My name is Jason andI will be your conference facilitator today. At this time I would like to welcome everyone to the Red Hat third quarter fiscal year 2008earnings conference call. All calls have been placed on mute to preventany background noise. After the speaker’s remarks there will be a question and answer period. (Operator Instructions) As a reminder, ladies and gentlemen, thisconference is being recorded today, December 20, 2007. Thank you. I would now like tointroduce Ms. Katrinka McCallum, Vice President of Investor Relations. Ms. McCallum, you may begin your conference.
Great, thanks,Jason. Welcome to Red Hat’s thirdquarter 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 pressrelease and our press release announcing the separation of the Chairman and CEO roles were issued after marketclosed today and may be downloaded from www.redhat.com or requested by calling InvestorRelations.
Various remarks thatwe may make about the company’s future expectations, plans, and prospects, includingstatements containing the words believe, anticipate, plan, project,estimate, expect, intend, or will, constitute forward-looking statements for the purposes of the Safe Harbor provision under the Private Securities Litigation Reform Act of1995. Actual results may differmaterially from those indicated by these forward-looking statements as a result of various important factorsincluding those discussed in the company’s most recent quarterly report on Form 10-Q filed with the SEC. In addition, any forward-looking statementsrepresent our estimates or views as of today, December 20th, 2007, and theseestimates or views may change. While the company may elect to update forward-looking statements at some point in the future, we specifically disclaim anyobligation to do so, even if our estimates or views do change and therefore you should not rely on theseforward-looking statements as representing our estimates or views on any datesubsequent to today.
Now I will turn the call over to Matthew.
Thank you, Katrinkaand thank everyone on the call today to discuss our third quarterresults which we think are outstanding. I’m very pleased to show the strong momentum for open source software andfor Red Hat. Before discussing our Q3results, I’d like to quickly discuss my decision to become Chairman and to briefly describe the hiring of Jim Whitehurst as President andChief Executive Officer. For many monthsmy family has been challenged by serious health issues. It became clear to me that I needed to direct the same level of attention and effort in support of my family at this time that I have invested in Red Hat for nearly a decade. During the past year Red Hat has made organizational and operationalimprovements, introduced new products, and expanded geographically, whilescaling and improving our competitive position in the Middleware markets. As evidenced by today’s financial results,these changes are driving positive results and positive momentum giving me and the Red Hat Board the confidence in the future for Red Hat and the solid transition point for the new Chief Executive Officer. Red Hat has been engaged in an extensive search supported by NosalPartners, a world-class executive search firm. The search process was thorough and we are very pleased with the caliber of executives that were interested in the role. Candidates came from a wide variety of industries, includingrepresentatives from some of the largest technology companies in the world.
In the final evaluation, Jim Whitehurst stood above the group a strong finalist in the technology industry. Let me tell you why. Jim joins Red Hat after most recently servingas Chief Operating Officer of Delta Airlines, a company with over $17 billion in revenue and approximately 55,000employees. Jim played an important role in the financial and operational restructuring at Delta Airlines. Prior, Jim was a partner at The Boston Consulting Group and the combination of work experiences, operationaland strategic in deploying technology and processes to improve operating performance andefficiency while boosting customer service across the enterprise, is highly relevant to Red Hat’sfuture.
For me, I wanted tofind an executive with an open mind and an unencumbered historical perspective. Jim has proven business development skills where he was the leader of the creation of Orbitz inside of Delta, whichresulted in billions of dollars in value for Delta Airlines. Jim’s work history is global, strategic, andexecution-oriented. He is a straightforward hands-on leader and I havespent considerable time with Jim leading up to today’s announcement. I am excited for Red Hat’s future with JimWhitehurst at the helm.
Now I’d like to turnour attention to the Q3 results. I’m very pleased withthe strong performance the company delivered in our third fiscal quarter. Red Hat delivered revenues of $135 million, an increase of 28% year over year and above the high end of our guidance. The combination of strong bookings momentum andprofitability margins contributed to a record quarterly cash performance of $77million which is more than half of the amount of revenue we generated in the quarter.
We believe that RedHat has established a long-term track record that distinguishes the company in terms of revenue growth, profitability, andvery strong cash flow performance. I’d like to focus onthe underlying drivers of our strong financialperformance. It all begins with the fact that Red Hat stands out when it comes to delivering real business value tocustomers. This is the focus of every employee at Red Hat and our business model actuallyrequires us to deliver value in order for the company to be successful. This is very different thantraditional software vendors that are interested in maximizing software sales and focusing oncustomer control.
We are delighted to have been ranked the most valued enterprise software vendor for the fourth consecutive year and the best overall IT vendor for the third year and fourth years in CIO Insight Magazine’s latest vendor valuesurvey. To achieve a first overall ranking for total value is a real honor for me and for all the associates here at Red Hat. We are pleased that we also achieved first place rankings for meeting expectationsfor lowering cost, meeting commitments on time and budget, and for overallcustomer satisfaction. This isconsistent with our goal to be the most responsive vendor to customersdelivering high quality products and services as promised. We have worked very hard to earn this levelof customer loyalty and it’s important to note that Red Hat topped the list that included Google, Microsoft,Oracle, Hewlett Packard, and Apple in the CIO Insight magazine survey.
We didn’t justoutperform our competitors; we outperformed every technology company in the world. It is this customer loyalty that leads to our high renewal rates, growingstatus as a strategic vendor to our customers, and significant market leadershipposition. It also positions Red Hat well from a long-term perspective as we introduce newtechnology and service offerings because our customers know our proven historyof delivering value.
We have all read reports over the past year that outline the poor quality of much of the software that continues to be written today and the high failure rates of big software projects. Open Source opens the opportunity to reduce the cost and delays associated with these failuresfrom initial development through ongoing support. The Open Source mind for our developing software in small, easily digestible increments results in high quality code and sound designprocesses. In Open Source software, innovation happensevery day to produce a more highly reliable and higher quality product. When we originally launched Enterprise Linux in 2002, we pioneered the subscription model to keep us focused onlong-term customer satisfaction and service rather than just the initial software sale. It has been a highly disruptive approach, not just in the delivery of the product and pricing, but in the fundamental approach of how the supply chain of computing software has been built.
Our efforts andinnovations are shared and multiplied through our customer and communitycollaboration. We deliver our value to the customer as an integrated service behind the technology. In an environment where many technologies do not live up to their expectations, they takelonger to implement than expected, they cost more to deploy and maintain than expected,and vendors do not deliver the service and support that customers require. We increasingly find that the combination of our technology and ourbusiness model deliver real synergies for our customers. Customers are willing and interested in paying Red Hat when they can easily see the value that they are going to receive.
At Red Hat we continue to push the envelope as it relates to broadening and deepening ourvalue proposition for customers. An example of this is our Linux automationarchitecture that was announced earlier this quarter. One of our ISV partners who is also one of the largest software application companies in the world noted, “Linux automation couldaccelerate the adoption of their own business transformation platform by givingcustomers a simpler, more efficient, and cost-effective infrastructure.” Red Hat’s Linux automation architectureenables customers to deliver new levels of service while providing greateroperating efficiencies. Linux automationreduces the cost of owning and using applications. This is proprietary technology as customers must acquire, install,configure, optimize, deploy, and manage each application differently dependingon the type of server with which it will be run, and with Linux automation our customershave to go through this process just once and deploy the application on any type of serverresource: stand alone, virtual server,or hosted, such as Amazon EC2. It bridges IT silos that RHEL-certified applications can be run virtually on any server: RHEL, Windows, VMware, and Solaris. This enables better utilization of IT assets, better application performance, andperhaps most importantly of all, simplicity. It is the framework under which Open Source will deliver the next wave of value.
As an example of the Open Source collaborative developmentprocess, consider the Red Hat enterprise MRG beta we announced earlier this month. MRG is an important milestone in the vision of Linux automation. It builds new levels of performance, quality ofservice, and automation into the core of the IT infrastructure. The components of MRG were built with customersand partners globally, driven and focused based on customer input anddemand. One of our largest financialservices companies needed higher speed messaging for their core applications, and they approached Red Hat,asking for our leadership in building a community to develop an open inter-operable standard. What is most significant about thisinvestment that we have made with our customers is the growing application availability and demandfor horizontally scaled out and grid-based applications. MRG in combination with RHEL and our virtualizationtechnology will really provide the twenty-first century approach tohorizontally based good computing models.
We also released RedHat Enterprise Linux 5.1 in the quarter, another important milestone in our analytics automation strategy. It enables new levels of applicationavailability, performance, and mobility. Let me quickly share a few examples of how our customers are benefiting from RHEL 5.1 and how it has expanded our market opportunity.
With interactivesoftware companies, the key to value to them is to bring game capacity online more quickly to meetcustomer demands as new players join games. Red Hat virtualization allows our customers to instantly provision newservers in response to increasing demand. In the past they knew large amounts of idlecapacity waiting for demand. Now theycan bring new capacity online immediately. The result is greater customer satisfaction, revenue growth, and betterutilization of IT assets.
For a large telecommunications company, theirfocus has been hardware replacement. Byleveraging RHEL 5.1 for virtualization, our customer has been able to avoid running out of computerdata centers. This customer was able toconsolidate legacy RHEL 2.1 based applications onto their RHEL 5.1 anddecommission obsolete hardware to leverage performance benefits in new hardware. By using RHEL 5.1’s clustering capability,more applications now achieve high availability, which in the past was impractical due to applicationdependencies on physical servers. Theirwireless business is growing very quickly and they are now able to absorb many new servers intotheir environment and deliver a higher quality of service to their customer.
For a large energy company our first really $1million deal in the Latin America region, it‘s about moving from an unsupported environment of free Linux tohaving a trusted partner for supporting their mission-critical infrastructure in a paid-for Linux. They have recently converted from Red HatLinux 7 and Centos to RHEL 5.1. Fortheir business, file and print servers must be able to print shipping manifests on time andprevent very punitive waiting time penalties calculated per minute of delay and increased insurancecosts for having the ships at the docks. Their decision to create a common platform was driven by the quality of Red Hat’s customer support andOpen Source community involvement.
Finally, for a large movie and entertainment producer, theywant to simplify management and gain hardware independence to allow for fasterdeployment of the latest processor technologies without having to rebuild or re-certifyapplications. Leveraging RHEL 5.1, the customer can move virtual machines between servers based ondynamic resource requirements to meet production schedules. Their business is more nimble as a result of the flexibility to move their hardware investments and separateapplication investments.
Here we have givenyou a view into Red Hat that shows a customer moving from free solutions to ouradvanced platform, a customer on a lower-priced older version moving to our advanced platform, and newcustomers adopting our full-featured advanced platform out of the gate. Each of these customer examples also shows the tremendous value that Red Hat is deliveringto our customers, and in particular, how our customers are using the advanced features of RHEL 5, which is one ofthe most significant product releases in the history of the company.
Tens of thousands ofnew customers come to Red Hat each year while many others continually expandtheir strategic commitment to our platform. This is why we are confident that RHEL 5, including itsdifferentiated virtualization capabilities, will help us to fully exploit whatwe view as a very attractive, large, and growing market opportunity.
As excited as we are about the progress being made with Red Hat EnterpriseLinux, we are equally as encouraged by the many signs of progress in our Middleware business. For example, a leading supplier of integrated voice anddata communications moved from an unsupported Jboss to a fully supported Jboss enterprise applicationplatform. They first started usingunsupported Jboss over a year ago in non-mission-critical workloads as a way to lower their exposure to VEA. This quarter they moved to our enterpriseofferings and started deploying their mission-critical ticketing systems,billing applications, and network monitoring solutions on our Jboss enterpriseapplication platform.
Across all our solutions, it was extremely gratifying to hear 97% of ourcustomers say they would choose to do business with us again as a part of the CIO survey. This is consistent with what we see directly from our customers on a quarterly basis as evidenced by the fact that in Q3, 25 of our top 25 contracts that were upfor renewal did indeed renew for 128% of the value that was up for renewal. Moreover,over the past year and a half, we have renewed 148 of our top 150deals that were up for renewal during a timeframe that other large technologyvendors have made efforts to move into the Linux market.
There’s fantasticinnovation occurring in the world of Open Source software today. When you use open licensing and collaboration, you don’t care who gets the credit as long as the best idea wins. When you focus on the customer’s experience, you strive and make it lasting. We have long been driving twenty-first century culture in investment that will distinguish Red Hat formany years to come. We are not resting here; rather, we are constantly innovating our ability to createvalue and to deliver on our promises to our customers. It is rewarding to see our efforts recognized by customers and for it to shine through in a very strong financial performance for ourshareholders.
Now I will turn the call over to Charlie.
Thank you,Matthew. We’re pleased to report strongfinancial results for the third quarter of our 2008 fiscal year. Our financial results reflect strong globaldemand for Red Hat products and services and outstanding execution by ourassociates. We believe there’s a direct correlation between our rapid globalgrowth and the strong customer satisfaction statistic that Matthew discussed. As noted in the recent CIO Insight survey results, 97% ofthose surveyed say they will do business with Red Hat again. We see this customer loyalty reflected in our high level of renewal rates and the overall strength of our financial statements.
Let me give you an update on some key operational initiatives and then I’ll walkyou through our financial results and our guidance for Q4. As we’ve discussed on prior earnings calls,Red Hat has been increasing our direct sales presence, increasing our channel salesactivities, and improving our global sales processes. In the past 90 days we’ve made significant progresson each front, so let me address each of these, starting with direct sales.
During the quarter we opened new or enlarged offices in several countries, including our firstoffice in Taiwan, marking the 28th country in which we have a direct presence. We are continuing to add to our direct sales force,including inside sales, in all regions. Along with this growth, we’ve made significant improvements in the depth and intensity of our sales training,including a sales boot camp for all new hires, and it is what it sounds like, and it’s having the desired effect.
We continue to makesolid progress recruiting and motivating channel partners, including Middlewarepartners. In the US alone, we trained over 300 partnerpersonnel, sales, engineering, and support in the third quarter and we are repeating this process in every region of the world. We also launched the Red Hat Partner Center, an online resource offering a centralized place for Red Hat partners tomore easily and seamlessly conduct business with Red Hat. This destination website for each channelpartner is new to our APAC and Latin Americaregions and an improvement for EMEA and North American partners. Over 2,000 partners are registered through the Partner Center and have access to product, program,pricing, and training information on Red Hat and Jboss solutions and servicesfrom one single location. It’s localizedin many languages and the Partner Center also features a unified global agreement and enables clientrepeated access to the information needed to develop new business opportunities and renewexisting customers.
We also continue tofocus on other operational improvements, including sales force automationinitiated earlier in the year and the benefits are clearly beginning to show. As a precursor to a broader process and systems transformationproject which we have begun, we have been making consistent progress with salesforce automation. The project has been aimed specifically at making our sales force more efficient andincreasing the speed and capacity at which we can transact business. For example, this quarter we reduced orderprocess time with new processes and operations. We improved our CRM system with tighter links from sales toorder processing to finance and we introduced new dashboards to track real timeorder forms. Improvements are noticeable and they are continuing.
These initiativeswere targeted at helping Red Hat scale to the $1 billion and above level in revenue over the next several years. We’re very proud of the fact that we’re able to continue deliveringbest-in-class combined revenue growth and cash flow margins at the same time we’re making these highlystrategic investments in the business.
Now I’d like to takeyou through the Q3 results. Looking at the income statement, our total revenue for Q3was $135.4 million, an increase of 6% from last quarter and 28% from Q3 of last year. Total revenue exceeded our guidance as a result of continued global demand for OpenSource solutions and Red Hat’s strength at capturing this demand. Foreign exchange also added about $1 million to the total versus last quarter.
Subscription revenuewas $115.8 million, up 6% sequentially and 30% year over year. Training and services revenue of $19.6million was up 9% from last quarter and up 16% year over year. We’re pleased with the continuing improvement in the services business, as this can often lead toincreased demand for subscriptions for our technology platform andsolutions. In particular, we experienced a strong increase in demand for Middleware training andconsulting services. The strength of the overall business was very broad-based thisquarter. For example, in each of the past five quarters we’ve had at least one $5 million deal and in Q3 of last year we had three deals in excess of $5 million each. This quarter our results were not skewed byany deals of such size. Rather, we experienced strength in every geographic region in all project categories in multiple industry segments includingfinancial services and in both subscriptions and services resulting in the largest number of deals in excess of $1 million in our history, including two for Jboss.
We are encouraged by the trend that we’re seeing and the adoption of Red Hat Enterprise Linuxadvanced platform in all regions as Matthew mentioned. We’re also encouraged by signs of improved execution and future growthfor our Jboss solutions. I mentioned the increase in demand for training and consulting services in this area of our business a moment ago. We’re also seeing very nice growth in our Jboss sales pipeline on a worldwide basis. We continue to invest in our direct and indirect sales to takeadvantage of what we continue to believe will be a very large opportunity for Red Hat in the Middleware space.
Breaking down our Q3bookings, the channel generated 51% of bookings and 49% came from direct sales, whichwas a 53-47% split in Q2. In terms of geography, 58% of bookings camefrom the Americas, including a very strong showing from Latin America: 27%from EMEA and 15% from Asia Pacific. This compares to a respective 54%, 28%, and 18% split lastquarter. We are pleased with the traction we are seeing in Latin America, which grew 52% sequentially. We have a solid management team there recruitingseasoned talent for the organization, beginning penetration in large enterprise accounts and the public sector with a full range of our solutions, setting the foundation for this to be 3-5% of our overall business.
On a non-GAAP basis, excluding stock compensationexpense only, overall gross margin was 85% with 100 basis points better thanlast year. Subscription gross margin was93% while training and services gross margin was 36%. Several trends are apparent here. First and foremost, as Matthew mentioned, wedelivered value to our customer. Customers are willing to pay for outstanding support and the value they receive. Our disciplined approach to pricing has remained unchanged for the past three years. Second, we’re beginning to see existing customers upgrade from RHEL ES toRHEL Advanced Platform for the increased functionality. Many new customers are choosing RHEL Advanced Platform at the start. As you know, Advanced Platform is at a higher price point.
Finally,subscriptions now cost 85% of the revenue mix, improving the overall margin. Non-GAAP operating expense came in at $86.1 million, up 6% from last quarter. The increase in operating expense was attributableprincipally to increases in staffing, systems, and facilities expensesas the company continues to grow and expand worldwide. Foreign exchange changes also increased operating expensesapproximately $1 million last quarter.
Q3 non-GAAPoperating income was 31% higher than last year at $28.9 million, producing an operating margin of 21.4% compared tonon-GAAP operating income of $26.4 million and an operating margin of 20.7% last quarter andnon-GAAP operating income and margin of $22.1 million and 20.9% last year. Moving on, other income net which isattributable primarily to investment income was $12.9 million. Our non-GAAP tax rate which reflects actual cash taxes that weexpect to pay for the foreseeable future is still approximately 5%, resulting in non-GAAP net income of $39.7 million, up 8%from last quarter and up 32% from a year ago quarter. Our non-GAAP diluted earnings per share came to $0.19.
Now let’s turn to the balance sheet and the cash flow statement. We ended the quarter with approximately $1.3 billion in cash and investments, an increase of $76 million from the end of Q2, driven by very strong cash flow from operations. VSO was 55 days versus 58 days at the end of the second quarter. As a reminder, since days sales outstanding istraditionally a measure of receivables versus billings, our DSO calculation includes the change in deferred revenue. We’re pleased with the consistency of this metric. Total deferred revenue at the end of the quarter at $423 million, an increase of 12% from the prior quarter and an increase of 36% from last year. The increase is split relatively evenly betweencurrent and long-term deferred revenue.
Deferred revenueincludes an increase from the Q2 balance of approximately $10 million related to exchange rates. To see the change in deferred revenue excluding the foreign exchange impact, please refer to the statement cash flows and you will note therean increase of $35.8 million which is the result of just billings. In addition to the increase in deferred revenues, the strength of long-term subscriptions alsoresulted in double-digit million dollar increase in the value of subscriptions booked but not yetbilled. The strong growth in revenue, deferred revenue, and backlog isparticularly noteworthy when considering the fact that the prior year period was a very strong quarter and as I mentionedearlier, had three $5 million deals.
Moving to the statement of cash flows, non-GAAP cash flow from operations excluding the reclassification of excess tax benefits fromshare-based compensation arrangements was $76.7 million, up from $63.7 millionlast quarter. This represents a 20% sequential quarterly increase and a 24% increase over the prior year.
Now I’d like to turnto guidance. We are anticipating Q4 revenue to be in the range of $139.5 million - $141.5 million andnon-GAAP EPS to be approximately $0.19. We estimatestock compensation expense for Q4 is likely to be approximately $11 million. Based on year-to-date results and thesepieces of Q4 guidance, I’ll now offer the following guidance for the full fiscal year ending February 29, 2008.
First, revenue willexceed the earlier guidance given and is estimated to be $521 to $523 million. EPS is estimated to be approximately $0.70. Operating margin is estimated to be near 21%. That’s on a non-GAAP basis. The estimated GAAP tax rate is 39% and the cash tax rate is likely to be less than 5%. That brings us to just operating cash flow and since I do not provide guidance on quarterly cash flow,I don’t intend to change that now. Suffice it to say that I have high confidence that the non-GAAP operating cash flow for the full year will be at or will exceed the high end of the guidance which I provided at the start of the year which was a range of $250 to $260 million. Year to date non-GAAP operating cash flow at November 30th is $192.8 million,which means that we would need at least $67.2 million in Q4 to reach the top of the range.
So that you can plan ahead in your modeling, please be aware that beginning in fiscal year 2009, I will report only GAAPoperating cash flows since we will finally have year-to-year comparability in how the tax benefits related to NOLs are reported. Such comparability does not exist this year. Our intention is to provide detailedguidance on fiscal year ’09 on our next financial results conference call. From a high level perspective, we are optimistic about the strong demand we continue to see for our solutions on a worldwide basis. We will continue to balance investing in the business to drive revenue growth and marketshare gains along with our desire to deliver strong profitability margins. To this point, we believe that Red Hat ishighly unique for a technology company of our size considering our combined revenue growth,profitability, and cash flow profile.
I would now like toturn it back over to Matthew.
Thank you,Charlie. Folks, for the past 32 quarters, that’s been a long time, I’ve been addressing the investor audience. You’ve seen the industry of Open Source software grow from an isolated geek movement to an innovation service and economic model thatis growing, sustainable, and thriving. From what I have observed in the past decade, the global opportunity and momentum for Red Hatand Open Source software is fantastic. Red Hat is uniquely positioned with a compelling brand, great customer loyalty,and an innovation model that is without peer.
In summary, and in keeping with the holiday spirit, what I’d like to do is thank all of you for your support. Like the movie It’s A Wonderful Life, it is because of your support that I have beenable to stare in the eyes of Mr. Potter and spare the customer during all this time to spare them from the equivalency of mediocre products and reallylousy service. So on behalf of everyone here, we’d like tothank you for your time and support of our company and support of me during this period.
I’ll turn the call over to questions. Thanks.
Thanks. Jason, forthose asking questions today, we’ll beasking our callers to limit themselves to one question. Can you go ahead and poll theaudience for questions?
(Operator Instructions) Your first question comes from BrentThill from Citigroup.
Brent Thill -Citigroup
Thanks. Matthew, congrats on your success over theyears. Just a questionaround advanced platform, if you can give us asense of what percent of theoverall mix is advanced platform and where you seethe biggestopportunities to moveto that base.
Matthew J. Szulik
Theadvanced platform, as you know, Brent, hasbeen in themarketplace for less than ayear but in terms of therenewal, as customers arebuilding out data centers, we seecontinued strong growing momentum for advanced platform as customers arestarting to scale out of their grid based environment. They arestarting to leverage thevirtual capabilities which areinside of 5.0 and 5.1.
Just this past week, I was with anumber of large Wall Street customers that were seeing fantastic performanceimprovements in 5.0and 5.1, and I think increasingly over time, itwill start to become if not thedominant at leastsomewhere between 30% to 40% of our growing penetration within theenterprise.
Brent Thill -Citigroup
Your next question comes from Jason Maynard from CreditSuisse.
Jason Maynard -Credit Suisse
Good afternoon, guys, and Matthew, congratulations as well.I guess my question here is I appreciate thefocus on efficiency and operational control and as acompany, you guys have demonstrated stellar operating margins over theyears. But the hiringof somebody from more of anoperations and finance kind of background versus maybe more product technologyand being an advocatefor someone whose been around maybe thedevelopment in theopen source community I guess surprises mea bit.
SoMatthew, maybe help meunderstand how Red Hat looks forward, I guess, about extending thebrand quality that you have inyour new product areas and extending distribution soyou can take advantage of what I think is still anearly stage opportunity around open source.
Matthew J. Szulik
Thanks, Jason. I think first of all, we were interviewingand recruiting for people who had atrack record of successful leadership first and foremost and their valuesystems, quality of their intellect and strategic thinking.
As we went through therecruiting process, we did interview anumber of people that I amsure are familiar tothis audience listening from thetechnology industry and what we encountered, of course, was inmany cases a lack ofunderstanding of open source software development, alack of understanding of our model. And as importantly for me, theopen mindedness that would come to both thecreation of new economic models and contemporary thinking as itrelates to software development.
Inmy first meeting with Jim Whitehurst, we discussed thefour Linux distributions that hewas running on his home personal network. Hewas running Fedora Core6 and Fedora Core 7 athome. He was runningSlackware at home and hewas an experiencedsoftware developer up until thetime that he was atBCG. So we aregetting a technicallysavvy executive who happens to have strong operational, financial, andstrategic skills and itwas in my view that incomparison to his peers that were finalists for thejob, that he stoodhead and shoulders above, inlight of all of thequalities that we were looking for inmy successor.
Jason Maynard -Credit Suisse
I appreciate thecomments on that. I guess maybe as afollow-up, where -- and maybe this is more apt for him, but where doyou see or where doyou think the companygoes, broadly speaking, when you look atwhere you are attoday with themiddleware platform anJBoss. You’ve made some moves around data management. How doyou think about Red Hat extending theproduct line maybe to take advantage of other faster growing areas inopen source that could perhaps beleveraged better underneath theRed Hat banner?
Matthew J. Szulik
I’ll speak for myself, Jason, and I’m sure when Jim getswith the managementteam here, he may havehis own views but if you look atwhere -- I made astatement recently that Red Hat by 2015 seeks to have 50% of theworldwide server marketplace. So20% to 25% of that will bein thehigh performance and high throughput computing marketplace over that period oftime, which is acritically important marketplace for Red Hat technically and strategically, butalso one that I think that Bryan Stevens and Paul Cormier are doing afantastic job of building great solutions, most recently with theMRG work, to participate and compete for that segment.
Sothat leaves us with theremaining 25% to 30% of theexisting marketplace, of which I think we aredoing a damn good jobservicing today in thecore infrastructuremarket.
We haven’t spoken awhole lot to you inrecent quarters regarding thegrowth and theadoption of our management technologies around RHN. There’s another majorrelease that is getting ready to come out. Some of theguys here are going tobe screened on that inthe next couple ofweeks, which we arevery enthusiastic about.
And as you well know, when you leave theUnited States,we are very excitedabout the growthopportunities that we seefor the middlewareplatform in China,in India,Brazil, Argentina,Mexico, Russia.We don’t think we’ve scratched thesurface in thosemarkets.
State-less environments, which is also representing areally compelling solution both within thegrid environment but also now desktop solutions. I was inWall Street last week, as I mentioned, and customers arereally taking a closelook at what ourstate-less Linux offerings arein combination withtheir long-term technical activities.
And lastly, therole of security, both within information management and as acore component ofinfrastructure I think Red Hat is looking carefully atas well.
SoI think that theproduct pipeline is rich. Theproduct pipeline I think is strategically directed to sales and channelactivity over the last18 months that we’ve begun to drive aggressively -- allof this I think really bodes well for thestrategic position for Red Hat as anenterprise supplier.
Your next question comes from Brendan Barnicle from PacificCrest Securities.
Brendan Barnicle -Pacific Crest Securities
Thanks somuch. You know, we’ve seen more discussion inthe industry pressagain about Windows growing faster than Linux. Clearly you guys haven’t seenthat but this comes up frequently, Matthew. Where is thedisconnect? Do youhave any new thoughts on what is going on there?
Matthew J. Szulik
Well, it’s got apretty large installed base, Brendan, soit could bethe large -- thelaw of large numbers, but I spent alot of my time walking through alot of streets and visiting alot of customers over theyears and the numbershould reaffirm for you that this isn’t just CEO rhetoric, that this isreality, that there is abroad disconnect.
I think when one steps back and looks atthe selling anddistribution model of Red Hat, where free Linux, whether itbe Red Hat Fedora orsomebody else’s, is azero cost way topenetrate anenterprise, build skill and deployment within theenterprise, and have thecustomer have anexperience both at theapplication level and then strategically atthe performancewithout ever having asales person or someone call.
I don’t know how theresearch firms calculate that, how they evaluate that. And as we have provensince 7.3, we arereally good at beingable to monetize that through thedemonstration of value ata very lowcost once we areinvited into those opportunities.
SoI oftentimes read these research reports and I feel thesame confusion because itdoes not register with therate of penetrationthat we are seeingwith significant global enterprises on aworldwide basis.
Brendan Barnicle -Pacific Crest Securities
Great, and then also on JBoss, last quarter you mentionedthat you thought that ultimately will beable to grow 2X what theLinux organic growth rateis. Can you give us anupdate on how that -- how you pressed on that? You thought this quarter youwould start to seesome real traction around that.
Matthew J. Szulik
We did. We did seereal traction. I think as Charlie highlighted, thepipeline both within Q3 and going into Q4 is excellent for JBoss. I think we’vebeen very patient. As arenewal base business, we had to make sure that when thecustomers deployed JBoss inthe enterprise, thatwe had the capacity toservice them strategically and that’s not just from break-and-fix perspective but also from aconsulting at thepre-sales and post-sales activity, and we arestarting to see thathappen now strategically within very large global mission critical environments.
I think thecost performance iscompelling. I think therate of continuedtechnical innovation and as customers look strategically about informationmanagement and think about new data models that they arecreating, we will be ina good position tocompete for that business inthe future.
Our next question comes from theline of Kash Rangan from Merrill Lynch.
Kash Rangan - MerrillLynch
I’m just curious on theREL 5.0 with thevirtualization capability. Thestreet has been longworried about thecompression effect that you could potentially have with aninstalled base but you probably have not seen it, and I’m just curious, what areyour latest thoughts on how we should think about thecompression effects, since I as acustomer, if I could run four virtual machines from thesame VS license, could I not swap my one license for four virtual machinelicenses? What are theoffsets to that kind of thinking?
And also, as asegue into that, how doyou view VMWare in themarket relative to the[option, the 2%],beating themarketplace segments [inaudible] ina couple of differentways where you have some unique differentiation or is itmore of a battle formine share, market share versus VMWare atthis point? Thanks.
Matthew J. Szulik
Those arelots of questions, Kash.
Kash Rangan - MerrillLynch
Two questions, Matt.
Matthew J. Szulik
First of all, I think what we arebeginning to see iscustomers starting to movefrom early small scale pilots of virtualization and starting to moveit into productionenvironment, so forlargely on Windows-based machines, from what we have seen. I think customers arehaving a goodexperience with REL 5 and 5.1, as suggested through therenewal rates, and I think our strategy with VMWare continues to bevery good dialog, both strategically and technically. As you know, they havebeen a good partner ofRed Hat. I think customers would like tosee alevel of strategic coexistence. I thinkthey would like to seetechnical integration, improved technical integration and I think over time,that would probably allow Red Hat and VMware to bepretty good partners mutually.
There is great work going on inthe open sourcecommunity around KDM and theadvancement of the ZENKernel, and I think Red Hat planned for that through its technicalimplementation around BURT. I think thework that is being done around RHN and management and abetter instrumentation console, really fantastic tooling that our technicaldevelopment teams areworking on right now. I think we willcontinue to be able toprovide a very lowcost, high value alternative over time inthe upcoming calendar‘08 timeframe.
Kash Rangan - Merrill Lynch
I appreciate that, Matthew. So specificallyon the VMware side,what could be thenature of this relationship? Itsounds like it’s atechnical integration between your products, but can you just give us alittle bit more detail how exactly competing hypervisors can work together inthe market, becausethat is an interestingdirection in whichRHEL 5 can take thecompany. I am justcurious how themarketplace broadly shakes out, if there arethree or four broadly competing technologies?
Matthew J. Szulik
Well, acritical component to thesolution as you know, Kash, is going to beapplication availability and binary compatibility across thevirtualized environment. Sobare metal machineswill continue to constitute apretty fair shipment of Intel and AMDservers for theforeseeable future and socustomers that have had agreat experience on Linux performance, the5.1, 5.0 virtualization experience, thehypervisor independence, thetechnical integration with VMware. Butmost importantly from acustomer standpoint, theconsistency of application availability across virtualized environments is sucha compelling benefitto them and reduces their risk and their coststructure, we see itwill continue to be astrong benefit and competitive differentiator for Red Hat for theforeseeable future; which, within these installed customers is evidenced by ourrenewal rates. I think strategically positions Red Hat well relative to theother existing virtualization solutions.
Your next question comes from Adam Holt – JP Morgan.
Adam Holt – JP Morgan
Even if you adjust for theimpact of currency, billing still accelerated on asequential basis from thelast couple of quarters, and you called out afew things on the RHEL5 upgrade path; themovement to theadvanced platform as well as some execution improvements on thesales side.
I was wondering if you could maybe give alittle bit more detail as to what you think theprimary driver of that acceleration was? Was it salesback to the installedbase and a realaverage dollar increase perexisting customer or did you seean accelerationoutside the installedbase in terms of newcustomer wins?
I think that just going back to what I said earlier, itwas very broad-based across allproduct lines, allregions and sizes of customers. Imentioned the largestnumber ever of deals over $1 million. Wealso had a very largenumber of new accounts inthe quarter. So, it’s not just therenewals, the 25renewals that Matthew mentioned that renewed ata 128% of last year. Itwas also a lot of newbusiness in manydifferent regions. Itwas improvement inJBoss, it was strengthin RHN, itwas strength in RHELand it wasspecifically pointed out inLatin America aregion that we really got going on adirect basis early ayear ago and madeterrific progress.
Adam Holt – JP Morgan
If I could just follow-up with anumbers question, last quarter you talked alittle bit about theimpact of off-balance sheet bookings. What role did those play inthe quarter?
I mentioned that we had adouble-digit millions increase inthe off-balance sheetbacklog this quarter. Soin addition to thebillings number which you pointed out, I didn’t actually mention that butyou’ve done the mathof revenue plus changein deferred and you areright; it was avery strong billings quarter and itwas also a strong quarterfor increase in theunbilled backlog.
Your next question comes from Sarah Friar - Goldman Sachs.
Sarah Friar - GoldmanSachs
Charlie, on themargin front you seem to finally besettling into nice margin improvement quarter by quarter and on ayear-over-year basis. What can we beginto assume as we look forward interms of the abilityto keep that almost 100 bip type of improvement every quarter going forwardover the next yearplus? What are some ofthe bigger shifts youcan make in thesystem to ensure that?
Areyou speaking specifically about theoperating margin?
Sarah Friar - GoldmanSachs
Operating margin, yes.
Operating margin for thequarter on a non-GAAPbasis we are at21.4%. Theguidance I gave for thefull year was 21%; thefull year of fiscal year ‘08 and I will provide guidance for fiscal year ‘09 onthe next call.
I think one of thethings I also said is clearly we believe we have alarge growth opportunity sowe are trying tobalance the decisionabout investment for growth and for expansion of operating margins. We have clearly demonstrated on severalprevious occasions that we can expand theoperating margins. We know how tocontrol expenses quite well. It’s amatter of balancing how much to invest inmore sales or more R&D inparticular versus going for operating margin. But I will provide some specific guidance for fiscal year ‘09 on thenext call.
Sarah Friar - GoldmanSachs
You made acomment on your renewals being 128% this quarter or year over year. Is that mostly customers upgrading to theadvanced platform and taking on ahigher ASP, or is there alot of extra build out, JBoss and soon, that you have mentioned going on there?
I think it’s actually acombination of both. Clearly inthat renewal list we had anumber of customers that moved from theES up to AP but we also had expansion inother types of implementations.
Your next question comes from Tim Klasell - Thomas WeiselPartners.
Tim Klasell - ThomasWeisel Partners
Congratulations to you Matthew, and good luck inthe future. Thequestion is about therenewal rates. I think inthe last call youmentioned several initiatives to improve therenewal rate even atthe very smaller customers. Can you give us any update on how that’sprogressing and did that have any material effect on thequarter?
I think specifically, Tim, what you arereferring to is therenewal on theindirect side of thebusiness because our renewal rateon the direct side hasalways been very high and we have made alot of improvement this year inreally beginning theprocess a little bitmore than a year agoin terms of gatheringdata for the endcustomer, finding other ways including third parties, to help with renewalbusiness that has comethrough thechannel. I think we have madesignificant progress. There still iswork to do and we arestill doing that work. SoI look forward to more improvement there.
Your next question comes from Brent Williams - TheBenchmark Company.
Brent Williams - The Benchmark Company
One of thethings that we arehearing about virtualization is increased interest inhigher end storage. Have you seen that as driving either directly serverlicense revenue, increased interest inGFS or manifesting indragging other products behind, just using them?
Matthew J. Szulik
Brent Williams - The Benchmark Company
Any way we can think about how much incremental interestthere is, qualitatively about how much incremental interest there is instorage, maybe over thelast three months or sixmonths?
Matthew J. Szulik
As you know, Brent, I think thewhole notion of virtualization as abenefit device SCSI, new storage paradigms that areevolving, the role of statelessLinux in thatenvironment and simplifying thewhole process of software development, therole of directory services inall of this activity,better security models. Allof this, I think, is going to continue to increase demand and I think will ultimatelyaccrue to more innovative storage solutions both with Red Hat by theopen source community and by strong partners like EMCand NetApp.
Your next question comes from Heather Bellini - UBS.
Analyst for HeatherBellini - UBS
Just aquick one on the moveto advanced platform. What arethe trigger points forcustomers who move to theadvanced platform? Is itat therenewal time or arethey coming to you even otherwise and asking for movement to theupper end, higher end version? How longdo you think itwill take for you to getto your 30% or low 30%installed base on theadvanced platform?
Thenice thing about thesubscription model is thecustomer has theright to move to thenext level whenever it’s right for them. So sometimesthat happens at therenewal time and sometimes ithappens earlier, depending upon what their need is. I don’t think there is any way for meto generalize what theanswer is.
Analyst for HeatherBellini - UBS
I think Matthew laid out thetarget of low 30s fromthe install base to beon the advancedplatform. How long doyou think it will takeand where are you inthat whole process?
I think it’s still early. Matthew said that itwill take some time and we’ve seen good movement already, but we only launchedRHEL 5 back earlier this year, soit will take abit of time; probably through next year.
Your next question comes from Mark Murphy - Broadpoint.
Mark Murphy - Broadpoint
Charlie,the long-term deferred revenue made an unusually big advance in the quarter. We are aware that you’ve had this pushto try to move customers to three yearcontracts, but did you dothat much more aggressively during thequarter or is that just occurring naturally atsuch a fastpace?
I would just sayI don’t think it was anunusually large shift other than deferred revenue intotal made a largeshift; there was about a$43 million total increase, almost equally split between current and longterm. If you go back and look atwhat happened in Q2, infact there was no increase inlong term. Essentially itwas all current.
Sosome of it’s just timing I think. If youlook at thetotal mix of short term and longterm on a year-to-datebasis it looks about theway it alwayshas. I dothink that one of thethings that we arebenefiting from is thecustomer satisfaction. Thecustomer satisfaction is extremely high, and soif a customer is goingto come back every year, inmany cases they aresaying: “why should I renew every year, why don’t I simply doa long-term deal, Idon’t have to got through theadministrative work of allof that over a periodof time.”
Theother thing I would mention is that I think what’s happening is many ITdepartments are tryingto whittle down thenumber of suppliers that they areusing. There is some consolidation of suppliers going on. Again, because we deliver value alot of customers arejust signing up with us.
Mark Murphy -Broadpoint
As afollow up for Matthew, thequarterly results areextremely strong across -- effectively every single metric I think is wellabove probably thehighest numbers on TheStreet. Inthe context of that,does it feel to you asif virtualization currently is anet benefit to Red Hat as adriver of the advancedplatform adoption, or is virtualization just effectively having no real impacton the business?
Matthew J. Szulik
Itis definitely helping our business, Mark. I think once again thecustomers have great insight into what’s happing within theopen source communities sothey can see some of thework being done around important technology, parallel memory activities, PNFShappening; things that they seeRed Hat very active inthat will strategically accrue to their long-term technical architectures andstrategies.
Of course, virtualization and allof its benefits and thehorizontal scale out of that grid-like environment is really inRed Hat’s sweet spot for theforeseeable future. SoI think this is what we arestarting to see, that thecompetency of thecompany, the globalservice and support, allthe things that we’vebeen telling you about for many quarters is really starting to accrue to thefinancial benefits of thecompany.
Your next question comes from Todd Raker - Deutsche Bank.
Todd Raker - Deutsche Bank
Hey guys, nice quarter. With asubstantial amount of cash on thebalance sheet, can you talk about potential acquisitions? Where you think youmay have holds versus stock buyback and how you arethinking about thecapital structure of thebusiness?
If you can just comment interms of any exposure, specifically to thefinancial services vertical and how you expect that to play out, given some of theheadline risk here?
Well first of all, relative to thecash on the balancesheet and acquisition strategy, I think there is really no changethere. What you have heard mesay before is that welook at acquisitioncandidates all thetime; we basically arelooking attechnologies to build out our existing offerings and look for areas that cancomplement or supplement what we dothere.
We also look atacquisition candidates that might begood candidates for geographic expansion. So for example,last year it was Argentina,Brazil and Indiaand something in theCzech Republic. We arevery active and we arealways looking.
You should assume that acquisitions aresomething that we’ll continue to beinvolved with. Beyond that, we dohave an authorizationfor both share repurchase and bond repurchase.
Thesecond part of your question, which was exposure to thefinancial services industry, as you have heard mesay, this quarter we had strength across allsegments including thefinancial services industry, including alarge new customer in thefinancial services industry.
Having said that, I did seethe analyst report inthe last week or twowhich was quite off base interms of theexposure. My assessment of our total inthe financial servicesindustry is probably less than 15%. Iwould say that’s on aglobal basis. Sowe have financial services customers that happen to besome of the largest exchangesin theworld in multiplegeographies. We have large investment banks, we have commercial banks and wehave other types of financial institutions; again, allover the world. I think we area very diversifiedcustomer base and I think we arein good shape there.
Your next question comes from Steve Ashley - Robert W Baird.
Steve Ashley - RobertW Baird
My question relates to virtualization. I’m just trying tounderstand the role ofhosting Windows guests inthe future, what yourexpectation is and how actively you would you expect to beinvolved in that?
I think we recognize that we arecompeting in aheterogeneous environment. I think thecustomers are startingto see strongperformance benefits of our virtualized environment. Inorder to get deeperand improve our relationship with them, hosting and supporting Windows guestenvironments I think is amust-have for us to continue to expand penetration.
Steve Ashley - RobertW Baird
Allright. Charlie, you mentioned that theyear-ago period had three $5 million deals. Were those allbilled and included either inthe reported revenue inthe P&L ordeferred revenue last year?
As I’ve described on previous calls, two of those werebilled in Q3 ayear ago and one ofthose was not billed; itis billed on aperiodic basis going forward from then.
Your next question comes from Tom Curlin - RBC.
Tom Curlin - RBC
Good afternoon. Iknow you are notcommenting on anoperational basis for next fiscal year, but can you just give us some flavorfor how your cash tax rateand non-GAAP tax ratewill evolve over thenext couple of years? Doyou think your NOLs areexhausted over thenext one or two years or not? What does that trajectory look like from anon-GAAP and from acash tax basis?
At theend of Q3 our NOLs arestill going to be inthe neighborhood ofalmost $300 million, and inaddition to that, I would expect that over thenext couple of years we will generate additional stock option deductions on atax return basis that would create more booked tax differences inthat regard. Specifically, relative tonext year, I have not done aneffective tax rate fornext year. I have seen many analyst reports out there that arestill using a 40% rateand I would assume atthis point if you aretrying to build amodel, something like that to memakes sense. I’ll give you betterguidance on the Q4call.
On thecash tax rate, I also would assume for thenext probably at leasttwo to three years and maybe beyond that the5% cash tax rate makessense. Again, I’ll give you some betterguidance on that at theend of the Q4 call.
Tom Curlin - RBC
Allright. Thank you.
Your next question comes from Kirk Materne - Banc ofAmerica.
Kirk Materne - Banc of America
Matthew, good luck on yourinitiatives going forward. Charlie, onJBoss in terms of whenyou talk about direct hiring, how much of that is really centered around theMiddleware area and how much of that is just for thebroader platform? Where doyou see thesplit in terms ofJBoss business being interms of channel and direct? I think historically ithad been pretty much alldirect. Do you thinkthat you can get thesame kind of leverage inthe channel atJBoss as you are withRHEL today?
Thefirst part on hiring, I think as you know our salesforce generally oursalesforce is covering allproducts with some overlay insome regions. It’s hard to sayspecifically on thesales side, how that breaks down. On theengineering side, obviously they arevery specific and we have added engineering inQ3 as well. But I amnot going to provide any specific breakdown on that.
On thechannel side, you arequite right. Ayear ago onacquisition there was no really channel business for JBoss and we have done anawful lot of work building channel partners; today have over 70 channelpartners on theMiddleware side and still growing.
Your next question comes from Erika Bukavinski - Jefferies.
Erika Bukavinski - Jefferies
Can you give us anupdate on theconference call about amonth ago when yousaid you hit 18,000 servers virtualized using RHEL virtualization, is there anupdate there?
We don’t have any update on that for this call.
Erika Bukavinski - Jefferies
Matthew, as you moveinto the next phase,how important is itfor your successor to keep thepurity of an opensource model? Would you ever consider buying or building closed sourcesolutions?
We have certainly bought open proprietary software companiesand we continue to work on open sourcing and GPLing that technology. Certainly I think being apure play open source company is thevery fabric in theDNA of thecompany. Of course, I think that is thedevelopment model; that is what drives this whole end user innovation that ourteams are able tocontribute. Soto me that is really thecore fabric of thebusiness, and to me isa non-negotiableactivity.
We dohave time for one final question, and that question comes from Trip Chowdhry -Global Equities.
Trip Chowdhry -Global Equities
I have aquestion on thebalance sheet. I think you have about$400 million plus indebt securities, and they may beall ina AAA bond. I was wondering, should we investors bea little worried thatthere may be somemarkdowns, because directly or indirectly some of those bonds may beassociated with themortgage-backed securities and CMOs? Anythoughts on it? Areyou marking to market those bonds? What should we bethinking about it?
That’s agood question, Trip. We have avery conservative investment philosophy which thenumber one criteria is principal preservation first, and sometimes I guess I’vebeen criticized on theincome side of it. Atthis point, I think I amvery pleased with our investments.
Of thetotal, which is roughly $1.3 billion of investments, we have less than $10million in any sort ofmortgage-backed security, and thevast majority of our investments arein fact AAA rated.
Thanks again, everyone for joining Red Hat’s managementtoday. This concludes thethird fiscal quarter earnings call. Thanks.
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