Red Hat Management Discusses Q2 2013 Results - Earnings Call Transcript

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 |  About: Red Hat, Inc. (RHT)
by: SA Transcripts

Operator

Good afternoon, my name is Ali, and I will be your conference operator today. At this time, I would like to welcome everyone to the Red Hat Q2 2013 Earnings Conference Call. [Operator Instructions] I would now like to turn the conference over to your host, Tom McCallum, Vice President of Investor Relations. Mr. McCallum, you may begin your conference.

Tom McCallum

Thank you, Ali. Hello, everyone, and welcome to Red Hat's earnings call for the second quarter of fiscal 2013. Speakers for today's call will be Jim Whitehurst, President and CEO; and Charlie Peters, Executive Vice President and CFO.

Our earnings press release was issued after the market closed today and may be downloaded from redhat.com on the Investor Relations page. Also on this page, you will find a historic reconciliation schedule of GAAP to non-GAAP financial metrics, as well as the schedule on currency rates.

Various remarks that we may make about the company's future expectations, plans and prospects, including the statements containing the words believe, anticipate, plan, project, estimate, expect, intend or will, constitute forward-looking statements for the purposes of the Safe Harbor provisions under the Private Securities Litigation Reform Act of 1995. Actual results may differ materially from those indicated 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, as well as the Safe Harbor statement in today's press release.

In addition, any forward-looking statements represent our estimates or views only as of today, September 24, 2012, 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 at any date subsequent to today.

With that, I'd like to turn the call over to Jim.

James M. Whitehurst

Thanks, Tom, and welcome to everyone joining us on today's call. We continue to deliver steady growth in our key measures, with 22% constant currency growth in subscription revenue and over 30% operating cash flow growth for the fourth straight quarter. For both the quarter, as well as for the first half of the year, our global organization has executed well, and I'm pleased with our progress towards our long-term growth initiatives. We remain focused on serving the needs of our customers and in investing in technologies that enterprises require in the new era of computing. This strategic focus has led to a broad-based demand while elevating Red Hat as a strategic vendor and enabling us to gain market share by delivering innovation, combined with a compelling value proposition. It has also led to a significant expansion in our value proposition and addressable market opportunity.

The rate of software innovation in the data center has been phenomenal over the last few years. Clearly, open source technologies are the DNA of the software-defined data center based on projects such as KVM, Linux and OpenStack. Red Hat is able to both benefit from and help drive this rapid pace of innovation as a result of our community-driven development process, which we view as a significant competitive advantage. I'm proud to announce that we've been recognized on the Forbes World's Most Innovative Company list, ranking #4. We're also proud that our customers, who have built mission-critical systems on Red Hat technologies, are also on that Forbes list of innovative companies.

Our open source technologies are key to creating innovation, scale and flexibility in our customers' data centers and their businesses. CIOs are only beginning to wrap their arms around how they can best modernize their data centers for competitive advantage, and we're seeing early investments in proof of concepts in the next-generation IT architectures. We barely scratched the surface of this tremendous opportunity, and Red Hat's proven value proposition and trusted vendor status position us very well.

Many of you were able to attend our highly successful Red Hat Summit, where we experienced nearly a 40% surge in attendance. For those in attendance heard from key partners and users and saw community-powered innovation in action. Attendees have the chance to learn firsthand about innovations at our core RHEL and JBoss solutions.

We also introduced exciting new technologies that will address trends in cloud computing, storage and virtualization. For those who are unable to attend, let me provide a few important highlights. And for those who did make it, I'll discuss some updates.

First, we introduced open hybrid cloud, a set of solutions designed to enable enterprises to build and manage their cloud computing environments. In an open hybrid cloud, enterprise customers will receive the benefits of consistency, portability and choice for developing running applications across sites. In a hybrid cloud environment, Red Hat enables workload portability, providing -- by providing consistent runtime environment across private and public cloud. Leveraging the entire Red Hat portfolio, open hybrid cloud enables customers to take advantage of the efficiencies and cost effectiveness of this new paradigm of computing. For example, developers can write and test software in a public cloud environment and then deploy their applications on premise or in another certified public cloud without needing to worry about differences between development in the production runtime environment.

Second, we launched Red Hat Storage 2.0. Built on the leading RHEL operating system, Red Hat Storage allows customers to deploy cost-effective, scalable and highly available storage for their unstructured data needs. Red Hat Storage Server can be easily deployed on premise or in hybrid cloud environments. Red Hat scale-out open source storage software solution is optimized for storage-intensive enterprise workloads. Interest in this technology is growing rapidly, with over 30 global companies running POCs, many of them new to Red Hat Storage. In addition, we plan to integrate our storage technology with Red Hat's virtualization technology in RHEV 3.1 beta, further expanding our virtualization capabilities. We're excited about our position and the potential to disrupt traditional storage marketplace for big data.

During the summit, we announced the acquisition of FuseSource, an open-source provider of integration and messaging middleware. We followed up this acquisition with a second acquisition of a start-up, Polymita, which brings complementary BPM capabilities. In the next couple of months, you'll hear more about our comprehensive plans to combine these technologies with existing JBoss technologies to deliver a next-generation application integration platform.

At summit, we discussed our involvement in the OpenStack project and recently announced the developer preview of the OpenStack Infrastructure-as-a-Service cloud platform. We've been involved in OpenStack in a meaningful way and are now a top 3 contributor to the project. It's still early in the development phase for the enterprise, but we believe that future versions could be commercialized in the same way that the RHEL model with the strong ecosystem and world-class support.

Red Hat also announced innovation awards that recognize customers, partners and communities for their outstanding use of Red Hat solutions to solve unique problems and business issues. For instance, UNE Telecommunications, Columbia's leading provider of IT and telecommunication services, implemented Red Hat's comprehensive platform across their entire infrastructure. This allows UNE to reduce recovery time by 95%, cut their operational costs in half and provide relevant innovative technologies to its customer base. This was just one of many use cases where customers were able to innovate to save on costs while providing new services to their customers.

We're dedicated to the success of our customers, and we work with them as partners in driving innovation forward. This has led customers to renew and expand their deployments of Red Hat technologies. I'm pleased to report that all of our top 25 deals that were up for renewal this quarter not only renewed, but did so at a total value of over 120% of their original value. From an overall perspective, the second quarter was another step forward in solidifying Red Hat's position as serving global enterprises. I want to thank each of our Red Hat associates for their contributions to making Red Hat a top global innovator, and I'd like to also welcome our new Red Hat associates from FuseSource and Polymita.

With that, let me turn the call over to Charlie.

Charles E. Peters

Thanks, Jim. Currency volatility continued to be a significant factor in Q2, with most foreign exchange rates continuing to weaken against the dollar, thereby reducing revenues and expenses translated in U.S. dollars. The impact of these foreign currency headwinds is particularly significant on a year-over-year basis, where the impact on U.S. dollar translated revenues is over 400 basis points. Although I will base most of my comments on U.S. dollar comparisons where appropriate, I may add comments in constant currency terms using last year's rates.

Here are a few financial highlights on a year-over-year basis. Subscription revenue growth was 22% in constant currency or 17% growth in U.S. dollars. Short-term deferred revenue grew 17%, and total deferred revenue grew 16%, both in U.S. dollars. Q2 and year-to-date operating cash flow grew 35% and 36%, respectively, and we experienced continued strength in large deals and renewals. Our top 30 deal metrics reflect continued wins across multiple global industry verticals. We had 27 deals of $1 million or greater, including 4 deals that were in excess of $5 million, and 2 over $10 million. This is the first time that we've ever had 2 8-figure deals in one quarter. Not surprisingly, government and financial services were our top core verticals as they've been in the past. However, we continue to see a diverse representation within our mainstream verticals with large wins in health care, logistics and energy.

Now let's turn to our financial performance. Our deal metrics continued to illustrate good global demand, with double-digit growth across all regions. In U.S. dollars, 58% of bookings came from the Americas, 24% from EMEA and 18% from Asia Pacific. The Q2 sales distribution mix was 66% from the channel and 34% from our direct sales force versus a 64%-36% split in Q1. Although the percentage varies from quarter-to-quarter, the general trend of higher channel sales reflects, in part, efforts we continue to make to broaden our reach to market.

Our billings proxy, which we calculate by adding revenue plus the change in deferred revenue on the cash flow statement, was $349 million for the quarter, up 15% year-over-year. If one also factors in the year-over-year foreign exchange impact on revenue in this calculation, billings grew by 19% on a constant currency basis. I've also seen some models that remove the lower gross services revenue component to create a foreign exchange adjusted subscriptions-only billings growth rate, which would have been approximately 22%.

Now let's shift to the income statement. Second quarter revenue was $323 million, a 20% year-over-year increase in constant currency and 15% year-over-year increase in translated U.S. dollars. As a reference point if translated the same foreign exchange rates which I used to provide guidance, revenue would've been over $325 million. The main driver of our total revenue growth was subscription revenue, which is important because that's the renewable segment of our business.

Subscription revenue now constitutes 86% of total revenue. Subscription revenue was up year-over-year 22% on a constant currency basis and 17% in U.S. dollars to $279 million. The training and services component of revenue was $44 million, up 7% in constant currency and up 2% in U.S. dollars from last year. I expect that this services mix may continue for the balance of the year.

I'll now discuss the rest of our results on a non-GAAP basis, excluding stock compensation and amortization expense, starting with gross margin. Subscription gross margin was 94%, consistent with prior periods. Training and services gross margin was 36.4%, up 380 basis points year-over-year. Overall, Q2 gross margin was 86.2%, 170 basis points higher than last year. The improvement in overall gross margin was mainly the result of the higher percentage of subscriptions in the mix and the improved services margin.

Moving on to non-GAAP operating expenses, we continued to focus on investing in growth opportunities. Q2 non-GAAP operating expense came in at $199 million, up 23% in U.S. dollars year-over-year. This included marketing and program expenses related to new technology launches; the Red Hat Summit, our largest event of the year; over $1 million of acquisition-related expenses; and the continuing build out of sales, engineering, support and services for Red Hat Storage, among others. Q2 non-GAAP operating income was $79 million, producing an operating margin of 24.6%, in line with our guidance. In addition, overall hiring was approximately 300 associates, keeping us on track to add between 900 and 1,000 new associates to Red Hat this year.

Interest and other income was $1.5 million, and it was $2.7 million or $0.01 per share less than last quarter and $1 million less than the year-ago quarter. Our estimated annual effective tax rate was 32% for both GAAP and non-GAAP results. Non-GAAP diluted earnings per share came to $0.28, which is in line with our guidance range. When comparing EPS year-over-year, please note the $0.02 per share swing resulting on -- from: First, the inclusion in last year's Q2 of a $2 million discrete tax benefit, which added $0.01 a share last year; and a reduction of this year's Q2 income by $0.01 caused by the acquisition-related expenses and a lower other income discussed earlier.

As I said, foreign exchange volatility and foreign exchange headwinds remain high especially year-over-year, so let me lay out the impact for you. First, the year-over-year impact. Using average currency rates from Q2 last year, this Q2 would have shown revenue of $14 million higher, expenses $10 million higher and operating income $4 million higher. Further, the actual average foreign exchange rates for the quarter were generally lower than what I used in June for guidance. If the foreign exchange rates used for Q2 guidance had remained unchanged, Q2 revenue would've been approximately $3 million higher; expenses, $2 million higher; and operating income, $1 million higher.

Now let's turn to the balance sheet and the...

[Audio Gap]

Outstanding and traditionally a measure of receivables compared to billings, our DSO is calculated using our billings proxy. Total deferred revenue at quarter end was $944 million, an increase of $131 million or 16% from the same quarter a year ago. In U.S. dollars, current deferred revenue grew 17% and long-term deferred revenue grew 13% from 1 year ago. Sequentially, deferred revenue increased approximately $31 million from last quarter.

To isolate the foreign exchange impact, let me break down the components of deferred revenue for you. Short-term deferred revenue, which ended Q1 at $683 million, had a real increase from Q2 of $19 million and increased an additional $3 million as a result of changes in foreign exchange spot rates, ending Q2 at $705 million. Long-term deferred revenue, which ended Q1 at $231 million, had a real increase in Q2 of approximately $8 million, and increased an additional $1 million as a result of changes in foreign exchange spot rates, ending Q2 at $240 million.

The total increase in deferred revenue without the impact of currency changes was over $26 million and can be found on our statement of cash flows. We've recently completed 2 technology acquisitions in the middleware area, as Jim described. Polymita closed at the end of August, and FuseSource closed in early September. Neither had any material impact on Q2 except for the previously mentioned acquisition-related expenses, which amounted to about $0.01 per share.

For Q3 and Q4 together, these acquisitions will add approximately 80 employees and about $4 million per quarter of expenses or approximately $0.03 a share reduction of EPS in the back half of the year. We do not expect any meaningful contribution to revenue in fiscal year '13 from these deals. We do expect that for the longer term, these transactions will broaden and strengthen our middleware offerings.

Turning to guidance. There are 2 things I'd like to point out. First, I don't forecast foreign exchange rates, but for purposes of this guidance, I have assumed the average foreign exchange rates for Q3 are as they were last week, that is the euro was at $1.30 and 78 yen to $1. As information, these assumed foreign exchange rates represent about a 5% headwind year-over-year for the euro and a 1% headwind for the yen. Secondly, while our business momentum and the underlying demand trend for our subscriptions remain strong, we do expect our services business to continue a single-digit growth for a while longer.

With those assumptions in mind, I offer the following outlook for Q3: Q3 revenue is estimated to be approximately $336 million to $339 million. Operating margin, including the impact from the acquisitions just mentioned, is estimated to be in the 24% area. Interest and other income should be around $2 million and non-GAAP EPS is estimated to be approximately $0.28 to $0.29, assuming the same 32% estimated annual effective tax rate. For the full year, if these exchange rates hold, we estimate that revenue will be in the range of $1,320,000,000 to $1,330,000,000. Excluding the impact of the 2 acquisitions, the original March estimates of operating margin and EPS would be unchanged at 24.7% to 24.9% and $1.16 to $1.20 earnings per share, respectively.

Including the impact of these acquisitions, we currently estimate full year operating margin of 24.4% to 24.6% and EPS of $1.15 to $1.17. Operating cash flow has been strong year-to-date, giving us increased confidence that the full year result will be near the high end of the previously guided range, which was $460 million.

In summary, the company continues to execute well, growing our market share of core technology solutions while expanding our addressable market with our portfolio offerings. We are continuing to invest for the long-term growth at a time when others are pulling back. Our open source solutions continued to be in demand, and we believe this is not the time to slow down.

Operator, I'd now -- we'd now like to turn it back over to you for the first question.

Question-and-Answer Session

Operator

[Operator Instructions] And your first question comes from Adam Holt with Morgan Stanley.

Adam H. Holt - Morgan Stanley, Research Division

I just had 2 quick questions for you. One, it looks like a little bit of a tweak to the annual guidance. Could you just walk us through the puts and the takes on that?

Charles E. Peters

Yes, so the -- I mean, we basically tweaked the annual guidance a little bit based upon the impact on operating margin and on earnings per share from the acquisitions. We've brought the top end of the revenue guidance down a shade based upon what's happening in the service side of things, and we've sort of reaffirmed the high end of guidance on the cash flow. This fall [ph], we see year-to-date and based upon the exchange rates that we're seeing at this point in time.

Adam H. Holt - Morgan Stanley, Research Division

And so the delta again is principally on the services side?

Charles E. Peters

Yes, exactly.

Adam H. Holt - Morgan Stanley, Research Division

And then my second question is, if you could just drill down a little bit on what you saw from an offering perspective. What were the relative growth rates between the middleware business and the core? And maybe any updates on contributions from RHEV and/or the new Storage offering?

Charles E. Peters

Just a little bit on the segments we report are subscriptions and services. Well, I will say this, that we have talked from time to time about the -- in particular, the middleware business, it continues to grow faster than the core business. And Jim commented about proof of concepts growing in the Storage area, and we're on track and that is still a relatively young area for us, and I hope that will answer your question. Work [ph] also continues along with the latest version of RHEV.

James M. Whitehurst

And again, so it's just -- so things like Storage, even the activity we've done that's turned into bookings won't turn into revenue until over the next year.

Operator

Your next question comes from Kash Rangan with Merrill Lynch.

Kash G. Rangan - BofA Merrill Lynch, Research Division

A couple of small things here to drill into. One is that you've not talked about 2 $10 million deals in any 1 quarter before. So, Jim, maybe you could just walk us through what exactly is driving that large deal activity? And also if you could give us some anecdotes on what's happening in the European theater and also the financial services and government theaters? I know that you commented that the business trends were holding together pretty well. But just given that, that is the topic of great scrutiny on Wall Street. I just wanted us to get a little bit more color, and if you have the time, if not, don't worry. I think you commented last time that your bookings were greater than billings. So I'm wondering if that was the case again this quarter.

James M. Whitehurst

All right. Well, let me start on the big deals. I think what we're seeing which is really, really nice, is our large RHEL customers are starting to significantly use JBoss. And JBoss, it has longer sales cycle, but when those things start to come in, they're just much bigger dollar type of opportunities. So I think what you see there, with our largest deal as a longtime RHEL customer, there's still growth in RHEL as UNIX to Linux continues. But I would say the significant bite -- or part of that deal was middleware and the middleware we're still in the early days of. So really leveraging the strength and credibility we've built with RHEL has been phenomenal. In terms of EMEA, EMEA is holding up very, very strong. We're seeing, again on the subscription side, I'd say, at least as strong as we're seeing for the total business, so well over 20% growth there in euros, which I guess would be the same thing as staying in constant currency. So in euros, we're still seeing strength in really across all 3 regions. So we break Europe out into North America -- or sorry, Northern Europe, Central Europe and Southern Europe, but we saw strength really in all 3 segments, including in Southern Europe. So I feel good about that.

Operator

Your next question comes from Joel Fishbein with Lazard Capital.

Joel P. Fishbein - Lazard Capital Markets LLC, Research Division

Just wanted to follow-up on a couple of the other questions earlier in terms of new products that could accelerate, that you're most excited about, and maybe, Jim, if you could just give us some indication where you guys are most excited in terms of some of the new products coming to market knowing that they're not going to affect revenue until next year, which you've clearly stated.

James M. Whitehurst

Well, Storage, we are just seeing significant interest in. So the Storage space, obviously, has some well-established, well-regarded large vendors in this space. But it also looks a lot like Linux did a decade ago, relatively expensive solutions that have really, we call it, first-class capabilities. But not all your data and including most of your unstructured data really doesn't need to fly first class. And with the explosion of unstructured data, so you get an exponential growth in unstructured data, you have linear growth at best in IT budgets. We have a lot of interest in it. And I would say most of that interest has manifested itself in POCs, the Storage folks rightly so are conservative. So we had -- even though it's only been out for several months, we had our first 6-figure Storage deal, and we have a lot of POCs going. But that's one where I think we could see very strong growth. I also think, again, we've talked about the JBoss portfolio, and it has grown very, very nicely and much faster than the core. Much of that has been around the application server, so the platform side. We're starting to see a lot of interest on the integration side as well and the acquisitions we did has helped shore that up. And as we get those fully integrated, have a holistic offering. There's quite a bit of interest in an open-source kind of alternative in that area as well.

Operator

Your next question comes from Mark Murphy with Piper Jaffray.

Mark R. Murphy - Piper Jaffray Companies, Research Division

Jim, wondering if you could compare and contrast where you are with Gluster and the Storage products at this early stage versus where you were with Cooler Net [ph] in the virtualization products when you were about a year into that acquisition. In other words, what feels like a more monetizable opportunity when you consider the ASPs of those products and the relative stickiness of the competition? And I'm also wondering, ultimately, do you think it's going to be easier to compete against and displace vSphere or Isilon deployments

James M. Whitehurst

Well in terms of absolute dollars as a separate product line, no question in my mind that Storage is a significantly bigger opportunity in the sense that, again, Storage is growing rapidly and the cost of those solutions are quite high. And not only do we have a significant cost advantage by being software-based, we offer huge amounts of flexibility, so you can burst up on the cloud, you can move your data, your applications that need to know some things are much higher to do with the appliance model. So without a doubt, as a line item storage has significantly more opportunity. But the reason I emphasize that is the biggest part of RHEV is the hypervisor itself is built into the operating system. So much of the growth that you see associated with the strategic use among our customers for RHEV is built into the operating system. So basically, we're monetizing a management platform, and so that's going well but you don't have that kind of order of magnitude kind of savings relative to VMware. When you look at it, it's purely the management tool versus vSphere that you have Gluster versus Isilon and the other storage solutions. So for us, virtualization is incredibly strategic, but a lot of that manifests itself in faster RHEL growth, where from a separate product line, Storage, you'll certainly see just a greater absolute revenue in that over time. Sorry for the long answer. But it's subtle, but important.

Operator

Your next question comes from Michael Turits from Raymond James.

Michael Turits - Raymond James & Associates, Inc., Research Division

Michael Turits. Just double back on this, can you just go over what some of the factors are behind the services slowdown? And then I've got a follow-up.

Charles E. Peters

Yes, this is Charlie. So the first thing is as we've stated on the March conference call, we have proactively pushed a strategy this year of trying to enable our partners to provide services, in particular on the middleware side because what we're looking for there is a broader base of people to help move subscriptions. And we have partners that have an interest in doing some of this consulting work, they're more likely to recommend JBoss as a solution and increase our subscription business. So that was a planned piece of business. Second thing is -- on the training side, the training side in a slower macroeconomic situation, the training side may be an area where travel and training is cut a little bit. So there's 2 different things, one is on the consulting side, some that we've proactively pushed and then on the training side, just a little bit slower.

James M. Whitehurst

Just on the services side, you can imagine, when we're providing services and our partners provide services, you get channel conflict and in technology, we live in a world of channel conflict, but we're trying to minimize that by being very, very clear. We're going to do work for a certain number of customers, but really trying to drive the growth to our partners ultimately to drive the higher-margin subscriptions. And again, we talked about that in March.

Operator

Your next question comes from Jason Maynard with Wells Fargo.

Jason Maynard - Wells Fargo Securities, LLC, Research Division

Two-parter on go-to-market and some of the growth into your product areas. What are the couple of things that you're looking for in United [ph] sales to improve in go to market for especially middleware and potentially the Storage products? And the basis for the question is, it's taking you guys a long, long time to make a dent in the middleware business. You guys have had a lot of fits and starts and the product strategy hasn't necessarily been fast evolving. I mean, you just made the recent acquisition here this summer. So help me better understand, a, what do you have to do on the product side to make this a more meaningful business; and then b, what are some of the things that you have to do for moving, if you will, from an order taker like mentality to actually being able to drive these longer sales cycles and become a more meaningful, if you will, force inside your customer base?

James M. Whitehurst

Well this relates back a little bit to the last question about working with partners who are implementing business solutions for customers, right? That's not really our business. And so Arun has really been pushing for us to invest more heavily in enabling and working with system integrators on the JBoss side. He's also been a big proponent to move beyond the application server, which is certainly important and where we're seeing great traction into offering some higher value-added integration products, and you'll certainly see that as we integrate Fuse and Polymita in with our own SOA suite. And you'll hear more about that in the next couple of months. And really continuing to work to leverage channels more broadly that's just to scale faster. And middleware is one of these things that's sticky and it's not about just unplugging one and plugging the other. It's when you're implementing business functionality, you choose a partner. So making sure we have partners that implement business functionality and then having them use the JBoss technologies.

Operator

Your next question comes from Bhavan Suri with William Blair.

Bhavan Suri - William Blair & Company L.L.C., Research Division

Just a quick one on contract duration, Charlie. Did that change at all? And what was it?

Charles E. Peters

Yes, the contract duration, a couple of statistics that we sometimes talk about 21 months hasn't changed. The single year portion of bookings was 75%. The out year portion, 25%. That's also been very consistent.

Operator

Your next question comes from Matt Hedberg with RBC Capital Markets.

Matthew Hedberg - RBC Capital Markets, LLC, Research Division

My question is on cash flow, Charlie. Obviously, very good results here going for the fourth straight quarter, over 30%. I guess I'm wondering, yes, longer term, should we expect that to grow back to more of a normalized range? Obviously, you took your guidance up to the high end of the range here. But kind of walk us through what's driving the strong cash flow growth.

Charles E. Peters

I think -- well, first of all, we've got, I think, good control of the working capital elements of cash, and our overall business, in terms of bookings and billings, has been good. And so -- and the profitability has been fairly consistent. That's what's driving the cash flow. Although I don't guide quarterly cash flow, I do feel comfortable, as I said, at the high end of the range, something in the $460 million range for the full year. But it's just a -- it's a very consistent business model that is producing good results.

James M. Whitehurst

[Operator Instructions]

Charles E. Peters

The next question is from...

James M. Whitehurst

Brent Thill.

Charles E. Peters

Brent Thill, are you on the line?

Brent Thill - UBS Investment Bank, Research Division

My name is Brent Thill and I'm from San Francisco. The bookings, Charlie, you mentioned in Q1 was stronger than you've seen it in past Q1s. And I was just curious, and I apologize if I missed this early in terms of the translation and billings this quarter, and I think just following up on Kash's original question, did you see that bookings strength continue above billings into the current quarter?

Charles E. Peters

I'm not going to comment on bookings other than to say that on our fourth quarter call, we will have a lot more detailed information about the full year performance, as well as where we stand with the off [ph] balance sheet backlog at that point in time. I think one conclusion that you can draw is a pretty substantial change in deferred revenue. What drives that is bookings that drives billings. And so, obviously, it was a positive result relative to how it performed in deferred revenue. But I will have a lot more detailed comments about the full year result in bookings and backlog when we come to the fourth quarter report.

Operator

Your next question is from Derrick Wood with Susquehanna.

James Derrick Wood - Susquehanna Financial Group, LLLP, Research Division

So Charlie, last year in the November quarter, there was a bit of a surprise on the deferred revenue side. So just curious, if you looked at last year's Q3 number, it was up about $30 million, and deferred revenue was in real dollars. Is there -- is that a good base case to work off from as we kind of think about our models for Q3, or are there any different elements working on the model to be aware of?

Charles E. Peters

Well, I guess what I would say is, as we've described from time to time, with the recurring revenue model, we have a pattern of business that tends to repeat itself each year. First quarter is typically the low quarter. Second quarter, a little bit stronger. Our third quarter, historically, has been a little bit stronger. The fourth quarter has typically been quite strong. And all I can say is because it's a recurring revenue model, I would expect that the subscription piece of the business will follow that pattern. But I don't have any specific guidance to give you on what deferred revenue might do in Q3.

Operator

Your next question comes from Heather Bellini with Goldman Sachs.

Heather Bellini - Goldman Sachs Group Inc., Research Division

Given that the conference call ins and outs, whether this question has been answered already, but in particular, Charlie, I was wondering if you could share with us kind of on your renewals, especially those customers that were on longer-term contracts and maybe -- and when thinking about JBoss, how are customers, long-time customers of Red Hat, when they're coming to renew, how should we think about their propensity to add JBoss to their contracts. Now are there any stats you could share with us about the percentage of renewals that now include middleware?

Charles E. Peters

Okay, thanks, Heather. It's a good question. I didn't mention it on the call, but I would say that of the top deals this quarter, 50% of them include a JBoss component. That, I believe, is probably the highest we've ever seen that metric. Last quarter, I think it was 40%, so 50% of the top 30 deals had a JBoss component this quarter. So the cross-selling continues to be good, and as Jim mentioned, that's leading to larger deal sizes.

Operator

The next question comes from Steve Ashley with Robert W. Baird.

Steven M. Ashley - Robert W. Baird & Co. Incorporated, Research Division

Number one, I wonder if you could mention if there were any standalone middleware deals in the top 30; and then number two, the government budget flush, some of it fell in your August-ended period that you just reported, but maybe more of it has happened here in September, and if you could give us any color on what you're seeing there?

Charles E. Peters

I think from a government perspective, as I said in my industry vertical comments, government and financial were the 2 largest verticals. I don't know if there was anything necessarily about the government budget flush. The continuing resolution that's just passed the other day so I would -- the government continues to be funded. Of course, at the time, they didn't know that, but they do know that now, and I would expect the government will continue to be a good part of our business. In terms of -- Steve, the answer to your question of top 30 deals, 4 of them were JBoss only.

James M. Whitehurst

And just a comment there. It's hard to do a JBoss-only deal that's just the application platform, especially as our BRMS solution, jBPM and SOA are getting traction. That helps push some of those deals to be larger.

Operator

Your next question comes from Kirk Materne with Evercore Partners.

Stewart Materne - Evercore Partners Inc., Research Division

I guess just maybe to drill a little bit more into the middleware deals. I guess, Jim, were these technology gaps that people were asking you guys to fill and I guess with these deals, are these acquisitions that you guys can help accelerate? It sounds like middleware is still growing faster than the core business. As you get these integrated, do you think that can actually help that business accelerate further off these growth rates as you guys get bigger? Just maybe a little bit more color about sort of the impetus behind them and then sort of what you hope to have happen once you get them integrated?

James M. Whitehurst

Yes, sure. Well, a couple of things. A, I misspoke. It was actually 5 deals were middleware only of the top 30, as we're kind of looking down the list here. Certainly, the other products help a lot in 2 senses. Typically, people picking middleware vendor as a partner and certainly, there are specialized needs and that's why the TIBCOs of the world have nice market. But in terms of a broad overall partner for middleware, your choices are Oracle, IBM and Red Hat. And as we filled in the other components and strengthened some of the other components, it certainly allows the figure [ph] dollars like deals based on BRMS and those things, just standalone, can be quite big. But they also help to have people say, "Wow, I'm going to go ahead and start on my new development on JBoss application platform because I know over time I can move the whole portfolio over." So it certainly drives bigger deals and companies do want to choose us long term as their strategic partner. I was with a very, very large German financial services company last week. They've just made the strategic decision that everything new is on JBoss from their portal to their SOA suite. They've dedicated a full time person who is committing code to our next-generation SOA platform. Those are the types of relationship that just naturally kind of bulk up and get bigger. In terms of growth, it is growing a lot faster. And as it grows faster, it's growing off of a higher base. So it does affect our growth rate more and more as it grows. And so, yes, you will continue to see it having a bigger impact on our growth rate just because its higher growth rate off of a larger base affects the overall number more. Obviously, part of the strategy.

Operator

Your next question is from Walter Pritchard with Citigroup.

Walter H. Pritchard - Citigroup Inc, Research Division

So I guess first question, Jim, just on OpenStack, I think you mentioned you were the third largest contributor to the project. Could you talk to us about how ultimately you see yourselves monetizing OpenStack?

James M. Whitehurst

You'll see us do the same thing we've done with RHEL. Ultimately, Infrastructure-as-a-Service applications are going to need to be somehow certified against something. In the same way, nothing can certify to RHEL because RHEL is a bunch of different fragmented things. We think we can certify, too. We can offer one [ph] life support and really play the same role that we do for Linux around OpenStack. It's the perfect type of software that lends itself to having a kind of a reference standard.

Operator

Your next question comes from Ed Maguire with CLSA.

Edward Maguire - Credit Agricole Securities (USA) Inc., Research Division

I was wondering if you could comment, now that you're looking to get partners engaged in more strategic deals and your stack of offerings is getting more strategic, how that may be changing the value proposition that's driving the business from UNIX to Linux conversions to more strategic data center deals and how that may be changing your win rates, your competitive rates against competitors like Microsoft and VMware.

James M. Whitehurst

It's hugely important. I mean, you can imagine, frankly, to be blunt, no CIO I know of cares about Linux, right? It's so far down in the stack. Yes, they know they use it, and they know it helps them save money, but that's not what makes it strategic. It's the middleware stack and now Storage that CIOs are actually interested in, as well as kind of cloud, and we're a player there. So I can just see in my own conversations out in the marketplace, we're much more strategic. And, obviously, that allows us to drive through more RHEL and application platform that goes along with it. So very synergistic across the portfolio and positions us in a whole new light with our customers.

Operator

Your next question comes from John DiFucci with JPMorgan.

John S. DiFucci - JP Morgan Chase & Co, Research Division

Charlie, you mentioned a couple of times here, the government and financial services remain your 2 top verticals. I guess just looking out because they do continue to be verticals you watch really closely and they continue to hold up. But I guess what's implied in your guidance for these 2 verticals? Are you expecting business as usual, or does guidance imply some relative softness as we progress through the second half of the calendar year?

Charles E. Peters

I think what I would say is business as usual. As we look through the worst part of the great recession 3 years ago, we actually picked up business in both of these verticals. And I think as Jim said, we are deepening and broadening the relationship, not only in the products they're currently in, but in some of our newer products. So we continue to expect these 2 will be our largest verticals going ahead.

Operator

Your next question comes from Rob Owens with Pacific Crest.

Rob D. Owens - Pacific Crest Securities, Inc., Research Division

I got kicked off, so apologies if this has been delved into too much. But on the middleware side, you guys talked about strength there. How much of that strength is on application server side versus the application integration side? And as a second part, can you talk a little bit about how -- or the potential that you see for commoditization, for lack of a better word, of the middleware market versus Linux and versus the other markets you're addressing?

James M. Whitehurst

Yes, well, the majority of the growth in absolute dollars is still the application platform because it's the largest. But the things is, starting to drive the bigger deals, it's higher value-added integration pieces, especially we're seeing that with rules but with SOA as well. And as we kind of announce a more holistic story that with the Fuse and Polymita integrations, which we'll talk about in a different venue in a couple of months, it really helps drive the bigger deals and therefore, the growth. But the absolute dollars are still application server. The primary go-to-market on that is the commoditization of the application server. It's Web 3.0 and Weblogic migrations to JBoss. That's still the big, big, big chunk of the business. So it's very much like UNIX to Linux.

Operator

Your final question comes from the line of Ross MacMillan with Jefferies.

Ross MacMillan - Jefferies & Company, Inc., Research Division

I just had a big-picture question. As you look forward, let's say, into next year, if you had to take a view on which would be a bigger contributor to billings, all your cloud assets or the Storage assets, do you have a strong view as to which would be a bigger contributor next year?

Charles E. Peters

Ross, it's a good question. But at this point, we're still working on Q3 and Q4. We'll be putting together our plans for next year really beginning in the December, January time frame. I'll have a better point of view on that at that point in time. It's premature at this point to speculate about what the result might be next year.

James M. Whitehurst

My only other comment, I think they're all related, right? I mean, the power of our Storage offering is that it's cloud ready. So hard to even split that out.

Thank you very much. Thank you, everyone, for joining us, and we look forward to following up with you later this fall. Thank you, operator.

Operator

Ladies and gentlemen, this does conclude today's conference call. You may now disconnect.

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