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Red Hat, Inc. (NYSE:RHT)

F3Q08 Earnings Call

December 20, 2007 5:00 pm ET

Executives

Katrinka McCallum - Vice President of Investor Relations

Matthew Szulik - Chairman, President, and Chief Executive Officer

Charles Peters - Executive Vice President and Chief Financial Officer

Analysts

Brent Thill - Citigroup

Jason Maynard - Credit Suisse

Brendan Barnicle - Pacific Crest Securities

Kash Rangan - Merrill Lynch

Adam Holt – JP Morgan

Sarah Friar - Goldman Sachs

Tim Klasell - Thomas Weisel Partners

Brent Williams - The Benchmark Company

Heather Bellini - UBS

Mark Murphy - Broadpoint

Todd Raker - Deutsche Bank

Steve Ashley - Robert W Baird

Tom Curlin - RBC

Kirk Materne - Banc of America

Erika Bukavinski - Jefferies

Trip Chowdhry - Global Equities

Operator

My name is Jason and I will be your conference facilitator today. At this time I would like to welcome everyone to the Red Hat third quarter fiscal year 2008 earnings conference call. All calls have been placed on mute to prevent any background noise. After the speaker’s remarks there will be a question and answer period. (Operator Instructions) As a reminder, ladies and gentlemen, this conference is being recorded today, December 20, 2007. Thank you. I would now like to introduce Ms. Katrinka McCallum, Vice President of Investor Relations. Ms. McCallum, you may begin your conference.

Katrinka McCallum

Great, thanks, Jason. Welcome to Red Hat’s third 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 and our press release announcing the separation of the Chairman and CEO roles were issued after market closed today and may be downloaded from www.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 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 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, December 20th, 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 on any date subsequent to today.

Now I will turn the call over to Matthew.

Matthew Szulik

Thank you, Katrinka and thank everyone on the call today to discuss our third quarter results which we think are outstanding. I’m very pleased to show the strong momentum for open source software and for Red Hat. Before discussing our Q3 results, I’d like to quickly discuss my decision to become Chairman and to briefly describe the hiring of Jim Whitehurst as President and Chief Executive Officer. For many months my 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 operational improvements, introduced new products, and expanded geographically, while scaling 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 Nosal Partners, 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, including representatives 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 serving as Chief Operating Officer of Delta Airlines, a company with over $17 billion in revenue and approximately 55,000 employees. 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, operational and strategic in deploying technology and processes to improve operating performance and efficiency while boosting customer service across the enterprise, is highly relevant to Red Hat’s future.

For me, I wanted to find 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, which resulted in billions of dollars in value for Delta Airlines. Jim’s work history is global, strategic, and execution-oriented. He is a straightforward hands-on leader and I have spent considerable time with Jim leading up to today’s announcement. I am excited for Red Hat’s future with Jim Whitehurst at the helm.

Now I’d like to turn our attention to the Q3 results. I’m very pleased with the 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 and profitability margins contributed to a record quarterly cash performance of $77 million which is more than half of the amount of revenue we generated in the quarter.

We believe that Red Hat has established a long-term track record that distinguishes the company in terms of revenue growth, profitability, and very strong cash flow performance. I’d like to focus on the underlying drivers of our strong financial performance. It all begins with the fact that Red Hat stands out when it comes to delivering real business value to customers. This is the focus of every employee at Red Hat and our business model actually requires us to deliver value in order for the company to be successful. This is very different than traditional software vendors that are interested in maximizing software sales and focusing on customer 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 value survey. 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 expectations for lowering cost, meeting commitments on time and budget, and for overall customer satisfaction. This is consistent with our goal to be the most responsive vendor to customers delivering high quality products and services as promised. We have worked very hard to earn this level of 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 just outperform our competitors; we outperformed every technology company in the world. It is this customer loyalty that leads to our high renewal rates, growing status as a strategic vendor to our customers, and significant market leadership position. It also positions Red Hat well from a long-term perspective as we introduce new technology and service offerings because our customers know our proven history of 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 failures from 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 design processes. In Open Source software, innovation happens every 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 on long-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 and innovations are shared and multiplied through our customer and community collaboration. 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 take longer 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 our business 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 our value proposition for customers. An example of this is our Linux automation architecture 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 could accelerate the adoption of their own business transformation platform by giving customers a simpler, more efficient, and cost-effective infrastructure.” Red Hat’s Linux automation architecture enables customers to deliver new levels of service while providing greater operating efficiencies. Linux automation reduces the cost of owning and using applications. This is proprietary technology as customers must acquire, install, configure, optimize, deploy, and manage each application differently depending on the type of server with which it will be run, and with Linux automation our customers have to go through this process just once and deploy the application on any type of server resource: 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, and perhaps 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 development process, 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 of service, and automation into the core of the IT infrastructure. The components of MRG were built with customers and partners globally, driven and focused based on customer input and demand. One of our largest financial services 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 this investment that we have made with our customers is the growing application availability and demand for horizontally scaled out and grid-based applications. MRG in combination with RHEL and our virtualization technology will really provide the twenty-first century approach to horizontally based good computing models.

We also released Red Hat Enterprise Linux 5.1 in the quarter, another important milestone in our analytics automation strategy. It enables new levels of application availability, 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 interactive software companies, the key to value to them is to bring game capacity online more quickly to meet customer demands as new players join games. Red Hat virtualization allows our customers to instantly provision new servers in response to increasing demand. In the past they knew large amounts of idle capacity waiting for demand. Now they can bring new capacity online immediately. The result is greater customer satisfaction, revenue growth, and better utilization of IT assets.

For a large telecommunications company, their focus has been hardware replacement. By leveraging RHEL 5.1 for virtualization, our customer has been able to avoid running out of computer data centers. This customer was able to consolidate legacy RHEL 2.1 based applications onto their RHEL 5.1 and decommission 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 application dependencies on physical servers. Their wireless business is growing very quickly and they are now able to absorb many new servers into their environment and deliver a higher quality of service to their customer.

For a large energy company our first really $1 million deal in the Latin America region, it‘s about moving from an unsupported environment of free Linux to having a trusted partner for supporting their mission-critical infrastructure in a paid-for Linux. They have recently converted from Red Hat Linux 7 and Centos to RHEL 5.1. For their business, file and print servers must be able to print shipping manifests on time and prevent very punitive waiting time penalties calculated per minute of delay and increased insurance costs 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 and Open Source community involvement.

Finally, for a large movie and entertainment producer, they want to simplify management and gain hardware independence to allow for faster deployment of the latest processor technologies without having to rebuild or re-certify applications. Leveraging RHEL 5.1, the customer can move virtual machines between servers based on dynamic resource requirements to meet production schedules. Their business is more nimble as a result of the flexibility to move their hardware investments and separate application investments.

Here we have given you a view into Red Hat that shows a customer moving from free solutions to our advanced platform, a customer on a lower-priced older version moving to our advanced platform, and new customers adopting our full-featured advanced platform out of the gate. Each of these customer examples also shows the tremendous value that Red Hat is delivering to our customers, and in particular, how our customers are using the advanced features of RHEL 5, which is one of the most significant product releases in the history of the company.

Tens of thousands of new customers come to Red Hat each year while many others continually expand their strategic commitment to our platform. This is why we are confident that RHEL 5, including its differentiated virtualization capabilities, will help us to fully exploit what we view as a very attractive, large, and growing market opportunity.

As excited as we are about the progress being made with Red Hat Enterprise Linux, we are equally as encouraged by the many signs of progress in our Middleware business. For example, a leading supplier of integrated voice and data communications moved from an unsupported Jboss to a fully supported Jboss enterprise application platform. They first started using unsupported 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 enterprise offerings and started deploying their mission-critical ticketing systems, billing applications, and network monitoring solutions on our Jboss enterprise application platform.

Across all our solutions, it was extremely gratifying to hear 97% of our customers 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 up for 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 150 deals that were up for renewal during a timeframe that other large technology vendors have made efforts to move into the Linux market.

There’s fantastic innovation 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 for many years to come. We are not resting here; rather, we are constantly innovating our ability to create value 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 our shareholders.

Now I will turn the call over to Charlie.

Charles Peters

Thank you, Matthew. We’re pleased to report strong financial results for the third quarter of our 2008 fiscal year. Our financial results reflect strong global demand for Red Hat products and services and outstanding execution by our associates. We believe there’s a direct correlation between our rapid global growth and the strong customer satisfaction statistic that Matthew discussed. As noted in the recent CIO Insight survey results, 97% of those 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 walk you 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 sales activities, and improving our global sales processes. In the past 90 days we’ve made significant progress on 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 first office 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 make solid progress recruiting and motivating channel partners, including Middleware partners. In the US alone, we trained over 300 partner personnel, 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 to more easily and seamlessly conduct business with Red Hat. This destination website for each channel partner is new to our APAC and Latin America regions 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 services from one single location. It’s localized in many languages and the Partner Center also features a unified global agreement and enables client repeated access to the information needed to develop new business opportunities and renew existing customers.

We also continue to focus on other operational improvements, including sales force automation initiated earlier in the year and the benefits are clearly beginning to show. As a precursor to a broader process and systems transformation project which we have begun, we have been making consistent progress with sales force automation. The project has been aimed specifically at making our sales force more efficient and increasing the speed and capacity at which we can transact business. For example, this quarter we reduced order process time with new processes and operations. We improved our CRM system with tighter links from sales to order processing to finance and we introduced new dashboards to track real time order forms. Improvements are noticeable and they are continuing.

These initiatives were 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 delivering best-in-class combined revenue growth and cash flow margins at the same time we’re making these highly strategic investments in the business.

Now I’d like to take you through the Q3 results. Looking at the income statement, our total revenue for Q3 was $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 Open Source solutions and Red Hat’s strength at capturing this demand. Foreign exchange also added about $1 million to the total versus last quarter.

Subscription revenue was $115.8 million, up 6% sequentially and 30% year over year. Training and services revenue of $19.6 million 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 to increased demand for subscriptions for our technology platform and solutions. In particular, we experienced a strong increase in demand for Middleware training and consulting services. The strength of the overall business was very broad-based this quarter. 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 by any deals of such size. Rather, we experienced strength in every geographic region in all project categories in multiple industry segments including financial 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 Linux advanced platform in all regions as Matthew mentioned. We’re also encouraged by signs of improved execution and future growth for 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 take advantage of what we continue to believe will be a very large opportunity for Red Hat in the Middleware space.

Breaking down our Q3 bookings, the channel generated 51% of bookings and 49% came from direct sales, which was a 53-47% split in Q2. In terms of geography, 58% of bookings came from 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 last quarter. We are pleased with the traction we are seeing in Latin America, which grew 52% sequentially. We have a solid management team there recruiting seasoned 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 compensation expense only, overall gross margin was 85% with 100 basis points better than last year. Subscription gross margin was 93% while training and services gross margin was 36%. Several trends are apparent here. First and foremost, as Matthew mentioned, we delivered 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 to RHEL 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 attributable principally to increases in staffing, systems, and facilities expenses as the company continues to grow and expand worldwide. Foreign exchange changes also increased operating expenses approximately $1 million last quarter.

Q3 non-GAAP operating income was 31% higher than last year at $28.9 million, producing an operating margin of 21.4% compared to non-GAAP operating income of $26.4 million and an operating margin of 20.7% last quarter and non-GAAP operating income and margin of $22.1 million and 20.9% last year. Moving on, other income net which is attributable primarily to investment income was $12.9 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 $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 is traditionally 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 between current and long-term deferred revenue.

Deferred revenue includes 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 there an 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 also resulted in double-digit million dollar increase in the value of subscriptions booked but not yet billed. The strong growth in revenue, deferred revenue, and backlog is particularly noteworthy when considering the fact that the prior year period was a very strong quarter and as I mentioned earlier, 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 from share-based compensation arrangements was $76.7 million, up from $63.7 million last quarter. This represents a 20% sequential quarterly increase and a 24% increase over the prior year.

Now I’d like to turn to guidance. We are anticipating Q4 revenue to be in the range of $139.5 million - $141.5 million and non-GAAP EPS to be approximately $0.19. We estimate stock compensation expense for Q4 is likely to be approximately $11 million. Based on year-to-date results and these pieces of Q4 guidance, I’ll now offer the following guidance for the full fiscal year ending February 29, 2008.

First, revenue will exceed 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 GAAP operating 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 detailed guidance 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 market share gains along with our desire to deliver strong profitability margins. To this point, we believe that Red Hat is highly unique for a technology company of our size considering our combined revenue growth, profitability, and cash flow profile.

I would now like to turn it back over to Matthew.

Matthew Szulik

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 that is growing, sustainable, and thriving. From what I have observed in the past decade, the global opportunity and momentum for Red Hat and 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 been able 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 really lousy service. So on behalf of everyone here, we’d like to thank 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.

Katrinka McCallum

Thanks. Jason, for those asking questions today, we’ll be asking our callers to limit themselves to one question. Can you go ahead and poll the audience for questions?

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Brent Thill from Citigroup.

Brent Thill - Citigroup

Thanks. Matthew, congrats on your success over the years. Just a question around advanced platform, if you can give us a sense of what percent of the overall mix is advanced platform and where you seethe biggest opportunities to move to that base.

Matthew J. Szulik

The advanced platform, as you know, Brent, has been in the marketplace for less than a year but in terms of the renewal, as customers are building out data centers, we see continued strong growing momentum for advanced platform as customers are starting to scale out of their grid based environment. They are starting to leverage the virtual capabilities which are inside of 5.0 and 5.1.

Just this past week, I was with a number of large Wall Street customers that were seeing fantastic performance improvements in 5.0 and 5.1, and I think increasingly over time, it will start to become if not the dominant at least somewhere between 30% to 40% of our growing penetration within the enterprise.

Brent Thill - Citigroup

Thanks.

Operator

Your next question comes from Jason Maynard from Credit Suisse.

Jason Maynard - Credit Suisse

Good afternoon, guys, and Matthew, congratulations as well. I guess my question here is I appreciate the focus on efficiency and operational control and as a company, you guys have demonstrated stellar operating margins over the years. But the hiring of somebody from more of an operations and finance kind of background versus maybe more product technology and being an advocate for someone whose been around maybe the development in the open source community I guess surprises mea bit.

So Matthew, maybe help me understand how Red Hat looks forward, I guess, about extending the brand quality that you have in your new product areas and extending distribution so you can take advantage of what I think is still an early stage opportunity around open source.

Matthew J. Szulik

Thanks, Jason. I think first of all, we were interviewing and recruiting for people who had a track record of successful leadership first and foremost and their value systems, quality of their intellect and strategic thinking.

As we went through the recruiting process, we did interview a number of people that I am sure are familiar to this audience listening from the technology industry and what we encountered, of course, was in many cases a lack of understanding of open source software development, a lack of understanding of our model. And as importantly for me, the open mindedness that would come to both the creation of new economic models and contemporary thinking as it relates to software development.

In my first meeting with Jim Whitehurst, we discussed the four Linux distributions that he was running on his home personal network. He was running Fedora Core 6 and Fedora Core 7 at home. He was running Slackware at home and he was an experienced software developer up until the time that he was at BCG. So we are getting a technically savvy executive who happens to have strong operational, financial, and strategic skills and it was in my view that in comparison to his peers that were finalists for the job, that he stood head and shoulders above, in light of all of the qualities that we were looking for in my successor.

Jason Maynard - Credit Suisse

I appreciate the comments on that. I guess maybe as a follow-up, where -- and maybe this is more apt for him, but where do you see or where do you think the company goes, broadly speaking, when you look at where you are at today with the middleware platform an JBoss. You’ve made some moves around data management. How do you think about Red Hat extending the product line maybe to take advantage of other faster growing areas in open source that could perhaps be leveraged better underneath the Red Hat banner?

Matthew J. Szulik

I’ll speak for myself, Jason, and I’m sure when Jim gets with the management team here, he may have his own views but if you look at where -- I made a statement recently that Red Hat by 2015 seeks to have 50% of the worldwide server marketplace. So 20% to 25% of that will bein the high performance and high throughput computing marketplace over that period of time, which is a critically important marketplace for Red Hat technically and strategically, but also one that I think that Bryan Stevens and Paul Cormier are doing a fantastic job of building great solutions, most recently with the MRG work, to participate and compete for that segment.

So that leaves us with the remaining 25% to 30% of the existing marketplace, of which I think we are doing a damn good job servicing today in thecore infrastructure market.

We haven’t spoken a whole lot to you in recent quarters regarding the growth and the adoption of our management technologies around RHN. There’s another major release that is getting ready to come out. Some of the guys here are going to be screened on that inthe next couple of weeks, which we are very enthusiastic about.

And as you well know, when you leave theUnited States, we are very excited about the growth opportunities that we see for the middleware platform in China, in India, Brazil, Argentina, Mexico, Russia. We don’t think we’ve scratched the surface in those markets.

State-less environments, which is also representing a really compelling solution both within the grid environment but also now desktop solutions. I was in Wall Street last week, as I mentioned, and customers are really taking a close look at what our state-less Linux offerings arein combination with their long-term technical activities.

And lastly, the role of security, both within information management and as acore component of infrastructure I think Red Hat is looking carefully at as well.

So I think that the product pipeline is rich. The product pipeline I think is strategically directed to sales and channel activity over the last 18 months that we’ve begun to drive aggressively -- all of this I think really bodes well for the strategic position for Red Hat as an enterprise supplier.

Operator

Your next question comes from Brendan Barnicle from Pacific Crest Securities.

Brendan Barnicle - Pacific Crest Securities

Thanks so much. You know, we’ve seen more discussion inthe industry press again about Windows growing faster than Linux. Clearly you guys haven’t seen that but this comes up frequently, Matthew. Where is the disconnect? Do you have any new thoughts on what is going on there?

Matthew J. Szulik

Well, it’s got a pretty large installed base, Brendan, soit could bethe large -- the law of large numbers, but I spent a lot of my time walking through a lot of streets and visiting a lot of customers over the years and the number should reaffirm for you that this isn’t just CEO rhetoric, that this is reality, that there is a broad disconnect.

I think when one steps back and looks atthe selling and distribution model of Red Hat, where free Linux, whether itbe Red Hat Fedora or somebody else’s, is a zero cost way to penetrate an enterprise, build skill and deployment within the enterprise, and have the customer have an experience both at the application level and then strategically atthe performance without ever having a sales person or someone call.

I don’t know how the research firms calculate that, how they evaluate that. And as we have proven since 7.3, we are really good at being able to monetize that through the demonstration of value ata very lowcost once we are invited into those opportunities.

So I oftentimes read these research reports and I feel the same confusion because it does not register with therate of penetration that we are seeing with significant global enterprises on a worldwide basis.

Brendan Barnicle - Pacific Crest Securities

Great, and then also on JBoss, last quarter you mentioned that you thought that ultimately will be able to grow 2X what the Linux organic growth rate is. Can you give us an update on how that -- how you pressed on that? You thought this quarter you would start to see some real traction around that.

Matthew J. Szulik

We did. We did see real traction. I think as Charlie highlighted, the pipeline both within Q3 and going into Q4 is excellent for JBoss. I think we’ve been very patient. As a renewal base business, we had to make sure that when the customers deployed JBoss inthe enterprise, that we had the capacity to service them strategically and that’s not just from break-and-fix perspective but also from a consulting at the pre-sales and post-sales activity, and we are starting to see that happen now strategically within very large global mission critical environments.

I think thecost performance is compelling. I think therate of continued technical innovation and as customers look strategically about information management and think about new data models that they are creating, we will be ina good position to compete for that business inthe future.

Operator

Our next question comes from the line of Kash Rangan from Merrill Lynch.

Kash Rangan - Merrill Lynch

I’m just curious on the REL 5.0 with the virtualization capability. The street has been long worried about the compression effect that you could potentially have with an installed base but you probably have not seen it, and I’m just curious, what are your latest thoughts on how we should think about the compression effects, since I as a customer, if I could run four virtual machines from the same VS license, could I not swap my one license for four virtual machine licenses? What are the offsets to that kind of thinking?

And also, as a segue into that, how do you view VMWare in the market relative to the [option, the 2%], beating the marketplace segments [inaudible] ina couple of different ways where you have some unique differentiation or is it more of a battle for mine share, market share versus VMWare at this point? Thanks.

Matthew J. Szulik

Those are lots of questions, Kash.

Kash Rangan - Merrill Lynch

Two questions, Matt.

Matthew J. Szulik

First of all, I think what we are beginning to see is customers starting to move from early small scale pilots of virtualization and starting to moveit into production environment, so for largely on Windows-based machines, from what we have seen. I think customers are having a good experience with REL 5 and 5.1, as suggested through the renewal rates, and I think our strategy with VMWare continues to be very good dialog, both strategically and technically. As you know, they have been a good partner of Red Hat. I think customers would like to see a level of strategic coexistence. I think they would like to see technical integration, improved technical integration and I think over time, that would probably allow Red Hat and VMware to be pretty good partners mutually.

There is great work going on inthe open source community around KDM and the advancement of the ZEN Kernel, and I think Red Hat planned for that through its technical implementation around BURT. I think the work that is being done around RHN and management and a better instrumentation console, really fantastic tooling that our technical development teams are working on right now. I think we will continue to be able to provide a very low cost, high value alternative over time inthe upcoming calendar ‘08 timeframe.

Kash Rangan - Merrill Lynch

I appreciate that, Matthew. So specifically on the VMware side, what could be the nature of this relationship? It sounds like it’s a technical integration between your products, but can you just give us a little bit more detail how exactly competing hypervisors can work together inthe market, because that is an interesting direction in which RHEL 5 can take the company. I am just curious how the marketplace broadly shakes out, if there are three or four broadly competing technologies?

Matthew J. Szulik

Well, a critical component to the solution as you know, Kash, is going to be application availability and binary compatibility across the virtualized environment. Sobare metal machines will continue to constitute a pretty fair shipment of Intel and AMD servers for the foreseeable future and so customers that have had a great experience on Linux performance, the 5.1, 5.0 virtualization experience, the hypervisor independence, the technical integration with VMware. But most importantly from a customer standpoint, the consistency of application availability across virtualized environments is such a compelling benefit to them and reduces their risk and their cost structure, we see it will continue to be a strong benefit and competitive differentiator for Red Hat for the foreseeable future; which, within these installed customers is evidenced by our renewal rates. I think strategically positions Red Hat well relative to the other existing virtualization solutions.

Operator

Your next question comes from Adam Holt – JP Morgan.

Adam Holt – JP Morgan

Even if you adjust for the impact of currency, billing still accelerated on a sequential basis from the last couple of quarters, and you called out a few things on the RHEL 5 upgrade path; the movement to the advanced platform as well as some execution improvements on the sales side.

I was wondering if you could maybe give a little bit more detail as to what you think the primary driver of that acceleration was? Was it sales back to the installed base and a real average dollar increase per existing customer or did you seean acceleration outside the installed base in terms of new customer wins?

Charles Peters

I think that just going back to what I said earlier, it was very broad-based across all product lines, all regions and sizes of customers. I mentioned the largest number ever of deals over $1 million. We also had a very large number of new accounts inthe quarter. So, it’s not just the renewals, the 25 renewals that Matthew mentioned that renewed ata 128% of last year. It was also a lot of new business in many different regions. It was improvement in JBoss, it was strength in RHN, it was strength in RHEL and it was specifically pointed out inLatin America a region that we really got going on a direct basis early a year ago and made terrific progress.

Adam Holt – JP Morgan

If I could just follow-up with a numbers question, last quarter you talked a little bit about the impact of off-balance sheet bookings. What role did those play inthe quarter?

Charles Peters

I mentioned that we had a double-digit millions increase inthe off-balance sheet backlog this quarter. Soin addition to the billings number which you pointed out, I didn’t actually mention that but you’ve done the math of revenue plus change in deferred and you are right; it was a very strong billings quarter and it was also a strong quarter for increase in the unbilled backlog.

Operator

Your next question comes from Sarah Friar - Goldman Sachs.

Sarah Friar - Goldman Sachs

Charlie, on the margin front you seem to finally be settling into nice margin improvement quarter by quarter and on a year-over-year basis. What can we begin to assume as we look forward in terms of the ability to keep that almost 100 bip type of improvement every quarter going forward over the next year plus? What are some of the bigger shifts you can make in the system to ensure that?

Charles Peters

Are you speaking specifically about the operating margin?

Sarah Friar - Goldman Sachs

Operating margin, yes.

Charles Peters

Operating margin for the quarter on a non-GAAP basis we are at 21.4%. The guidance I gave for the full year was 21%; the full year of fiscal year ‘08 and I will provide guidance for fiscal year ‘09 on the next call.

I think one of the things I also said is clearly we believe we have a large growth opportunity so we are trying to balance the decision about investment for growth and for expansion of operating margins. We have clearly demonstrated on several previous occasions that we can expand the operating margins. We know how to control expenses quite well. It’s a matter of balancing how much to invest in more sales or more R&D in particular versus going for operating margin. But I will provide some specific guidance for fiscal year ‘09 on the next call.

Sarah Friar - Goldman Sachs

You made a comment on your renewals being 128% this quarter or year over year. Is that mostly customers upgrading to the advanced platform and taking on a higher ASP, or is there a lot of extra build out, JBoss and so on, that you have mentioned going on there?

Charles Peters

I think it’s actually a combination of both. Clearly in that renewal list we had a number of customers that moved from the ES up to AP but we also had expansion in other types of implementations.

Operator

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

Tim Klasell - Thomas Weisel Partners

Congratulations to you Matthew, and good luck inthe future. The question is about the renewal rates. I think inthe last call you mentioned several initiatives to improve the renewal rate even atthe very smaller customers. Can you give us any update on how that’s progressing and did that have any material effect on the quarter?

Matthew Szulik

I think specifically, Tim, what you are referring to is the renewal on the indirect side of the business because our renewal rate on the direct side has always been very high and we have made a lot of improvement this year in really beginning the process a little bit more than a year agoin terms of gathering data for the end customer, finding other ways including third parties, to help with renewal business that has come through the channel. I think we have made significant progress. There still is work to do and we are still doing that work. So I look forward to more improvement there.

Operator

Your next question comes from Brent Williams - The Benchmark Company.

Brent Williams - The Benchmark Company

One of the things that we are hearing about virtualization is increased interest in higher end storage. Have you seen that as driving either directly server license revenue, increased interest in GFS or manifesting in dragging other products behind, just using them?

Matthew J. Szulik

Yes.

Brent Williams - The Benchmark Company

Any way we can think about how much incremental interest there is, qualitatively about how much incremental interest there is in storage, maybe over the last three months or six months?

Matthew J. Szulik

As you know, Brent, I think the whole notion of virtualization as a benefit device SCSI, new storage paradigms that are evolving, the role of stateless Linux in that environment and simplifying the whole process of software development, the role of directory services inall of this activity, better security models. All of this, I think, is going to continue to increase demand and I think will ultimately accrue to more innovative storage solutions both with Red Hat by the open source community and by strong partners like EMC and NetApp.

Operator

Your next question comes from Heather Bellini - UBS.

Analyst for Heather Bellini - UBS

Just a quick one on the move to advanced platform. What arethe trigger points for customers who move to the advanced platform? Is itat the renewal time or are they coming to you even otherwise and asking for movement to the upper end, higher end version? How longdo you think it will take for you to get to your 30% or low 30% installed base on the advanced platform?

Charles Peters

The nice thing about the subscription model is the customer has the right to move to the next level whenever it’s right for them. So sometimes that happens at the renewal time and sometimes it happens earlier, depending upon what their need is. I don’t think there is any way for me to generalize what the answer is.

Analyst for Heather Bellini - UBS

I think Matthew laid out the target of low 30s from the install base to be on the advanced platform. How long do you think it will take and where are you in that whole process?

Charles Peters

I think it’s still early. Matthew said that it will take some time and we’ve seen good movement already, but we only launched RHEL 5 back earlier this year, soit will take a bit of time; probably through next year.

Operator

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 push to try to move customers to three year contracts, but did you do that much more aggressively during the quarter or is that just occurring naturally at such a fast pace?

Charles Peters

I would just say I don’t think it was an unusually large shift other than deferred revenue in total made a large shift; there was about a $43 million total increase, almost equally split between current and long term. If you go back and look at what happened in Q2, in fact there was no increase inlong term. Essentially it was all current.

So some of it’s just timing I think. If you look at the total mix of short term and long term on a year-to-date basis it looks about the way it always has. I do think that one of the things that we are benefiting from is the customer satisfaction. The customer satisfaction is extremely high, and so if a customer is going to come back every year, in many cases they are saying: “why should I renew every year, why don’t I simply doa long-term deal, I don’t have to got through the administrative work of all of that over a period of time.”

The other thing I would mention is that I think what’s happening is many IT departments are trying to whittle down the number of suppliers that they are using. There is some consolidation of suppliers going on. Again, because we deliver value a lot of customers are just signing up with us.

Mark Murphy - Broadpoint

As a follow up for Matthew, the quarterly results are extremely strong across -- effectively every single metric I think is well above probably the highest numbers on The Street. Inthe context of that, does it feel to you as if virtualization currently is a net benefit to Red Hat as a driver of the advanced platform adoption, or is virtualization just effectively having no real impact on the business?

Matthew J. Szulik

It is definitely helping our business, Mark. I think once again the customers have great insight into what’s happing within the open source communities so they can see some of the work being done around important technology, parallel memory activities, PNFS happening; things that they see Red Hat very active in that will strategically accrue to their long-term technical architectures and strategies.

Of course, virtualization and all of its benefits and the horizontal scale out of that grid-like environment is really in Red Hat’s sweet spot for the foreseeable future. So I think this is what we are starting to see, that the competency of the company, the global service and support, allthe things that we’ve been telling you about for many quarters is really starting to accrue to the financial benefits of the company.

Operator

Your next question comes from Todd Raker - Deutsche Bank.

Todd Raker - Deutsche Bank

Hey guys, nice quarter. With a substantial amount of cash on the balance sheet, can you talk about potential acquisitions? Where you think you may have holds versus stock buyback and how you are thinking about the capital structure of the business?

If you can just comment in terms of any exposure, specifically to the financial services vertical and how you expect that to play out, given some of the headline risk here?

Charles Peters

Well first of all, relative to the cash on the balance sheet and acquisition strategy, I think there is really no change there. What you have heard mesay before is that we look at acquisition candidates all the time; we basically are looking at technologies to build out our existing offerings and look for areas that can complement or supplement what we do there.

We also look at acquisition candidates that might be good candidates for geographic expansion. So for example, last year it was Argentina, Brazil and India and something in theCzech Republic. We are very active and we are always looking.

You should assume that acquisitions are something that we’ll continue to be involved with. Beyond that, we do have an authorization for both share repurchase and bond repurchase.

The second part of your question, which was exposure to the financial services industry, as you have heard me say, this quarter we had strength across all segments including the financial services industry, including a large new customer in the financial services industry.

Having said that, I did seethe analyst report inthe last week or two which was quite off base in terms of the exposure. My assessment of our total inthe financial services industry is probably less than 15%. I would say that’s on a global basis. So we have financial services customers that happen to be some of the largest exchanges in the world in multiple geographies. We have large investment banks, we have commercial banks and we have other types of financial institutions; again, all over the world. I think we area very diversified customer base and I think we arein good shape there.

Operator

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

Steve Ashley - Robert W Baird

My question relates to virtualization. I’m just trying to understand the role of hosting Windows guests inthe future, what your expectation is and how actively you would you expect to be involved in that?

Matthew Szulik

I think we recognize that we are competing in a heterogeneous environment. I think the customers are starting to see strong performance benefits of our virtualized environment. In order to get deeper and improve our relationship with them, hosting and supporting Windows guest environments I think is a must-have for us to continue to expand penetration.

Steve Ashley - Robert W Baird

All right. Charlie, you mentioned that the year-ago period had three $5 million deals. Were those all billed and included either inthe reported revenue inthe P&L or deferred revenue last year?

Charles Peters

As I’ve described on previous calls, two of those were billed in Q3 a year ago and one of those was not billed; it is billed on a periodic basis going forward from then.

Operator

Your next question comes from Tom Curlin - RBC.

Tom Curlin - RBC

Good afternoon. I know you are not commenting on an operational basis for next fiscal year, but can you just give us some flavor for how your cash tax rate and non-GAAP tax rate will evolve over the next couple of years? Do you think your NOLs are exhausted over the next one or two years or not? What does that trajectory look like from a non-GAAP and from a cash tax basis?

Charles Peters

At the end of Q3 our NOLs are still going to be inthe neighborhood of almost $300 million, and in addition to that, I would expect that over the next couple of years we will generate additional stock option deductions on a tax return basis that would create more booked tax differences in that regard. Specifically, relative to next year, I have not done an effective tax rate for next year. I have seen many analyst reports out there that are still using a 40% rate and I would assume at this point if you are trying to build a model, something like that to me makes sense. I’ll give you better guidance on the Q4 call.

On the cash tax rate, I also would assume for the next probably at least two to three years and maybe beyond that the 5% cash tax rate makes sense. Again, I’ll give you some better guidance on that at the end of the Q4 call.

Tom Curlin - RBC

All right. Thank you.

Operator

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

Kirk Materne - Banc of America

Matthew, good luck on your initiatives going forward. Charlie, on JBoss in terms of when you talk about direct hiring, how much of that is really centered around the Middleware area and how much of that is just for the broader platform? Where do you see the split in terms of JBoss business being in terms of channel and direct? I think historically it had been pretty much all direct. Do you think that you can get the same kind of leverage inthe channel at JBoss as you are with RHEL today?

Charles Peters

The first part on hiring, I think as you know our salesforce generally our salesforce is covering all products with some overlay in some regions. It’s hard to say specifically on the sales side, how that breaks down. On the engineering side, obviously they are very specific and we have added engineering in Q3 as well. But I am not going to provide any specific breakdown on that.

On the channel side, you are quite right. A year ago on acquisition there was no really channel business for JBoss and we have done an awful lot of work building channel partners; today have over 70 channel partners on the Middleware side and still growing.

Operator

Your next question comes from Erika Bukavinski - Jefferies.

Erika Bukavinski - Jefferies

Can you give us an update on the conference call about a month ago when you said you hit 18,000 servers virtualized using RHEL virtualization, is there an update there?

Charles Peters

We don’t have any update on that for this call.

Erika Bukavinski - Jefferies

Matthew, as you move into the next phase, how important is it for your successor to keep the purity of an open source model? Would you ever consider buying or building closed source solutions?

Matthew Szulik

We have certainly bought open proprietary software companies and we continue to work on open sourcing and GPLing that technology. Certainly I think being a pure play open source company is the very fabric in theDNA of the company. Of course, I think that is the development model; that is what drives this whole end user innovation that our teams are able to contribute. So to me that is really thecore fabric of the business, and to me is a non-negotiable activity.

Operator

We do have time for one final question, and that question comes from Trip Chowdhry - Global Equities.

Trip Chowdhry - Global Equities

I have a question on the balance sheet. I think you have about $400 million plus in debt securities, and they may beall ina AAA bond. I was wondering, should we investors bea little worried that there may be some markdowns, because directly or indirectly some of those bonds may be associated with the mortgage-backed securities and CMOs? Any thoughts on it? Are you marking to market those bonds? What should we be thinking about it?

Charles Peters

That’s a good question, Trip. We have a very conservative investment philosophy which the number one criteria is principal preservation first, and sometimes I guess I’ve been criticized on the income side of it. At this point, I think I am very pleased with our investments.

Of the total, which is roughly $1.3 billion of investments, we have less than $10 million in any sort of mortgage-backed security, and the vast majority of our investments arein fact AAA rated.

Katrinka McCallum

Thanks again, everyone for joining Red Hat’s management today. This concludes the third fiscal quarter earnings call. Thanks.

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