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Red Hat, Inc. (RHAT)

Q4 2006 Earnings Conference Call

March 28, 2006, 5:00 p.m. EST

Executives:

Matthew J. Szulik, Chairman, Chief Executive Officer, and President

Charles E. Peters, Jr., Executive Vice President & Chief Financial Officer

Dion Cornett, Vice President of Investor Relations

Analysts:

Mark Murphy, First Albany

Kash Rangan, Merrill Lynch

Brendan Barnicle, Pacific Crest Securities

Brent Williams, KeyBanc Capital Markets

James N. Gilman, Cross Research

Chris Clock, SIG

Kirk Materne, Banc of America Securities

Jason Maynard, Credit Suisse

Heather Bellini, UBS Investment Research

Todd May, Deutsche Bank

Christopher Russ, Wachovia Capital Markets

Tim Klasell, Thomas Weisel Partners

Terry Tillman, SunTrust Robinson Humphrey

Rick G Sherlund, Goldman Sachs & Co

Katherine Egbert, Jefferies and Company

Steven M Ashley, Robert W Baird & Co

Trip Chowdhry, Midwest Research

Eric Rubel, Miller Tabak Roberts

Gary McDaniels, Standard & Poor’s Equity Research

TRANSCRIPT SPONSOR
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Operator

Good afternoon. My name is Shanell and I will be your conference facilitator today. At this time, I would like to welcome everyone to the Red Hat Conference Call. All lines have been placed on mute to prevent any background noise. After the speaker’s remarks, there will be a question and answer period. If you would like to ask a question during this time, simply press “*�? and the “1�? on your telephone keypad. Please limit your questions to one question and one followup question. If anyone should need assistance during the call, please press “*�? then “0�? and an operator will assist you. As a reminder, ladies and gentlemen, this conference is being recorded today, March 28, 2006. Thank you. I would now like to introduce Mr. Dion Cornett, Vice President of Investor Relations. Mr. Cornett you may begin your conference.

Dion Cornett, Vice President of Investor Relations

Thank you Shanell. Welcome to Red Hat’s Fourth Quarter Fiscal Year 2006 Earnings call. Speakers for today’s call will be Matthew Szulik, Chairman, President, and Chief Executive Officer; Charles E. Peters, Executive Vice president & chief Financial Officer, and myself. Our earnings press release was issued after the markets closed today. If anyone has not yet obtained a copy, it may be downloaded from redhat.com or requested by calling Linda Brewton, Manager Investor Relations at 919-754-4476.

Various remarks that we may make about the company’s future expectations, plans, and prospects including statements contained in the words believe, anticipate, plan, expect or will constitute forward-looking statements for purposes of the Safe Harbor provision under the Privacy 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 assessed in the company’s most recent quarterly report on Form 10-Q filed with the SEC. In addition, any forward-looking statement represent our views only as of today and should not be relief upon as representing our views as of any subsequent date. While we may elect to update forward-looking statements at some point in the future, we specifically disclaim any obligations to do so, even if our estimates change, and therefore you should not rely on these forward-looking statements as representing our views as of any date subsequent to today. I would now like to turn the call over to Matthew.

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Matthew J. Szulik, Chairman, Chief Executive Officer, and President

Thank you Dion. We are pleased with our strong finish to a great year for Red Hat and our shareholders. Robust sequential bookings growth, global operational enhancements contributed to both our fourth quarter and our full year results. The driver of our company’s performance continues to be Red Hat’s capability to deliver the highest value for the lowest cost to our global customers. This capability was highlighted during the quarter as Red Hat for an unprecedented second year in a row took top honors for delivering the highest value reliability in the annual CIO insight survey. Moreover, Red Hat was chosen as the number one vendor that CIOs continued to do business with, ahead of excellent companies like Cisco, Symantec, Research in Motion, and others that generally receive high marks for customer loyalty. We are proud of this customer acknowledgment, but we recognize that we are in the early days of a very large global market and we are driven to avoid complacency as we enter fiscal year 2007.

Looking back at the Analyst Day in New York City, I referred to our approach last year as “smash-mouth�? software, day to day, hour to hour solid execution. I would characterize our fiscal year 2006 as a year of solid execution. The senior management experience and those who were new during the prior year are now fully up the learning curve. We continue to scale our business with operations now in seventeen countries in seven new offices and 278 new employees added during the year. We invested approximately $17 million in capital expenditures, principally in new and improved systems to further increase our operating efficiency. We added over 50,000 new customers during the fiscal year and our renewal rate with large customers has been outstanding. We have provided solid leadership in the open source community; we plan on continuing to do so. Finally, we improved our financial performance along virtually every operating metric while providing continued strong value to our customers. Now, I’d like to highlight a few of the initiatives that we have underway to further enhance our value creation.

During our last three earnings calls, we quantified the renewal rates of our top 25 transactions from the prior year’s quarter We are pleased to report that during the fourth quarter 25 of our top 25 fields that were upper renewal were renewed again bringing our total for the fiscal 2006 to 99 out of 100 potential renewals. We continued to seek out ways to better serve these large accounts. As part of the effort, we have unified our sales, support, learning, and services organizations within our largest global accounts under a single senior Red Hat executive unifying sales and delivery. The measure is already winning customer praise and tightening relationships with our ecosystem partners. By jointly delivering technical roadmaps, we create new opportunities for our value-added partners.

In one example I’d like to share with you, a major Wall Street brokerage firm recently challenged Red Hat to reduce its cost associated with hardware failures. After identifying one of the firm’s most expensive outages, the Red Hat team helped replace proprietary closed solution with Red Hat GFS on Red Hat Enterprise Linux, trained its IT staff and reduced trading system failover time from 2 minutes to less than 10 seconds. The customer estimated that this savings and this upgrade will produce more during the next fault condition and would be roughly more than $4 million. More importantly, the dedicated team serving this account now has a template for value creation that is broadly applicable. The transformation underway in these accounts is thus Red Hat as an operating system vendor has transitioned to becoming a strategic trusted advisor.

Two weeks ago along with AMD, Intel, Network Appliance, and XenSource we formerly announced our integrated virtualization strategy. Virtualization technology allows for more efficient utilization of a customer’s computing infrastructure. We believe that our implementation of virtualization technology integrated in the industry standard Red Hat Enterprise Linux Platform will offer unsurpassed value to the enterprise. During previous earnings calls I had referenced the strategic importance to Red Hat’s customers of the community driven process. The process described is end-user driven innovation. Red Hat works closely with the community, our partners, and customers well ahead of the launch through the Fedora release. Customers can have confidence that Red Hat brand and technologies are enterprise, qualified, and appropriate for their business needs. It is this community process that has resulted in highly reliable, scalable and secure, broadly supported offerings. We encourage investors to attend our open house on April 11th to hear more about our platform strategy.

Finally, our ability to create value for the enterprise is resulting in wider adoption of broadening set of offerings and stronger relationship with our business partners. During the fourth quarter we added more than 12,000 net new customers and bookings from layered solutions more than quadrupled year over year. Even more telling for the full year FY06, our revenue in billings growth exceeded 40% versus fiscal year 2005, and our OEM business more than doubled. The investment and technology to support our channel partners in tandem with excellent field-based execution were key drivers of this global indirect sales success. Looking geographically, whether in the US, India, Russia, China or Brazil, as the industry shift from heavily regulated to unregulated, federal forces are causing management within these industries to focus on more flexible and more agile computing infrastructures. Industries facing increased competition in pricing pressure, banking in Russia and India, telecom in China and Brazil, are pursuing solutions based on open source software. During the FY06 campaign, Red Hat successfully grew its customer base and its market share. We improved our global capabilities to educate, service, and retain customers, ISVs and OEMs. We continued to build our online model with the goal of complete customer and partner self-service. Hopefully, the success communicated by our financial statements today is evident to all. Charlie will now address specific financial performance.

Charles E. Peters, Executive Vice president & chief Financial Officer

Thank you Matthew. I’m pleased to report that once again we have delivered strong financial performance to our shareholders. Total fourth quarter revenue was $78.7 million and represents an increase of 8% from last quarter at 37% from the same quarter in fiscal year 2005. Driven by strong bookings, subscription revenue of $66.7 million grew 11% sequentially and 44% year over year. Training and services revenue came in at $12.1 million. This was strong seasonal performance given the normal reduction of training opportunities around Christmas and the New Year holidays and speaks to the growing demands of Red Hat expertise. Breaking down bookings, we generated 61% of our bookings from the channel at 39% from direct sales versus 57%; a 43% split in Q3. From a geographic perspective, 56% of bookings came from the Americas, 24% EMEA, and 21% from Asia Pacific. This compares to a respective 55%, 22%, 23% split last quarter.

Our billings proceeds, which we defined as revenue plus change in deferred revenue, was $102.5 million, up 40% year over year and 16% sequentially. Overall, gross margin was 84% compared to 84% last quarter and 81% in the year ago period. Operating expenses came in at $46.5 million, up 10% from last quarter. Note that the growth and operating expenses not only reflect the full quarter effect of third quarter’s head count additions and the fourth quarter’s new hiring, but also roughly $1.5 million of employer payroll factors associated with exercise and stock options. The tax deductibility of these option exercises had a positive impact on income taxes, and where the primary reported income tax benefit down below.

Our operating income came in at $19.8 million for the quarter or an operating margin of 25%. This compares to operating income of $18.7 million, operating margin of 26% last quarter; an operating income of $7.5 million and 13% operating margin in the fourth quarter last year. But with even significant investment in people on systems and increase in stock option related payroll taxes, the fourth quarter year-over-year revenue growth still more than doubled the expense growth.

Moving on, other income nets, which is attributable primarily to investment income was $5.9 million. Our effective GAAP tax rate was 2.8% for the fiscal year and as I mentioned previously, our corporate income taxes were lower than expected, primarily due to deductions related to option exercises which occurred during the fourth quarter. Net income was $27.3 million, an increase of 18% from last quarter and 131% year over year. Net income for purposes of the diluted per share calculation was $28.7 million, an increase of 17% from last quarter and 115% year over year. This translates into fully diluted earnings per share of $0.13 of the quarter. Looking at our income statement performance for the full year, subscription revenue of $230 million grew 53% versus fiscal year 2005, and total revenue of $278 million grew 42%. The timing of scale and improved operating efficiencies helped push operating income up 116% to $58.1 million, representing a full year operating margin of 21%. Net income for the full year grew 75% to $79.7 million or $0.41 per diluted share.

Now, let’s turn to the balance sheet from the cash flow statement. We ended the quarter with approximately $1.1 billion in cash and investment, an increase of $77 million from the end of Q3, driven by strong cash flow from operations and cash receipts related to employee stock option exercises. At the end of Q4, total receivables, which include earnings in excess of billings, were $59.8 million, which translates to an adjusted DSO of 52 days versus 57 days at the end of the third quarter and 64 days at the end of fiscal year 2005. This result was achieved at the same time the ____ expense was reduced approximately $1 million from the prior year. We believe that our low DSOs not only indicate effective collection efforts but also satisfaction in our overall customer base. As a reminder, as DSOs are traditionally a measure of receivables versus billings, our DSO calculation includes the change in deferred revenue.

Total deferred revenue ended the quarter at $223 million, which is an increase in $24 million or 12% of the prior quarter and $86.2 million of last year, a 63% increase. Looking to the statement of cash flows, cash flows from operation increased 64% year over year to $50.1 million for the fourth quarter. Cash flows from operations for the full year grew 53% to $186.6 million. We believe that cash flows from operations for live investors with a potentially useful means of assessing the performance of the business and from time to time may discuss this metric for that purpose. For the quarter, cash flows from operations was $0.23 per share and for the full year about $0.90 per share using the fully diluted share count of 213 million shares for the quarter and 208 million shares for the year.

Now, I’d like to turn to guidance. Let me start with guidance on apples-to-apples basis by first excluding the effects of FAS 123R since the first quarter of the fiscal year 2007 will be the first year we implement FAS 123R. I will then provide our preliminary estimates of non-cash stock compensation expense under FAS 123R, which you can or not to your model as you see fit.

First of all, we are anticipating the first quarter revenue to be in the range of $82.5 million to $83.5 million representing year-over-year growth of 37-38%. It’s our intention to continue to invest in people and systems over the course of fiscal year 2007 including approximately 100 new staff per quarter. We anticipate roughly $4 million of incremental Q1 cash expenses versus Q4 given the full quarter impact of fourth quarter hires and continued investment. As we have discussed on prior calls, our estimated effective GAAP tax rate for fiscal year 2007 is 35%. However, as we’ve also stated on prior calls, because we have large tax loss carry forwards, we anticipate a cash tax rate of approximately 5% for at least the next five or six years. In the first quarter, if one assumes an effective GAAP tax rate of 35% and a diluted share count of say 215 million shares, one would estimate diluted EPS of approximately $0.08 before FAS 123R expenses. For the full fiscal year of 2007, we anticipate revenue in the range of $370-375 million on 300 basis points to 400 basis points and improvement in full year operating margin before the impact of FAS 123R versus fiscal 2006. We anticipate a 35% GAAP effective tax rate for only 5% cash taxes for the foreseeable future.

Let me now address FAS 123R. Our current estimates for full year fiscal year 2007 non-cash stock compensation expense under FAS 123R is approximately $33 million pretax and approximately $22 million after tax, assuming the same 35% effective tax rate. For the first quarter, you should assume probably 25% of this total. This is quite a bit lower than the quarterly FAS 123R expense disclosed in the footnotes in prior forms 10-Q, and we intend to discuss operating cash flows per share during subsequent earnings calls. We believe this is a calculation that best represents performance of the company versus other software companies, whether they use license or subscription accounting or some combination thereof. While cash flows from operations may fluctuate quarter to quarter given the mix of direct versus indirect business, one year versus three year deals, changes in foreign exchange rates, timing of payments and receipts, and other factors, we anticipate steady growth on an annual basis. Based on the strength of the business in fiscal year 2006 and our outlook, we believe it’s appropriate to raise our previous guidance on operating cash flow. For the full fiscal year 2007, we expect cash flow from operations to be $1.05 with $1.10 per diluted share, which is $0.10 per share higher than the $1 for fully diluted share guidance which we had previously provided. I would now like to turn it over to Dion and he’ll discuss some additional investor considerations.

Dion Cornett, Vice President of Investor Relations

Charlie, thank you. As we did last quarter, we were trying several metrics to help investors evaluate our business. In the fourth quarter, the percentage of forward-looking values beyond one year was 19% versus 22% last quarter. Our average contract length remained in the 18-21 month range and again the vast majority of our long-term deals continue to be three-year contracts. For modeling purposes, we did have one large mid-seven figure deal where the client requested deferred billing into March due to internal budgeting issues. And finally, I would like to discus market shares give our completion of fiscal year 2006. We believe that Red Hat continues to gain market share on a global basis because our billings and revenue growth for the full year substantially exceeded mid 20% Linux growth rate estimate published by various leading industry analysts. Also, related to marketshare our growth dramatically outpaced the open source subscription revenue growth reported by other market participants. I’d now like to turn the call over to Matthew Szulik for closing remarks.

Matthew J. Szulik, Chairman, Chief Executive Officer, and President

Thanks Dion. In closing, I’d like to thank our customers, partners, and shareholders for their continued commitment to Red Hat, and I especially want to thank our Red Hat associates all over the world whose hard work, team spirit, and innovation all contributed to a great quarter and a fantastic fiscal year. The fact that our cash flow from operations in fiscal year 2006 was nearly equivalent to the total revenues we generated in FY05 effectively summarizes Red Hat’s growth and operational effectiveness over the last four quarters. We are so pleased that this performance translated into excellent returns to shareholders and our bond holders. Dion…

Dion Cornett, Vice President of Investor Relations

Operator, please poll the audience for questions.

Question-and-Answer Session

Operator

At this time, I would like to remind everyone, if you would like to ask a question, press “* and 1�? on your telephone keypad. Your first question is from the line of Mark Murphy with First Albany.

Mark Murphy, First Albany

Thank you very much. Matthew, how large do you think the revenue opportunity for virtualization technologies is relative to the other parts of the stack such as the security or application server, and also can you detail what kind of success you might be seeing with virtualized environments through Fedora Core 5 so far?

Matthew J. Szulik, Chairman, Chief Executive Officer, and President

Thanks Mark. You know, I think the size of the virtualization opportunity globally is substantial. Clearly, it’s in the multi-billions of dollars when one considers both software and the related services. As you know in Fedora Core 5 it’s just been released, but some of the hypervisor technologies that was in Fedora Core 5 we saw a number of our large enterprises testing, kicking around, but clearly I think our focus is on building the integrated solution, not just the hypervisor but also the management technologies and the tools and the related services to help the organization implement and deploy, Mark. And as I said, in total, we think that that’s a multi-billion dollar opportunity.

Mark Murphy, First Albany

Thank you and as for followup for Charlie, looking at the balance sheet, the short-term revenue looks like it has increased at a slower rate over the last two quarters, whereas the long-term deferred revenue has been accelerating, and that’s on a sequential basis; can you walk us through what might be driving that, and then moving into FY07 would we expect maybe a rebound in the short-term deferred revenue?

Charles E. Peters, Executive Vice president & chief Financial Officer

I’m not sure if you heard Dion’s watermark, but there was a mid-seven figure deal that was booked at the end of the quarter where the customer for their internal budgetary reasons did not want to be billed until March, so that was not in any of the deferred revenue or in the billings, all of which would have been in current deferred revenue had it been billed. So, that had an influence in the quarter. I guess I would say that the total deferred revenue balance has grown substantially. If you look at the current deferred revenue in relation to the total revenue for the year or the revenue guidance I gave you for next year, what you can see is that we have a higher percentage of current deferred revenue this year than we did last year compared to the guidance I provided at that time or compared to the actual results. So, we feel good about the deferred revenue in total and the split. I think as we’ve said before one of the things that are driving the long-term deferred revenue is the good business with the OEM partners and some of the long-term contracts that are being provided there.

Mark Murphy, First Albany

Okay, thank you and congratulations.

Operator

Your next question is from the line of Kash Rangan with Merrill Lynch.

Kash Rangan, Merrill Lynch

Hi, thank you very much and congrats on the quarter. I was looking to see if you had any comments on the cash flow seasonality going into the first quarter. I know you raised the guidance for the year, but should we be surprised to see any down take in the first quarter in cash flows, what’s your thinking there? I have a followup question.

Charles E. Peters, Jr., Executive Vice President & Chief Financial Officer

Kash, as I’ve said for the last probably I think four quarters I’m not going to provide any quarterly cash flow guidance, because quarterly cash flow guidance can be tricky as you know going back more than a year ago, it was difficult to predict. I’m very comfortable with full year guidance that we have provided, but I’m not going to provide any quarterly guidance.

Kash Rangan, Merrill Lynch

Great, and also if you look at the offering margin guidance looking for an expansion to probably the high end of your range, 27%, which line items are you expecting to get that operating margin expansion? That’s it, thanks.

Charles E. Peters, Jr., Executive Vice President & Chief Financial Officer

Let me just clarify what I said, because I don’t think you heard what I said properly. What I said is that our expectation is that the operating margin can improve 300-400 basis points on the full year operating margin and in fiscal year 2006.

Kash Rangan, Merrill Lynch

Okay, that’s cash flow for fiscal year 2007, right?

Charles E. Peters, Jr., Executive Vice President & Chief Financial Officer

Yes correct, but to your question, as I said on a couple of previous calls, we are continuing to invest strongly in the sales and marketing functions and the support function where I think you will see — this is sort of prior to FAS 123R impact — reductions in G&A spending as we move forward.

Kash Rangan, Merrill Lynch

Yeah, that’s where you’re getting the operating margin expansion from, mostly from the G&A line?

Charles E. Peters, Jr., Executive Vice President & Chief Financial Officer

Well, it’s operating efficiencies across the board. For example, the gross margin has also been improving and that has contributed to the operating margin improvement as well.

Kash Rangan, Merrill Lynch

Okay, good, that answers my question, thanks.

Operator

Your next question is from the line of Brendan Barnicle with Pacific Crest Securities.

Brendan Barnicle, Pacific Crest Securities

Hi, I was wondering if you can give us any update on sort of Windows to Linux migration, I know we’ve seen a lot of UNIX to Linux, but we started to pick a little of that, have you started to see any of that?

Matthew J. Szulik, Chairman, Chief Executive Officer, and President

Hey Brendan, this is Matthew Szulik. We’re certainly seeing that in both Europe, EMEA, and the Asia Pacific region, and certainly I think there will be those customers in the Enterprise in the SMD space now rather than Windows delay that I think will reflect over their software assurance investment and really I think create a potential opportunity now as Linux and open source becomes more pervasive as looking out as a reason to transition from Windows over to Linux. So, we’re starting to see that as I mentioned in the international markets; we expect to see that more popular here in the US markets.

Brendan Barnicle, Pacific Crest Securities

And what are the main factors that are driving that transition?

Matthew J. Szulik, Chairman, Chief Executive Officer, and President

A big one is not wanting to have a dependence on a single supplier. The second key driver is the maturity and the reliability and the security of open source software, so you’re getting a robust reference base. The value that I described earlier in the conference call is being received with referencibility of some of the world’s largest corporations, and of course the multi-platform heterogenous environment I think is contributing to that capability.

Brendan Barnicle, Pacific Crest Securities

Thank you.

Operator

Your next question is from the line of Brent Williams with KeyBanc Capital Markets.

Brent Williams, KeyBanc Capital Markets

Hi, just a quick question following up on Brendan’s question about Windows migrations. As a result of the slippage of this, and I realize it’s very recent news but hardly unexpected, is there anything that you encourage the community to put into Fedora Core, is there anything that you do differently now versus what you would have been doing differently a month or so ago to help crack that opportunity open further?

Matthew J. Szulik, Chairman, Chief Executive Officer, and President

I don’t think so. Brent, I think, as you know you’ve probably followed the trails of Fedora Core 4 leading into Fedora Core 5, and the community does continue to be vocal about the functionality and the improvements. You saw great advancements around usability, you saw certainly the implementation of virtualization, better memory management, better I/O capabilities, so I think that these have been on planning and on course now for well over a year.

Brent Williams, KeyBanc Capital Markets

Hey, and do you have any preliminary thoughts as the virtualization stuff goes out, kind of where the relative economics would be in terms of selling higher end server subscriptions because you’ve got more powerful hardware out there versus the amount of money that’s spent on management tools versus the amount of money that’s spent on storage, just qualitatively?

Charles E. Peters, Jr., Executive Vice President & Chief Financial Officer

It would be fairly objecting, which I’m unwilling to do Brent, but as you know a great concern that I have is that the opportunity for virtualization to be implemented successfully is going to become time consuming, require careful planning, a very clear understanding of what the customer’s business objectives are. We don’t believe that the solution is going to be delivering incremental functionality. It’s a complicated internal matter for most of our large enterprise accounts that we’re speaking with, so I don’t really have a good opportunity to quantify that for you, but it’s something that our strategic enterprise accounts are beginning to take quite seriously now.

Brent Williams, KeyBanc Capital Markets

Okay, that’s it for me, thank you.

Operator

You next question is from the line of James Gilman with Cross Research.

James N. Gilman, Cross Research

Hi, good day gentleman. I have three questions for you. The first would be in reference to the deferred revenue, and you had the customer that pushed off into March. If that had occurred as you expected, what would have been the mix of the deferred revenue?

Charles E. Peters, Jr., Executive Vice President & Chief Financial Officer

It’s all within 12 months, it would all be current with bills.

James N. Gilman, Cross Research

No, but you had 162, what would have been the current deferred if that had come through?

Charles E. Peters, Jr., Executive Vice President & Chief Financial Officer

It would have been 162 plus the mid-seven figure number I spoke about.

James N. Gilman, Cross Research

Okay, the other question is, how important is SELinux to Red Hat?

Matthew J. Szulik, Chairman, Chief Executive Officer, and President

It’s important to Red Hat, it’s very important to our government customers, and I think it is strategic to the long-term security strategy of our global market.

James N. Gilman, Cross Research

The last question is in reference to your most closest competitor, Novell. At their most recent analyst day in Brainshare, they announced that with Dell on their provisioning software that they were going to target Red Hat customers, do you have anything you’d like to say about that?

Matthew J. Szulik, Chairman, Chief Executive Officer, and President

Certainly I know that Novell and Dell have had a long-term relationship. I read the same things that you read. I think that we have been very pleased by the productivity of Dell and their Red Hat relationship and all of OEMs got highlighted in our earnings announcement tonight, and we’ll continue to focus on the things that we do correctly with Dell.

James N. Gilman, Cross Research

Well, thank you for taking my questions and congratulations on a nice quarter.

Operator

Your next question is from the line of Chris Clock with SIG.

Chris Clock, SIG

Great, good afternoon. Just a question on the guidance; if you take the midpoint for the full year, 370-375, and Charlie, if I heard you correctly, you said you could add 300-400 basis point above the fiscal ’05 operating margin number and using a 37% tax rate, it seems like you’re getting around $0.40 assuming pretty much everything else is equal below the operating margin line, does that sound right?

Charles E. Peters, Jr., Executive Vice President & Chief Financial Officer

The guidance I did was just a guidance I gave, Chris. Anything else you said other than your conclusions, I’m not going to try to confirm you conclusions, but the revenue earnings is correct…the operating margin improvement of 300-400 basis points we think is realistic again before you factor in FAS 123R, and then it goes on down from there, but this seems reasonable.

Chris Clock, SIG

And in terms of the head count growth that you’re expecting in the plans for expansion, can you talk to specifically geographies or is it mostly international, what areas it mostly sails, can you just walk through that?

Charles E. Peters, Jr., Executive Vice President & Chief Financial Officer

I think it’s fair to say that we work everywhere around the world and if you look at our hiring this past year, it was probably a little bit more than 50% international and a lot of it in Asia Pacific. As to where it will be this coming year, I guess I wouldn’t get into that now but I probably do think a fair amount will be international, may be at 50% international. In terms of functions, as I said before, we won’t be adding a lot to the G&A functions. We will be adding engineering and we will be adding on sales and marketing.

Chris Clock, SIG

Just to followup, Charlie, I think you said that roughly about 61% of your bookings were from your OEM partners in the channel, is it safe to assume most of that is North America or is that North America, New York, across the world evenly distributed?

Charles E. Peters, Jr., Executive Vice President & Chief Financial Officer

Yeah, the 61% is from all the channels and it’s fairly evenly distributed. As the majority of our business is done outside of this country, a very large part outside of this country is through channel partners.

Operator

Your next question is from the line of Kirk Materne with Banc of America Securities

Kirk Materne, Banc of America Securities

Yeah, thanks very much. Charlie, I know you’re not going to quantify but may be try to qualify how you feel about the visibility into the indirect renewals through your OEM partners. I know it’s been a big focus for you guys to try and make that automated. I was wondering where that’s may be today versus say 12 months ago?

Charles E. Peters, Jr., Executive Vice President & Chief Financial Officer

Well, I think the good news as we continue to get better and better, we have taken a number of steps this year to improve it including some specific steps with each partner in terms of better data collection of that end-customer, in some places it is automated and some places it’s still manual, but we’ve come a long way in the year. We’re certainly not there yet, in terms of being everywhere we want to be, but it has gotten substantially better than where we were 12 months ago. I would expect to be able to report a year from now a continued and very good improvement.

Kirk Materne, Banc of America Securities

Okay, and then may be, Matthew, you talked about the bookings around layered solution were up 4X versus last year. If you could maybe breakdown which ones you guys are seeing the most traction in right now and I guess what you expect over the next fiscal year for each of the solutions?

Dion Cornett, Vice President of Investor Relations

Hi Kirk, this is Dion. In terms of that metric, I’d say that the fourth quarter was probably one of the more diversified quarters in terms of seeing a spread between the various player offerings, but again as Charlie said in the past, we’re not going to be too specific there given that that business felt fast growing is still small and it’s still more than 10% of our revenue.

Operator

Your next question is from the line of Jason Maynard with Credit Suisse.

Jason Maynard, Credit Suisse First Boston

Hey guys, good afternoon. Some questions on operating margins; 300-400 basis points as improvement for ’06-’07 is pretty robust, may be a contrary question here, with all the growth opportunities you have in front of you, why are operating margins growing so quickly and could you perhaps accelerate hiring to take advantage of some of the new areas that you could build your business?

Charles E. Peters, Jr., Executive Vice President & Chief Financial Officer

First of all, consistently, I think quarter after quarter, we want to invest for growth. We are agreeing with you that this is the time to invest. The thing that makes this possible is the graphic growth of the subscription revenue line that has 93% gross margins. So, it offers gross margin that we could use at the OpEx level before we get down to the operating margin. I think what the guidance I’ve given there is some very good room for investment.

Jason Maynard, Credit Suisse First Boston

I didn’t catch your head count at the end of this fiscal year?

Charles E. Peters, Jr., Executive Vice President & Chief Financial Officer

It’s approximately 1200 people.

Jason Maynard, Credit Suisse First Boston

So, you were talking about may be adding 100 people per quarter?

Charles E. Peters, Jr., Executive Vice President & Chief Financial Officer

Roughly 100 per quarter. The other thing, Jason, is that we have invested quite a bit — Matthew mentioned almost $17 million in CapEx this past year with probably another $20-23 million of CapEx in the year we’re now in, and most of that investment is going to internal automation systems to help this become more efficient and effective.

Jason Maynard, Credit Suisse First Boston

Okay, then maybe just one last followup; the share count that you’re assuming to get to the $1.05 to $1.10 in operating cash flow?

Charles E. Peters, Jr., Executive Vice President & Chief Financial Officer

I think if that’s an assumption now it’s something like about 215.

Operator

Your next question is from the line of Heather Bellini with UBS.

Heather Bellini, UBS Investment Research

Hi, thank you. I was just wondering if you could give us an idea, Charlie, of it; if you’re looking at your optimal business model, following up on Jason’s question, where do you see operating margins peaking over the next few years. How long do you think this…I mean I know you’re still investing for growth, but 300-400 basis points is an improvement, do you think that you can replicate that aside from just fiscal year ’07, where should we expect margins to top out? Then my followup would be on head count growth; where specifically is that focus, if you could give us a sense for what the SG&A, sales and marketing, etc., and where by geography?

Charles E. Peters, Jr., Executive Vice President & Chief Financial Officer

Okay, first the operating margin, I think that what we fully demonstrated this year is the leverage in the model and that there is room for gradual operating margin expansion at the same time that we’re investing. I’ve also said in the past that there’s no reason in the long term that we can’t be as good as the best, but we are still very early in the growth opportunity and there’s a lot of investments to be done. So, I don’t want to try to project now how much the operating margin expansion might be next year, and I would say again because I know it’s going to confuse lots of people, but this was before the FAS 123R and I just don’t know how the analysts and investors will factor those numbers in.

Heather Bellini, UBS Investment Research

But when you say you could be at their best, are you talking about other companies like Oracle where they’re at 40% or are you referring to…how should we think about that comment? I’m not talking about fiscal year ’08, I’m talking further out than that.

Charles E. Peters, Jr., Executive Vice President & Chief Financial Officer

Like I said, it is in the very long term. Given our ability to scale and the gross margins we have, there’s no reason over quite a long time that we can’t be included with the best. Your second question had to do with the head count. As I mentioned to someone else about this question, the principle investment in terms of the numbers of people, where they’re going to be hired, engineering, sales and marketing would be the functions principally and some in support, very little in G&A, and then geographically probably at least 50% and may be more outside the United States.

Dion Cornett, Vice President of Investor Relations

Actually Heather I’ve got some statistics from last year that may be helpful as you do your modeling. If you look at our head count additions for last year, our growth in G&A was in single digits while the growth in the various functions that Charlie talked about -- operations, sales, and research all grew at rates anywhere from three to five times the pace that growth in G&A. And in terms of geographic mix of hiring last year, nearly half of our hires in last fiscal year were in Asia Pacific, relatively downswing EMEA and the Americas given some hiring here in the fourth quarter, but I would intensify it against what Charlie said, more hiring overseas.

Operator

Your next question is from the line of Todd May with Deutsche Bank.

Todd May, Deutsche Bank

Thank you. I was wondering if you guys could tell which geography was the mid-seven figure deal that was pushed to March, which geography would that have popped up from?

Charles E. Peters, Jr., Executive Vice President & Chief Financial Officer

United States.

Dion Cornett, Vice President of Investor Relations

We’ll just remind you that number was reflected in the bookings breakout that Charlie did provide, however.

Todd May, Deutsche Bank

Okay, great, and then regarding operating expense guidance for next year, is there any stock-based compensation expense in the operating expense numbers that you mentioned for next year or is it all not being broken out based up on 123R? I don’t know if that question is clear.

Charles E. Peters, Jr., Executive Vice President & Chief Financial Officer

In the numbers that I mentioned, this does not include stock compensation expense. I did say separately that for FAS 123R our initial estimates are for the full year, about $33 million pretax and then you have the 35% tax benefit that offsets it, so that $22 million after tax, which works to about $0.025 per quarter earning per share impact per quarter. Just one other piece of detail that might help us if in trying to build the model, our initial estimates of how you’d spread that FAS 123R expense by category, probably 5-6% of it would be in cost of revenue, probably 7-29% of it in sales and marketing, 17-20% of it in R&D, and 47-50% of it in G&A. And the reason I’m giving the ranges is because none of those numbers are at this point absolutely final, but it gives you some idea if you’re trying to build a model.

Todd May, Deutsche Bank

Okay, great, just a couple. And then just you thoughts for fiscal year ’06, was your recognized stock-based compensation expense around $4.7 million?

Charles E. Peters, Jr., Executive Vice President & Chief Financial Officer

For which now, for ’06?

Todd May, Deutsche Bank

Yes, fiscal year ’06 ______.

Charles E. Peters, Jr., Executive Vice President & Chief Financial Officer

That number is in the ballpark, I have to look to see if I can confirm.

Todd May, Deutsche Bank

Thank you.

Operator

Your next question is from the line of Chris Russ with Wachovia Securities

Christopher Russ, Wachovia Securities

Yes, good afternoon. Just a question on the tax benefit of $1.6 million in the quarter, Charlie, was that as you said related to all employee stock option exercise?

Charles E. Peters, Jr., Executive Vice President & Chief Financial Officer

Yes, we had substantial exercises in the quarter which as I said generated an additional $1.5 million of payroll tax expenses, ended up in OpEx, but tax benefit on the income tax more than offset that down below the line. So yes, it was all related to the stock option deductions for the quarter.

Christopher Russ, Wachovia Securities

And then I think, Dion, you mentioned that you’re still gaining share in paid Linux versus Novell, but are you seeing anything unusual in customers’ willingness to deploy unpaid Linux or any competitor, in fact from Solaris 10 on AMD Opteron?

Dion Cornett, Vice President of Investor Relations

Chris, I had the opportunity to recently spend some time traveling with Alex Pinchev, our head of sales, and in terms of the competitive environment, consistently over this quarter we’ve really seen no change.

Christopher Russ, Wachovia Securities

Okay.

Operator

Your next question is from the line of Tim Klasell with Thomas Weisel Partners.

Tim Klasell, Thomas Wiesel Partners

Yes, good afternoon everybody, congratulations on the good quarter. First question, on the bookings numbers of the breakout you gave between the various geographies, was there any impact there from the revenues you couldn’t recognize because you didn’t have all the manuals and stuff last quarter in Asia, and if so can you give us a sort of quantification of how much that impacted either revenues or deferred revenues?

Charles E. Peters, Jr., Executive Vice President & Chief Financial Officer

It wouldn’t have had any impact on the bookings because the order was in, so a booking is basically an order.

Tim Klasell, Thomas Wiesel Partners

So the breakout wasn’t bookings?

Charles E. Peters, Jr., Executive Vice President & Chief Financial Officer

Yeah, bookings were not impacted. It’s essentially billing obviously and so you ship it and send the invoice and at that point in time it also becomes part of deferred revenue. So, if you look at the billings proxy last quarter, which was relatively flat, and when you look at the billings proxy this quarter, which was up 16% sequentially, that will explain some of that.

Tim Klasell, Thomas Wiesel Partners

Okay, and then sort of the next one goes on the quadrupling of the value-added solutions, can you give us an idea of the maturity of that market? Is the sales there coming from direct sales going into your existing accounts, are you seeing some traction with the resellers and into new accounts with those products?

Matthew J. Szulik, Chairman, Chief Executive Officer, and President

Tim, I think as we’ve consistently said over the last couple of calls, we’re seeing an adoption curve for these value-added solutions very similar to the adoption curve that we saw with the introduction of Red Hat Enterprise Linux in August 2002, and initially the sales were predominantly driven by sales organizations, as the customers become more familiar and comfortable with the solution, as the community continues to build…revenue invasion that Matthew talked about, then we are increasingly seeing that business start to be picked up by our channel partners. However, it’s fair today to say that sales is already best being driven by the inside team.

Tim Klasell, Thomas Wiesel Partners

Okay great, thank you very much.

Operator

Your next question is from the line of Terry Tillman with SunTrust Robinson Humphrey.

Terry Tillman, SunTrust Robinson Humphrey

Hi Matthew, I had a question in terms of you’ve guys have had great success with renewals in your top 25 accounts. I think last quarter you may have even quantified when those top 25 accounts were renewing, they also had an increase in the subscriptions. Can you may be talk qualitatively or quantitatively in the fourth quarter how that played out?

Matthew J. Szulik, Chairman, Chief Executive Officer, and President

Actually Terry, I’ve got that number, and so if you look at the top 25 deals that we’ve had in the fourth quarter of fiscal year ’05 and then again an apples-to-apples comparison for the same application within that customer, not including additional deployments the customer may have rolled out, the value of the contract of those top 25 deals in the fourth quarter of ’06 was 16% higher than the initial value last year.

Terry Tillman, SunTrust Robinson Humphrey

Okay, great, and then Charlie, a financial question. I know we should be looking at cash flow as the key parameter of the health of your business, but as it relates what first call is on earnings, the estimates are all over the place. I mean it’s a wide dispersion of estimates. I know that you’re talking about kind of margin assumptions with that 123R. If you’re really going to do apples-to-apples and considering the tax situation where you’re only paying 5% cash taxes, shouldn’t we be doing an adjustment on taxes, some sort of EPS adjusted for that tax rate?

Charles E. Peters, Jr., Executive Vice President & Chief Financial Officer

That’s a judgment I need to leave to the analysts, but I think I provided all the data for which you can do that. I do think you hit on a chief point that the because of the vast discrepancy between the GAAP tax rate that we report and the actual taxes that we’re going to pay for a very long time and the fact that we have these non-cash stock compensation expenses, many people will factor those out and do some sort of pro-forma. I’m not trying to provide guidance one way or the other as to how you should do it, though.

Terry Tillman, SunTrust Robinson Humphrey

Understandable, but I were to fully and accurately reflect your cash tax situation and publish the non-GAAP number, the rate I would use is 5% for the next several years?

Charles E. Peters, Jr., Executive Vice President & Chief Financial Officer

It certainly is five or six years. If were saying that cash tax rate, five or six years is a long time or may be longer.

Terry Tillman, SunTrust Robinson Humphrey

Okay, thanks guys, great quarter.

Operator

Your next question is from the line of Rick Sherlund with Goldman Sachs.

Rick G. Sherlund, Goldman Sachs & Co

Yes Charlie, and just to talk about that previous question, because it would seem to me the 5% tax rate is benefitting from the EFO, so I’m not sure we should give you the credit for the 5% tax rate, must be penalize you for the EFO cost, I mean wouldn’t that be inconsistent?

Charles E. Peters, Jr., Executive Vice President & Chief Financial Officer

So just to clarify from a tax perspective, we have substantial tax loss carry forwards, in excess of $450 million of tax loss carry forwards related to deferred tax asset, almost $185 million, which is fully reserved. And so, the fact is the accounting has nothing to do with it. We simply will not be paying taxes for a long time. And in terms of where you should put it through the P&L, the higher tax rate and the FAS 123R, they certainly should be tax effective I think in the P&L, that would have it done that way. I think the key thing is to make sure from a cash perspective you understand what the real result is going to be.

Rick G. Sherlund, Goldman Sachs & Co

Absolutely. Okay, let’s see, Matthew, as far as Oracle, I’d be curious whether your views are if Oracle moves on to open source, it would seem that it would be positive for Linux and therefore positive for you, I’m curious on your observations. On the other hand it might be preempting some market opportunities for you longer term, I’d be curious what your views are on that. And also if you could comment on virtualization, it’s not real clear to me your relationship with XenSource and who gets paid as you move virtualization in?

Matthew J. Szulik, Chairman, Chief Executive Officer, and President

First of all you should know Red Hat and Oracle have had a successful relationship for a long time and I believe that Oracle is certainly one of the beneficiaries of the continued growth and adoption of Linux in the enterprise. So, I think Rick, as you know, it’s proven validation of open source, I think the more contributors that we have and the more communities of open source development, I think the better it will be for customers, so I would see that as a near term positive, Rick. Regarding virtualization and XenSource, I think it’s a good question. I was recently out in California and spent a fair amount of time with Peter Lavine, their new CEO. I think as you know, we’ve worked very hard with the founders of XenSource regarding the hypervisor and support of the GPL implementation of the hypervisor. Our teams are in active discussions within the Fedora release, and I think that that financial and technical relationship is evolving, and I think we’ll see what the results are within Fedora 5. But I think clearly the Red Hat’s business, we don’t view it exclusively as the incremental functionality within the hypervisor. We’re really viewing it in tandem with the completeness of the file systems, the question that I got asked earlier regarding the policy management within security with an SELinux, the tools that we are building now so that customers can build virtualized solutions, and I think this will be a complicated problem for customers to solve as they look at deploying virtualization across their enterprises.

Operator

Your next question is from the line of Katherine Egbert with Jefferies.

Katherine Egbert, Jefferies and Company

I have a question, I think Matthew mentioned something about moving to a global account base in sales, can you talk more about that?

Matthew J. Szulik, Chairman, Chief Executive Officer, and President

You know, we have a strong lead by our core enterprise accounts which we’ve defined as arguably the 60 largest global accounts. As a desire to bring the know how that we have in open source, the technical proficiencies, matching technical roadmaps with our strategic OEM and ISV partners and having a service delivery competency all under one single executive with a targeted focus, direct selling and services organization, that organization is segmented of course from the global 3000, it is also segmented from the inside selling channels, so that these core global 60 accounts are having a single face globally, a single support organization globally, and minimizing and reducing any of the complexity of doing business with Red Hat. And I think as I highlighted, Katherine, on the call, we’ve already seen benefit of that in terms of both vertical understanding of the industry we’re selling into, consistency and delivery, and certainly better day-to-day account management.

Katherine Egbert, Jefferies and Company

And are you defining those 60 accounts by total potential or by current standards of Red Hat?

Matthew J. Szulik, Chairman, Chief Executive Officer, and President

All of the above and in some cases some of those global 60 have no relationship with Red Hat.

Katherine Egbert, Jefferies and Company

Okay fair enough. Then, directly, what was the size of a large deal that you didn’t get paid that flipped into March?

Charles E. Peters, Jr., Executive Vice President & Chief Financial Officer

It’s a mid-seven figure deal. It wasn’t that we didn’t get paid, we actually didn’t bill them. After we talked with the customer, we took the booking, but they had their own budget issues and wanted to be billed in March.

Dion Cornett, Vice President of Investor Relations

I realized a lot of investors and analysts will make the assumption that all our one-year bookings get billed in quarter as part of their modeling process. If you’re working on that type of function this quarter, you’d probably be best served by assuming that approximately $6 million or $7 million of one year bookings weren’t billed this quarter, the largest obviously being related to this one contract Charlie just said.

Katherine Egbert, Jefferies and Company

Okay thanks a lot, Dion, this helps. Good job.

Operator

Your next question is from the line of Steve Ashley with Robert Baird.

Steven M. Ashley, Robert W. Baird & Co

Hi, most of my questions have been answered, but if it’s correct, I’m just assuming that FX did not have an impact on deferred revenue this period, is that right Charlie?

Charles E. Peters, Jr., Executive Vice President & Chief Financial Officer

If it did, it was very small, Steve. It was not a major factor.

Steven M. Ashley, Robert W. Baird & Co

Great, and can you say whether there were any bookings greater than $5 million in the period?

Charles E. Peters, Jr., Executive Vice President & Chief Financial Officer

Yes.

Steven M. Ashley, Robert W. Baird & Co

And just lastly, Dion, you mentioned you were out traveling and had the opportunity to go out with your head of sales, is there anything anecdotally, may be qualitatively you could discuss regarding if more of your customers are having conversations around standardizing with Red Hat in the data center?

Dion Cornett, Vice President of Investor Relations

I think absolutely. I think one of the things I was very happy to see was customers really coming to Red Hat as in many of the accounts as the point person for their IT infrastructure needs, and whereas historically these may have been very large multi-billion dollar revenue companies that were sort of leading the technology roadmap. I think in some of these key accounts that Matthew referenced, we’re now to the point where Red Hat is the point person now working with these partners together come up with a comprehensive strategy to solve the customers infrastructure needs.

Steven M. Ashley, Robert W. Baird & Co

Thank you.

Operator

Your next question is from the line of Trip Chowdhry with Global Equities Research.

Trip Chowdhry, Global Equities Research

Thank you, congratulations on a very strong execution especially in the international market. Two questions, first on XenSource virtualization; I was wondering what is your strategy regarding go to market, are you thinking of migrating the customers of the N-ware and into XenSource or probably going after Greenfield opportunities. And I have a second question.

Matthew J. Szulik, Chairman, Chief Executive Officer, and President

Trip, as you know, right now there is a strong opportunity for the Greenfield opportunities because we continue to see the historical unit machines being so underutilized. So, as far as we can see there is more than enough market breadth for us to go after those Greenfield situations.

Trip Chowdhry, Global Equities Research

The second impression I had is regarding the stacks that you have been in a way not so vocal about, but our contacts are very vocal and very excited, first was the technology stack you talked about last quarter and I think probably you may have some more concrete plans to be announced in the month of June. Recently, we picked up some more interesting news from our contacts regarding business stacks, the education stack, the small and medium business stack, and the government stack in which Red Hat is the platform; and all these initiators are in the ____, have you thought about bringing those initiatives to the US, and if not why not?

Matthew J. Szulik, Chairman, Chief Executive Officer, and President

Trip I’m impressed by your diligence, because I think you’ve appropriately highlighted a number of key product marketing initiatives that we had in those _____countries. As you know the computing environment, the hardware platforms, the network topologies certainly vary from one region to another. Those have been some of the determinants of why we have not brought those vertical stacks to the domestic US stack and I think quite frankly that our hands are fully right now readying and getting prepared to deploy the LAMP stacks, the certification and testing initiatives that we announced about 60 days ago and readying those for the domestic US and international markets.

Trip Chowdhry, Global Equities Research

Congratulations on a very good quarter.

Operator

Your next question is from the line of Gary McDaniels of Standard & Poor’s Equity Research.

Gary McDaniels, Standard and Poor’s Equity Research

Good afternoon, congratulations on the quarter. I just wanted to be clear on one thing, the stock compensation. The guidance that you’re giving includes no stock comp, not even what you get under APB 25?

Charles E. Peters, Jr., Executive Vice President & Chief Financial Officer

The guidance I’m giving is all stock comp.

Gary McDaniels, Standard and Poor’s Equity Research

Right, but the guidance for operating margin improvement is not including any stock compensation at all, because half of the margin improvement then is coming from there because under APB 25 you add about 147 basis points of ops and costs in FY06 could be knocked out in guidance for FY07, and ___ so it will be a marginal improvement there, does it not?

Charles E. Peters, Jr., Executive Vice President & Chief Financial Officer

You’re talking about the existing deferred comps, so may be I’ve misspoken. The guidance I’ve given you assumes basically the similar sort of expense that we’ve had this year.

Gary McDaniels, Standard and Poor’s Equity Research

So, it is including APB 25 expense that you had this year?

Charles E. Peters, Jr., Executive Vice President & Chief Financial Officer

Not what you see in the footnotes of the financial statements, which is more representative of the FAS 123R expense. That was already there, for example, restricted stock amortization.

Gary McDaniels, Standard and Poor’s Equity Research

Okay, thanks for clearing that up.

Operator

You next question is from the line of Eric Rubel with Miller Tabak Roberts.

Eric Rubel, Miller Tabak Roberts

Hi, good afternoon gentleman, most of my questions have been answered. I’ll just ask on the deferred revenue assuming as you clarify that some of the inventory that slipped last quarter was included in this quarter’s shipments and the number was up by 16%. If you had this sort of straight line there, what would have been the sort of pro-forma growth for the two quarters?

Charles E. Peters, Jr., Executive Vice President & Chief Financial Officer

Just to clarify on the third quarter comment about the inventory, I think we made it clear on that call that we were talking about only a couple of million dollars in the third quarter, though it is not a big factor in terms of the fourth quarter change.

Eric Rubel, Miller Tabak Roberts

Alright, congratulations for this quarter.

Operator

Your next question is from the line of Kash Rangan with Merrill Lynch.

Kash Rangan, Merrill Lynch

Hi, I just had a followup question. Matthew, I was just curious where do you think the growth in Linux is coming from compared with two years back or so? It seemed like two years back we were replacing a lot of UNIX and may be even other versions of UNIX if you will, just curious to see where you find the incremental growth coming from. Are we seeing as much as UNIX replacements or are we seeing actually new applications and new boxes being both on new projects increasing your drive and demand?

Matthew J. Szulik, Chairman, Chief Executive Officer, and President

Well Kash I think there’s still a large amount of UNIX that is being transitioned over to Linux. What we are seeing of course is that we’re getting deeper penetration into the data center. The question I think should be asked ____ and I think that is feeling quite a maturity in the operating environment in a related ISV support in and around that. Secondly, we’re also starting to see very strong support in software development. So, as Linux now starts to be used as both a development platform and a host and targeted platform, the tools are maturing in the Linux and open source category, we’re starting to see strong deployments in those categories as well. And thirdly is the growth in the small-to-medium sized business, whether it be a hosting solution or direct implementation, we’re starting to see broadening as evidenced by the growth in new customers that we saw during our FY06. So I think it’s those three core factors.

Kash Rangan, Merrill Lynch

Are we at all seeing evidence of new projects in large enterprises being completely built ground up on LAMP stack or is it still too early to make that call?

Matthew J. Szulik, Chairman, Chief Executive Officer, and President

We are definitely seeing that and that to me is perhaps one of the bright spots during my tenure at Red Hat because customers five years ago that would claim if they would never deploy or build a software development organization or internally develop application in around the LAMP stack, now through technologies such as the existing Linux kernel, SELinux open source technologies like AutoBuild and Red Hat Network are really building sophisticated software development environments and therefore really secure open source applications as a part of their key core operating environments, and that’s kind of a very bright spot for me to see this quickly in the market.

Kash Rangan, Merrill Lynch

Right, thanks.

Operator

There are no further questions at this time. Mr. Cornett are there any closing remarks?

Dion Cornett, Vice President of Investor Relations

Thank you very much everyone for your participation today.

Operator

This concludes today’s Red Hat conference call, you may now disconnect

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