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Red Hat (NYSE:RHT)

Q4 2012 Earnings Call

March 28, 2012 5:00 pm ET

Executives

Tom McCallum -

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

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

Analysts

Philip C. Rueppel - Wells Fargo Securities, LLC, Research Division

Joel P. Fishbein - Lazard Capital Markets LLC, Research Division

Mark R. Murphy - Piper Jaffray Companies, Research Division

Adam H. Holt - Morgan Stanley, Research Division

Matthew Hedberg - RBC Capital Markets, LLC, Research Division

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

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

Kash G. Rangan - BofA Merrill Lynch, Research Division

Stewart Materne - Evercore Partners Inc., Research Division

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

Walter H. Pritchard - Citigroup Inc, Research Division

Heather Bellini - Goldman Sachs Group Inc., Research Division

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

Brent Thill - UBS Investment Bank, Research Division

Jesse Hulsing - Pacific Crest Securities, Inc., Research Division

James Derrick Wood - Susquehanna Financial Group, LLLP, Research Division

Operator

Good afternoon. My name is Jamaria, and I will be your conference operator today. At this time, I would like to welcome everyone to the Red Hat's Fourth Quarter and Fiscal Year 2012 Earnings Conference Call. [Operator Instructions] I would now like to turn the conference over to Mr. Tom McCallum. Sir, you may begin.

Tom McCallum

Thank you, Jamaria. Hello, everyone, and welcome to Red Hat's earning call -- earnings call for the fourth quarter of fiscal 2012. Speakers on today's call will be Jim Whitehurst, President and CEO; and Charlie Peters, Executive Vice President, CFO. Our earnings press release was issued after the market closed today and may be downloaded from redhat.com on the Investor Relations page. Also on this page, you will be able to find a historic reconciliation schedule of GAAP to non-GAAP financial metrics as well as the schedule on currency rates.

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

Actual results may differ materially from those indicated by these forward-looking statements as a result of various important factors, including those discussed in the company's most recent quarterly report on Form 10-Q filed with the SEC, as well as the Safe Harbor statement in today's press release.

In addition, any forward-looking statements represent our estimates or views only as of today, March 28, 2012, and these estimates or views may change. While the company may elect to update forward-looking statements at some point in the future, we specifically disclaim any obligation to do so even if our estimates or views do change. And therefore, you should not rely on these forward-looking statements as representing our estimates or views as of any date subsequent today.

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

James M. Whitehurst

Thank you, Tom, and let me add my welcome to all of you joining us on today's call. I'm pleased to report that we delivered fourth quarter results that exceeded the high end of our guidance, and it represented a very strong finish to another record year for Red Hat. Red Hat associates around the globe have contributed to 40 straight quarters of sequential revenue growth, culminating in fiscal 2012 revenue that exceeded the $1 billion mark.

Red Hat has become the first pure-play open source company and one of a few select software companies to have ever achieved this milestone. Our consistent strong growth over the last decade stems from the high value we deliver to customers, the power of our subscription model and the freedom, flexibility, reliability and security that our customers find with our open source solution.

Let me share with you just a few of our financial highlights: records billings proxy of $418 million for the quarter up 31% year-over-year; full year revenue growth of 25%, a 160 basis point improvement in our operating margin for fiscal 2012 even while we invested aggressively in growth opportunities in virtualization, cloud computing and unstructured data storage. Finally, we delivered record operating cash flow, up 35% for the quarter and for the fiscal year. The strong growth that we achieved for fiscal 2012 is all the more impressive when considering the strength of our fiscal 2011 performance.

Red Hat's top line growth indicates that we are gaining market share from our competitors. In addition, we believe we are one of the few technology companies that is helping to define the new era of computing and enabling it through our technology and value proposition. Customers are looking to Red Hat to help modernize their data centers with reliable high-performing and agile technologies that prepare their infrastructure for cloud computing and the growth of big data.

We also see a structural shift in the global economy where companies have been forced to become more lean and productive by doing more with less. One of the key enablers for success in this new economy is innovative technologies like Red Hat's portfolio of enterprise-class solutions. To shift simply -- this shift simply cannot be addressed by legacy proprietary software.

So from Wall Street firms to Main Street global retailers, CIOs are partnering with Red Hat more and more. These shifts in how business and data centers are run have enabled Red Hat to expand our footprint at existing customers and to attract new customers. An illustration of this expansion can be seen in our largest renewal. This quarter, we renewed 24 out of our top 25 largest deals or 99 out of 100 for the year, and we experienced 130% growth in these top accounts. Included in this metric was a record financial services deal with a global bank that significantly increased their purchases to an 8-figure deal

In a minute, I'll discuss our progress in expanding beyond our core customer verticals. But we also continued to add meaningful new customers in our largest and longest standing markets. For instance, in the government segment, we've expanded beyond the security-focused agencies by winning significant deals with agencies like the IRS, the Patent Office, the Veterans Administration and the National Oceanic and Atmospheric Administration.

In the telecommunications segment, we've added cloud providers on top of our existing business with telecom equipment providers, global and national telecommunication service providers and wireless providers. We continue to expand our business with technology, hardware and software companies, Internet companies and technology service providers while also adding SaaS, Web 2.0 and social media customers.

In the financial services vertical, we continue to add insurance providers, commercial banks and investment firms while expanding business with the early adopters of Red Hat technology, the global investment banks. This has contributed to a substantial increase in large deals. Charlie will discuss the details of our Q4 top 30 deals metrics in a minute. But let me add that for the full year, the number of million-dollar deals were up approximately 50% year-over-year.

This type of traction with new and existing customers drove another terrific quarter and fiscal year for our core offerings. I'm pleased to say that our core offerings and operating systems in middleware delivered record-breaking bookings. In fact, total bookings had its highest Q4 growth rate in 5 years.

Now let me update you on the progress we're making relative to our multiyear growth initiatives, which are already having an impact on our success and positioning us well moving forward. First, we continue to expand our marketing and commercial capabilities to drive further adoption outside of our core verticals, expanding in the mainstream industries such as logistics, health care, transportation, retail and energy. This year, we achieved 40% growth in the number of deals from mainstream customers and our quarterly top 30 deals compared to the last fiscal years or quarter.

Second, we continue to deliver consistent results from our Free to Pay program this year. We added significant deals throughout the year, and during the fourth quarter, we saw one 7-figure deal and one 6-figure deal that included a Free to Pay component.

Our third strategic initiative is to further enhance our routes to market distribution model. For the second year, we achieved our annual goal of a 60-40 split between channel and direct sales while driving rapid sales growth across all routes to market.

The fourth initiative is to execute on our technology roadmap to enable us to maintain and extend our technology leadership position. We expanded our core offerings and emerging technologies. Let me give you a recap of recent technology announcements from Q4.

In virtualization, we were joined by a number of successful customers and industry-leading technology partners as we launched RHEV 3, our virtualization management technology, which features over 1,000 enhancement and is now built on our open source technology.

We had a major milestone announcement related to our storage offerings. We launched the Red Hat Storage Appliance, a software appliance for unstructured data that is built on RHEL and is available on-premise or in the Amazon cloud.

In the cloud space, we continue to build out our commercial offerings in certified cloud ecosystem, which now includes 9 partners among the premier cloud providers the world, including Amazon, IBM, NTT, Savvis and recently, Swisscom. We further enhanced our benchmark setting platform technology with the release of RHEL 6.2 and extended life cycle support, increasing the value we deliver to our customers. And we added new technologies, bringing benefits to use cases ranging from cloud to financial services to communications in our messaging, realtime and grid offering or MRG.

Something that can get overlooked from the outside but which is extremely important to Red Hat is our solid execution relative to the foundation that supports continued growth beyond $1 billion. I'm referring to building out our functional capabilities such as customer engagement, execution discipline, systems enhancement and core people processes, all of which are critical to managing the rapid growth at our customer base, as well as the expansion of our technology portfolio.

In summary, I'm very pleased with our financial results for fiscal 2012. We're about to celebrate the 10-year anniversary of Red Hat Enterprise Linux, following record results from the platform technology. Our platform offerings are the most relevant to customers addressing the shift in the data center. Coupled with our early success in middleware and our emerging technologies in virtualization, storage and cloud computing, Red Hat is well positioned to expand our role as a strategic vendor for Enterprise customers.

Once again, I want to thank each of our Red Hat associates around the globe for their hard work in achieving the $1 billion mark. I'm confident that we have only just begun to address the opportunity in the data center, and we will continue to deliver value for our customers and stakeholders in the years ahead.

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

Charles E. Peters

Thanks, Jim. In the fourth quarter, we experienced strong demand across all geographies and technologies and the numbers clearly show it. Today, we reported year-over-year quarterly growth rates for the fourth quarter of fiscal 2012 of 21% for revenue, 27% for non-GAAP operating income, 31% for billings and 35% for operating cash flow, all compared to last year's very strong fourth quarter results.

And for full year growth rates, we reported 25% for revenue, 28% for billings, 33% for operating income and net income and 35% for operating cash flow. Red Hat's technology and value proposition continued to resonate with our customers, independent of the economic climate. Importantly, we drove this strong growth at significant scale with expanding profitability and cash flow. At the same time, we continued to invest for the future. For example, during fiscal 2012, we added substantially to our engineering support and sales staff, including overlay sales teams to drive further adoption of our middleware virtualization and cloud computing solutions.

We added sales offices at 4 additional countries this year to expand our geographic reach. We acquired Gluster, now known as Red Hat Storage, that add to our infrastructure offering and enter the unstructured data storage market. And we delivered major releases of our technology. In total, we ended the fiscal year with over 4,560 employees, an increase of 800 employees. We believe these investments will position Red Hat for additional market share gains in fiscal 2013 and beyond.

Now let's discuss the financial results. We are pleased to report another record quarter for both bookings and billings. We continued to add new customers and extended our strategic position in data centers around the globe.

Here are few of the statistics from the top 30 deals in the quarter. For the second time this year and the third time overall for this metric, all of the top 30 deals were greater than $1 million. In fact, many deals beyond the top 30 also exceeded $1 million. Three deals were over $5 million, 40% of the top 30 deals include a middleware component, and financial services has the highest representation in the top 30 deals, closely followed by mainstream customers as we continue to add new customers and expand in new industry verticals. By mainstream customers, I mean those industries other than the traditional top 4 verticals for us of financials, government, telecom and media/technology.

As I've done on other year-end calls, I'll add a few additional statistics about bookings. To be clear, similar to prior years, we will not be updating you with booking statistics on a quarterly basis. Our bookings growth was over 30% for the fiscal year and was higher than our billings growth. The average contract duration for the quarter was approximately 21 months, consistent with the last several quarters. We ended the year with off-balance sheet backlog in excess of $200 million, of which approximately $120 million is expected to be billed in fiscal year 2013.

As a reminder, bookings that are billed increase deferred revenue, and bookings that are not yet billed increase backlog. Our billings proxy for Q4 set a new record at $418 million, up 31% year-over-year over a very strong Q4 last year. This was a difficult comp. As a reminder, our billings proxy is calculated by adding revenue to the change in deferred revenue shown on the cash flow statement, which excludes the impact of foreign exchange rates on deferred revenue.

Moving on to bookings by channel and geography, our Q4 bookings mix was 59% from the channel and 41% from direct sales, the same as Q4 last year. As Jim already mentioned, the full year split was 60% channel, 40% direct. Our geographic split also remains little changed with 60% from the Americas, 26% from EMEA and 14% from APAC, essentially in line with Q3 split of 60%-24% and 16%, respectively. For the full year, we saw strong 25%-plus growth in every region.

Now let's talk about our financial performance for the quarter, starting with revenue. Fourth quarter revenue was $297 million, up 21% from the prior year and above the high end of our guidance of $292 million. Strong demand and sales execution, including better-than-expected upselling and cross-selling were important factors. Subscription revenue for the quarter was $255 million, up 22% from the prior year. Subscription revenue, which is a renewable revenue stream, constituted approximately 86% of total revenue in Q4. Training and services revenue was $42 million, up 18% from the year ago quarter, and as expected, was down $2 million sequentially as a result of holiday downtime at customer sites around the globe.

Now I'll discuss the rest of our results on a non-GAAP basis, excluding stock compensation expense and amortization expense. Overall, gross margin was 86% in Q4, up 60 basis points sequentially and up 180 basis points from the prior year due to better services margins and more subscription in the mix. Services margins were up due to 2 factors. On the training side, this year, we contracted with a global training partner, which has made our training expenses more variable with demand. The second factor is due to higher-than-anticipated utilization rates in the consulting business.

Subscription and gross margin remain consistent with last quarter and last year at 93.8%. Q4 non-GAAP operating expense came in at $178 million, up 6% sequentially and up 23% from the prior year. In Q4, we continued to hire aggressively for sales, engineering and support, and we’re making systems investments that enable further growth.

Q4 non-GAAP operating income increased 27% from last year, resulting in Q4 non-GAAP operating margin of 26%, up 110 basis points year-over-year. Net interest income was $2 million, consistent with the prior year. Our annual effective tax rate was approximately 30% for both GAAP and non-GAAP results, lower than the 31% which has been -- which we've been estimating in earlier quarters, primarily as a result of the discrete tax benefit which we record in the second quarter. The non-GAAP tax rate was 28% in order to adjust for this annual rate.

Our non-GAAP diluted quarterly earnings per share is $0.29, up 12% compared to non-GAAP diluted EPS of 26% in Q4 of last year. Keep in mind that fiscal year 2011 Q4, that's the year-ago fourth quarter, included a discrete tax item related to the U.S. R&D credit, which benefited the year-ago net income by approximately $0.02 per share.

I can't remember the last time when I could say this, but foreign exchange rate changes had no material impact on the income statement, whether you use this quarter's average rates, average rates from last quarter, average rates from Q4 a year ago or the rates I used in providing guidance in December of 2011.

Now let's turn to the balance sheet and the cash flow statement. We ended the year with $1.3 billion in cash and investments. We repurchased approximately $76 million of Red Hat common stock in Q4, which brings our total purchase to $133 million for the fiscal year. We're pleased to announce that the Board of Directors have authorized a new $300 million stock repurchase plan to replace the previous $300 million plan which will expire on March 31. A separate press release to that effect went out this afternoon.

The duration and consistency of our days sales outstanding continues to be very good, which I take as an indication of satisfied customers and the good work of our collections team. DSO was 55 days for Q4 versus 50 days last year and down from 60 days last quarter. As a reminder, since days sales outstanding is traditionally a measure of receivables versus billings, our DSO calculation includes revenue plus the change in deferred revenue.

Total deferred revenue at quarter end was $947 million, an increase of $175 million or 23% over the prior year end. Sequentially, deferred revenue increased approximately $127 million from last quarter.

Let me break down the components of deferred revenue for you while factoring in the impact of foreign exchange. Short-term deferred revenue, which ended Q3 at $609 million, had real growth in Q4 of $98 million and increased $4 million as a result of changes in FX spot rates, ending Q4 at $711 million. Long-term differed revenue, which ended Q3 at $210 million, had a real increase in Q4 of approximately $23 million and was further helped by changes in foreign exchange spot rates by $2 million, ending Q4 at $235 million. Total increase in deferred revenue without the impact of currency changes was $121 million, up 15% sequentially and can be found on our statement of cash flows.

Moving to the statement of cash flows. We produced record quarterly operating cash flow of $128 million, up 38% -- excuse me, up 35% and full year operating cash flow of $392 million, again up 35% and well above the high end of our upwardly-revised guidance.

Now let me briefly recap and summarize highlights for the full fiscal year. Revenue grew to $1.13 billion, up 25% year-over-year and above the high end of our guidance. Subscription revenue grew to $966 million, an increase of 25% while services grew 23%. This is the second year in a row that services revenue was above the historic services revenue growth rate of around 10%.

Non-GAAP operating income grew by 33%, and non-GAAP operating margin expanded by 160 basis points, 26.4%. We ramped up hiring and investments for growth all year long as we said we would. A terrific revenue growth allowed us to deliver operating margins higher than our original 100 basis point goal. Non-GAAP EPS ended at $1.10, up 33% year-over-year. Overall, it's another tremendous year for Red Hat.

Now I want to shift to fiscal year 2013 guidance. For this guidance, I'd assume average foreign exchange rates of $1.33 for the euro and JPY 83 to the dollar. This represents a 4% weakening of the euro and a 5% weakening of the yen from the average rate for fiscal 2012. I'm not attempting to forecast exchange rates. I'm simply pegging guidance at this point.

With that in mind, we are forecasting total revenue in the range of $1.34 billion to $1.36 billion for fiscal 2013, representing an annual revenue growth rate up to 20% in U.S. dollars. On a constant currency basis, this would represent about 22% growth. This growth rate assumes that subscriptions will grow faster than services revenue, and that services revenue growth will be somewhere in the low teens, closer to our historic services growth rates. We plan to build engineering sales and support for our nascent storage business and ramp up investments and other growth opportunities as we have described previously. Based on our strong finish to fiscal year 2012 and our current outlook, we are targeting non-GAAP operating margins in the range of 24.7% to 24.9% for this fiscal year. I'm estimating full year other income, principally net interest income, up approximately $8 million or $2 million a quarter.

The estimated annual effective tax rate for fiscal year 2013 is 32%, rising principally as a result of the non-extension of the U.S. R&D tax credit. This should come as no surprise to any of you since all of your portfolio companies with billing R&D are similarly impacted. If, as in prior years, Congress reinstitutes the R&D credit retroactively, then we may have a onetime tax benefit in the quarter in which Congress acts. We'll continue to report non-GAAP net income and EPS using our expected GAAP tax rate.

As far as cash taxes are concerned, we still expect our cash tax rate to be about 5% throughout fiscal year 2013, principally as a result of stock compensation deductions and tax credits carryforward. Assuming a 32% tax rate and approximately 196 million diluted shares, one would estimate diluted non-GAAP EPS in the range of $1.16 to $1.20 a share. On a GAAP basis, we are estimating annual stock compensation expense of approximately $90 million and annual amortizations expense of approximately $20 million.

From a cash flow perspective, we anticipate operating cash flow for the full year between $440 million to $460 million. I expect additional cash flow of $30 million to $40 million, not included in GAAP operating cash flow, which is related to tax savings from excess tax benefits from stock compensation. This will be recorded in cash from financing activities line as it has been in the past.

After adding over 800 people last year, we plan to add around 1,000 more this year. To accommodate this and additional future growth, we will be expanding our offices in Raleigh, North Carolina; Westford, Massachusetts; and Brno, Czech Republic, among others. We anticipate that these expenses will give us capacity for years, which we need in those locations. As a result, I anticipate capital spending this year to be in the $100 million range, which is about $50 million higher than I would expect our normal run rate today. This is not a capital-intensive business, but we do have a step function investment necessary this year to allow us to scale.

Finally, when looking at the fiscal quarters, I would remind you all that with our recurring revenue model, there's a natural ebb and flow to the business. Bookings and billings historically are lowest in Q1 and then have grown each quarter to the fourth quarter and then repeat the pattern again the following year. The revenue on the other hand has grown every quarter for the last 10 years.

For Q1, we offer the following guidance: Revenue is estimated to be $307 million to $311 million. Non-GAAP operating margin is estimated to be approximately 24% to 24.2%, as we continue our global expansion of sales and marketing as we ramp up our investments in the storage business.

Using my earlier estimates of quarterly interest income of $2 million and a 32% tax rate, non-GAAP EPS is estimated to be approximately $0.25 to $0.27 a share, assuming approximately 196 million diluted shares. Consistent with my past practice, I do not guide quarterly cash flow. I think that it can be quite variable depending upon individual large payments or receipts. However, I would say it seems likely that last year's pattern of higher cash flow in Q1 than Q2 will repeat given our strong year-end balance sheet.

To conclude, we're extremely pleased with our results for fiscal year 2012, and we believe that we're well positioned as we gain market share and growth. We're continuing to invest in areas such as virtualization, cloud computing, middleware and now storage, but we're also prudently managing costs. We are optimistic about this fiscal year and looking -- and the forward-looking pipeline continues to look strong.

Before turning the call to the operator, I'd like to remind our financial community to register for your exclusive VIP pass to our 2012 Red Hat Summit in Boston, Mass., where we will host a financial analyst meeting on June 27.

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

Question-and-Answer Session

Operator

[Operator Instructions]

Tom McCallum

[Operator Instructions]

Operator

Your first question will come from the line of Philip Rueppel with Wells Fargo Securities.

Philip C. Rueppel - Wells Fargo Securities, LLC, Research Division

Yes, just a quick question about sort of demand trends during the quarter. Last quarter, you had mentioned that linearity was sort of back-end loaded. Did it go back to normal this quarter, or did you still see a surge in orders near the bookings -- near the end of the quarter? And did the introduction of Red Hat Enterprise Virtualization or the Gluster product affect that pattern at all during this quarter when they were introduced?

Charles E. Peters

Thank you. The linearity this quarter was sort of back to a more 25%-25%-50% kind of split by month and quarters, and therefore, we enjoyed good linearity relative to the impact of both Red Hat Storage and RHEV 3.0. RHEV 3.0 was introduced in mid-January, so had little impact on the billings results for the linearity of the quarter.

Operator

Your next question will come from the line of Joel Fishbein with Lazard Capital Markets.

Joel P. Fishbein - Lazard Capital Markets LLC, Research Division

Just real quick, I'd like to get an update on Gluster and the market opportunity there. I know you mentioned a little bit, Jim, on the call, but love to really understand how that business is going and what the competitive dynamics are.

James M. Whitehurst

Well yes, so we obviously just acquired the company in our fiscal Q3, so we have just beta-ed last week the first Red Hat-branded storage. So obviously, it's not for sale, Red Hat Storage 2.0. So it had no material impact on our revenues or even bookings for Q4. We have a very strong pipeline for high-performance computing environments for unstructured data. There's a lot of interest in the technology. It's -- given that there's software only, which provides flexibility and allows for elasticity in the cloud, we're seeing a lot of interest there. So we'll have the product GA-ed in the not-too-distant future, and we'll certainly be able to talk to you a lot more about it at the Analyst Day at the Summit.

Joel P. Fishbein - Lazard Capital Markets LLC, Research Division

Just as a follow-up, can you give us a little bit about the competitive dynamics? It looks like a pretty unique technology. I'm just understanding opportunity there, so that'll be great.

James M. Whitehurst

Yes, the -- on the competitive dynamic side for Gluster, it's the traditional -- I'd say, Isilon would be the closest competitor there. It's -- Red Hat Storage is a software-only scale out system that for unstructured data, really, is a unique technology to solve that problem. So it's hard to come up with a direct competitor because there's not another software-only storage solution like that.

Operator

Your next question will come from the line of Mark Murphy with Piper Jaffray.

Mark R. Murphy - Piper Jaffray Companies, Research Division

Jim, I wanted to ask you, do you sense an extra layer of growth occurring due to the build out of large public clouds like Amazon, Salesforce.com, Facebook, et cetera, for those that rely on Red Hat infrastructure? Is that dynamic tangible and material enough to be layering on an additional 5 or 10 points of growth and basically to be causing your growth trajectory to be bumping up against this 30% level?

James M. Whitehurst

Well, I guess first off, Salesforce.com is a public reference. So, obviously, companies like that -- and, yes, I mentioned that we have other Web 2.0 and social networking-type companies who've become customers in the last couple of quarters. So certainly, that's relevant to us. But I think more broadly, as companies look at workloads and look to get them cloud-ready, so to speak, so to get them on modern architectures, I think the thing that's driving most isn't necessarily a direct move now to cloud, but it's since they need to go ahead and get their applications ported to a platform that can move to cloud. So just the move from UNIX to Linux and getting those applications ported even though they're still in their current data center is something that's really we're seeing a lot of tailwind as people are getting ready to ultimately potentially move those to cloud.

Operator

Your next question comes from Adam Holt with Morgan Stanley.

Adam H. Holt - Morgan Stanley, Research Division

Terrific. My question is about margins. If you look at the margin guidance for next year and then think about margins longer term, do you see next year as sort of a temporary investment cycle then will return to longer-term margin expansion over time? Or how should we be thinking about margins going forward?

Charles E. Peters

Good questions. As we described back in October when we acquired the storage business, this is a heavy investment year ahead of us, but we do think that it is realistic to be expecting that in the following year and years thereafter that getting back on a margin expansion kick, again, of somewhere in the 50 to 100 basis points a year would be a realistic assumption.

Adam H. Holt - Morgan Stanley, Research Division

And then you -- along that line, you're also guiding to operating cash flow growing faster than operating income. Should we expect that relationship to continue in that kind of perspective? We saw it last year, but we hadn't seen it in years past. Is that how we should think about it going forward?

Charles E. Peters

Frankly, that's a harder one to guide, but my assumption is that, that is definitely possible for a couple of years here.

Operator

Your next question comes from the line of Matt Hedberg with RBC Capital Markets.

Matthew Hedberg - RBC Capital Markets, LLC, Research Division

Circling back a little bit on the Gluster. I know it's still early, but could you talk about sort of your initial reaction on the sales force going after different IT executive that -- in the virtual storage group?

James M. Whitehurst

Yes, actually frankly, that's one of the things that we feel best about with Gluster is it depends on the company. Most companies, it's in the infrastructure group, and so it's often the same buyer. If not, you may have a -- their own storage management organization. It still reports up to the same head of infrastructure typically. So if it's not someone that we have a direct relationship with, it's somebody they run into in the halls and someone whose boss we know, which is very different than JBoss, where you've had to go build a whole different set of relationships in a whole different part of the organization. So I think one of the reasons I think our sales force is feeling good about Gluster is they do know the people and feel very, very good about it. And actually, I should call it Red Hat Storage. Gluster is the open source project. But yes, our sales force feels very, very good about Red Hat Storage and the relationships we already have to be able to drive sales there.

Operator

Your next question comes from Michael Turits with Raymond James.

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

Back on the cloud question. Just a little bit more precision maybe, and I know you said, Jim, that you weren’t -- it was more prep for cloud than cloud right now, but maybe you could just detail where you're getting more or less traction, say, within private cloud and then think about maybe a sort of small- to medium-sized public service provider cloud and then large. And specifically relative to commercial sales of RHEL, not just people maybe using the community version or open source Linux.

James M. Whitehurst

Well, yes, I'll try to do a bit there. I mean, obviously, we do extremely well with private clouds because people are confident running it in their data centers. They feel confident that our technologies allow for applications to move. And so we do well there. In relation to public cloud, we just GA-ed RHEL on Amazon, oh, about 6 months ago, and that's been going tremendously well with huge growth rates. But it's obviously off of a small base. But I think it's certainly exceeding our expectation. So across the board, we're seeing good, solid strength. I'd still say it's too early days to say what are going to be the big, mega drivers among those over the next year or 2.

Operator

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

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

I'd like to just ask a couple of questions on the middleware business. Number one, Charlie, I don't know if you can provide us with the number of top 30 deals that were middleware only. And then secondly, if you could comment about the -- just the general or subjective, I should say, qualitative growth rate of the middleware business versus the core business of billings growth in the quarter?

Charles E. Peters

Sure. So on the first question of the top 30 deals, 40% of them had a middleware component. Well, it could've been substantially middleware, but none of them were just middleware. So I think -- the good news is there, we've got a good cross-sell going on. The second part of the question relative to relative growth rates, we had just a booming quarter in the fourth quarter for our basic platform business, and so the middleware business and the platform business grew at about the same pace in our fourth quarter.

Operator

Your next question comes from Kash Rangan with Merrill Lynch.

Kash G. Rangan - BofA Merrill Lynch, Research Division

I'll echo my positive thoughts on the quarter as well. It looks like the deferred revenues grew about $270-plus million, which is about 2x relative to 2 years earlier. And given that you have really started investing higher in your sales and marketing the past 12 months, is there any reason why that kind of absolute dollar growth rate should not continue as you look out? And also secondly, the cash flow guidance was much appreciated, but I think you surprised us with the CapEx. And if I heard you right, Charlie, the CapEx is going up to $100 million, which I think is a very big increase. Is that -- that takes away a little bit of the free cash flow growth, but I'm just wondering if you could tell us a little bit more about what's going into that number. Is that number going to start to come down in fiscal '14 so we can expect free cash flow growth to resume, or is this the permanent level from which you're going to be operating at in the future?

Charles E. Peters

So on the first question about deferred revenue, can we expect the same level of growth in subsequent years? Obviously, it depends upon the market at the time. But given the type of guidance I've given, both relative to the P&L and the cash flow numbers for next year's, one must assume reasonable deferred revenue growth to achieve that. So I don't know. I haven't guided a specific number, but I think you could assume that's going to be a pretty good number. The second thing on the CapEx, in my comments, I actually had said it's -- I think this is a onetime as a step function change for this year. We're adding facilities, major facilities in Raleigh, North Carolina; Westford, Massachusetts; and Brno, Czech Republic, among others. So I would say our normal run rate CapEx is probably something closer to $50 million. But most of that is fitting out the buildings with this expansion of almost 1,000 people in addition to the 800 we just added in the last year.

Operator

Your next question comes from Kirk Materne from Evercore Partners.

Stewart Materne - Evercore Partners Inc., Research Division

I just want to ask a little bit about RHEV. You had version 3.0 out for about 1.5 months in the quarter. Could you just talk about if that had any impact on the numbers in the quarter and if any of your top 30 deals actually included a virtualization component to it? And then just sort of lastly, I guess along your -- with your conversations with RHEV, I think, Jim, you've talked about only about 10% of RHEL servers are currently being -- or running in a virtualized environment. Do you expect that, now that RHEV is out, do you think that could sort of accelerate in terms of seeing a higher percentage of that -- a higher percentage of RHEL move towards virtualized?

James M. Whitehurst

Okay, sure. Well first off, we released RHEV 3.0 in mid-January, so with less than 45 days left in the fiscal year, and while we have incredible sales people out there, that's a little too short a sales cycle to be able to get a product through POC and up in the production in a material way. A number of our deals -- and I'm just scanning the list, I don't have an exact number. A number of our deals had RHEV components in the top 30. Those again likely would have been relatively small kind of POC-ish-type beginning. So I wouldn't say it had a material impact on our overall numbers, but we do have a lot of POCs going on right now. And again, on a key point, only about 10% of Linux workloads are virtualized. That, obviously, is a very logical market where we have great relationships and we have the best technology solution there. So I do think there's a big market there that's really been waiting for us to come out with a true open source Linux-based virtualization solution. So I do think there's a lot of opportunity out there but it wouldn't -- didn't have time in Q4 to materially impact our numbers.

Operator

Your next question comes from John DiFucci with JPMorgan.

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

Charlie, non-GAAP sales and marketing was greater than we expected. And as a percentage of revenue, I think it's greater than it's been at least ever in our models, it goes back 8 years. I understand the outperformance on the top line and that had some impact on that. But as a percentage of revenue, I'm not sure I do understand. And I was just wondering, was there a greater impact this quarter? Were you more aggressively this quarter than the last couple of quarters hiring or was it -- what's happening there? Because that line, we expect at some point see some leverage but we just haven't seen any yet. In fact, you're going the other direction.

Charles E. Peters

Good question. So, obviously, with the acquisition of Red Hat Storage business in October, one of the early things we said is we are going to build this business and building the business is principally adding people, so adding people in the sales functions, engineering functions and support functions. So a portion of that increase you're seeing in the fourth quarter in the sales and marketing line is this additions to the storage business. We hired aggressively for sales for all functions on all regions in fourth quarter and continued to do so. As I also said in my prepared remarks, the other things we did for sale this year, which I would call a kind of start-up as we entered 4 new countries, opened offices there, hired sales people and then beginning the ramp up. Typically, when you hire a salesperson, it's a 6- to 9-month ramp up period to full productivity. So it does take a little bit of time to do that.

Operator

Your next question will come from the line of Walter Pritchard with Citigroup.

Walter H. Pritchard - Citigroup Inc, Research Division

Charlie, your buyback level for the fourth quarter here increased materially, and I think sort of back, we fill it back to the downturn in the market when your stock get really cheap to see levels like this, and I saw you authorize a new buyback. So I'm just wondering, is there a change in your thinking here around use of the cash? Did you take advantage of a stock rate you thought was attractive, or just in general, how should we think about buyback and use of the cash going forward?

Charles E. Peters

Okay, all right. Just as I've said before, in terms of use of cash, really, the first and most important use of cash is organic growth. We invest in our business, we expand geographically, add people and so forth. The second thing we try to do is something on the -- on an M&A front, we can find appropriate targets that fit our business, whether it's a technology acquisition, a service acquisition or possibly a regional distribution acquisition, that would be appropriate second use of cash. And the third use of cash is stock buyback. And the reason for the new authorization -- the old authorization had been substantially used up, but it was, nevertheless, it was expiring anyway on March 31. So the board felt it's appropriate to put the new authorization in place for the next 2 years.

Operator

Your next question comes from Heather Bellini with Goldman Sachs.

Heather Bellini - Goldman Sachs Group Inc., Research Division

Two quick questions. One, I guess for Jim, where do you think customers are in terms of modernizing their data centers? And how long do you think the opportunity can play out for you guys on that front? And then I guess the second one for Charlie is just that you really outperformed your initial cash flow guidance in fiscal '12, so congratulations on that. I'm just wondering, if you reflect back on the performance, what were the key driving factors that kind of you weren't expecting at the time you gave guidance a year ago?

James M. Whitehurst

Yes. So first off, I would say, if we want to use a baseball analogy, I'll put us in about the third inning. If you looked at our core customer franchises, we do really well in investment banking. We're probably in the sixth inning or seventh inning with investment banking. We are literally scratching the surface on the commercial banking side of those banks. If you look at telcos, we started off in all the periphery systems. We now have people like Amdocs there, standardizing on RHEL and with most of the major players, we'll be moving into the OSS and BSS systems. So the absolute number of systems, we're maybe 40% done. The dollar value maybe 20% done because those are obviously the higher-value system. So we have a long way to go on the core RHEL. Obviously, we're nowhere near that far with JBoss, which I would still call kind of bottom of the first inning. So there is still a massive opportunity out there. The good news now is as we've expanded with our core verticals, we have credibility with telcos and financial services and government, now it's expanding out to a whole different set of workloads and use cases through those enterprises so -- which is always easier. And obviously, you're seeing a tremendous growth in what we call mainstream customers, so outside of those core verticals. There's still a lot of those to attack and even the ones we've gotten, again, are small parts of their footprints. And we kind of land and grow into that.

Charles E. Peters

And Heather, the second part of your question is about the cash flow expectations at the start of the year compared to where we ended up. Clearly, cash flow at the end of the year is substantially higher than the initial guidance. In fact, I believe I increased cash flow guidance each quarter in the last fiscal year, something extremely unusual for me or probably for anyone. But the reason for that is that each quarter, the total outlook got stronger starting with the revenue guidance got higher, the profit guidance got higher on overall performance of the business, including a great control of working capital in the balance sheet, it all got better, which produced a terrific cash result.

Operator

Your next question comes from Ed Maguire with CLSA.

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

I wanted to switch to Platform-as-a-Service and ask if you could provide some color around your progress around OpenShift, ultimately what your expectations there? And how that might be impacting the JBoss and middleware businesses as well?

James M. Whitehurst

I'll take a stab at that. As we said when we launched it, it's as much a business model beta as it is a technology beta. So there's obviously no revenue. There is no revenue stream at all. It is kind of a gratis service that we are offering to anyone. The number of -- and our major measure of that is the number of running applications. So these are durable applications that people write, put up and continue to use. And that has grown massively. Now obvious, it's hard to put a specific growth rate on that because it started off at a very low base. But we've had just tremendous week-over-week growth, really, since the beginning. We had a huge inflection point in about August with getting JBoss up and running, so having a JEE alternative there. It hit a real inflection point and is really taken off and continues to grow solidly since then. There's great synergy between JBoss and the middleware portfolio in general and Platform-as-a-Service. Obviously, for us, when and how we think about monetizing that, something we're obviously thinking hard about. But that's mainly been continuing 6-week spreads, get new functionality up and on the site and continue the momentum of getting applications written up and continuously running on the platform.

Operator

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

Brent Thill - UBS Investment Bank, Research Division

Jim, on your comments on gaining share, who are you having an easier time against right now in the field?

James M. Whitehurst

I think we -- there are really a bunch of macro drivers to get people off of all of the proprietary systems onto Linux, both from just the sheer cost of risk-based architectures, obviously, as well as people looking to get on modern architectures to prepare them for this kind of the new paradigm, whether that's in cloud or private cloud. And so really it'd be hard to pick out any individual one. It's just kind of across the board.

Operator

Your final question will come from the line of Rob Owens with Pacific Crest Securities.

Jesse Hulsing - Pacific Crest Securities, Inc., Research Division

Jesse in for Rob. Would you say that you're seeing customers focused more on defensive cost takeout-type spending versus maybe last year at this time? What are the trends there?

James M. Whitehurst

Yes. I wouldn't necessarily say that. I think you kind of get -- it's kind of a double whammy, which I think is one of the things that's driving our growth. People want to modernize to a new architecture that they believe will be ready for public or private cloud, and they want to take cost out. And the nice part about especially going from UNIX to Linux is you do both at the same time. So people look at it as some on saving costs, others of, “Wow, moving to a new architecture.” I think one of the tailwinds we've seen is people kind of say, "While I get the best of both worlds, I'm getting a modern modular kind of future-proof architecture. Oh, and by the way, it's a lot cheaper, too." I think that's one of the reasons you've seen so much strength over the last couple of quarters. Operator, I think we have time for one more quick question, if you have one out there.

Operator

Yes, we have a quick question from Derrick Wood with Susquehanna International.

James Derrick Wood - Susquehanna Financial Group, LLLP, Research Division

You guys obviously had a nice acceleration of billings growth off of a tough comp. Do you think that closing of deals that slipped out of Q3 created any kind of artificially higher growth rate in the quarter, or does it feel like the sales conditions you saw in Q4 are a good proxy for a run rate going forward? And then I guess based on your cash flow guidance, should we assume that the billings growth tracks higher than your 18% to 20% revenue growth target?

Charles E. Peters

Thanks, okay. So there were 3 questions there. So the first one and first of all, we did not have any slips of deals out of the third quarter. That was not Red Hat who made that comment on an earnings call. Our third quarter was good. Our fourth quarter was better. I guess I would refer to our fourth quarter in NCAA terms, we hear about double doubles, rebounds and points. We have 30, 30. So we had 30% growth in Q4 last year, we had 31% growth in billings in Q4 this year. The second question about -- is it a proxy going forward? Really, every quarter stands on its own. In my prepared remarks, I talked about the ebb and flow of a recurring revenue model business. So it should be obvious to everyone that our Q1 results will ebb and flow the same as Q1 last year. We don't try to predict billings growth by quarter. And then your last question, I guess, I think was predicting billings growth. I guess you all have the job of trying to do that sort of building a model based on the earnings guidance I gave you and the cash flow guidance I gave you. I'll have to kind of work backwards, I suppose, to see what your estimate of billings are going to be. I don't forecast billings.

Tom McCallum

Thank you, everyone, for joining our call today. And we look forward to seeing you at our Analyst Day. Thank you, operator.

Operator

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

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