Red Hat F2Q08 (Qtr End 8/31/07) Earnings Call Transcript

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Red Hat, Inc. (RHT)
F2Q08 Earnings Call
September 25, 2007 5:00 pm ET

Executives

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

Analysts

Brendan Barnicle - Pacific Crest Securities
Steve Ashley - Robert W. Baird
Kirk Materne - Banc of America Securities
Terry Tillman - SunTrust Robinson Humphrey
Denny Fish - JMP Securities
Brent Thill - Citigroup
Mark Murphy - Broadpoint
Sarah Friar - Goldman Sachs
Jason Maynard - Credit Suisse
Tim Klasell - Thomas Weisel Partners
Heather Bellini - UBS
Kash Rangan - Merrill Lynch

Presentation

Operator

I would like to welcome everyone to the Red Hat second quarter fiscal year 2008 earnings conference call. (Operator Instructions) I would now like to introduce Ms. Katrinka McCallum, Vice President of Investor Relations. Ms. McCallum, you may begin your conference.

Katrinka McCallum

This Katrinka McCallum, and welcome to Red Hat's second quarter fiscal year 2008 earnings call. Speakers for today's call will be Matthew Szulik, Chairman, President and Chief Executive Officer; and Charlie Peters, Executive Vice President and Chief Financial Officer.

Our earnings press release was issued after the market closed today, and may be downloaded from RedHat.com or requested by calling Investor Relations.

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

In addition, any forward-looking statements represent our estimates or views as of today, September 25, 2007, and these estimates or views may change. While the company may elect to update forward-looking statements at some point in the future, we specifically disclaim any 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 to today.

Now I will turn the call over to Matthew.

Matthew Szulik

Thank you Katrinka, and thank you, everyone for taking your time this afternoon to participate in Red Hat's second fiscal quarter earnings call. Q2 marked another productive quarter of improved global sales channel performance, customer acquisition and overall operating performance by the company.

Financial results for the quarter were at or above the high-end of company guidance. Revenue of $127.3 million was a 28% increase from one year ago. Operating income was $26.4 million, a 49% increase from one year ago, leading to earnings of $0.17 per share. Cash flow from operations was $63.7 million, up 44% over the prior year. Overall, another consistently solid quarter by Red Hat.

The thesis of the Red Hat economic model is to help customers attack the 40% to 60% of an IT department's budget that is consumed with operating and maintenance costs; those costs that reduce the available dollars for innovation in support of new business initiatives. In the last 60 days it was reported by Baan that in surveys of business users 85% of the respondents said that they were dissatisfied with the performance of their IT organizations. During my time at Red Hat IT executives and I have met, and they have described to me that they're focusing on the same issue, replacing these costs with innovative, flexible solutions that improve their firm's competitiveness.

In 2007, the macro global issues that IT departments faced are even more dramatic as purchase price becomes a smaller element of the total purchasing criteria. The customers I speak with are focused on creating a contemporary computing architecture that provides agility at the lowest cost; an infrastructure that is reliable and responsive to increase in workloads, security models, and application support. Today Red Hat is engaged at the most senior levels of our enterprise and government customers in helping them plan and build out their open source architectures.

From virtually no enterprise customers in 2001 to present, the Red Hat Enterprise Linux technology and Red Hat service model has delivered value and superior service that has been recognized by an unprecedented CIO Insight ranking of being number one in customer value for three consecutive years. This quarter in Japan, the fourth largest IT market in the world, in a business survey conducted by Nikkei Market Access, Red Hat was named as the number one vendor that customers intend to conduct business.

In 2006 Red Hat acquired JBoss, a technology-driven startup company with an excellent development team. The core driver behind this acquisition was and remains that industry and governments would be experiencing an unprecedented migration of their computing infrastructure and application environments over the next ten years. This migration would see a major shift to x86-based multicore machines as their compute platform, and the corresponding move to low latency, high performing messaging-based web-serviced applications. Customers are unlocking data from their application environments. Customers are seeking to have their data in a vendor neutral independent format.

The JBoss acquisition was a strategic decision for Red Hat to participate in this future network-based application build out. CIOs recognize that they're not producing apps and services quickly and fast enough for their businesses to stay competitive. As importantly, the social demographics of the developer is changing. We are increasingly seeing a next generation of application developer who has the literacy, experience in open source community relationships and building open source applications that continue to reduce the 40% to 60% of an IT operating cost with more high performing, efficient applications. We envision a future where object orientations, component reuse, simplified build systems, easy to deploy governance models are being built and deployed using open source software, all at the lowest total cost.

We have made great progress with JBoss in the past year, but we have much more work to do. Let me just describe a few facts for you. During the past 12 months the JBoss product line has been integrated into a global Red Hat open source development ecosystem. JBoss has been made production quality. 12 months ago JBoss was an English language only product line and today JBoss has been localized into multiple international languages. A globally integrated service and support model has been constructed to support production in customer environments where none previously existed.

Hibernate, Drools, Seam, clustering, messaging, monitoring, all contain and continue to innovate at a very rapid rate. The latest implementation of Hibernate is an incredibly creative release.

JBoss.org was created, modeled after the Fedora open development environment. In Q2 alone Red Hat trained over 200 technologists and salespeople on JBoss. This total, plus Q1, equates to over 500 individuals and channel partners trained globally on JBoss.

Perhaps most significant, since the completion of the acquisition one year ago, Red Hat has created at least one seven-figure JBoss end-user sales win in each quarter. Prior to the acquisition, there were none.

In Q2, professional services improved as we increasingly respond to customer requests to become involved earlier in the application design and development process. Although this may lead to slightly longer sales cycles of the JBoss product, I believe our growing knowledge of the customer environment and expanded Red Hat and JBoss skill base will continue to lead to larger, more strategic and perhaps most importantly, more recurring sales.

This past week I was in Europe visiting our customers. I met with the leaders of various European customers. In each case they have either replaced or are in the process of replacing aging Unix systems and middleware products with Red Hat Enterprise Linux and JBoss middleware, citing significant improvements in performance, speed to deployment, and lower total operating costs. These are mission-critical environments focused on performance and costs.

IDC projects that the application deployment market will grow to be $12.1 billion by 2011. We will compete aggressively in this market by continuing to innovate and deliver unprecedented value at the lowest possible cost. We have proven that open source software, due to its transparency of code base and end-user participation is the most innovative development model. Red Hat has produced four major versions of a multiplatform, multi-architecture OS in that timeframe, in which our competitors have barely delivered one major release.

Today Red Hat Enterprise Linux runs the most complex computing infrastructures in the world, from major stock exchanges to systems used to fight global terror.

Let me update and provide investors with some additional information on the Red Hat Enterprise Linux side and virtualization to support my opinions. Customers are aware that hardware changes rapidly. They are increasingly investigating solutions that build value on their bare metal machines. By selecting REL5 as the virtualization layer, customers are finding that they are able to deploy legacy-based certified applications on Red Hat Enterprise Linux 3, 4 and Windows machines, while taking advantage of the latest hardware advances.

For example, in a recent internal benchmark for a customer who was running Red Hat Enterprise Linux 3 across their grid, we virtualized those workloads on the latest Intel Cayman machine running Red Hat Enterprise Linux 5 and we saw more than 2X the performance within that virtualized workload. So think of this if you are a customer. Without having to port to REL5, without having to spend time and money chasing down ISV compatibility or compiler compatibility, customers can simply take advantage of the latest hardware changes in improved system performance and reliability without having to migrate to a completely new infrastructure and training environment.

In contrast for example, VMWare does not scale this way. VMWare supports four execution threads per operating system and we can apply all 16 Cayman threads to one guest operating system. We feel strongly that Red Hat Enterprise Linux 5 virtualization avoids locking at the hypervisor level, while delivering an incredible foundation for the future of SMP applications. This type of innovation from Red Hat and the open source community is the driver for all future Red Hat opportunities.

Next I would like to update you on the performance of our selling channels. It wasn't long ago that the majority of Red Hat sales were direct. In Q2 53% of sales were indirect, a number that we expect will increase over time to our stated goal of 60%.

In meeting with investors I have repeatedly described our plans to create a modern value-added system. In May at the Red Hat Summit we introduced RHX, a prospective value-added channel model. In the next 30 days Red Hat will roll out our integrated partner portal, a site that electronically allows a channel partner anywhere in the world to self-authorize, license and very shortly to self-certify applications online with no human involvement. We believe when integrated with RHX, that this online experience and model will give developers access to global markets and create the opportunity to monetize their work through a common Red Hat service experience.

Also within the quarter we advanced our channel strategy into vertical markets, first by being selected by SAIC as a strategic partner for their health care and government initiatives. Secondly with McKesson for its Horizon Clinical software product lines. In February, McKesson announced an important architectural update deploying their Horizon clinical applications on Red Hat and JBoss to improve platform cost-effectiveness for their hospital customers, while maintaining the mission critical reliability that is absolutely required for patient care. McKesson and Red Hat now have dozens of joint customers who in turn deploy McKesson software on hundreds of Red Hat servers, equally serving hundreds of thousands of patients annually.

In addition on a regional basis, SAP and Red Hat announced during the quarter the delivery of joint offerings for the Russian marketplace. Red Hat delivers the only operating system that complies and is certified with the Russian government for both security and military certification standards. Our ecosystem continues to grow, both in quality of partners and with global scale.

To place in context the scope of the total Red Hat opportunity, let me offer investors some additional facts. There are at least 80 national government open source software policies that have been either proposed or already approved. In addition, there are at least 34 states, provinces and four cities in Europe which are either proposing or have already approved open source software policies. In addition, there are at least 265 government policy initiatives ranging from open source software pilot projects to open source software preferences; or as importantly, open source software mandates in governments around the world.

Finally in May at the Red Hat Summit, I described for investors what we internally have called our 2020 vision for the future of our company. 2020 is focused on a set of organizing principles that drive the global scale for Red Hat to $1 billion and beyond. Points of emphasis within 2020 are increased accountability, efficiency and decentralization of decision-making. 2020 was developed with the Red Hat Board of Directors, and we began our internal rollout of 2020 18 months ago.

In March of this year Red Hat completed an important phase of 2020 by transitioning to a geography-based general management model. Today each of our major geographic markets is led by a general manager. The general manager is compensated on the profitability of their business and on a set of market activities such as market share and service performance.

In addition, Red Hat is transitioning from the previous functional model of engineering, marketing and sales to a line of business model. Today we're transitioning to three lines of business within Red Hat that integrate product development and product marketing. These lines of businesses are infrastructure, middleware and online services which includes RHX. These lines of businesses will be led by general managers and the general managers and their team will be compensated on the profitability of their business which they lead and the market metrics, such as market share and service levels.

By these changes we have reorganized marketing. The general manager of the line of business will own the product marketing responsibilities and therefore we have created a corporate marketing function inside the company which is led by Michael Chen, who recently returned to the United States after opening up and leading Red Hat China for the past three years. Corporate marketing is focused on brand, corporate communications and customer experience.

I have repeatedly told investors that Red Hat is a performance-based culture. We recognize that we're competing against the best technology firms in the world. We have planned for these changes through our investments and activity and succession planning enterprise-wide throughout our organization.

In order to develop our managers and staff, we have over the past two years built Red Hat University, our internal college that develops and trains our people to lead. We continue to focus to drive change internally and externally to scale Red Hat to meet our global opportunity. Let me reinforce that we're building the defining technology company of the 21st century.

I will turn the call over to Charlie Peters, Red Hat's Chief Financial Officer.

Charlie Peters

Thank you, Matthew. We are pleased to report strong financial results for the second quarter of our 2008 fiscal year. In Q2 we focused on continuing the operational improvements initiated earlier in the year to help streamline the business and enhance our internal systems and processes. As demand for open source solutions continues to grow globally, we believe it is in the best interest of our shareholders to invest in infrastructure that will enable us to scale to meet that demand. At the same time, we continue to deliver strong operating profitability and cash flow.

Let me give you a little color around two key operational initiatives and then I will walk you through our financial results and guidance for Q3.

First, as we have mentioned in the past, Red Hat has been implementing improvements to our global sales processes to increase the efficiency of our sales and back office teams. In addition to creating consistency in sales operations worldwide, these process improvements combined with technological enhancements have enabled us to begin to increase our sales efficiency by reducing the administrative workload on our sales reps.

For example, we have been able to reduce two venues of effort annually associated with the receipt of orders from our channels in EMEA by automating the load process into our front-end systems. We expect to see similar benefits as we rollout this effort in North America and APAC during the second half of fiscal 2008.

In addition, we are revamping many of the back office processes such as automating the credit approval process to increase operational efficiency and expand our capacity. For example, more than 40% of our credit approvals are now done without manual intervention, freeing up more time for collections and speeding approvals to sales. We are currently working on many such operational initiatives which are individually small, yet important in total, to achieve our goal of improving our operating margin of approximately 200 basis points per year.

Our second key operational initiative is to improve our renewal business through indirect channels. The plan encompasses four key areas of emphasis: to encourage the move from one to three-year subscriptions; to link systems to get end-user data; to use marketing development funds to incent and to help our channel partners to resource the collection of end-user data; and in the last 90 to 120 days we have begun to use a third party to help renew accounts that channels ought not to pursue. We have much more work to do, but we're encouraged by the early results of these efforts so far.

Focus on operational excellence and is a long-term strategic priority for Red Hat, and will require investments for the next two to three years as we transform our processes and systems to efficiently scale. The majority of CapEx during this period will be focused on this effort, and some increase in OpEx, principally over the next 12 months, will be related to this transformational work. We're investing in our processes, infrastructure and organization to help the company scale to the multibillion dollar level.

Now looking at the income statement, total revenue for Q2 was $127.3 million, an increase 7% from last quarter and 28% from Q2 of last year. Total revenue exceeded the guidance we provided last quarter as a result of the continued strength in the market demand and Red Hat's business momentum.

Subscription revenue was $109.2 million, up 6% sequentially and 29% year-over-year. Training and services revenue was $18.1 million, up 14% from last quarter and 23% year over year. The sequential growth in training and services was driven mainly by the demand for training related to REL5; it is a great early indicator of the future.

As Matthew described, we continue to see strong global demand for our open source solutions, and growing interest in our recently introduced solutions. We're encouraged that both of these trends will continue based upon our strong market position and our strong pipeline going into Q3.

Our billings proxy, which we define as revenue plus change in deferred revenue, was $141 million, up 26% from the $112 million in Q2 of last year. As I explained in Q2 last year, the billings proxy should not -- and does not -- include the $17 million of deferred revenue acquired from JBoss a year ago. The reason is simple: as the name suggests, the billings proxy is meant to represent the amount billed. The Q1 to Q2 billings pattern was similar to last year also, since a number of large deals were new in Q1 each year; that is how our recurring revenue model is supposed to work. Importantly, the Q2 to Q1 change in current deferred revenue was strong and bookings grew sequentially. As a result, off balance sheet backlog grew substantially.

Breaking down our Q2 bookings mix, the channel generated 53% of bookings and 47% came from direct sales versus a 57%/43% split in Q1. We expect this to vary between quarters due to deal sizes as we aimed toward our goal of driving 60% of the business through channel partners. A majority of our largest deals are done direct, while our channel partners typically handle high volume. We are actively adding channel partners, particularly for our middleware business.

In terms of geography, 54% of bookings came from the Americas, 28% from EMEA, and 18% from APAC. This compares to a respective 56%, 25%, 19% split last quarter. APAC delivered another solid performance. This quarter we closed our largest deal ever in Europe with an international financial services customer that bought its first copy of Red Hat Enterprise Linux just a few years ago. We also closed new business with a multinational airline that was faced with a complex IT integration following a large merger. In both of these European wins, Red Hat has been selected as their strategic platforms. We continue to enjoy a globally balanced business serving a widely diversified and large customer base. Our goal is toward a balance in our business 50% of bookings coming from outside of the Americas.

In Q2 we renewed 25 of the top 25 customers in addition to renewing the one top 25 customer that was not closed in Q1. These customers expanded their footprint of Red Hat solutions by renewing at 122% of last year's contract value. Clearly we are adding continued value at our customers' bottom line, as we help them lower operating and capital costs.

On a non-GAAP basis, excluding stock compensation expense, overall gross margin of 85% was the same as last year, as was subscription gross margin at 92%. Training and services margin was 38% in Q2, representing a 300 basis point improvement from 35% in Q1. We are pleased with this improvement, and it was primarily driven by better utilization in our training business.

Non-GAAP operating expense came in at $81.4 million, up 5% from last quarter. The increase in operating expense was attributable principally to increases in staffing, systems and facilities expenses, as the company continues to grow and expand worldwide. You will note that sales and marketing expense was virtually unchanged from Q1. The cost of additional sales staff in Q2 is offset by reductions in marketing expense due to the completion in Q1 of several significant marketing events including the Red Hat Summit, the REL5 launch and JBoss product launches.

Q2 non-GAAP operating income was $26.4 million, producing an operating margin of 21% compared to non-GAAP operating income of $23.3 million and operating margin of 20% last quarter and non-GAAP operating income and operating margin of $17.8 million and 18% last year.

Moving on, other income net which is attributable primarily to investment income was $14 million. Our non-GAAP tax rate, which reflects actual cash taxes that we expect to pay for the foreseeable future, is still approximately 5%, resulting in non-GAAP net income of $36.9 million, up 10% from last quarter and up 50% from a year ago quarter. Our non-GAAP diluted earnings per share came to $0.17.

Now let's turn to the balance sheet and the cash flow statement. We ended the quarter with $1.3 billion in cash and investments, an increase of $63 million from the end of Q1, driven principally by cash-flow from operations and excess tax benefits from share-based compensation.

DSOs were 58 days compared to 60 days at the end of last quarter. As a reminder, as DSOs are traditionally a measure of receivables versus billings, our DSO calculation includes the change in deferred revenue. We are pleased with this improvement, especially with improvements made by our EMEA team. Total deferred revenue ended the quarter at $377 million, an increase of 4% from the prior quarter and an increase of 33% from last year. More importantly, the entire increase is in current deferred revenue.

Moving to the statement of cash flows, non-GAAP cash flow from operations, excluding the reclassification of excess tax benefits from share-based compensation arrangements, was $64 million, up from $52 million last quarter. This represents a 44% increase over the prior year. This quarter's cash flow was in part positively impacted, as expected, by changes in working capital.

Now I would like to turn to guidance. We are anticipating Q3 revenue in the range of $131 million to $133 million and non-GAAP EPS to be approximately $0.18 a share. We estimate stock compensation for Q3 to be approximately $9 million, and the GAAP tax rate is still estimated to be at 40%.

Now I would like to turn it back over to Matthew for some closing comments.

Matthew Szulik

Thank you, Charlie. Before turning it over to QA, let me say a few words about Q3 and the remainder of our fiscal year. Overall we believe the demand for our solutions continues to be strong around the world. The first half of the year we continued to emphasize scale and efficiency within our operating model. We believe in partnership with our customers that we have established a good foundation for 2008's overall performance.

The momentum in the Red Hat Enterprise Linux virtualized product family, which is the majority of our business today, is strong. As customers begin to move from the rollout of 10 machines to 100 machines to thousands of Linux servers, demand continues to increase for the Red Hat Network management platform.

Global demand and interest in JBoss products is growing and the pipeline for JBoss at the close of Q2 was higher than it has been since we completed the JBoss acquisition. However, the rate of JBoss bookings and revenue growth to date has not met my expectations. Our expectation is that the rate of JBoss growth can double the percentage growth of RHEL. So far this year the growth rates are about the same. We're making good progress with this business, but we know we can do much better.

In that regard we have made several organizational changes to bring more focus to the middleware business. We continue to recruit and train channel partners globally. We are scaling our global channels of distribution, and look forward to JBoss World Orlando in February. We will accelerate JBoss growth in the second half of the fiscal year.

We have had a solid start to the fiscal year and we are optimistic about our outlook for the remainder of the year based on the strength of our open source software market, our strong brand, and most importantly, the trust which our customers are increasingly placing in us, which gives us a very solid pipeline of opportunity.

With that let me open up the call to questions.

Question-and-Answer Session

Katrinka McCallum

May I reminded our questioners today to limit themselves to one question please. Nicole, you can go ahead and open the call to questions.

Operator

(Operator Instructions) Your first question comes from Brendan Barnicle - Pacific Crest Securities.

Brendan Barnicle - Pacific Crest Securities

Thanks so much. Matthew, I wanted to follow-up on the virtualization where you guys are dealing with Intel. I think Sun has announced a technology transfer they were doing with them that got some of their virtualization pieces embedded with Intel. Are you guys working on anything similar with Intel, or is any of this is embedded?

Matthew Szulik

We're doing many things with Intel. The one that we have made public is called vPro, Brendan. I'm not sure if you're familiar with that.

Brendan Barnicle - Pacific Crest Securities

No, I'm not.

Matthew Szulik

It is a pretty cool piece of technology aimed at virtualizing the desktop and automating the desktop virtualization space, which is built around the Red Hat virtualization model. Red Hat and Intel are now working with their leading ISV providers, people like Symantec, to incorporate that within the application suite of software products within the Intel ecosystem. That, in concert with our server-based virtualization strategy, we think provides some very exciting opportunities for customers to have both a desktop and a server side virtualization implementation.

Brendan Barnicle - Pacific Crest Securities

Will there be anything further that comes with you guys and Intel on the server side?

Matthew Szulik

Absolutely.

Operator

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

Steve Ashley - Robert W. Baird

Thank you. I would like to just follow-up on the JBoss comment you made. You talked about making a number of organizational changes. Can you maybe give us a little bit more color on that? Thank you.

Matthew Szulik

Steve, what we continue to find in the marketplace, of course as Red Hat transitions from a single product company to a multi-product company, is really understanding and learning the requirements of the application market. What we continue to find is that JBoss has an excellent reputation with developers, the product line continues to be rich and innovative. And that for Red Hat making sure that the enterprise level buyers, the CIOs and the leading IT executives, are aware of JBoss and its capabilities, and as importantly Red Hat's global capabilities to support those customers as I have described, both in products and service levels.

So as I highlighted in the call, we are increasingly moving our sales and distribution strategy from what I would describe as a product-based approach to a much more integrated consulting approach, where we are involved with line of business executives as well as their technical teams, that allow us to be involved much earlier in the selling process and the system design and development process as opposed towards the end of the process where they historically would make product buying decisions.

This allows us to be involved much more strategically. And as I have highlighted in my remarks, may create a bit of a longer selling cycle. But the size of the orders, as I have highlighted, and the recurring nature of that relationship with the customer is much more positive, I believe, for both JBoss and Red Hat long term.

Operator

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

Kirk Materne - Banc of America Securities

Charlie, I just wanted to go back to some of your commentary around the pipeline and the billing patterns in the second quarter. Clearly last year you saw some decent sequential movement from the second quarter to the third quarter in terms of billings. Is it fair to say that you're getting into more of a seasonal pattern around billings?

What should our expectations be heading into next quarter in terms of just the trend around that? It sounds like the pipelines are good in both groups. But is JBoss, some of the transition there, holding back some of the benefits we should be seeing? I'm just trying to get some more color around that area.

Charlie Peters

I'm not so sure it is as much seasonal as there is sort of a natural rhythm to the business. For example Q1 a year ago, as I mentioned in my remarks, had some very large deals and those deals renewed in Q1 this year, which then caused a bump. As you rightly pointed out, Q3 last year was a very strong quarter. We also noted on the Q2 call last year that we had a good pipeline, a very strong pipeline.

I think maybe there is a rhythm to the business, but it hasn't really nothing to do with seasonality. It has to do with when specific deals come to closure.

But around the billing, the billing remarks additionally, the billing is an indicator of the timing in which we bill our customers. As I have been trying to tell people, that is probably what it should be used for. It is an indicator of the timing of when we bill; it is not necessarily indicative of the overall strength of the business.

Kirk Materne - Banc of America Securities

I guess maybe just to follow-up on that last point, is it fair to comment, or consider, that the bookings levels of this quarter were clearly in line with what you were looking for, or was there a disconnect on the billings perhaps to what we're seeing?

Charlie Peters

I think from my commentary what you could deduce is the billings grew sequentially, and there was a substantial increase in the off-balance sheet backlog. I think that would probably answer your question.

Operator

Your next question comes from Terry Tillman - SunTrust Robinson Humphrey.

Terry Tillman - SunTrust Robinson Humphrey

The first question, Charlie, just relates to the long-term deferred revenue line. I may have just missed it earlier. Are you saying that seasonally that is why it could be somewhat flat in the second quarter? Because I would have thought it would have been up. I know you did say off-balance sheet it was up strongly, the backlog, but can you comment on maybe directionally what was going on in the second quarter there?

Charlie Peters

The change in long-term deferred revenue is primarily based upon when we bill long-term contracts and whether or not we bill them all upfront for three years or whether they are billed one year at a time. If we have large contracts that are billed all upfront, you will see a fairly sizable increase in long-term deferred revenue. When you see a smaller increase in deferred revenue, or like this quarter almost no increase in long-term deferred revenue, what you should deduce is that we had more long-term contracts billed one year at a time.

Terry Tillman - SunTrust Robinson Humphrey

Just my follow-up question, Matthew, relates the idea on the JBoss side maybe you need to move to more of a solution sell approach. How do you avoid maybe having some of your Red Hat sales reps that are focused on selling RHEL, maybe get disrupted because maybe there is some change to processes in terms of trying to broaden the conversation to make it more of a solution sell? How do you mitigate any potential disruption as you try to change sales processes?

Matthew Szulik

A couple of things I would like to highlight for you and the other investors is that just reminding that renew and service levels are the core pieces to the Red Hat business. So perhaps I have managed things a little bit cautiously, but it was very important for Red Hat to understand the application environment, the mission critical responsibilities that come with servicing a customer at the application level and making sure that the customer has a fantastic experience not only with the code base, but also with the service levels.

So I think what we have learned, of course, is that it is a much more consultative sale; that it is requiring an understanding of both architecture and business activities within the enterprise. We are pleased when we have delivered that approach to the customer, we have seen the resulting very, very high-end high six-figures, low seven-figures transactions.

We are considering a range of options that include potentially the creation of an overlay salesforce, who I have highlighted in the call today, partnering with the high-end systems integrators like SAIC. You should expect to see where relationships like that in the future both domestically and globally. I think we have also changed our hiring of our selling profiles over the last six months to include people with skills that are much more solution oriented.

Operator

Your next question comes from Denny Fish - JMP Securities.

Denny Fish - JMP Securities

In terms of creating the three divisions -- infrastructure, middleware and the online services -- how does that impact the development of Red Hat and JBoss networks? Will those fall into respective groups, or will that still be an integrated offering? Maybe you could just comment on that a little bit?

Matthew Szulik

Let me just make sure you separate them. JBossON and Red Hat Network will be integrated as a common management platform. Denny, is that what you mean?

Denny Fish - JMP Securities

Yes.

Matthew Szulik

Clearly, once again, as a part of the learning and making sure that we understand the customer environment Red Hat Network 5.0 within the quarter was released to very, very positive reviews by our customers. We want to continue to work and integrate those teams, as I have described, with the creation of a common management platform that will certainly deal with, as you have seen in Fedora and now RHEL5, with the management of both the RHEL bits, the Microsoft environment and the virtual environment, and ultimately including some of the good functionality within JBossON, like monitoring, within a common management platform which our customers have requested. That development is ongoing.

Denny Fish - JMP Securities

Is it fair to say that is primarily ongoing in engineering and that won't fall into the responsibility of the GMs for the core infrastructure or middleware offerings?

Matthew Szulik

That will fall into the GM of the infrastructure business, not the online services business.

Operator

Your next question comes from Brent Thill - Citigroup.

Brent Thill - Citigroup

Charlie, could you just comment on the operating cash flow? I think you have given a guidance of $250 million to $260 million for the year. Are you still comfortable with that?

If you could also just follow-up, you have repeatedly mentioned that off-balance sheet backlog grew substantially. I am just curious if you can just provide a couple of high-level comments around helping us quantify, or really digging into what was driving that? Was that due to deals that closed late in the quarter as the billings lagged, or how should we think about that metric going forward?

Charlie Peters

Let me start with the longer-term and the full year guidance. We're halfway through the year. I think we've had a solid start. I don't see anything that has developed at this point that would cause me to change my guidance that I said at the start of the year.

The second question again was?

Brent Thill - Citigroup

Just as it relates to your comment about off-balance sheet backlog growing substantially.

Charlie Peters

I think off-balance sheet backlog is the portion of bookings that we have not yet billed the customers. As we have commented on occasionally, by substantially you could assume it is double-digit millions. I think that the increase is double-digit millions in the quarter.

Operator

Your next question comes from Mark Murphy - Broadpoint.

Mark Murphy - Broadpoint

Matthew, with RHEL5 and the virtualization technology, obviously we are expecting that it will take some time to ramp up. When do you expect you would be able to document some large-scale customer wins, get white papers and case studies published, the types of things that would help drive user adoption?

Matthew Szulik

First of all, we have been doing that. I think if you go to RedHat.com you'll see a variety of cases. Most recently there was a good case within Swisscom, which is a very, very large Swiss telecommunications company that made a very aggressive rollout really of the RHEL5 virtualization implementation.

Secondly, as I have described, customers want to make sure that in a virtualized world they have absolute ISV compatibility, device driver compatibility, hardware compatibility. They are not simply looking for inexpensive optimization of their existing server environment.

So what we see of course is that customers are concerned with that level of stability before moving it into production. Yet net new customers I think continue to experience it, are deploying it. A number of the customers that I met with in Europe have already moved to RHEL5 virtualization. We're engaging them to produce those white papers and case studies as well.

We have something going on currently across the United States, Mark, called the Value Tour. It has basically received standing room only. This last week in New York City Paul Cormier with the Intel executives spoke at the Value Tour. I think you'll continue to see that kind of promotion and education for our marketplaces both domestically and abroad, both on and off line, to educate them on our really hypervisor independent strategy, the huge boost in performance that they are seeing, and ultimately the management direction that I described earlier.

Mark Murphy - Broadpoint

Charlie, can you talk about what is embedded in your guidance as far as the billings growth rate for the core OS business and then for the JBoss offerings? It looks like the core billings growth accelerated to roughly 25% this quarter, just as a guesstimate. But on the other hand it was an easy comp, and then you're moving into tougher comps in the second half. Is there any way you can help us to gauge maybe how that should trend either in the second half or even beyond into FY 09?

Charlie Peters

The only thing I will offer clarification on is just the what Matthew said in his closing remarks that in the second quarter our bookings performance on the operating system side and the JBoss side were relatively similar on percentage terms. What our expectation is that with some of these moves that Matthew described, we would hope that the JBoss growth rate would in percentage terms double that of RHEL. But I don't have any further clarification.

Mark Murphy - Broadpoint

Charlie, would you subscribe to say at least high teens for the core growth rate of the business?

Charlie Peters

I think, yes, that is certainly well within what we're thinking, and probably higher.

Operator

Your next question comes from Sarah Friar - Goldman Sachs.

Sarah Friar - Goldman Sachs

Matthew, just first a technology question for you. You have talked a lot about server virtualization or virtualization in general, which we can see is really hitting mainstream. But you can't really ignore the strongly lead that VMWare obviously has in the market.

How do you think about as you go to market going into Red Hat's customer base who may already have deployed VMWare, can you work side-by-side with them? Can you be complementary? Or is it really about trying to find new greenfield opportunities for the RHEL5 offering?

Matthew Szulik

That is a great question. I would like to remind investors that Red Hat has a good relationship and a partnership with VMWare that is almost two-and-a-half years old, that VMWare continues to ship a run-time implementation of the Red Hat Enterprise Linux operating system. So both technically and strategically we have a good foundation to build on.

I believe that we are going to continue to look for ways to explore partnerships as opposed to driving a wedge between us competitively. As I described in some earlier calls, and I think that it came out in the VMWare World, we continue to see them penetrating the Windows environment and optimizing Windows servers. Customers through their subscription relationship with Red Hat, especially enterprise customers going back to 2002, have continued to standardize on Red Hat Enterprise Linux, and therefore get the virtualization implemented for free as a part of their overall subscription.

So we have an education component. We have continued to build out the tooling infrastructure, the management platform, work with the ISV community. Because remember, Sarah, as you know, a key component of virtualization is making sure that that ISV and IHV compatibility layer, device drivers, ISV support goes with that virtual either appliance or soft virtual appliance, whether it be hosted or whether it be deployed internally.

As a result of that, those are the messages that we want to continue to sell and send to our customers, and therefore continue to build out that value on top of Linux, whether it be in the data centers, whether it in a large financial services company that you are familiar with, and increasingly the customers.

Just last week when I was in Europe I met the Chief Technology Officer of a very, very large global financial services company that was just beginning to examine Linux, as an example.

Sarah Friar - Goldman Sachs

Great. That's very helpful. Then maybe as a follow-up to that, there obviously has been a lot of concerns about the overall macro environment. Hopefully the rate cut is helping right now. But what are you hearing in terms of budgets for '08 from verticals like financials where people have been particularly concerned?

Matthew Szulik

I continue to see pressure on IT spend. I think there is a role that open source is playing in that. I don't see the projections of sizable IT increases in budget and spend going into calendar 2008.

Charlie Peters

I want to also add that relative to the financial services sector, we have a very broad, well diversified customer base, very geographically diverse by verticals, diverse by size, then diverse by renewal dates. I don't think we have any significant exposure to the financial vertical from the standpoint of the sub-prime market issue that has been talked about.

Operator

Your next question comes from Jason Maynard - Credit Suisse.

Jason Maynard - Credit Suisse

Just as a follow-up on the cash flow comment around for the full year guidance. I know you don't give cash flow guidance, but help us understand how you think about the GAAP cash flow number relative to the pro forma number with the excess benefit? Any sort of help or assistance in terms of how we should think about modeling the difference between the two.

Charlie Peters

I think in terms of modeling it, keep in mind that we still have almost $360 million of NOLs that exist today, all of which come from so-called excess tax benefits from stock compensation. So as those are monetized it will all go into this caption on the cash flow statement. As the earnings go up, so will the portion that is called the excess tax benefit. This quarter that number was approximately $14.5 million. That was $12.6 million last quarter. So I think you can model it based upon that number will grow as earnings grow.

Jason Maynard - Credit Suisse

It has grown a couple of million even since Q4. Is that the consistent ramp we should think about then?

Charlie Peters

Again, it is principally related to the growth in earnings. It should mirror the growth you are seeing in whatever your earnings model looks like.

Jason Maynard - Credit Suisse

Just as a follow-up on some of the changes that you're talking about, it sounds like right now the sales-related functions are going to stay put. But how would you consider the overlay salesforce and holding that in? Matthew, you mentioned you are kind of considering that. What is your thought process on pro or con versus actually putting an overlay salesforce back in place?

Matthew Szulik

We really never had an overlay salesforce to begin with. It is incredibly regional dependent. The performance of that kind of model implemented in the U.S. may not look the same way in Asia Pacific, where we have a very strong channel presence and a growing JBoss distribution network through the value-added partners. I think what we will continue to do is work with the general managers of this business that have been studying this issue for the last 90 days, we have some meetings here in early October and really listen to their findings. They are much closer to the customer situation.

Operator

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

Tim Klasell - Thomas Weisel Partners

First, just a bookkeeping question for you, Charlie. Can you give us the percentage of bookings greater than a year in this quarter?

Charlie Peters

The percentage of bookings greater than a year is 27%. Another statistic I know you follow from time to time is the average length of our contracts. As you know, from about a year ago, third quarter of last year, the percentage of long-term contracts moved up somewhat. The average length of our contracts, which was in the range of about 18 to 21 months, is now closer to about 19 to 22 months. It is at the higher end, closer to 22 months at this point.

Tim Klasell - Thomas Weisel Partners

Can you give us an idea of how many direct reports, or how many reports will be for each one of the product lines that each general manager will be directly responsible for?

Charlie Peters

All that is still being worked out. It would be certainly a very manageable number, but beyond that we're not going to go into specifics I think on this call.

Tim Klasell - Thomas Weisel Partners

It is not going to be a massive reorganization of the entire organization. Can you give us an idea maybe roughly speaking what percentage of your employees would be affected?

Charlie Peters

It is actually not a large reorganization. It involves basically engineering and marketing I think, as Matthew described.

Matthew Szulik

Tim, as I described in my remarks, we have been working on this process for 18 months. We completed the sales and geographic component in March of this fiscal year. This next step is a move that we have been contemplating now. We wanted to make sure that we got the core releases out the door. That means RHEL5, that means JBoss 4.2, that means Red Hat Network 5. Those were completed in the April/May time frame and over the course of the last 90 days we have integrated, as I have described, product development and product marketing under the GM model as described.

That will allow us to begin at the fiscal '09 budgeting process with that common GM model globally, geographic and general management globally, with an emphasis on accountability and efficiency, as I have described.

Operator

Your next question comes from Heather Bellini - UBS.

Heather Bellini - UBS

Could give us an idea if you're seeing a migration to the high-end offering with RHEL5 as a result of the unlimited virtualization capabilities you're offering? And if there is some metrics you can share with us on the trends you're seeing here?

Charlie, a question for you on margins. I believe you mentioned earlier in the call that we should see that you're shooting for about 200 basis points per year in margin improvement. I was wondering if that is a comment that holds true for this year as well as into the next fiscal year? Thank you.

Charlie Peters

The transition of customers from RHEL 4 to RHEL 5 and to the higher price point in RHEL5, I think we are beginning to see some of that. I think that some of the reason for the 122% of value that was renewed in the top 25 this quarter compared to last quarter relates to the fact that some of those customers have moved from RHEL 4 to RHEL 5.

Heather Bellini - UBS

I'm talking specifically about the high-end product. I'm not just talking about migration from RHEL 4 to RHEL 5. Are you seeing them actually move and take advantage of the unlimited virtualization capabilities?

Charlie Peters

That was specifically what I meant to say.

Heather Bellini - UBS

Okay, perfect.

Charlie Peters

My comment about the operating margin and the annual growth, 200 basis points, no, I have not changed any guidance for this year. So the goal for this year that we set six months ago within the 21% to 22% range, our goal beyond this year for the longer-term goal is looking at a couple hundred basis points a year.

Operator

Your final question comes from Kash Rangan - Merrill Lynch.

Kash Rangan - Merrill Lynch

Matthew, I was just wondering if you could clarify a little more about the productivity improvement you expect from JBoss out of the equation? When I look at the reorganization, it doesn't look like it is back into salespeople. You're basically moving to a GM type role. You're moving the marketing to product development under separate umbrellas. How does this impact the productivity in a positive way for the JBoss sales organization, where you're looking to double the billings growth as you get into the second half? Thanks.

Matthew Szulik

A couple of things. First of all, we have been for the last six to seven months now been focusing on upgrading the skills and the enterprise solution skills of the North American and European sales organization. That so far is showing good progression.

Secondly, we have been adding skills in our professional services organization, consulting organization, because in the middleware space customers want something more than just technology enablement and so we have been adding that functionality to the consulting services organization globally.

Last and perhaps as strategically has been the global build out of both the production service competency of JBoss, and not the least of which is the service competency when a customer has issues, both if it is within the integrated Linux and JBoss stack, or whether it is an integrated Microsoft and JBoss stack, or Unix and JBoss stack, that we have the capability of servicing that customer in a mission critical environment at a very high level.

That is creating reference ability for us. That in turn is being able to validate the capabilities of Red Hat in a multi-product environment to our large enterprise and government customers. This is why I think over time we have continued to see that the growth in pipeline and confidence of the selling organization.

Kash Rangan - Merrill Lynch

Are you confident enough to say that these moves in and of itself should not lead to any particular disruption to JBoss sales, and particularly the operating cost structure as you get into the second half of this year?

Matthew Szulik

I would say that's accurate.

Katrinka McCallum

Thanks everyone for joining Red Hat's management team today. This now concludes our second fiscal quarter earnings call. Thank you very much.

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