within Q2.

We are beginning to see JBoss opportunities advance and develop within our installed bases. Customers look to expand their open source stack of an integrated operating system and JBoss middleware solution.

More strategically, Red Hat is increasingly engaged in the dialog of strategic IT decisions because of the superior value being delivered by our offerings.

Data center and data center expansion, Linux standardization, global deployment, application development tools are a few of the core themes that I have personally been involved with, with senior IT leaders within our customer base.

The discussions have moved from technology to speed of deployment and business line benefits. Two years ago when Red Hat sales were dominated by a direct selling model, I described to investors a Red Hat goal to have 60% of total sales being delivered by indirect sales channels.

Over the course of Q4 and Q1, Red Hat aligned its sales incentive systems, added channel leadership and support personnel to deliver 50% of global sales through indirect channels.

The renewed growth of our indirect sales is a positive forward indicator of demand, growing technical competency within the channel, and a quality of value-added partners capable of servicing a demanding end-user base.

Within the quarter, two JBoss sales greater than $500,000 were created and delivered to our value-added partners.

In Q1, over 200 sales and technical professionals from our reselling partners were trained by Red Hat personnel. Another example of our channel advancement is the acceptance of global customers in our expanded Linux solutions for IBM zSeries mainframes.

Three years ago, Red Hat was not a serious partner with IBM for Linux on the zSeries. IBM continues to hear from its global customers the need to standardize on one Linux OS, and challenge Red Hat to create an excellent implementation for IBM zSeries platform.

Through excellent technical work by Red Hat engineering and support personnel in tandem with IBM Engineering, REL 5 was available for zSeries. And within the quarter, Red Hat saw strategic wins within our global customer base for the zSeries platform.

Thirdly; and another initiative that we created was to deliver innovations in customer service. We made an important announcement within the quarter, to create a Red Hat Joint Escalation Center.

As part of the Red Hat Cooperative Resolution Center, this center provides the deepest level of technical support relationship with our key technology partners, enabling effective and efficient issue identification and resolution, by making a single phone call by our customers.

Early participants in the Joint Escalation Center include Symantec, EMC, Sybase, and within the quarter we will have additional partners to communicate. The Joint Escalation Center consists of shared laboratory environments, with cyclical training and development for support staff, and common issue resolution and process for global issue resolution.

As Red Hat technology continues to drive deeper into the data center, customer issues become more complex, involving multiple hardware and software products for multiple vendors. In such mission critical environments, customers require rapid issue resolution and desire a single point of accountability.

Through our Joint Escalation Centers, our customers now can reach out to Red Hat and know that we will take work, and with other vendors on their behalf, to resolve the problem without any finger pointing.

We have received many positive comments from our Enterprise and Federal Government class customers. We appreciate the leadership role that Red Hat and our support organization has taken, as we work with our business partners to resolve their multi-vendor issues.

As an example, one of our largest financial institutions told us and experienced a complex issue involving multiple technology providers. And I would like to quote, "It was a great comfort and relief to be able to rely on Red Hat for taking the issue, working it out with the other vendors, and providing us with a quick and stable resolution. This type of accountability and problem solving is what makes our relationship with Red Hat highly valuable."

In a key note I delivered at the OSPC Conference last month in San Francisco. I spoke to the need for entrepreneurs and developers of open source software to shift their strategies from pitching open source software to communicating value, innovation, and standard support, delivered through the process of open source software development.

Investors should take note that Red Hat continues to build out an open source reference architecture that is tightly integrated, high-performing, and delivering substantial value to our customers. In Q1, we announced the delivery of a suite of Eclipse-based software development tools that provide an integrated reference platform for the creation and delivery of services and multithreaded applications.

In the continued innovation with the integrated JBoss/RH and management platform to update, deploy, patch, provision and manage virtualized instances, is seen as a compelling idea and solution for our customers. We expect the work that we are developing with Intel on a project called vPro, which lowers operating cost by managing virtual desktops to contribute economic benefits both to Red Hat and our customers throughout the fiscal year.

And Red Hat has moved into a position to deliver complete application lifecycle management to an integrated open source platform. Multi platform, multi architectural operating systems, a complete open source development environment, middleware and management technologies are what we have created. The deepening Red Hat relationship with our enterprise IT leadership is enabling Red Hat to continue to collaborate with and lead the industry through customer driven innovation.

Now, let me turn the call over to Charlie to review financial results.

Charlie Peters

We're pleased to report solid financial results for Q1 and a strong start for our 2008 fiscal year. This quarter was the beginning of a major product cycle for both our operating system and our middleware products. Based on the momentum in our business and the open source market, we accelerated investments in sales and marketing at the beginning of the fiscal year. These include extending our channel reach with focus on advanced business partners, and the launch of Red Hat Exchange.

We also increased spending in research and development to strengthen our efforts there. With these important investments underway, we've laid the groundwork for additional long-term growth drivers for Red Hat and set the stage to further differentiate our value proposition.

Looking at the income statement, total revenue for Q1 was $118.9 million, an increase of 7% from last quarter and 42% from Q1 of fiscal year 2007. Total revenue came in above the guidance we provided last quarter as a result of continued strong demand and about $900,000 due to the strong Euro.

Subscription revenue was $103 million, up 7% sequentially and 44% year-over-year. Training and Services revenue was $15.8 million, it was up 4% from last quarter and 27% year-over-year.

Our billings proxy, which we define as revenue, plus change in deferred revenue, was $143 million, up 4% from last quarter and 24% from the prior year quarter. While billings do vary quarter-to-quarter, we are pleased with the strong billings performance compared to a seasonally strong Q4.

Breaking down our Q1 bookings mix, the channel generated 57% of bookings. To just to clarify what was stated previously, it's 57% of bookings for the channel and 43% came from direct sales, versus a 52% -48% split in Q4.

In terms of geography, 56% of bookings came from the Americas, 25% from EMEA and 19% from Asia Pacific. This compares to respective 61%, 25%, 14% split last quarter. We are pleased to see APAC begin to accelerate again. Overall, gross margins 85% and subscription gross margin of 93% both continued the trend of improvement from last year.

Training and services gross margin declined 100 basis points on a non-GAAP basis 35% in Q1 versus 36% last quarter. This decline was due to additional cost associated with outsourcings and training and consulting activities this quarter. We believe that we have opportunity to improve the gross margin of our service business and we will continue to focus efforts there.

Non-GAAP operating expense excluding stock compensation expense came in at $77.9 million, up 12% from last quarter. The increase in operating expense was attributable principally to increases in sales and marketing and R&D. We added approximately 100 new employees this quarter, most in these functions.

In addition, as I said at the beginning, we turned up spending in connection with Q1 product launches, the Red Hat Summit and other marketing events to kick off the year. Those expenses, related to one-time events and travel, subside in Q2, so the growth in spending is expected to moderate going forward. The strong Euro increased operating expenses approximately $800,000 compared to last quarter.

Q1 non-GAAP operating income was $23.3 million producing operating margin of 20% compared to non-GAAP operating income of $24.7 million, and operating margin of 22% last quarter and non-GAAP operating income and margin up $20.2 million and 24% last year. The decrease in non-GAAP operating margin in Q1 was attributable to the focused investments in our operations that I outlined previously.

Moving on, other income, net, which is attributable primarily to investment income, was $13.6 million. Our non-GAAP tax rate which reflects actual cash taxes that we expect to pay for the foreseeable future, is still approximately 5% resulting in non-GAAP net income of $33.7 million, up slightly from last year and up 20% from the year ago quarter. Our non-GAAP diluted earnings per share came to $0.16 beating our previous guidance by $0.01.

Now let's turn to the balance sheet and the cash flow statement. We ended the quarter with approximately $1.2 billion in cash and investments, an increase of $35 million from the end of Q4 driven by cash flow from operations and excess tax benefits form share-based compensation. This was offset somewhat by cash used for CapEx and acquisitions.

Moving to the statement of cash flows; non-GAAP cash flow from operations excluding the reclassification of excess tax benefits from share-based compensation arrangements was $52.3 million down from $56.4 million last quarter. Cash flows vary from quarter-to-quarter and as you can see from especially the balance sheet, this quarter was impacted somewhat due to the timing of payments of accounts payable and to the account receivables.

Having said that DSO was still in an acceptable range, it was at 60 days versus 57 days at the end of Q4. As a reminder DSO is traditionally a measure of receivables versus billings, our DSO calculation includes the change in deferred revenue.

Total deferred revenue end of the quarter at $363.1 million, an increase of 7% from the prior quarter and an increase of 43% from last year.

Now I'd like to turn to guidance. We are anticipating Q2 revenue in the range of $124 million to $126 million and non-GAAP EPS to be approximately $0.17 per share. We estimate stock-compensation expense for Q2 to again be between $8 million and $9 million and the GAAP tax rate of about 40%, non-GAAP tax rate will remain at 5%. For the fiscal year we anticipate approximately $30 million to $35 million in total capital expenditures, mainly for internal systems and facilities to scale for growth. The full year estimates that we made in March still seem reasonable.

Now I would like to turn over to Matthew for a few closing remarks.

Matthew Szulik

Thanks Charlie. We are privileged to have the relationship with each of our customers globally, that I continue to meet to be encouraged by their acceptance in adoption of open source, and as open source software continues to be a strategic part of their long-term compute strategy. We know that they wrote with their dollars every renewal period more pleased to see that the investment that we have made in our global service competency, the integration and the development of our technology continues to produce superior financial returns for them.

We want to thank all of our associates for their continued efforts to focus on delivering superior customer value with innovative services to meet an increasingly demanding set of customer needs. And our partnerships continue to distinguish Red Hat amongst the competitive landscape of choices that our customers have. And as importantly we want to thank and appreciate the values of the investors made in the support of Red Hat in our very encouraging future.

With that we would like to turn it over to investors' questions.

Katrinka McCallum

Thanks. Today's question-and-answer period will be asking our callers to limit themselves to one question. Jason you can go ahead and poll the audience for questions.

Question-and-Answer Session

Operator

(Operator Instructions). Your first question comes from Sarah Friar from Goldman Sachs.

Derek Bingham - Goldman Sachs

Hi, thank you it's Derek Bingham on behalf of Sarah. Just interested, if you could comment on progress and attach rate of higher levels of service and also the adoption of the advanced platform and how those two things are impacting ASPs?

Charlie Peters

I think relative to your first question, if your first question is around the rate of renewals for the 24 or 25 that renewed, I believe the statistic was 105% of last year. And for the second part of your question, I believe the question was what we are seeing relative to activity on REL 5, the advanced platform sorry.

Matthew Szulik

So the positive take up on the advanced platform, it's really as you know that is describing a production oriented release of the product, but virtually all of the customers that I have spoken are using the advanced platform in a preproduction test environment, throughout the quarter.

Derek Bingham - Goldman Sachs

Okay. Got it. And then just one follow-up, if I could. On middleware, just curious if there is any color you could give in terms of, if there are specific products that attending to be adopted more than others at this point and if there are in particular customer environments where you are having the most success so far in selling middleware subscriptions?

Charlie Peters

Yeah, remember what we have done with the JBoss packaging is try to deliver to the market in integrated platform as opposed to an independent set of components.

Derek Bingham - Goldman Sachs

Okay.

Charlie Peters

And I think what we continue to see is first of all the JBoss product is widely used by developers all over the world and the success that they have had being able to rapidly prototype and deliver applications/services to that lines of business, continues to be a key driver to encourage our customers to roll a product out into production environments as we have described on earlier calls. We have invested significantly in the back end and the production side to deliver and certify the tested production version of JBoss.

And I think that's encouraged a lot of our customers quarter-over-quarter now to seriously consider JBoss as an alternative to some of the propriety solutions. But now being able to deliver 7/24 production level quality support has given them the encouragement to move it not only from the development stage now into to the production backend. But I think, it's largely been driven by reliability, speed of deployment, and a comfort that is backed by a global 7/24 arm.

Operator

Your next comes from Mark Murphy from First Albany.

Mark Murphy - First Albany

Thank you. Matthew, I know it's still very early here. But if you look at how your customers are using REL 5 virtualization thus far, can you estimate how frequently they are using it for server consolidation versus testing QA or splitting applications across multiple servers. In other words what I am trying to get at is activities that could cause unique compression versus those that would not?

Matthew Szulik

Yeah, Mark, in the last two weeks, I have spoken with five very prominent CIOs, and none of them have moved virtualization near their production environment.
Some of the discourse that they have with me is that, although virtualization has been effective in some single server environments, as a way to potentially reduce the cost of adding additional servers, and potentially to add more value to a single-server environment, none of them have described moving virtualization into production environments.

They actually have almost uniformly described virtualization as still being a young technology, and awful lot of application dependency and workflow issues needed to be discovered and worked through. The requirement of management services and other discovery technologies are still quite immature to move it into a full enterprise wide scale out.

So the conclusion is that, it is still embryonic, and the REL 5 product gives them a very low risk way to test and validate some learning.

Mark Murphy - First Albany

As a follow-up, Matthew, did the sales reorganization during the quarter or the Microsoft patent noise seem to have any impact on the quarter, either positive or negative?

Matthew Szulik

Well, I think the sales issue was an important issue for us as a part of the channel expansion, Mark. So, inevitably when you move people around like the way we did, there was probably some lag that was created.

On the other question regarding the Microsoft patent. It became an objection to the selling process, but was not negative in our selling efforts.

Operator

Your next question comes from Trip Chowdhry from Global Equities Research.

Trip Chowdhry - Global Equities Research

Thank you and congratulations on good execution. Matthew, I was wondering regarding the virtualization; you are supporting three different paradigms. You have XenSource, VMware, and also KVM. I was wondering; are you sensing any natural segmentation within your customer base?

Matthew Szulik

Well, I think you described three interesting approaches to a complex problem Trip. I think the KVM side would really be an interesting advanced emerging technologies kind of activity, if you will, that we are exploring.

We've had a successful relationship with Diane and the VMware team. What I want to say almost three years now, as a part of an embedded implementation of Red Hat Enterprise’ Linux, and that has been a part of our OEM strategy.

And of course, within the integration of a high provider to the operating system, that is really the core part of Red Hat's business model and strategy. So, I think what you see is, is really three different stages of our approach to the virtualization opportunity.

Trip Chowdhry - Global Equities Research

And last question I have is, regarding your sales execution. Do you have a dedicated sales team that is only focused on start-ups and innovative companies?

The reason I am asking that is, you have a phenomenal success rate with start-ups and Web 2.0 event style companies. Any color on that? Thanks again and congratulation on good execution.

Matthew Szulik

There is no discreet activity on early-stage companies.

Operator

Your next question comes from Todd Raker from Deutsche Bank.

Todd Raker - Deutsche Bank

Hey guys two quick questions. First on Red Hat Exchange, can you give us a sense for the magnitude in the investment, and how should we be thinking about metrics from milestone since it's not going to be material on a revenue basis in the near term?

Matthew Szulik

I have no color to offer you about the magnitude of the investment. I think that the investment going forward is based on the performance of the business unit every 90 days.

As I've tried to describe for investors that this is a normal activity, that we want to make sure that we not only create customers but deliver the same high level of service and support by integrating third party applications into a common open source platform.

So, I think what we continue to do is evaluate the progress of the business unit on a month-to-month basis, quarter-over-quarter, and I think what we wanted to be sure is that the opportunity doesn't run away from us either through hype or interest that we cannot continue to support customers in a way that they have been accustomed to receiving.

So, I just wanted to be very clear to investors is that we expect no material contribution within the fiscal year.

Todd Raker - Deutsche Bank

Are you going to be able to give us a sense for the number of partners or some kind of metric to kind of show or demonstrate the growth?

Matthew Szulik

It’s our plan to do that when those numbers become material.

Todd Raker - Deutsche Bank

Okay. And then just one quick financial question. You commented on the currency impact on the revenue line, any currency impact on deferred revenue, the balance sheet?

Charlie Peters

I think the numbers are about $2 million.

Operator

Your next question comes from Brendan Barnicle from Pacific Crest Securities.

Brendan Barnicle - Pacific Crest Securities

Hi, just two quick ones. Charlie, prepaid expenses had a bit of a hike in the quarter. Just wondering whether that was attributable? And then Matthew just any change in kind of competitive or pricing environments? Thanks a lot

Charlie Peters

There's two changes in the balance sheet that are sort of linked. One is the increase in prepaid expenses; the other is the increase in the long-term obligations. Both of those items are related to the adoption of the new Accounting Standard for FIN 48.

Matthew Szulik

And no changes in the competitive pricing environment, Brendan.

Brendan Barnicle - Pacific Crest Securities

Great.

Operator

Your next question comes from Heather Bellini from UBS.

Heather Bellini - UBS

Hi, thank you. Charlie, I just had a question. I was wondering if you could give us an idea how we should expect the cash flow to ramp this year. And then on the DSO front, I might have missed this, but was there anything in particular that caused the jump in DSOs this quarter that might reverse itself in the August quarter? Thank you.

Charlie Peters

Sure. So on the first question on cash flow, I have refrained from trying to guide the quarterly cash flow now for a couple of years. So I will continue to refrain. I think I did say from a total year basis, I think I reaffirmed the prior estimates.

If you look carefully at the balance sheet what you will see is accounts payable and accounts receivables, both have some movements this quarter that negatively impacted cash flow. And if you add those back, it obviously could have been a better result. I don't think we ever anticipate that cash flow is going to be leveled every quarter across the year. It does vary.

The second part of your question Heather?

Heather Bellini - UBS

Was there anything in particular that caused the DSO to jump? In the past you might have had a large deal that you might not have been able to find late in the quarter. Is there anything that happened this quarter that will be an easy reversal in the August quarter?

Charlie Peters

Yeah. First I would say this, I think that DSOs in the range where we have been, somewhere between low 60s and low 50s is a good range, so I don't feel bad about it. But the biggest factor that influences our DSOs is the timing of when we actually bill the deals.

And in this particular quarter, I think we had a little bit of aging in our foreign and more foreign business. You will also note, if you look at the cash flow you will see our bad debt expense of $500,000 or thereabout. It's just due to aging. And I certainly hope we will improve that as we get forward next quarter.

Heather Bellini - UBS

Thank you.

Operator

Your next question comes from Kash Rangan from Merrill Lynch.

Kash Rangan - Merrill Lynch

Hi, thank you very much. I am just curious if you could talk about REL 5.0 impact on your blended pricing. We are indeed getting the uptake on the Advanced Platform side. At what point during this fiscal year should you start to experience blended pricing going higher per server effectively, and would that cause you to change your guidance? Because, I thought Charlie said the last time, that the guidance does not include any mix shift between the ES relative to AP.

And secondly, I am just curious, Matthew, you said that virtualization seems to be still in a test and dev mode. If that moves into production, let's assume that it moves into production. How do you counter some of the bearish arguments in the street that virtualization is a long-term negative for Red Hat? If you can just walk us through your reason, that will be great. I will shut up right now. Thanks.

Charlie Peters

I will take the first part of the question about pricing, and it kind of goes back to my philosophy three years ago. We don't talk about average selling prices and stop being as a constructive discussion to have. But, qualitatively I would say this, that what we have said is that the majority of our historic REL business in the last couple of years has been to the ES side, and much less on the AS side.

And the idea with positioning of REL 5 was to encourage people to move to the platform, which would go to a higher price point. But, beyond that I am not going to offer any additional color on that.

Kash Rangan - Merrill Lynch

And where are you in that evolution of moving people to AP. Is it still too early? Could that offer an upside if it happens sometime this year?

Matthew Szulik

Yes. Matthew Szulik, I think that there is certainly room for upside globally probably towards the back end of the fiscal year. It's certainly moving into fiscal '09 and beyond. Let me answer the second part of your question about what has been suggested by some of the media about bearish impact on Linux sales regarding virtualization.

Having just returned from visiting customers and business partners around the world, I don't share that point of view for the following reasons. I think what we will continue to see in the enterprise and in the global government marketplace is that virtualization holds out the potential to see the acceleration of legacy applications to move into a different computing paradigm. That is number one.

Number two, I think it has the potential to accelerate UNIX to Linux migration. As more and more of the enterprise and government customers receive success with Linux and open source software, now the Linux with the JBoss and opens source middleware stack. As more and more development tools like Seam and others becomes more pervasive within the enterprise, J2EE environments become more pervasive.

I think that in tandem the combination of virtualization, high-performing middleware messaging technology, real-time OS enhancements. That in aggregate should provide superior economic benefits to customers to accelerate from UNIX to Linux.

And not to mention the growing maturity of the tools and the related services that do more than just provide single server optimization of a virtualized environment. But, really we start to get into what we think will be compelling economic benefits to the enterprise customers regarding dynamic workloads, the ability to ship either virtual client or virtual workloads around the world, to either reduce power consumption or to improve the efficiency and the throughout of the business application in a virtualized environment.

So, we think those three in tandem start to really move the discussion away from simply single server virtualized environments to really virtualizing work loads in instances globally, that I think ultimately will be a great catalyst for our long-term business.

Kash Rangan - Merrill Lynch

Got it. Thanks.

Operator

Your next question comes from Jason Maynard from Credit Suisse.

Jason Maynard - Credit Suisse

Hi, good afternoon. I have two questions, just first on JBoss, maybe Matthew can you describe a little bit of what you think some of the benefits are to moving to the Fedora-like model and how did that influence either customer buying behavior or the ability of your sales organization to perhaps deliver more value to customers?

Matthew Szulik

One of the most important benefits that we wanted to derive was tighter integration with the global open source community around the JBoss platform, Jason. So part of it was leveraged, part of it was increased contribution from open source developers and certainly a part of our global strategy not just at the operating system and now at the middleware level, but we certainly are doing the same with the Red Hat Network Technology, because clearly we believe that the superior innovative model for our business and for our customers.

Secondly, what we wanted, what we heard continuously from customers what was they wanted a bulletproof highly certified, highly qualified platform. And so previously JBoss had really a single size, a one size it's all implementation and our customers wanted that bulletproof implementation of the JBoss activity.

And thirdly, of course, was to create an environment that provided more innovation from third party developers and third party contributors that wanted to integrate and add value to the JBoss environment. So we see those as three compelling activities.

Jason Maynard - Credit Suisse

If I zero-in on point number two, where may be a lot of JBoss users have production or just may have a lot of test and dev type of deployments. Do you get any sense I am going to try and continue down here to quantify this. But what the attach rate might be now that you've got, maybe a little bit more of an enterprise class version of JBoss that you can deploy for production house?

Charlie Peters

Well. When you say attach rate, could you help me understand what you mean by that?

Jason Maynard - Credit Suisse

Just moving, if you will production apps, or moving test and develop apps into production environments and anything for subscription contract on top for those applications?

Charlie Peters

As you know, unlike the operating system that maybe tied to a hardware and platforming, increasingly JBoss is moving more and more towards either pilot projects or prototypes and the test of Red Hat’s support competencies before customer moves it from test/dev into production. And I think the good news Jason, is that over the last nine month, the company has added the multilingual capabilities. And all of those other elements that make us qualify to compete those production services. So, I would say I don't have any quantitative data to deliver to you but what I have described in today's call was that we are entering the game to your part of the discussions. The pipeline within the global sales organization is starting to become populated with opportunities that six months ago were not evident outside of test/dev.

Jason Maynard - Credit Suisse

Okay. And if I could squeeze one more quick question and I just love to get your take on some of the recent press around your decision as well as Ubuntu's not to participate with Microsoft and some of their I don't know what do we call them, patent agreements or unique relationships with other Linux providers, what sort of your official stance on sort of dealing with Microsoft on some of these issues?

Matthew Szulik

We continue and invite the opportunity to participate with Microsoft around standards and about improving the customer relationship and experience of being able to operate successfully within a heterogeneous environment. So, for us this is less religious and I think more importantly is how do we create a win-win for the customer. So, our position hasn’t moved as it relates to your question. It's been the same for as long as I have been at Red Hat.

Operator

Your next question comes from Steve Ashley from Robert W. Baird.

Steve Ashley - Robert W. Baird

First of all can I get a couple of housekeeping things, I think historically you’ve talked the number of new customers you’ve added, and you've also talked about the percentage of booking is greater than one year, can we get those metrics?

Matthew Szulik

Yeah Steve, I think it was in a multiple of thousands of customers within the last 90 days.

Steve Ashley - Robert W. Baird

And the percentage of bookings greater than one year?

Charlie Peters

Yes, the percentage of bookings greater than one year is 27%.

Steve Ashley - Robert W. Baird

Okay, and in terms of JBoss qualitatively can you tell us if the bookings increase sequentially in the first quarter?

Charlie Peters

They did.

Steve Ashley - Robert W. Baird

And can you tell us if JBoss was a negative at the pro forma EBIT line?

Charlie Peters

No, and that's what I'm -- I am not going to get down to sort of segment reporting or segment reporting is not required so I don’t want to go there.

Operator

Your next question comes from Adam Holt from JP Morgan.

Adam Holt - JP Morgan

Hi, good afternoon. My first question has to do with some of the changes on the distribution side, obviously you referenced earlier the internal sales re-org, you did see a shift in your mix, direct versus indirect. Now that you do the other side of those changes, should we expect the Q1 level to be sort of the going forward level for that mix or should we expect to see continued changes there?

Matthew Szulik

The Q1 level should be a baseline going forward, and we want to continue to expand that from the 56%, 57% that I qualify today.

Adam Holt - JP Morgan

And then secondly, if I can turn down a little bit on the REL 5 release, you mentioned earlier, it's obviously quite early. So, at this point maybe we are talking more about pipeline opportunities versus actual. But you talked about virtualization. I was hoping maybe you could touch on where you think some of the opportunities are building around, some of the other products like GFS?

Matthew Szulik

Well, in many ways, the GFS technology is partly linked to the implementation of virtualization and the other activities. And on a global basis, GFS continues to see positive uptake within the customer base. We had a number of successful global successes within the GFS technology.

And the other question regarding RHN, we are very pleased with the continued performance of the RHN within our customer base, as customers are now starting to move out to wider implementations of Linux, multiple thousands of servers, and are looking to the monitoring and looking towards the patch management and update capability of RHN.

So, I think collectively on the layered products, we like the progress that we see. We just released this past week an updated version of the satellite implementation of RHN that our customers have been looking forward to receive. So, I think as we start to think about next generation management platforms for virtualized environments, we are encouraged by the reception and the progress that our customers are communicating to us.

Operator

Your next question comes from Kirk Materne from Banc of America Securities.

Kirk Materne - Banc of America Securities

Yeah, thanks very much. I guess Charlie and Matthew, can you just give me an idea of how you guys look at sort of the deal flow around JBoss, meaning obviously the operating systems had a great success going through a number of your indirect partners, but JBoss would seem to be a little bit more of a consultative sale.

Have you seen demand in terms of JBoss consultant over the last couple of quarters, and how does that portend in terms of future opportunities and how do you sort of gauge that in terms of this businesses' ability to accelerate over the course of the fiscal year?

Matthew Szulik

Well Kirk, I think the way to look at this is that the organization to move from a single product company to a multi-product company where the buyer is, in many cases different than the buyer of an operating system, to invest in the support services that qualified us to set production levels 7x24 supports, moving into mission-critical environments where the application not the operating system is determined impact the customer success, building out the development tool that make us credible in that environment. That activity in total, while we were investing in and building our channel program and channel management I think what we saw in Q1 was encouraging both directly through our direct sales entity and as importantly the development of the value-added partners globally.

I just returned from Asia, and in virtually all of the customer visits that I had and meetings with the third party business partners across Asia there was strong interest and strong support for JBoss as they start to build up their competencies around the J2EE environment.

Those investments, I think, are now getting us into the game to support something more than a small purchase in their development dev and test environments. But now it's starting to think about broad scale deployment into mission-critical environment. So I am encouraged for future quarters.

Kirk Materne - Banc of America Securities

Again, maybe just one follow-up on the same topic. When JBoss was bought, one of the big opportunities was obviously taking it from a local business to more of an international business.

Is that something that you believe can really start to take off in fiscal '08 or is that something that's going to continue to take more investments over the course the year with the real payoff may be in fiscal '09?

Matthew Szulik

Well, I think you have to assess that. First of all, getting a technically trained audience that is JBoss literate and within the continued innovation that’s happening around things like Hibernate and Seam, the addition of a MetaMatrix technology that I think is allowing the JBoss to build on the success that JBoss had in the test and dev environment. So, when I look at the pipeline and I look at the size of some of the large orders that we have received over the last two quarters, I am encouraged globally for the future potential.

And the movement of the business increasingly through third party channels, although there would be some level of additional investment. I don't believe that that should be out of the norm of the guidance that Charlie has provided. As I highlighted this quarter, we trained over two hundred technical and sales professionals from our value-added partners.
We should have better data for you at the next earnings call about the number of new value added partners that we've signed up in North America, Europe and Asia. And I see that being as a positive indicator of demand in the market price.

Operator

Your next question comes from Brent Williams from The Benchmark Company.

Brent Williams - The Benchmark Company

Hi guys. Okay, so you mentioned in your prepared comments, Matthew, that you had seen dramatic performance improvements from some of the software company partners that you have. And in their comments, are they coming back to you and saying that they think the reasons for those performance improvements are perhaps other than maybe the key benefits that you were touting. In other words, is there some new drivers of performance that maybe you hadn't expected when you released the product.

Matthew Szulik

I bet, Brent, that they are all of those, I think as I highlight it when REL 5 was released. On an end-to-end basis I had forecasted that this would be really our best enterprise class operating system for a lot of the reasons that you technically know about.
I also think that the testing and certification process that we initiated starting with Fedora through our ISV community was probably the best that we have had till date as an organization.

And so what you have is competency and literacy and open source and Linux within our ISV community, better platform and hardware support from the chip manufacturers; Intel, AMD, and certainly better sophistication within our development and testing environment to allow our ISV community to pursue the optimization of a platform that we have experienced to date. And I expect that to continue when you get in to multi-core environments.

Brent Williams - The Benchmark Company

Okay, great. And then also relatedly, you mentioned that you hired up, may be more aggressively than you had expected to on the R&D front. What kinds of areas are those guys going in to? Is it more virtualization? Is it accelerating some core features, like the Fair Schedule that I've been hearing about, and stuff like that?

Matthew Szulik

All that is true. I think what I highlighted in my remarks that it was not the R&D side, which was in the channel side. But I think you have appropriately highlighted were Paul and his team have made very, very good and strong technical hires. But, the piece that you left out, of course, was the investments that we continue to make in building out the JBoss platform area that we're encouraged by.

Operator

Your next question comes from Katherine Egbert from Jefferies.

Katherine Egbert - Jefferies

Hi, thanks. Can you tell us what the size of the government deal that’s getting renewed was?

Charlie Peters

No. We don't get to the individual deals. As Mathew said it's a deal that we expect to renew in Q2.

Katherine Egbert - Jefferies

Okay. I mean is it under million, over million, anything?

Charlie Peters

I am not going to offer any color on it.

Katherine Egbert - Jefferies

Okay. It's okay. Next one Charlie, can you help us out what your non-GAAP operating margin can be, say, as like a target a the end of this year or may be a mid-term target over the next couple of years?

Charlie Peters

So, just to recap what I said at the end of Q4 for guidance for this year. What I said is 21% to 22% and I reaffirm that guidance for the full year today. I think that what you will see is hopefully the operating margin will improve gradually as the year goes along. We are going to continue to invest in the business and build the infrastructure of the business and therefore it won't accelerate probably any faster than that. Once we get beyond this year I think I have said on numerous previous occasions that there's no reason why over a period of time, as probably in fair amount of years we can get right up there with some of the best. But, it will be a while.

Operator

Your next question comes from Brent Thill from Citigroup

Brent Thill - Citigroup

Thanks. Charlie, on the deferred revenue the sequential improvement was the lowest level, I think, in over a year. Can you just maybe talk though what some of the factors that caused somewhat a lower level of improvement in that line item?

Charlie Peters

I think, obviously, what drives deferred revenue number is a difference between billings and revenues. So, when revenue accelerates very rapidly it makes the relative change in deferred revenue look a little bit smaller. I'd also say if you are comparing it to Q4, Q4 was an absolutely a gangbusters quarter relative to bookings and billings, so it was tough comparing.

I don't think that you should necessarily get too concerned about quarterly billings or quarterly change in deferred revenue. One thing if you might try is looking at our fourth quarter rolling average of billings and what that might do to deferred revenue.

Brent Thill - Citigroup

Okay. And for Mathew, can you speak about preloads with the OEM partners with REL 5, where we stand and the progress that you are making with some of the OEM partners?

Matthew Szulik

I think I'd say for the North American, the big three in North America, I think continue to be progressing with them positively, no different than the REL 4 rollout. I think some of them largely because of their manufacturing and packaging issues have moved out REL 5 preload shipments by a quarter or two. Some of the Asian manufacturers are preloading and shipping now. So, I think it has been historically tied to their manufacturing and adoption cycle as opposed to market cycle, on a preload basis.

Operator

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

Tim Klasell - Thomas Weisel Partners

Yeah. Good afternoon everybody. I just wonder, you put up some more emphasis on the channel and I believe a while back you served a program to improve the renewal rates. Can you give us any color on how those renewal rates have been trending and what are you doing with the new partners to make sure that the renewal rates are as high as your direct sales force?

Matthew Szulik

Yeah. We are encouraged by the growth that we are starting to see, Tim, through non-direct renewals. This has been largely investments that have been made in IT and IS systems. This has been made by tighter coordination with the distributors and value-added partners. And I don't have a specific figure to quote you on this call, but I can tell you that on a quarter-to-quarter basis over the last three quarters the increase in indirect renewals has increased appreciably.

Tim Klasell - Thomas Weisel Partners

Very good, very good. And then, I know Charlie you hate to talk about the off-balance sheet, but just sort of from my calculations it seems like the off-balance sheet must have improved sequentially, is that true?

Charlie Peters

I think your first comment was right that I don't usually talk about the off-balance sheet backlog. I typically once a year or at the end of the year talk about bookings and off-balance sheet backlogs in little bit more details. I am not going to comment quarterly.

Operator

Your next question comes from James Gilman from Cross Research

James Gilman - Cross Research

Good evening, Matthew and Charlie. Charlie, with reference to MetaMatrix, I believe you closed that during the quarter. When did that occur?

Charlie Peters

It was in the last week of the quarter.

James Gilman - Cross Research

Okay.

Charlie Peters

Just to go on, I think if you look at the cash flow statement you can see acquisition there about $12 million. We have not done the purchase price allocation. That would probably be accomplished in Q2 or Q3. It had no appreciable impact. It had no impact on revenues and not much of an impact on expenses in the quarter.

James Gilman - Cross Research

All right. Those answered my questions. Thank you very much.

Operator

There are currently no further questions. Do you have any closing remarks?

Katrinka McCallum

We just want to thank everybody again for the joining the Red Hat management team today. And this will now conclude our first fiscal quarter earnings call. I appreciate your time.

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