Here’s the entire text of the prepared remarks from Red Hat’s (ticker: RHAT) fiscal Q3 2006 conference call. The Q&A is here. We recognize that this transcript may contain inaccuracies - if you find any, please post a comment below and we’ll incorporate your corrections. And please note: this conference call transcript is a Seeking Alpha product, so feel free to link to it but reproduction is not permitted without the explicit permission of Seeking Alpha.
Dion Cornett, VP, IR
Matthew Szulik, Chairman, President, Chief Executive Officer
Charles Peters, EVP, Chief Financial Officer
Jason Maynard, Credit Suisse
Brent Thill, Prudential
Brendan Barnicle, Pacific Crest Securities
Terry Tillman, SunTrust Robinson Humphrey
Tim Klasell, Thomas Weisel Partners
Chris Kwak, SIG
Mark Murphy, First Albany
Rick Sherlund, Goldman Sachs
Brent Williams, Keybanc Capital Markets
Todd May, Deutsche Bank
Heather Bellini, UBS
Trip Chowdhry, FTN Midwest Security
Steve Ashley, Robert Baird
Chris Russ, Wachovia security
Good afternoon. My name is Casey and I will be your conference facilitator today. At this time I would like to welcome everyone to the Red Hat Third Quarter Earnings Conference Call. All lines have been placed on mute to prevent any background noise. After the speaker’s remarks there will be a question and answer period. If you would like to ask a question during this time simply press “*” then the “1” on your telephone keypad. If anyone should need assistance at anytime during the conference please “*” then “0” and an operator would come back online to assist you.
As a reminder ladies and gentlemen this conference is being recorded today December 21, 2005. Thank you. I will now like to introduce Mr. Dion Cornett, Vice President of Investor Relations. Mr. Cornett you may begin your conference.
Dion Cornett, Vice President of Investor Relations
Thank you, Casey. Good afternoon and welcome to Red Hat’s third quarter fiscal year 2006 earnings call. Speaker’s for today’s call will be Matthew Szulik, Chairman, President and Chief Executive Officer covering overall highlights for the quarter, Charlie Peters, Executive Vice President and Chief Financial Officer, discussing financials followed by myself, providing certain additional metrics. The press release was issued after the market closed today and by now everyone should have seen the copy. If anyone has not yet seen a copy and would like to get one please call Linda Brewton, Manager, Investor Relations at 919-754-4476 and ask her to send you one.
Various remarks that we may make about the company’s future expectations, plans and prospects including statement containing the words belief, anticipate, plans, expects, or will constitute forwards-looking statements for the purposes of the Safe Harbor provision under the Private Securities Litigation Reform Act of 1995. Actual results may differ materially from those indicated by these forward-looking statements, as a result of various important factors, including those expressed in the company’s most recent Quarterly Report on Form 10-Q filed with the SEC.
In addition any forward-looking statements represent our views only as of today and should not be relied upon as representing our views as of any subsequent date. While we 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 change and therefore you should not rely on these forward-looking statements as representing our views as of any date subsequent to today.
With that I would like to turn the call over to Matthew Szulik, Red Hat’s Chairman, President and Chief Executive Officer. Good afternoon Matthew.
Matthew Szulik, Chairman, President and Chief Executive Officer
Good afternoon and thanks Dion. We are pleased to present Red Hat’s third quarter results, which continued to be strong across key metrics including revenue growths, margin expansion, net income, and cash flow. The drivers of our performance remain sales growth and continued operational improvements, across Red Hat’s worldwide business.
First focusing on sales growth; our opportunity can be described as having 4 primary components. They are deeper penetration of our existing installed base customers, substantial broadening of that customer base, geographic expansion, and the addition of value-added solutions beyond the core operating system.
Let me address what we believe is currently our most significant dimension of growth, strengthening our relationship with our installed base of customers. At the end of the third quarter we continue to service 70% plus of the Fortune 500 companies. Within this installed base we see customers expanding their commitment to Open Source solutions as evidenced by the fact the 24 of our top 25 deals from the prior year were renewed and the majority of our top 25 transactions related to mission critical applications.
While these statistics convey our deepening customer relationships, I believe it is important to look at what is really driving our customers to increasing return to Red Hat for their IT solutions. One of the fundamental changes that is happening in the software industry today is that innovation is increasingly being driven not by the companies that package and distribute software code, but by the end-users of the software themselves, facilitated by the popular GNU public license. Distributed Internet based software development simplified code reuse, and relatively low cost development talent in India, China and Eastern Europe. Software consumers are increasingly in control of what code is available how it’s used and how it’s deployed. A prime example of this trend is the National Security Agencies development effort around Red Hat’s SELinux to securely enhance Linux. At the same time as consumers of technology become more integrated into the innovation process they require closer relationship with the providers who will continue to support their enhancements long after the original internal corporate architect moves on. Consequently we see that customers are narrowing their lists of approved vendors, which in turn magnifies the success of category leaders. As the Open Source leader Red Hat’s ability to leverage these broad market dynamics is clearly reflected in our Q3 results.
With respect to the broadening of our customer base we added 12,000 net new customers during the third quarter. Red Hat’s Global Learning Services played a meaningful role in this growth by reassuring customers that they will be able to find and develop knowledgeable trained engineers. It’s not only at this segment of our business strategic and providing the IT marketplace with readily available Red Hat’s certified talent, but a number of our enterprise clients report that having Red Hat’s certified engineers on staff allows them to enjoy server to technician ratios far better than that of other operating systems. During Q3 we surpassed the 200,000 cumulative students mark for Red Hat class participation.
Turning to geographic expansions, Q3 helped to firm Red Hat’s ability to enter new markets, leverage our brand and position the trust that we have with our markets and execute efficiently. More than half of the countries in which we now operate directly produced year-over-year bookings growth in excess of 100%. In many of these markets we are benefiting from the emphasis governments have placed on using Open Source software to avoid vendor lock-in in the monopolistic sales practices of competitors, to build an indigenous technology industry and have to educate their general populations, which Red Hat figures to play a prominent role. For example shortly after the quarter was closed we announced the agreement to acquire the remaining 40% of our India joint venture. India is one of scores of governments that have launched Open Source centers and the Government of India has a stated goal of quintupling per capita PC penetration by 2010. We are optimistic that Red Hat’s increased presence and continued investment in India will complement what we refer to as the democratization of technology.
Finally Red Hat continues to grow by expansion of our footprint in the server and software development markets. This includes taking a leadership role in key community initiatives around the state list Linux and virtualization. We believe that virtualization will deliver in order of magnitude improvement in the server infrastructure price performance and that Red Hat’s implementation of the operating system level will provide enhanced utility ease-of-use, significant improvements in management and deployment.
Furthermore we also recently announced plans to offer Red Hat’s certified and supported Open Source software stats. This allows customers to obtain the same trusted quality certification, maintenance and support from many of their Open Source needs that they were custom receiving with Red Hat Enterprise Linux. The initial feedback has been positive particularly given the recognition of the scale that Red Hat brings to the task and the desires of many of our customers to consolidate vendors.
More over, we believe that we are outgrowing the organic growth rates of our core markets. Markets which many industry analytics expect to grow in excess of 25% a year for the next several years. During Q3 we experienced sequential acceleration in multiple areas of our business. For example, our year-over-year bookings growth rate through Dell was higher in Q3 than it was in Q2. In countries such as the UK, in Ireland, the Netherlands, in Japan, our annual bookings growth rate more than doubled from the prior period. Part of this acceleration is attributable to our ability to expand our channels while maintaining and growing business through established and reputable channels of distribution. Furthermore expected returns on recent operational investments provide us growing confidence that we can continue to improve the efficiencies in the operating performance of our company.
During Q3 we rolled out a comprehensive sales management solution; we located key infrastructure offsite to reduce cost and bolster reliability worldwide and enhanced our online customer service capabilities. Continuing to deliver value to customers were, via an online relationship is a paramount important to maintaining our leadership and continuing to improve margins.
In whole we are pleased with the progress that we as a team are making and executing against our market opportunity and improving our operational effectiveness. Charlie will now address this specific financial performance.
Charles Peters, Chief Financial Officer and Executive Vice-President
Thank you, Matthew. We believe that the overall quarterly results; support the exertion that Red Hat is one of the fastest growing mid-cap technology companies in the world today. Total third quarter revenue of $73.1 million, exceeded guidance, represents an increase of 11% from last quarter, and 44% from the same quarter in fiscal year 2005. Our revenue growth combined with 75 net headcount additions for our annualized revenues per employee to $270,000 for the quarter, driven by strong bookings, subscription revenue of $60.2 million to 11% sequentially and 54% year-over-year.
Training and services revenue came in at $12.9 million, we believe that the more specific training and services labeling shown this quarter in our financial statements, better reflects the fact that our historic services revenue includes a substantial learning component. For example, during Q3 Global Learning Services comprised 2/3rds of the recorded 12.9 million in training and services revenue, as Matthew mentioned, the growing installed base of Red Hat certified IT professionals is a strategic component of our growth. With regard to bookings in Q3, we generated 57% of our bookings from the channel and 43% from direct sales versus 61%, 39% split in the last quarter.
From a geographic perspective, 55% of bookings came from the America’s, 22% from EMEA, and 23% from the Asia Pacific. This compares to respective 59%, 20%, 21% split last quarter. Our billings proxy which we define as revenue plus change in deferred revenue was $88.8 million up 22% year-over-year, but down 3% sequentially primarily due to a sequential doubling off-balance sheet backlog, and fluctuations in exchange rates.
Turning to margins, enterprise subscription gross margins are 92% in Q3 up 100 basis points from the prior quarter. This improvement is primarily attributable to greater scale and increased electronic delivery. Training and services margins were 46% and they are up more than 400 basis points from the prior quarter, partially reflecting product mix, higher utilization of personnel, and better operational efficiencies. Overall gross margin was 83.8% versus 82.4% last quarter and 80.2% in the year ago period.
Operating expenses came in at $42.5 million up 1% from last quarter. Control growth and operating expense was a result of improved efficiencies across all functional departments and some benefits from currency rates. It’s our intension continue to invest in people and systems, and we expect this investment to accelerate in Q4 and the first quarter of fiscal year ’07. As a result we anticipate greater operating expense growth in Q4 primarily based upon recent and planned headcount additions.
Our operating income came in at $18.7 million for the quarter, while operating margin up 25.6%, this compares to $11.9 million and 18.1% last quarter. This level of profitability is above what we expected because of strong revenue growth because many of our hirers and related expenses happened later in the quarter than planned.
Moving on to other income attributable to primary to investment income was $6.6 million. We now anticipate that our full-year annualized effective GAAP tax rate will be 7%. In order to bring the year to-date tax provision to 7%, a tax provision of 3% is necessary in Q3. This provision of the tax rate is based upon tax planning, and a clearer view of actual factors by country, there is only a quarter left in the fiscal year.
Net income was $23.2 million, an increase of 39% from last quarter, and 114% year-over-year. Net income for purposes of the diluted per share calculation is 24.6 million, an increase of 36% from last quarter, and 98% year-over-year. Taking all this into account this translates into fully diluted earnings per share of $0.12.
Now let’s turn to off-balance sheet and cash flow statement. We ended the quarter with $1 billion in cash and investments which is an increase of $35 million from the end of the second quarter driven by strong flow from operations, offset somewhat by our investment and the company start to promote Open Source innovation. At the end of Q3 total receivables, which includes earnings in excess of billings were $55.7 million, which translates to an adjusted DSO of 57 days versus 60 days at the end of Q2. As a reminder, as DSOs are traditionally measures of receivables versus billings, our DSO calculation including the change in deferred revenue. Total deferred revenue ended the quarter at $200 million, an increase of $16 million from the prior quarter. Moving to the statement of cash flows, cash flow from operations was $54.1 million or $0.26 for fully diluted share, and it increased 18% sequentially and 82% year-over-year.
Now I would like to turn to guidance for next quarter. For Q4 we are anticipating revenue to be in the $77.5 million to $78.5 million range, representing year-over-year growth of 35% to 37%. We anticipate roughly $3.5 million, an incremental Q4 expenses versus Q3 given the fourth quarter impact was of the 75 hires at the end of Q3 and the continued investment in people and systems that we expect in Q4. Then if you also assume a 7% effective tax rate in Q4, and a diluted share account for Q4 of $212 million shares one would estimate approximately EPS somewhere between $0.11 and $0.12 a share. Combining this Q4 guidance with the year to-date results thus far, produces revenue and EPS estimates higher than our prior fiscal year ’06 guidance.
Now at this point I’d like to turn it over to Dion to discuss some additional metrics.
Dion Cornett, Vice President of Investor Relations
Charlie, thank you. As we did last quarter, we are providing several metrics to help investors evaluate our business. For the third quarter the preceding in book, fully bookings value beyond year was 22%, up 2% from last quarter. Our average contract length remained in the 18 to 21 month range again the vast majority of our long-term deals continue to be 3 year contracts. However, we have a slight up tick in single year deals booked not billed this quarter relative to past quarters and our expectations going forward. For modeling purposes, I would point listeners to Charlie’s comments earlier in the call, that off-balance sheet backlog that is bookings not billed doubled sequentially.
Turning to cash flow, came the strong performance year to-date, we are raising our previous cash flow guidance from operations for fiscal year ’06 greater than $160 million, to greater than $175 million, or about $0.82 for fully diluted share. We believe that cash, we believe that per share cash flow from operations provides with this meaningful comparison of Red Hat results to that of other technology companies. Moreover feedback suggested pending adoption of FAS 123R, relates to the expensing of stock options is already directing some investors to more closely consider growth multiples of cash flow.
With that I would like to turn the call back over to Matthew Szulik for closing remarks.
Matthew J. Szulik, Chairman, Chief Executive Officer, and President
Thanks Dion. In closing I would like to thank our customers, our business partners, members of the Open Source community and shareholders, for their commitment to Red Hat. I specially want to thank our worldwide associates, whose hard work, team spirit innovation all contributed to a great quarter in growth and operational effectiveness. At this time I would like to turn the call over to there for question.
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