Red Hat's (RHT) CEO Jim Whitehurst on Q1 2017 Results - Earnings Call Transcript

| About: Red Hat, (RHT)

Red Hat, Inc. (NYSE:RHT)

Q1 2017 Earnings Conference Call

June 22, 2016 5:00 PM ET


Tom McCallum - VP of Investor Relations

Jim Whitehurst - President and CEO

Frank Calderoni - EVP, Operations and CFO


Mark Murphy - JPMorgan

Scott Zeller - Needham & Company

Kash Rangan - Bank of America/ Merrill Lynch

Abhey Lamba - Mizuho Securities Co., Ltd

Siti Panigrahi - Credit Suisse

Matt Hedberg - RBC Capital Markets

Michael Turits - Raymond James

Brent Thill - UBS

Heather Bellini - Goldman Sachs

Gregg Moskowitz - Cowen and Company

Karl Keirstead - Deutsche Bank

Kirk Materne - Evercore ISI

Keith Bachman - Bank of Montreal

Walter Pritchard - Citigroup

Edward Maguire - CLSA

John DiFucci - Jefferies LLC

Jason Velkavrh - Robert W Baird & Co

Jason Ader - William Blair & Company



Good day, everyone. And welcome to today’s Red Hot Incorporated Q1, FY17 Earnings Call. At this time, all participants are in listen-only mode. Later, you will have the opportunity to ask questions during a Q&A session. [Operator Instructions] Please note today's call is being recorded. And I'll be standing by should you need any assistance.

It is now my pleasure to turn the conference over to Tom McCallum, Vice President of Investor Relations. Please go ahead, sir.

Tom McCallum

Thank you, Elise. Hello, everyone. Welcome to Red Hat’s earnings call for the first quarter fiscal 2017. Speakers for today’s call will be Jim Whitehurst, President and CEO; and Frank Calderoni, Executive Vice President, Operations and CFO. Our earnings press release was issued today after the market closed and may be downloaded from on the Investor Relations page. Also on this page, you’ll be able to find a copy of today’s prepared remarks, a schedule of currency rates, and a slide deck with financial highlights and supplemental metrics that include a reconciliation of GAAP to non-GAAP financial results.

During this call, we may make forward-looking statements about our future financial performance and other future events or trends, including guidance for our second fiscal quarter and full fiscal year. These statements are only predictions that are based on what we believe today, and actual results may differ materially. These forward-looking statements are subject to the risks, uncertainties, assumptions and other factors that could affect our financial results and the performance of our business and which we discuss in detail in our filings with the SEC, including today’s press release and the risk factors and other information contained in our most recently filed Form 10-K and Form 10-Q. Red Hat assumes no obligation to update any forward-looking statements we may make on today’s call.

With that, let me turn it over to Jim.

Jim Whitehurst

Thanks, Tom, and let me add my welcome to all of you joining us on today’s call.

Digital transformation and cloud computing are changing the way companies compete in virtually every industry today. Organizations that rapidly embrace agile IT technology are succeeding as industry innovation accelerates around them. With our open source-based technologies we are helping customers to capture the business benefits associated with this rapid rate of change. Strong adoption of our technologies is evidenced in our financial results where we delivered our highest Q1 total revenue growth rate in US dollars in three years; grew both Q1 total revenue and subscription revenue at 18% year-over-year, and had strong sales execution that led to a record number of deals over $1 million dollars in a Q1.

With that overview, let me discuss some of our recent business and technology highlights from the quarter.

Starting with OpenShift, our PaaS solution, where we made a number of recent announcements. First, our OpenShift Commons membership crossed 200 organizations from over 40 countries and includes Global 2000 enterprises, ISVs/SaaS providers, Systems Integrator partners and public sector institutions. OpenShift Commons is an open community that encourages collaboration, contribution and best practices for open source technologies in PaaS and containers.

Second, we announced the next generation of OpenShift Online that was made available in developer preview this week. OpenShift Online has had over 3 million applications deployed to it and has now been updated to become the industry's first multi-tenant, Docker container and Kubernetes powered public cloud platform.

And lastly, our OpenShift technology won a CODiE award for best platform-as-a service for second year in a row. This is a prestigious peer reviewed award presented by the SIIA. OpenShift also received InfoWorld's 2016 Technology of the Year earlier in the year for the second time.

As a headline sponsor of the OpenStack Summit in Austin, we announced the general availability of two new technologies that help bridge the gap between development and operations teams at the scale of cloud computing. First, we launched Cloud Suite that is designed to offer an integrated hybrid cloud stack with a container application platform, a scalable infrastructure based on OpenStack and unified management tools.

Second, and in conjunction with the event, we released the general availability of the latest version of our OpenStack distribution, Red Hat OSP 8, which is based on the OpenStack community Liberty release. A co-engineered solution, Red Hat OSP 8 integrates the foundation of RHEL with Red Hat’s OpenStack technology to form a production-ready cloud platform. Red Hat’s core OpenStack offering now natively includes additional automation for upgrades and updates, infrastructure and workload management and software-defined storage.

Our new offerings further solidify Red Hat’s early leadership position in OpenStack.

This is exciting given the considerable growth in OpenStack interest levels among enterprises, growing levels of customer adoption, and further signs of market maturation as more enterprises are moving to live production each quarter. Importantly, we believe that Red Hat OSP is increasingly being recognized as the gold standard for large-scale production OpenStack deployments.

We have hundreds of production deployments across the globe and even more proof-of-concepts are underway including recent wins with Cambridge University, Paddy Power Betfair, FastWeb, NASA JPL, and Produbon, the IT services division of Santander Bank.

A broadening group of enterprise and service provider customers that have deployed Red Hat Open Stack Platform include Verizon and CA Mobile; a strong ecosystem of industry leaders that have rallied around RHEL Red Hat OSP for transformative network functions virtualization and software-defined networking deployments.

Of course Red Hat OSP and Cloud Suite are just part of a portfolio of technologies that customers are deploying to address their digital transformation needs. To this point, we had an important new win in Q1 with a global financial services provider, BBVA that speaks to the power of the breadth and depth of Red Hat’s offerings. This global strategic collaboration with BBVA, establishes Red Hat as one of their priority partners. The partnership is designed to focus on business and technical alignment, enabling BBVA to accelerate innovation, manage the growth of financial transactions on digital devices and deliver digital banking services through its global customers.

Moreover, new IaaS and PaaS-based platforms utilizing Red Hat technology will enable BBVA to focus on developing applications that can support the heavy demands of those global digital banking services and provide customers with the service and information they want, when it is needed. BBVA is a fantastic example of a global enterprise that has turned to an open source-based cloud solution and Red Hat in particular, to drive business innovation through technology. We are thrilled to collaborate with them on this journey to transform their business and to help them reach their goal of becoming the world’s first truly digital global bank.

More broadly, we believe that Red Hat is seeing and winning a growing number of large deal opportunities due to the breadth and depth of our stack. As customers move workloads to the cloud and develop innovative new applications, they are turning to open-source based solutions to provide them with speed, agility, security, reliability and enterprise features. They are turning to Red Hat, and we believe we are well positioned to benefit as organizations invest in private, hybrid and public clouds.

Today we announced the acquisition of a JBoss middleware partner, 3scale. 3scale was founded in 2007 with a goal of enabling organizations of all sizes to successfully create, manage, and use APIs in a web-enabled world where APIs are paramount. It offers a hybrid cloud-based API management solution that separates the cloud management layer from the API gateway, offering customers more flexibility, performance, and scale.

The company powers more than 700 APIs for more than 500 organizations across many industries, including Coldwell Banker, Johnson Controls, SITA, Crunchbase, and the University of California, Berkeley. 3scale has offices in Barcelona and San Francisco. And I want to formally welcome the 3scale associates to Red Hat.

Next week, we will be showcasing more of our portfolio of technologies, customer success stories and partner traction at Red Hat Summit in San Francisco. Once again we are expecting strong attendance at our premier user event which is also one of the largest annual open source events. I hope many of you will be able to join us.

In summary, we are excited about our strong start to the fiscal year. We remain optimistic about our outlook for the remainder of the year as Frank will detail in a moment.

As a final note, I want to thank all Red Hat associates around the globe for the innovative ideas and technologies that led Red Hat to being recognized by SDTimes as a top 10 Influencers in 2016 along with companies like Apple, Facebook, Google and Microsoft. SDTimes publishes that these companies are making their mark on the entire industry and whose work has made a significant impact on what others build, how they build it, and ultimately, who uses it.

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

Frank Calderoni

Thank you, Jim. We are seeing very good momentum in our business and solid execution. This enabled us to deliver results that exceeded our guidance across a number of metrics. At the same time, we continued to invest in our high growth application development platform and emerging technologies, which are responding to our customer’s needs to enable cloud computing and digital transformation.

Let me begin with the financial highlights of our Q1 performance. For a more detailed view of our results and reconciliations of our non-GAAP measures to GAAP, please refer to our press release.

I am pleased to announce total revenue of $568 million, above the high-end of our guidance and representing growth of 18% in US Dollars and in constant currency on a year-on-year basis. In general, currency rate volatility has stabilized to a point where many of our USD and constant currency growth rates are essentially equivalent. So, for this quarter I will keep my prepared remarks focused on our reported US dollar results where appropriate and you will find a table of constant currency results in our press release.

Subscription revenue continued to be the largest driver of our growth at $502 million for the quarter, an increase of 18% year-over-year. This renewable revenue stream now constitutes 88% of total revenue providing a large base for future renewals and upselling opportunities for new technologies.

We continued to drive high growth across our technology portfolio. Subscription revenue for our Infrastructure-related offerings was $403 million, an increase of 14% year-over-year. Our application development related and emerging technologies subscription revenue was $98 million, an increase of 39% year-over-year. Application development related and emerging technologies revenue was approximately 17% of total revenue, up 260 basis points from the year ago quarter. We are pleased to see that we have reached an annualized run rate of nearly $400 million a year as customers continue to adopt our portfolio of technologies, like Middleware, the Red Hat OpenStack platform, OpenShift, cloud management and storage.

On a non-GAAP basis, operating income of $124 million grew 9% year-over-year and non-GAAP operating margin was 21.8%; this is consistent with the 22% operating margin direction we provided on our last call which included the investment in the Ansible acquisition. As a reminder, non-GAAP operating income adjusts for non-cash share-based compensation expense, amortization of intangible assets and transaction costs related to business combinations.

Using our non-GAAP estimated annual effective tax rate of 27%, non-GAAP diluted earnings per share came to $0.50; consistent with our guidance and up 14% year-over-year.

We ended the quarter with cash and investments of approximately $2.1 billion. We returned $66 million to shareholders in the quarter through the repurchase of approximately 900,000 shares of stock. Given our strong cash position, ability to generate meaningful cash flow and firm belief in our long-term prospects for the business, I am pleased to announce a new $1 billion stock repurchase program that will replace our previous $500 million plan. We believe this new plan will contribute further value for our shareholders.

Total deferred revenue at quarter end was $1.7 billion, an increase of $256 million or 18% over the same quarter a year ago. On a constant currency basis, total deferred revenue was up 17%.

The total change in deferred revenue from our cash flow statement which neutralizes most of the impact of currency fluctuations decreased $46 million compared to the end of 2016. This follows the pattern we’ve seen historically in Q1’s.

Operating cash flow of $232 million for the quarter was up 8% year-over-year and was at a record for a Q1. Strong collections contributed to this result with FX-adjusted Days Sales Outstanding at 56 days, that's down from 59 days in the year-ago-quarter. In addition, during the first quarter, we made the decision to adopt Accounting Standards Update 2016-09 earlier than required related to accounting for stock compensation. The impact to operating cash flow in Q1 FY17 was a benefit of $8 million and it was a benefit of $6 million when adjusting Q1 FY16. In Q2, we currently expect this benefit to be only $1 million. Also a schedule with historical adjustments for ASU 2016-9 to FY16 operating cash flows can be found in the supplemental data presentation that we provided with this call.

On a rolling four quarters basis, the billings proxy was $596 million, that's up 16% on a constant currency basis and 13% US Dollars year-over-year. The rolling four quarters billings proxy is calculated by adding revenue plus the change in deferred revenue on the cash flow statement for the last four quarters.

I will now review the metrics for business momentum and large deals in the quarter. Our geographies saw continued growth in bookings. This quarter 60% of bookings came from the Americas, 21% from EMEA and 19% from Asia-Pacific versus a 55/25/20 split in Q1 of last year. Although some companies have pointed to geographic weakness, we continue to see strong growth across all of our major geographies. In fact, while EMEA’s relative contribution to our total bookings was lower than the prior year, its underlying momentum was strong. In Q1, the EMEA sales team was faced with a smaller number of multi-year deals in its renewal base when compared to Q1 last year. There was a focus on driving significant new business and a higher growth rate in single year bookings.

Congratulations to the EMEA team on great execution in Q1 in renewing existing deals and growing their new business. The Q1 route-to-market mix was 78% from the channel and 22% from our direct sales force, compared to a 75/25% split in Q1 last year. Our proxy for booking duration was 21 months which was in-line with historic duration. Within our top largest deals, all of them were $1 million or more. And we had record six deals in Q1 that were in excess of $5 million and of these deals two were over $10 million.

This was a record first quarter for large deals with 45 deals over $1 million which was up 50% year-over-year. This traction highlights Red Hat’s growing strategic importance in our customers’ data centers and our talented sales teams’ ability to land and expand our wallet share of IT dollars. Cross selling was strong, with a record high of 80% of the top 30 deals including one or more components from our group of Application Development and emerging technologies offerings.

Mainstream customers in sectors such as healthcare, industrial & agricultural products and retail were the top verticals followed by Government and Financial Services customers. With our renewal business, we once again renewed all of the top 25 deals that we were expecting. The total subscription value of these top 25 renewals was approximately 105% of the prior value. Similar to what we experienced a couple of years ago, we had several large US Government deals that renewed at approximately 100% of their original values weighing on this metric for Q1. Excluding these Government renewals, the subscription value of our other top renewals was approximately 110%. It is important to note that overall, our Government sales team delivered double digit growth across the Federal segment in Q1.

Now I would like to turn to guidance. Our outlook assumes current business conditions, and the impact of the acquisition of 3scale and foreign exchange.

We are reaffirming our full year revenue guidance to $2.380 billion to $2.420 billion, up approximately 18% in US Dollars at the high end of the range. We are modestly decreasing operating margin to approximately 23% due to a $5 million impact from the 3scale acquisition. We are reaffirming the operating cash flow in the range from $800 million to $820 million. We are also adjusting our target for full year non-GAAP earnings per share to approximately $2.19 to $2.23 per share, assuming a 27% non-GAAP annual effective tax rate, approximately $1 million to $2 million per quarter forecast for other income and the investment related to 3scale which is approximately $0.03 per share.

For Q2 specifically, this implies the following outlook. We expect revenue to be in the range of $587 million to $593 million, which is up 18% in US Dollars at the high end of the range. We expect non-GAAP operating margin of approximately 22.8% and non-GAAP earnings per share of $0.54 which includes $0.01 impact for 3scale acquisition in Q2.

Consistent with prior practices, I will not forecast quarterly cash flow but I will note that it is important to consider the AR balances to reflect the quarter-over-quarter change to cash flows. Also although payments can fluctuate in a quarter, I would also anticipate AP balances to be approximately flat to slightly up with Q1 balances.

Overall, we are very pleased with our financial performance in the first quarter, and we believe we are off to a very good start for FY17. We are excited about the company’s long-term growth opportunity as we are uniquely positioned to further drive the adoption of open source technologies as IT organizations transition their application development and infrastructure to hybrid cloud environments. Finally, we look forward to seeing many of you next week in San Francisco for the Red Hat Summit and for our Analyst Day on Thursday, June 30.

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

Question-and-Answer Session


[Operator Instructions]

Our first question comes from Mark Murphy with JPMorgan. Please go ahead.

Mark Murphy

Yes, thank you very much. So, Jim, looking back on it, the Company has held onto this glide path of a mid-teens revenue growth rate for the past four years. And it looks like fiscal 2017 is going to mark a fifth year. So it has been very stable and consistent at an increasing scale. I'm wondering when you consider the cloud business and the emerging portfolio that you have, and you look forward to the next few years, do you see the potential to maintain roughly that type of a mid-teens glide path? Or if you don't want to comment on that, could you just walk us through what you think would determine whether the next move there is slightly higher or slightly lower?

Jim Whitehurst

Yes, sure. Look, I certainly don't want to get into providing any type of long-term view. So let me just talk about kind of the components and how we think about it right. RHEL continues to grow in the teens kind of nicely and the other businesses even as they scale and get pretty large continue to grow in the high 30s to high 40-ish percent. So the issue is as those other businesses that continue to grow a lot faster, a, can they continue that momentum and can RHEL continue to grow in the low double digits. And, if so, at some point those other businesses will weight the overall growth rate up not down. I think we feel confident that RHEL can continue to grow double digit. I think the other businesses we are confident can continue to grow especially things like OpenStack and OpenShift and storage continue to scale. And so as we do that, you put that together, I feel pretty good about the weighted average of those keeping our growth rate where it is or taking it up not down. I think there is better odds of it accelerating and decelerating again as you start to see the other products become a larger percentage of the total and those are obviously at a lot faster growth rate.


We will go next to Scott Zeller with Needham & Company. Please go ahead.

Scott Zeller

Yes, thank you. Your comments on OpenStack adoption earlier, could you give us a sense of how many of those are pilots versus actual production rollouts, and revenue impact? Thank you.

Jim Whitehurst

Well, the ones that I mentioned are actually -- they are actually used in production right. The pilots, we have a ton of those going, those I didn't mention those generally typically don't have the right to mention because they are pilots. Those are all actual deployments that are up and running. In terms of revenue it's still - immaterial might be too strong a word, but it's still quite small. Again, even when you put something in production, nobody buys a $1 million or rarely do you see $1 million initial deployment of OpenStack. You start, you put applications on it and you grow with it over time. So the deployments are still five figures maybe six figures and they will scale as the applications go on there. So it's still -- it's not having a significant impact on our revenue but you can kind of start to see the traction as the application portfolios that are running on the infrastructure grows, we will see it impacting over the next year or two.

Frank Calderoni

And the OpenStack summit that occurred last month was very successful as far as just the numbers of companies that showed interest in OpenStack and also how well Red Hat was received in that forum.


We'll go next to Kash Rangan from Bank of America/Merrill Lynch. Please go ahead.

Kash Rangan

Hi. Thank you very much. At what point Jim I think we've asked this question multiple ways, but at what point does OpenStack become material to the overall financial results? And also one follow-up -- as it relates to the cloud service providers, could you give us an update on what percentage of the overall infrastructure business do the CSPs represent and how are they tracking for the rest of the year? Thank you very much.

Jim Whitehurst

Well, I mean, OpenStack, when will it be material piece of revenue is something I wish I fully knew. We are seeing nice traction. Again these are things that take a while. There is a real S curve and we are still in the growing part of the S curve and when that inflects up is something I wish I knew. So we are feeling really, really good about it. If you look at OpenStack Summit I believe this is a non scientific but I believe we announced more new customers at OpenStack Summit than everybody else combined. So I mean we are seeing a nice traction there and it just these things have to grow and we will -- as we hit that kind of accelerating point it will start to make a bigger difference.

Frank Calderoni

Cloud service provider?

Jim Whitehurst

Cloud service providers, I don't think we are prepared to give an update. What I would say is it is still by far our fastest growing part of our business and obviously you can see our app dev in emerging technology has grown pretty fast. So it is growing faster than that. So we feel very, very good about it. It's -- but beyond that I don't think we have any numbers we’re disclosing.

Frank Calderoni

Yes. We shared last year that we achieved the $100 million run rate for our Cloud service provider business, as Jim said we are excited about the opportunity that we have there, continue to add to the 150 public cloud provider that we have as part of the ecosystem. And we will look to another update at some point as the business continues to evolve to provide some further color on that.

Jim Whitehurst

Show up next week and see if you can pry more out of Paul.


Our next question comes from Abhey Lamba with Mizuho Securities. Please go ahead.

Abhey Lamba

Yes, thank you. Jim or Frank, we continue to see strong momentum in your large deals, but your deferred revenues are becoming increasingly more seasonal. Can you talk about the payment terms of these large deals? Are you seeing any compression in payment terms or any changes from historical patterns? Just trying to see why we don't see these large deals translate into relatively comparable billings outperformance. Any color on that would be helpful.

Jim Whitehurst

Yes. I talked about this a little bit in Q4. It used to be with our large deals weren’t quite as large as they are now. People often paid upfront because they had budget for a project and they had the budget that year and they paid upfront. Even though for us we recognize that revenue over time over multiple years. As we have gotten bigger and we become a larger portion of their infrastructure, these numbers get really, really, really big. And as companies get more used to subscription type models, they are becoming more comfortable the kind of pay-as-you-go model. And so now to pay upfront they want a discount and we have plenty of cash in the bank as Frank talked about. We are not going to do abnormal things to get someone to pay upfront. And so now we still have multiyear commitments but there are people less likely to pay upfront as those deals have gotten bigger and people gotten more used to pay-as-you-go type model. So I think that's just their -- just those trends work slightly against people paying out your portion.

Frank Calderoni

And the only thing I would add to that is as we see much more content with some of the emerging technology products, those tend to be a shorter duration than some of the RHEL agreements that we’ve had in the past, so that mix is also a factor in addition to what Jim mentioned.


We will go next to Siti Panigrahi with Credit Suisse. Please go ahead.

Siti Panigrahi

Hi, guys. I just want to follow up on Mark's question about Linux growth. I'm wondering could you talk about some of the factors now influencing Linux growth. And also Gartner's recently talked about in a report that how the Linux cost within enterprises is increasing, and they talk about how you can reduce the Linux cost at this point. I'm wondering what you are hearing from your customers in the market about that.

Jim Whitehurst

Well, so two things. I think we continue to actually have share takes from Linux and from Windows. But the majority of the share take that we are seeing is that Linux wins the majority of net new workloads right. So if you look at something like Hadoop, I think it would be very, very, very rare to find a Hadoop workload it is running on Windows, right. It is 90 some percent Linux. If you look at containers right now 100% are on Linux because it's Linux native kind of technology. So as you start seeing so many of these new technologies they are 100% on Linux. So Linux overall is taking share vis-à-vis Windows and lend to Unix because that's where that new workloads are going. So you didn't say within Linux how our shares doing. And I have not seen a lot of customers that are actually transition from RHEL to free, so we feel very, very good about how we are doing in that environment. Obviously, as these contracts get big they go up further level in purchasing and so we have more negotiation on some of those as you would expect as they get bigger. But we have a pretty strong value proposition. The one area I would say you see particular push back would be a developers. Developers who want kind of low friction and they want to be able to try things quickly. And so even we now have developer subscription that's free. So people can use, our developers can use our production quality products for free. So again I think as we go forward as the dollars get bigger. Of course people are going to look from Window management perspective to try to get the best possible deal. But so far, again we haven't lost any when we talk about all our renewals renew and they renewed more than 100%. So we feel good about how we are doing there.


We go next to Matt Hedberg from RBC Capital Markets. Please go ahead.

Matt Hedberg

Yes. Thanks, guys. . In the past you've commented on what percentage of top deals contained a storage element. I'm curious if you can give us an update or some color on how that business is doing.

Jim Whitehurst

I'll start talking while Frank finds that number. Hopefully so we don't put for the top 30 deals had storage. Let me just say come next week we have some excited announcements on our storage product that I want to front run the announcement. You'll hear some exciting things about what we are doing in storage next week so please come to the summit and you'll hear more.


We will go next to Michael Turits with Raymond James. Please go ahead.

Michael Turits

Hi, guys. Two related questions. The Linux infrastructure business deceled slightly on both USD and constant currency basis. One, I wanted to find out if we should be thinking about the $5 million that you had a benefit, I believe, in the year-ago quarter and whether that was a bit of a headwind to growth. And, secondly, if you could just talk about how pricing is working and AR is working as people move over more to cloud Linux and whether or not that's having a positive or negative effect.

Frank Calderoni

So Michael, it is Frank. On the first part of your question, yes, the $5 million was an impact. So you do have to take that into consideration. The adjustments that we made for the cloud accounting a year ago in Q1 of FY16.

Jim Whitehurst

In terms of overall pricing, so we have two components of how we sell on cloud. One is our cloud access program where enterprises who have a subscription can run those in their own datacenter or on the cloud. So that pricing is basically equivalent wherever someone decides to run it. Our actual subscription sold on cloud in general, those are smaller number unit. And so they had better pricing than our traditional larger enterprise deployments. So overall it's a net positive given the pretty fast growth in the cloud business.

Frank Calderoni

And, Mike, take a look at the gross margin they have been very consistent over the years about 94% for subscription. So it's a good place to start.


Our next question comes from Brent Thill with UBS. Please go ahead.

Brent Thill

Thanks. Jim, this year on distribution, are there any changes that you see that you're making on the direct side or any additional tailwinds you see in terms of the some of the partnerships that are coming onboard that would maybe be different than what we saw last year?

Jim Whitehurst

Well, I mean I do think we are building greater capability with our partners on OpenStack. As there are two kinds of things happening there. It is our product is getting easier to use with each release as the installed and management tooling gets better. And our partners are getting better at it. So as we talked about we primarily been supply constrained on OpenStack. I think you will see with our partners a bit of tailwinds this year as they will be more capable of selling and installing that for us. Also, we continue to build out our storage partner ecosystem. And as we do that storage is much of that is a partner related sale. So, yes, I do think you'll see some tailwinds there; I wouldn't necessarily kind of call it out as a massive shift this year versus last year but it continuous to move in our direction.


We will go next to Heather Bellini with Goldman Sachs. Please go ahead.

Heather Bellini

Great. Thank you very much. I wanted to touch on two quick ones. One, you mentioned that ex those federal deals your contract renewals would have been at about 110%. I'm just wondering if you could put that in context. You guys have been running 120% or better for a while. What type of trend are you seeing that might be ticking that lower? I was also wondering if you could share with us a little bit, as you see more and more workloads go to places like AWS, how you think about the share that you guys have of the total Linux market versus the share you have on premise? Thank you.

Frank Calderoni

So, Heather, on the first -- the reason that we identified government deal was the kind of give a sense for the impact that has. And as I said in the earlier comments, we do tend to see that from time to time with some of the government deal size. That's why I wanted to put that aside. As far as the 110%, we continue to see a very good response from customers as it relates to our emerging technologies. And this year in particular we emphasizing that even more. We have been making much more investment in our sales organization and supporting customers around that. So the 110% that you mentioned in previous quarters we saw it as high as 120%. I don't see that as being an issue. It's something that maybe more specific to some of the agreements or the contract that we had in Q1. But we are optimistic as far as the pipeline and the types of transactions and the focus that we have around the emerging technologies as we continue throughout FY17.

Jim Whitehurst

Yes, and Heather obviously when you take out the Fed deals which are particularly heavy in Q1, you just get some lumpiness around which deals and what are they. Some people buy by project and therefore those stay flat and you get a separate deal to grow and others kind of it is one big thing and so but there is nothing in trends that looks like any change from the past. I feel pretty good about continuing growth in those renewals. Related to our share on Amazon or on cloud in general, again, as we talked about in the past, certainly if you looked at our overall share it is lower on cloud that it is on premise but trying to tease out how much of that is nature of workload versus something different about the cloud deployment model is one it's a lot harder to breakout. When we talked to customers and they talk about moving workload from on prem to cloud, the RHEL value proposition is really, really strong because of the kind of common technology, common support model. So we feel like our kind of share of production workload on cloud is feels like it is as high as our share of production workload on premise. It is harder for us to have quite as much as visibility because we don't see all that. In the same way that in dev test environment people don't pay for RHEL typically there. I think the same thing happens on Cloud. And so they are more dev in test these type workloads on cloud but as we are seeing more production workloads move to cloud, we are seeing continuing growth and accelerating kind of our business on the cloud providers. So we feel pretty good as the value proposition holds up. We haven't seen anything or any kind of customer saying; oh I am moving to cloud so I am not buying RHEL. Our customers as they move to cloud or using our stack there as well.


We will go next to Gregg Moskowitz with Cowen and Company. Please go ahead.

Gregg Moskowitz

Okay, thanks very much. I know its early days with having Ansible in the portfolio, but just wanted to ask about that because automation's being cited as an important priority from a lot of folks that we speak with. Can you just talk, Jim, to how adoption levels of Ansible are tracking relative to your expectations so far?

Jim Whitehurst

Oh, I think without a doubt it is well above what our initial expectation. Ansible's really hit an inflection point and it is really taking off. If you look at Google web search trends, if you look at the open source used in adoption, we talked to customers and we are seeing a tremendous amount of interest around Ansible. It certainly well beyond what we initially expected at the acquisition. Now again it's still early days but it's I would say that it's far exceeded our expectations at this point.


We will go next to Karl Keirstead with Deutsche Bank. Please go ahead.

Karl Keirstead

Thanks. I'm wondering if I could ask two related questions about the performance in the quarter on the revenue front on both a geographic and a vertical basis. On the geo front, you mentioned that the bookings mix in Americas was up, but I see the constant currency growth rate, the revenue growth rate in Americas decelerated. I'm wondering if you could explain that. And then on the vertical front, financials, banks are normally number one, number two. I noticed they were more like number four, number five in Q1. I'm wondering if you felt a little more heaviness, sluggishness in the banking vertical in the May quarter. Thanks.

Jim Whitehurst

Well, let me start on the top 30 deals and then Frank, he will try to do the mix one. Yes, we had a couple of really large, we had one large IoT deal that was kind of massive renewal which I think kind of skewed the results a bit which is kind of put other category is kind of the largest category. It is in the transportation industry IoT deal. And so I think that kind of had an impact. Otherwise, I think government is always kind of relatively stronger in Q1 which is just kind of I think that's more normal. Other than that it kind of was normal than with around financial services kind of stacked on down. But again I think it was skewed by one particularly large IoT deal in transportation.

Frank Calderoni

So on your question about the geographic split. As I mentioned earlier, we had good growth across. I am just looking at the performance of the Americas, EMEA, Asia Pacific, over the last several quarters. It has been fairly strong and consistent across the board. From a constant currency standpoint the growth rate clearly, it have been bit stronger in Europe an Asia Pacific. And we had some weakness I would say in LatAm in the last quarter or so that could have had an impact on the overall currency.

Jim Whitehurst

Currency weakness not business weakness.

Frank Calderoni

Yes, currency sorry. But overall as I looked at there is nothing really unusual that we are seeing across the geographies which is why we made the statement earlier. Good, consistent growth.


Our next question comes from Kirk Materne with Evercore ISI. Please go ahead.

Kirk Materne

Hi, thanks very much. Jim, I was wondering if you could talk a little about how we should think about OpenShift and the move of developers to the cloud versus a lot of the traction you've had with JBoss over the last few years. Is that at all cannibalistic I guess to the on-premise middleware world? I guess you get a lot of questions around that so I would just love your perspective on that, and how we should maybe be thinking about it. Thanks.

Jim Whitehurst

Yes, sure. Well, we recognize the majority of the revenue around OpenShift is still OpenShift on premise right. We originally started OpenShift as an online product offering and a lot of our customers then said, hey, we actually want this on prem. And so that still be a stronger part of that business. But overall it is pretty synergistic and that we now offer all the JBoss services as services on OpenShift. And so when someone is on OpenShift it actually does help pull through the JBoss services. And then vice versa if you are using the JBoss services then you are looking for a PaaS. It is a natural way to go. So there are some real synergy between the two. I am not sure if I have fully answered your question. If not next week we can go through that in the fair amount of detail.


We will go next to Keith Bachman of Bank of Montreal. Please go ahead.

Keith Bachman

Hi. Thank you very much for taking the question. In your remarks you indicated that you thought RHEL could sustain teens growth. Could you talk a little bit how you see containers, the growth and development of containers, as you look out impacting a fully grown or fully blown operating system or RHEL in particular: how you see the growth of containers impacting that growth rate? Thank you.

Jim Whitehurst

Well, we actually se containers as a fairly significant opportunity recognized containers they are form of virtualization but what they basically do is slice the operating system between kernel space and user space, right. So all the user space aspects have the operating system are in a container. And the reason we actually see this is a positive driver of our business is first off containers in general are 100% Linux. Containers are not -- do not run in Windows. They run in Azure today on Linux running on Azure. So, first off Linux is a 100% those today, at some point I am sure Microsoft will support it but my guess it will be like Hadoop where 1% or less of those workloads. So first off we get all of it and then within that because it is -- you have the user space in the container then two things. First off, you need to make sure that you are lifecycle managing that. And so most of the big security vulnerabilities that have happened in Linux, the Bash bug et cetera happen in user space. So it becomes extremely important to having operating system vendor that can push updates into the user space of the container. And Red Hat is particularly good at that. So as go containers go into production as ISVs want to deliver their application in a containerized format, unless the want to go into the Linux business and develop their own Linux security response team to patch and push those updates, the role that Linux vendor gets to be even more important. So we actually see containers is a great opportunity for us to continue to differentiate around, a, kernel space and user space being consistent. So having the same host and technology in the container itself. And then secondly just ability to lifecycle manages against that. So containers overall are good for Linux because it helps it grow overall share versus Windows. And then within that we think we have a definitely differentiated position given our position in the OS. So that's why we can see continue double digit growth in general in the OS category which includes containers.


Our next question comes from Walter Pritchard with Citi. Please go ahead.

Walter Pritchard

Hi, thanks. A question for Frank, just about the dilution from the acquisition. I guess it looks like that Company maybe had 50-ish people, based on just quick scan around. When do you get to the point where you can absorb that kind of acquisition without having to revise guidance for the year sort of in terms of tradeoffs with your own hiring plans that you might have internally?

Frank Calderoni

So, Walter, we would really looking at two acquisition like the Ansible one that we talked about the latter part of last year and then 3scale today. We are as I talked about before if I step back separate from the acquisition and look at the investment portfolio. We have needs within the company related to a lot of the emerging technologies that's what hinting to start to see that ramp both from an engineering and then also from a go-to-market perspective. The opportunity we feel is there. The investment required especially when you have lead time that can go from 12 to 24 months as far as working with customers. We feel the investment to make in those areas is extremely critical for us to drive the growth that Jim referred to earlier that we are looking forward to. Not only this year but as in the next several years. And so we are also kind of putting that in perspective of trying to make sure that we can balance it as it relate to margin. We know that investors are always interested and looking at operating margin and how that performing. So it is difficult when we want to also look at an acquisition especially in the near term. And not to say that we expect this to be dilutive forever. Jim talked about Ansible and how strong we feel about the performance so far. So as these acquisitions start to show some traction especially as part of Red Hat, we expect them to start to drive not only upside but also improvement in the bottom line. But in the near term with all the other competing priorities that we have in a company to add an acquisition or two that we have done right, it is hard to kind of balance that within the overall portfolio. If you step back and look at the margin, I did some analysis earlier and if you go back to FY the operating margin, and you look at FY15 we had about 23% and if you adjust both 2016 and 2017 looking at how much we are spending for the acquisition of Ansible and 3scale, we are actually looking at about 23%. In 2015, 23.6%, in 2016 and if you look at the guidance that we provided for FY17 adjusted to be about 23.6% as well. So with despite all the needs that we have internally we are kind of holding the margins and therefore adding a bit I think for both of those acquisitions is reasonable.


We will go next to Edward Maguire with CLSA. Please go ahead.

Edward Maguire

Hi. Good afternoon. It's encouraging to see the 3 million applications that are running on OpenShift. But I wanted to ask to what extent that adoption is driving pull-through of really the underlying RHEL and REVH components of the platform as a service.

Jim Whitehurst

Well, it is built on -- it is sold as a product that includes RHEL right. So OpenShift is a product is a full stack from the hardware up, I mean from OS up, so it pulls it through because it is all kind of built into one SKU together. So we want to close running on it, it is kind of our stack. Obviously, if the online runs on Amazon or Azure or Google, their infrastructure underneath that. But the rest of the stack is ours and it just kind of priced it is kind of SKU that include those components.


We will go next to John DiFucci with Jefferies. Please go ahead.

John DiFucci

Thank you. Jim, you talked a lot about the recurring subscription revenue. I guess the question for you or Frank, has there been any change to the revenue renewal rate over the last few years? I know Charlie used to talk about an 80% renewal rate across your entire business, and this excluding upsells. Is it still around the same rate today, or with larger deals has it gotten higher?

Jim Whitehurst

It's a little better than that now. So there are couple of issues in measuring that. And actually it's -- we believe it's a fair amount better than that. The piece where we sometime lose data is our business through OEMs. If somebody buys a server with a three year skew runs through all for three years throws away the server and buys another one that has RHEL in there that person would have been considered not renewed and then the new server would be new business. So if you leave that and you look at what we have visibility into, our renewal rates have increased pretty consistently over the last several years. How much of that's dynamic and larger deal versus how much of that is we have been focused on it, especially we have a very high renewal rate at large deals right. Very high close to a 100% for our larger customers. As you go down to some of the smaller customer it has been lower. And we had more of focus on that. We worked with partners; we build programs with our distributors. So our renewal rate continues to expand. If your question I'd say lot of that's because of better execution. In terms of just strategic dynamic around that, yes, we get to be more strategic to people that probably helps as well. But the renewal rate is still in the 80s but it continues to creep up.


We will go next to Steve Ashley with Robert W Baird. Please go ahead.

Jason Velkavrh

Hi, this is Jason Velkavrh on for Steve. Thank you for taking my question. I was just wondering if we can get an update on REVH, the performance of that product. And maybe if you can comment on the pace of REVH's growth versus RHEL's growth.

Jim Whitehurst

Yes. I mean well REVH has continued to perform better and better. As we talked about as people have started to look and say, hey, I am really interested in OpenStack and then there are set of customers who are looking, once they look there say well we are actually running stack for workloads and then you work through and it turns out what they really, really want is VMware replacement. We've seen the REVH business grow nicely. In terms of growth rate looks a lot more like application development in emerging technologies than like RHEL in terms of growth rate. It is substantially faster than RHEL overall. Yes, so yes that business is doing frank very nicely.


Certainly. Our final question comes from Jason Ader with William Blair & Company. Please go ahead.

Jason Ader

Yes. Thank you. Actually I wanted to follow up on REVH and just understand in terms of the top 30 deals how many of those included REVH. And then also just understand what are the prospects to actually accelerate the growth rate there. It seems like it hasn't quite hit the stride that maybe you expected it to at this point relative to when you introduced it, but seems like it's picking up momentum. Is there an inflection point in your mind where REVH kind of really takes off?

Jim Whitehurst

Yes. Well within four deals of the top 30 deals. I think we will see -- when we first introduced years ago we thought okay well this is a great alternative to the VMware. But frankly a lot of people had other issues to worry about or comfortable with their VMware infrastructure. And so we didn't get the same share take that we got there as we've gotten say in the Middleware portfolio or certainly Unix or Linux. And the majority of the REVH that we have seen has been more, hey, I am adding net new workload and I am going to do that on REVH because it is cheaper than the alternative. So we haven't had the normal I would say kind of rip and replace share take that we have of WebSphere and WebLogic to JBoss or Windows or Unix and Linux to RHEL. The big question I think we have in all of our mind is, will that change as OpenStack continues to grow when people say but I have a set of workloads that aren't really amenable to OpenStack. Once you have KVM as the underlying hypervisor and you have a set of management tools that look kind of similar across, that seems to be what's driving incremental REVH growth at this point. So, yes, I think they can kind of continue to pick up nicely. That's what we are seeing pretty fast growth in that overall. I think that -- does that hit an inflection point or not, it is generally kind of we are selling at this part of portfolio again with our other technologies. And I will say we are -- as we mature that technologies position really well against the VMware if you will, it's kind of feature for feature. So it is becoming, it is part of the portfolio something that kind of comes along.

Tom McCallum

Thank you. Operator, I am afraid that's all the time we have today. I hope to see a lot of you next week at our Analyst Day. And if you aren't able to make it please join us on the webcast and let us know if you have any follow up questions. Thank you very much.


Thank you. This does conclude today's conference. We appreciate your participation. You may disconnect at any time. And have a great day.