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Red Hat, Inc. (NYSE:RHT)

Q2 2009 Earnings Call

September 24, 2008 5:00 pm ET

Executives

Tom McCallum – VP IR

James Whitehurst – President & CEO

Charles Peters – Exec. VP & CFO

Analysts

Kash Rangan – Merrill Lynch

Brent Williams - The Benchmark Company

Michael Turits - Raymond James

Trip Chowdhry – Global Equities Research

Analyst - Pacific Crest Securities

Steve Ashley - Robert W. Baird

Heather Bellini – UBS Investment Research

Todd Raker – Deutsche Bank

Katherine Egbert - Jefferies and Company

Mark Murphy – Piper Jaffray

Brent Thill – Citigroup

Tim Klasell - Thomas Weisel Partners

Sarah Friar – Goldman Sachs

Tom Curlin – RBC Capital

Larry Patrone – WR Hambrecht & Co.

Operator

At this time I would like to welcome everyone to the Red Hat second quarter earnings conference call. (Operator Instructions) I would now like to turn the call over to Mr. McCallum, Vice President of Investor Relations; you may begin your conference.

Tom McCallum

Hello and welcome to Red Hat's fiscal second quarter 2009 earnings call. The speakers for today’s call will be James Whitehurst, President and CEO; and Charles Peters, Executive Vice President and CFO.

Our earnings press release was issued after the market closed today and may be downloaded from www.redhat.com on the Investor Relations page.

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.

In addition, any forward-looking statements represent our views as of today, September 24, 2008 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 as of any date subsequent to today.

With that, I’d like to turn the call over to James.

James Whitehurst

Thank you Tom and let me add my welcome to all of you joining us on today’s call. I’m pleased to announce another strong execution quarter that has delivered solid growth and financial results.

Our revenue grew 29% year-over-year and was above our guidance even in the headwinds from a sharply appreciating dollar while our deferred revenue grew approximately to $0.50 billion up 32% year-over-year.

In a moment Charles will provide you additional financial details and highlights, but let me summarize some of the key takeaways on the results for the quarter.

We continued to see strong renewals and up sell from our existing customer base across a diversified set of segments, product solutions and geographies. Our message around value specifically in terms of cost savings is resonating well with the current as well as new customers in this challenging macroeconomic environment.

Our core platform of products has been consistently growing while our middleware business continues to grow at over twice the rate of the platform business. The middleware growth this past quarter was driven by several factors: the number of companies selecting JBoss as their strategic application platform of record for the Enterprise; leveraging our RHEL success with customers for cross selling opportunities; and the increasing number of embedded JBoss opportunities with ISVs and the growing momentum of our recently released SOA platform.

Also in Q2 we announced several new virtualization products and initiatives addressing the rapidly growing virtualization markets. Now let me spend a few minutes specifically discussing our virtualization strategy and acquisition of Qumranet that we announced earlier this month.

This acquisition continues to broaden our leadership in open source virtualization that began with our introduction of our award winning REHL 5 platform last year that provided rich virtualization features such as live migration, clustering and support for Linux and Microsoft Windows Guest.

Since the launch of RHEL 5 we have continued to evolve our solution set with our announcements at Red Hat Summit in June. These included an imbedded hypervisor, small fast and with full hardware support for any Guest operating system.

Second, virtual infrastructure management based on the open managed standard we introduced to the market and which has been widely adopted by companies such as HP, IBM and Sun, called [inaudible] allowing inter operability between management applications and hypervisors.

And third, a security infrastructure for virtualized systems based on Red Hat’s identity, policy and audit technologies.

With the acquisition of Qumranet we have now assembled a comprehensive virtualization portfolio for Red Hat customers that will enable them to experience the next wave of real value from integrated virtualization.

We believe we are now one of only two major vendors capable of linking the critical components of infrastructure including the operating system to deliver new levels of virtualization and reliability to the market that can run Windows and Linux servers and desktops.

Specifically Qumranet allows us to accelerate time to market and deliver an expanded virtualization solutions portfolio to the rapidly growing virtualization market. That the market is projected by industry annalistic growth to over $5 billion by 2012 representing a 25% CAGR.

Second we have stronger stewardship and influence into the development of a key open source virtualization technology called KVM. This transaction permits us to employ additional personnel at the cutting edge of open source development around KVM, the only hypervisor imbedded in the Linux kernel and leading the next generation of virtualization technologies.

And the infusion of Qumranet’s technology and talented associates will advance our imbedded hypervisor based on KVM and our virtual infrastructure management tooling which we announced as part of the [overt] project.

Finally Red Hat enters the nascent virtualization desktop infrastructure or VDI market which is estimated to grow to more than $2 billion by 2011 by industry analysts.

This is an early stage market where the customer [pain] points are clear. No player has a dominant share. Numerous Greenfield opportunities exist, and the additional use cases are only beginning to be bedded.

CCO studies on VDI have shown savings of greater than 50% while offering the promise of improved security and reduced down time.

Strategically this acquisition furthers our goal to make virtualization ubiquitous and to enable customers to deploy any application, any where, any time. The early feedback from our sales team, partners and customers has been overwhelmingly positive.

We have held meetings with some of our largest customers who highly support the acquisition and are already considering proof of concept opportunities.

As a final note on the acquisition I want to acknowledge that we have been successfully collaborating with Qumranet since 2006. As members of Red Hat they bring exciting next generation technology, virtualization expertise, and a passion for market leadership.

These are all attributes that are highly valued at Red Hat so let me proudly and publically welcome all of our newly joined team members from Qumranet.

In summary Q2 was a productive quarter for both delivering results and accelerating our open source leadership in the datacenter.

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

Charles Peters

Thanks James, the combination of good market demand and focused execution has contributed to a number of consecutive quarters in which we have outperformed or met the high end of our revenue guidance.

A key factor to our growth is the value message that continues to resonate with customers as we introduce the cost savings aspect of our open source solutions coupled with our industry leading customer service.

First I’m pleased to report that all of the top 25 deals who were scheduled to renew this quarter did in fact renew at approximately 120% of the prior year’s value.

This increase is consistent with the last few quarters and indicates how delivering value to customers can translate into additional selling opportunities. We also had another strong quarter in terms of large deals. Two of our top 30 deals this quarter were over $5 million and 17 were over $1 million.

We did business with a diverse mix of customers from a number of industry segments including telecom, finance, government, healthcare, as well as new demand from business segments that had been hit by the soft economy such as retail, airlines and construction.

Along with the diversity of industry segments and customers, we also saw a good mix of our product offerings within these top deals. And finally nearly half of these top deals came from new customer relationships.

As James mentioned earlier, all of our product lines continued to perform well. We also saw a further cross selling traction among our solutions as customers increasingly look to Red Hat as a strategic partner to provide a complete open source solution to their datacenter needs.

In Q2 one of our platform business customers, a major telecommunications provider, significantly increased their purchase of embedded RHEL in their communications equipment and also committed to embed JBoss based in part on the value we’ve been providing them with RHEL.

This cross selling activity more than tripled this multi year opportunity. Another of the top wins this quarter was a major Japanese financial services firm. The customer in this deal purchased a complete set of our solutions, primarily RHEL coupled with JBoss, management and services in a multi year, multi million dollar deal.

Included in the top deals this quarter was another large multi national telecom provider who migrated from proprietary software to JBoss and capitalized on application performance and cost savings. In another case, Daiwa Securities, one of Japan’s largest securities brokerages migrated to the proprietary solutions, JBoss, which enabled them to save over $300,000 in licensing and hardware costs while improving application performance.

In fact, there was a major middleware component in over 25% of the top deals this quarter. Now let me take you through the financial details of the quarter.

Q2 was another strong quarter for Red Hat. Second quarter revenue was $164.4 million, an increase of 5% from last quarter and 29% from the year ago quarter and above our guidance.

Subscription revenue was $136 million or 83% of total revenue and it was up 24% year-over-year. The training and services component of revenue was $29 million, up 58% from last year largely due to the Amentra acquisition but also from solid demand for training and consulting services.

Moving on to bookings, the channel generated 52% of our Q2 bookings and 48% came from direct sales versus a 51%-49% split in first quarter. Our goal remains to increase the amount of revenue through the channel to 60% of total bookings.

From a geographical split, 58% was from the Americas, 25% from EMEA and 17% from APAC. This geographic breakdown is roughly similar to last quarter. Using our billings proxy of adding revenue to the change in deferred revenue shown on the cash flow statement, which excludes the impact of foreign exchange rates on deferred revenue, billings for the quarter were $180 million.

This was up 29% or nearly $41 million from the prior year quarter. On a sequential basis, the change in deferred revenue from the cash flow statement was $15 million which is an improvement over the same period from the prior two years.

As I’ve noted on previous calls, billings are not a proxy for bookings and can vary quarter to quarter. Investors may want to consider evaluating billings on a rolling four quarter average which for Q2 was $177 million. It was also up 29% year-over-year and consistent with the last several quarters.

Now I’ll shift back to the income statement, on a non-GAAP basis overall gross margin excluding stock-based compensation was in line with Q1 at 83.7% and slightly lower then last year due to the higher services mix.

As regards our subscription gross margins, our pricing and discounting policy remains consistent as evidenced by our steady subscription margins of about 93% which for the past eight quarters has remained at this approximate level.

Our Q2 services margin was 39%, up from the prior quarter of 34% and the year ago quarter of 38% due in part to the higher margins of the Amentra business and then the improved utilization of our consultants and our training resources.

Q2 non-GAAP operating expenses were up approximately $5 million to $105 million. The increase in sales and marketing costs was primarily related to higher staffing levels and expenses related to process and system improvements. The increase in R&D is primarily related to employee related costs and facilities expansion to accommodate our growth.

This led to a Q2 non-GAAP operating income of $32 million producing a 19.6% margin which was up nearly $2 million or more than 6% over the previous quarter.

Continuing on down the P&L, other income net was about $13 million in Q2, up approximately $5 million from the previous quarter. The change was primarily attributable to the realized gain of approximately $5 million pre-tax on the sale of an investment.

Our non-GAAP tax rate which reflects actual cash taxes as we expect to pay is still approximately 5% producing a non-GAAP net income of $43.2 million, up $6.3 million or 17% sequentially.

Our non-GAAP diluted earnings per share came to $0.20, up 11% sequentially and 18% year-over-year. Excluding the gain on the investment I mentioned earlier non-GAAP diluted EPS for the quarter would have been $0.18 per share.

Now let’s review the balance sheet and the cash flow statement. We ended the quarter with cash and investments of over $1.4 billion. Cash collections remain strong with DSOs of 60 days, which was consistent with Q1 and the prior year. As a reminder, since day sales outstanding is traditionally a measure of receivables versus billings our DSO calculation includes revenue plus the change in deferred revenue.

Total deferred revenue at quarter end was $497 million, an increase of 32% year-over-year. Breaking out the deferred short-term deferred revenue was $347 million and long-term deferred revenue was $150 million.

Short-term deferred revenue was negatively impacted by almost $10 million relating to the dollar-Euro foreign exchange spot rate at August 31 versus the spot rate at the prior quarter end. Excluding the foreign exchange impact, total deferred revenue increased by $15 million which as I said before the number you can see on the cash flow statement.

Moving on to the statement of cash flows, our GAAP cash flow from operations was $54.3 million, up $5.1 million or 10% from the prior year quarter. We continue to generate additional cash. This quarter it was another $15 million from tax benefits related to NOLs shown in cash flow from financing activities under the heading, excess tax benefits from share based payment arrangements.

This quarter we used approximately $45 million of our NOLs relating to stock options and our remaining balance of these NOLs is now approximately $145 million. On the Q4 call last year, I discussed the likelihood of fully utilizing our remaining NOLs either during or shortly after our next fiscal year, that’s fiscal year 2010.

In addition to the existing NOLs there may be tens of millions of dollars worth of additional tax savings that could be recognized depending upon the timing of future stock option exercises of existing stock options and the stock price at the time the options are exercised.

This makes predicting the amount of additional NOLs and the precise timing of utilization difficult. However in order to drive consistency and comparability among analyst models for fiscal year 2010, I would encourage investors to assume a 39% tax rate for both GAAP and non-GAAP purposes next year.

This should have very little impact on operating cash flow since the benefit of the NOLs relating to these stock compensation deductions has been and will continue to be reported in cash flow from financing activities, not in cash flow from operations.

In fiscal year 2009 we have focused our cash flow statements on GAAP results and we will continue this practice in fiscal year 2010 and beyond. We will also continue to report on the NOL balance for those of you who add it back to your valuation calculations.

Now I’d like to turn to guidance for Q3, our guidance today incorporates the diluted impact of the strategic acquisition of Qumranet which we announced earlier this month. To repeat what we said on September 4, we expect no material revenue from Qumranet this year and we expect operating expenses of approximately $3.5 million to $4.5 million per quarter before non cash stock compensation expense, amortization expense, and other charges resulting from the acquisition.

The transaction is expected to be dilutive in the second half of this fiscal year, GAAP earning by $0.05 to $0.06 per diluted share, and to GAAP cash flow from operations by $0.03 to $0.04 per diluted share.

This guidance is based on the assumption of foreign exchange rates approximately where they have been this week. You should adjust your revenue models upward or downward based upon future foreign exchange changes knowing that approximately 45% of our revenue is denominated in foreign currencies.

Historically the corresponding foreign exchange impact on operating expenses has moved in parallel with the foreign exchange change in revenues.

Looking at Q3 we offer the following guidance: revenue is estimated to be between $169 million to $171 million; non-GAAP operating expenses are expected to increase by approximately $6 million; non-GAAP operating margin is expected to be approximately 17.5% or working backwards, approximately 20% if one excludes the impact of the acquisition of Qumranet; other income which is principally net interest income, is expected to be around $7 million; the non-GAAP tax rate will remain at 5%; and the non-GAAP EPS will be approximately $0.16 to $0.17 a share.

In summary we are cognizant of the current volatile economic, foreign exchange and interest rate environment and are proactively managing through it. Our customers appreciate and value a Red Hat subscription all the more as they continue to drive costs out of their IT budgets.

We continue to deliver solid results across our key financial metrics of revenue, operating income and cash flows and I remain optimistic about Red Hat’s outlook as our recurring revenue model provides visibility into a solid financial performance in the second half of the year.

Before turning the call over for your questions, I’d like to remind the financial community about our upcoming Analyst Day on October 7th in New York City. It will be a great opportunity here from the Red Hat executive team as we provide deeper understanding on the overall Red Hat strategy and open source solutions. I hope to see all of you there and please remember to register for the event if you haven’t already done so.

I would now like to turn it over for your questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from the line of Kash Rangan – Merrill Lynch

Kash Rangan – Merrill Lynch

It looks like you were able to put up a good quarter despite the macro environment, in the month of September, the financial markets have [gyrated] a lot more then people would have liked, I’m just curious to get your perspective from talking to the people on the ground, what are you hearing from some of the more sensitive segments within your target verticals as to how they are prioritizing investments in Red Hat, and then just looking at this KVM product and the Qumranet acquisition more particularly, I know the [inaudible] has been that throughout [inaudible] we should start to see a pick up in blended ASPs as people migrate to the higher versions, how is that playing out and how do you think KVM could change that as you look at what it could do for you financially ext year? How should we think about the revenue or the up sell option?

James Whitehurst

Let me start with what we’ve seen, obviously we’re early days of this quarter and so early days of this latest round of impact, our pipeline continues to remain strong so clearly we’re watching the markets as with everyone else. Just to reiterate, the financial vertical is 10% or so of our revenues and investment banking is a low single-digit percentage so relative to our overall business, we haven’t been overly focused on that particular sector.

We also because of our typically with the big investment banks, have multi year deals, we don’t typically have a whole bunch of that coming up in one year either.

Charles Peters

I think we’re well diversified in terms of our overall industry segment exposure as James said. The financial sector for us is around 10% in total and low single-digits for the investment banks. We are nicely diversified by geography, by time and with the subscriptions have been entered into and the length of the subscription. So I don’t see any material exposure relative to the financial sector.

You started with KVM but I think you were ended up more about the potential positive impact on the pricing coming from RHEL 5 as people upgrade because of the virtualization capability built into RHEL 5 and if I understood that as being the question, the answer is we continue to get more and more adoption of RHEL 5 and we continue to see in some our larger deals people moving up like a very large one did in Q1, more and more people move up from RHEL 4 to a RHEL 5 at the advanced platform level.

James Whitehurst

Also you mentioned KVM, to be clear [KVM] is the virtualization technology in RHEL 5 and we will not be changing that out. I think there’s a little bit of a sense of various hypervisors. We strongly believe that the hypervisor over the long-term is relatively irrelevant. In the same way people used to buy TCPIP and now its kind of built into the operating system, that will happen with the hypervisor as well.

So we continue to push overt as a management platform that hypervisor agnostic and we’ll continue to look at the appropriate timing around KVM in RHEL but just to emphasize, RHEL 5 is [inaudible].

Kash Rangan – Merrill Lynch

Should I interpret that as—so if a customer really wants to do the RHEL deal because of the KVM capability, would having them be an impairment to that particular piece of business or would you have the flexibility to incorporate KVM’s virtualization technology into a RHEL deal?

James Whitehurst

Come to Analyst Day and we’ll have Paul walk you through that in a little more detail. We haven’t exactly disclosed the more detailed plans around KVM but we’ll certainly talk more about it then.

Operator

Your next question comes from the line of Brent Williams - The Benchmark Company

Brent Williams - The Benchmark Company

Circling back on Qumranet the solid [ice] product I assume is most of what they were getting their revenue from? How many customers did they have and what kind of timeframe is it going to be for open source? Is this going to be harder to open source then other stuff?

Charles Peters

As I said we don’t expect any material revenue from Qumranet this year but relative to open source we have a history of upon acquiring companies, looking for the appropriate timing and method to open source things which are proprietary at the time of acquisition and that will be developed over time and again, I think that would be a good question for Analyst Day in a couple of weeks in New York. You’ll have the appropriate technical people to ask that question to.

Brent Williams - The Benchmark Company

Are we getting relatively close to seeing JBoss at a reporting threshold?

Charles Peters

No, JBoss is not a reportable segment and I don’t expect that to be the case this year.

Operator

Your next question comes from the line of Michael Turits - Raymond James

Michael Turits - Raymond James

You gave the next quarter guidance, are you reiterating the full year guidance that you had as well?

Charles Peters

We are basically taking each quarter at a time, the reason is as I said, with the volatile interest rate, the volatile foreign exchange rates, in particular as demonstrated just in the last two weeks alone, its kind of hard to forecast that far out so we will update our Q4 forecast at the end of Q3.

Michael Turits - Raymond James

Could you give us what the FX effect this quarter was on revenues and expenses, I know you obviously give it on the deferred balance, and also for 2010 I assume when it comes time for that guidance I assume your guidance and the way you report non-GAAP will be on 39% for the full year so we should start modeling that way?

Charles Peters

On the first part of the question, on the foreign exchange impact, our revenues were impacted negatively by about $1 million this quarter from average foreign exchange rate in Q2 versus the prior quarter at the time I forecast and the expenses were basically declined and moved in the same direction. This time it was about a $400,000 decline in expenses which meant the net P&L impact on the quarter was about $600,000 negative.

Michael Turits - Raymond James

That’s sequentially right?

Charles Peters

Yes sequentially. And then the second part of your question, my advice to everyone just to restate it is for next year we will be reporting taxes at a 39% rate both on a GAAP and a non-GAAP basis.

Operator

Your next question comes from the line of Trip Chowdhry – Global Equities Research

Trip Chowdhry – Global Equities Research

I was wondering do you have any plans to change the business model for Fedora. The reason I’m asking that is like many of the flavors of Linux including [inaudible] OS, are pretty much playing in your backyard and I was just thinking if you start charging say $50 a year for Fedora, your revenue stream can be very good and I think we really need to take a hard look on how to monetize Fedora. Any thoughts on that?

James Whitehurst

Fedora is our key open source kind of development platform with the community. We have no plans to change that. It is a core component of what we do as a business. It is our community addition from which we developed a true enterprise class piece of software with RHEL. So it is core to what we do and its not something that we look at directly monetizing nor is that something that we are considering.

Operator

Your next question comes from the line of Analyst - Pacific Crest Securities

Analyst - Pacific Crest Securities

I think you mentioned there was 25% of the larger deals had some middleware, was that primarily JBoss or are there other applications that are driving that? And could you give us any color about the JBoss uptake in the quarter and what you’re seeing competitively?

Charles Peters

The 25% of the top deals had a middleware component. I would say that was principally JBoss and you heard James say it continues to grow at twice the rate of the base business. What we’re seeing is more strategic engagement now and discussion at higher levels in our customers. If you, even a year ago, I think we were probably still maybe a step above the developer level. We’re at the CIO level and one step below the CI level in the selling process now.

A number of big accounts are looking at this on a much broader basis then what we had before.

James Whitehurst

I think now that we have a true enterprise addition that is out with full service level agreements and support and people understand the stability, many more customers are looking at it not just for development but in production and so as large enterprise license agreements come up for renewal from on say [WebLogic] there’s a very compelling value proposition to look at transitioning to JBoss and so in some ways a difficult economic environment is kind of good news out there and so a lot of interest from some pretty large companies in moving over.

Analyst - Pacific Crest Securities

Are those largely displacement deals then or is it Greenfield when you get a JBoss opportunity?

Charles Peters

I think we’re seeing some of both actually. Some of the larger deals are displacement.

Operator

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

Steve Ashley - Robert W. Baird

On the guidance for the next quarter with 17.5% operating margins and $0.16 and $0.17, is that net of the amortization from the acquisition?

Charles Peters

That is our best estimate at this time of the amortization. As you know it typically takes some time to go through the acquisition accounting but that’s net of our best estimate of that as well.

Steve Ashley - Robert W. Baird

And the point there is that amortization is included in that estimate, or an estimate of that?

Charles Peters

Yes.

Steve Ashley - Robert W. Baird

You had two large deals, $5 million-ish; can you just qualitatively say were those billed or unbilled in the quarter? Is there any color you can give us on that?

Charles Peters

Those, the two that were over $5 million were each billed one year at a time.

Steve Ashley - Robert W. Baird

You had talked earlier in the year about cash flow from operations for the full year, $240 to $250 million, just wondering how we should think of that, is that something that is still on the table but you simply are not commenting on or is that number, that guidance now just off the table and no longer valid?

Charles Peters

Just to be clear, the last time I talked about that would have been in late March when we were setting guidance for the full year and since that time in Q1 we talked about the interest rate environment, so if you go back to the transcript for Q1, you’ll see some comments about interest income declining. Interest income is an item that’s included in operating cash flow. Other gains on investments are not so I took the guidance down somewhat in Q1 because of that.

And then secondly on September 4th when we announced Qumranet I made some additional comments about impact on operating cash flow. So I think if you put those pieces together you’ll get some sense.

Operator

Your next question comes from the line of Heather Bellini – UBS Investment Research

Heather Bellini – UBS Investment Research

Did you give the year-over-year FX benefit to revenue in the quarter?

Charles Peters

I did not give that number and frankly I don’t have that in front of me but I’ll be happy to follow-up and provide that.

Heather Bellini – UBS Investment Research

Is there any sense that you could give us in terms of how your operating margins have benefited from the FX tailwind that you’ve received over the last four quarters as well?

Charles Peters

Historically as rates have gone up and down our operating margin hasn’t changed a great deal and that is because we have some operations outside of this country which are just engineering offices, so there’s no sales, not a lot of profitability, its and expense center. And so historically let’s say if currency rates move revenue up by $1 million, normally it would move our expenses up by $8 or $900,000 and so very little change on the bottom line.

Heather Bellini – UBS Investment Research

Right but if you’re getting a five point benefit on a year-over-year basis as I think you’ve had in some quarters then it does become potentially material, is that accurate?

Charles Peters

I think unlikely. As I said, this quarter was a little unique in that revenue on a sequential basis actually was down about $1 million from what I had originally predicted and the expenses only went down by around $400,000 which meant there was a net P&L negative this quarter of about $600,000. The reason is the Euro moved pretty sharply and the Asian currencies really didn’t move that much and so there was a little bit of imbalance. Frankly what’s happening with the currency market at the moment as well as with all of the other financial measures that you follow is rather extraordinary.

It is very difficult to predict what is going to be happening with currency rates let’s say even 30, 90 days from now.

Heather Bellini – UBS Investment Research

Is there anything to talk about in terms of your—I know financial services and insurance and exchanges if you add those together, I think its probably 10% to 15% if you include the insurance companies in terms of your revenue exposure, how do we think about renewals as these companies are probably going to significantly curtail their IT budget potentially even more so then they are this year? You’ve had one year where you’ve been able to get through it in terms of contract renewals. As you look to next year you’re going to have another round of contracts and these industry groups renew, how do you see this potentially impacting your renewal rates? Not in terms of the percentage of renewing, in terms of the dollar value.

Charles Peters

Just to clarify, James was accurate when he said that the total amount of our financial vertical for us is now about 10%. It has really changed a lot, not because that business has declined but because the other pieces of business have grown. Government and telecom now are our largest sectors and have grown very nicely.

That 10% includes banks, investment banks, insurance companies, exchanges and other types of financial institutions on a global basis. James also said that the investment banks are low single-digits percent of the total. I also offered some color in terms of the timing of renewals so I’d say good news is in the last 12 months we’ve renewed a substantial number of these institutions generally on three year deals and therefore won’t revisit those deals for another couple of years.

Operator

Your next question comes from the line of Todd Raker – Deutsche Bank

Todd Raker – Deutsche Bank

On the consulting and services side, if you were to back out Amentra, any sense for what the organic growth profile looks like? Are you seeing any sense that its decelerating as a result of some of the macro challenges?

Charles Peters

The best way to think about that is prior to the acquisition of Amentra, what you normally saw for our own services business was growth on an annual basis of somewhere between 5% and 10%. It was not something that we were pushing aggressively and really a fast growth business. But this quarter they have done fairly well and I’d say probably 5% to 10% again compared to the prior year. The rest is going to be Amentra.

Todd Raker – Deutsche Bank

From a broader perspective would you view the infrastructure of JBoss side of the business as more discretionary then the platform side if we really start to hit some challenges from a macro perspective?

James Whitehurst

No, I don’t think I do and the reason I say that is there are two compelling reasons to consider using JBoss. One is just a platform replacement to save dollars and I guess one could argue those are discretionary but those generally benefit when times are tough and you’re looking for a way to save.

The other would be the deployment of new functionality. Obviously that is discretionary. Is that more or less discretionary then the platform business? I don’t see any particular drivers that would say it would be more or less so. I think if you take the net, net of the two its probably pretty similar.

Operator

Your next question comes from the line of Katherine Egbert - Jefferies and Company

Katherine Egbert - Jefferies and Company

You said your operating margin was going to be 20% without Qumranet in there; I was under the impression earlier that you were going to see some good operating margin expansion in the back half of the year. Can you talk about that?

Charles Peters

I don’t have anything additional to add on that other then given the existing forecast including the foreign exchange environment; I think that’s a reasonable guidance for Q3.

Katherine Egbert - Jefferies and Company

Related to that, are you handicapping the November quarter of revenue and operating margin for currency?

Charles Peters

My assumption on currency is just that the rates will be similar to what we’re seeing this week. As you saw in the last three weeks there’s been an incredible change in currencies based upon the US bail out plans, first in thinking its going to happen and then the debate that maybe its not happening, currency rates are [whipsawing] around so all I can do is peg my forecast at a point in time. So I’m pegging it to the rates we’re seeing this week.

Operator

Your next question comes from the line of Mark Murphy – Piper Jaffray

Mark Murphy – Piper Jaffray

The business accelerated this quarter versus last quarter in terms of the billings, were you positively surprised by close rates on deals late in the quarter or some other element of the business and also would you have any comment on bookings growth in Q2 and was it materially different then the billings growth?

Charles Peters

First thing I’d say is we were I’d say very happy about the billings. It’s the first time in three years in which Q2 billings exceeded Q1 billings so as I’ve said before there is some seasonality to our business as recurring revenue model, like a sign curve, so if its down the prior year its typically going to be down and up and so forth, so first time in three years in which Q2 billings exceeded Q1 billings. That’s a good thing.

Relative to the bookings I would offer this, we did add to the off balance sheet backlog in the quarter. That’s the only additional information I would provide on bookings at this point.

Mark Murphy – Piper Jaffray

On the topic of Qumranet, your revenue guidance which I believe is up to $20 million is your bias possibly sort of near the mid point or around $10 million and could you just clarify whether I believe that includes other Red Hat management products that are being developed around the KVM, could you just clarify that?

Charles Peters

The second part of your assumption is right. That is our assumptions up to $20 million and this is in next fiscal year not this fiscal year. So fiscal year 2010 and would be around the virtualization products that we have introduced and that will involve KVM and Qumranet.

James Whitehurst

On your first question you asked about close rates and do we see the increase in billings due to stronger close rates, quite frankly no. As middleware becomes a larger percentage of our total business, middleware by its nature is a longer sale cycle then is an operating system and so longer sale cycles obviously adds more variability in what you expect to see on close rates. So I don’t think we’ve seen necessarily improvement there, I think its more of a reflection of the strong pipeline.

Operator

Your next question comes from the line of Brent Thill – Citigroup

Brent Thill – Citigroup

Just on the operating margin, you exclude the acquisition the margins are still down year-over-year and I guess one of the concerns is that the operating margins are going to be in a state of downward trend over the next couple of quarters as your investing in this larger platform and not giving exact details, can you just walk us through your view on the margin structure over the next couple of quarters without being too specific about some of these investments you’re making I would assume that these investments aren’t going to go away in one or two quarters?

Charles Peters

What I didn’t mention on this call which I’ve mentioned on both of the previous two or three calls, is investments we’re making in systems and I have previously said that we’re spending between $1.5 million and $2 million a quarter on systems and so to your point, in fact we are coming in the next couple of quarters to the end of the operating expense portion of that. It will move once that design work is done it will move to CapEx.

But to your point we did not have that expense in the year ago quarter and it is in fact depressing the operating margin by somewhere pretty close to 100 basis points.

Brent Thill – Citigroup

So related to the off balance sheet you mentioned you won’t add any more, but was there any detail in terms of the growth rate or the sequential growth, anything you can give us confidence in in terms of how you’re thinking about that off balance sheet portion?

Charles Peters

I don’t have anything else about the off balance sheet at this point. We do have an opportunity at Analyst Day in October to delve into some of these things in greater detail.

Operator

Your next question comes from the line of Tim Klasell - Thomas Weisel Partners

Tim Klasell - Thomas Weisel Partners

Did you share the average length of the new bookings this quarter?

Charles Peters

I didn’t but its about 24 months.

Tim Klasell - Thomas Weisel Partners

You haven’t really mentioned anything about Red Hat and network uptake, as you’re doing more with the advance platform and virtualization environments are you seeing Red Hat network getting pulled along into more of those larger deals?

Charles Peters

I don’t know that anything has changed there; Red Hat network is a very important part of the solution for all customers that have a reasonable number of subscriptions. If you have above 10 subscriptions its probably useful. If you have above 50 subscriptions, its almost mandatory to save an awful lot of time and effort to have something to help you manage that number of machines.

Operator

Your next question comes from the line of Sarah Friar – Goldman Sachs

Sarah Friar – Goldman Sachs

On competitive landscape, the rhetoric from Oracle really seems to have died down, are you finding Oracle easier to work with these days and then around JBoss, as folks deploy JBoss, are they doing it as a replacement for other middleware or in fresh situations and what do you tend to find you’re winning, is it more IBM or more DEA post the acquisition?

James Whitehurst

For starters on Oracle, as we’ve continued to say for the last couple of years, we just rarely see them out there in deals so I think the rhetoric side down, its hard to say that the activity side is down because we didn’t see a whole lot of activity before. We do feel pretty strongly that it’s a [fork] that doesn’t provide a whole lot of incremental value but breaks all the certifications so we feel really good about our relative position competing with them there.

So I’m glad to see the rhetoric dying down but commercially it hasn’t been a major impact even prior. In terms of DEA, JBoss continues to gain traction and as I said before it really is a mix of new deployments and people looking just to reduce licensing costs with replacements. I don’t have a breakdown of exactly what that mix is because it can get blurry at times too when people maybe have WebLogic and then decide to add more JBoss. So it’s a bit of a blurry mix in there but we’re certainly seeing a lot of acceleration and I do think part of that is due to the tough economy.

Operator

Your next question comes from the line of Tom Curlin – RBC Capital

Tom Curlin – RBC Capital

Can you give us just quickly the percent of bookings greater then one year during the quarter, just a different way of looking at the bookings in terms of contract length? And then can you comment on given the turmoil in September how does September compare in terms of flow of business to say June to help us handicap downside scenarios in the event that the issues out there continue?

Charles Peters

Percent of bookings in excess of 12 months which would relate back to the question about the average contract length is approximately 36%, the percent beyond 12 months.

We’re in the month of September; we really don’t have anything to say about September. We have said before in terms of linearity of our business that for us like most other software companies, our linearity goes somewhere between months of the quarter 20, 20, 60 or 25, 25, 50 in terms of the percent of business we do each month in a quarter. I don’t think we’re seeing anything different in September then what we have seen in previous first months of a quarter.

Operator

Your final question comes from the line of Larry Patrone – WR Hambrecht & Co.

Larry Patrone – WR Hambrecht & Co.

I think you mentioned in your prepared remarks that half of your top deals were coming from new customers, I wonder if you could provide some color on those deals? For example I’m wondering if those customers are coming off of license deals with other software vendors or were they primarily Fedora users, were they a mix shop in terms of using Microsoft or some other vendor and then also are you looking again at these same deals, did any of these customers sign up for JBoss and/or RHEL advanced?

Charles Peters

Of the deals that were new deals there was a good combination of industry verticals and types of accounts that included some new JBoss customers and some new customers on the RHEL. Because they’re the largest deals, I’m not aware of any this quarter that for example came off of let’s say that moved from Fedora or [sent] OS over. We have had in previous quarter’s million dollar deals of companies that were going from free to pay. I’m not aware of any this quarter. It was a pretty good mix of industry verticals and it was a mix of a couple of them being on the middleware side and the rest being on the operating system side.

James Whitehurst

To be frank we don’t quite track it that way. So if you’re trying to get a mix of how much is new, net new servers versus Windows to Linux versus Unix to Linux, I’m sure it’s a mix and frankly I don’t have a lot of color on the exact percentages.

Operator

There are no additional questions at this time; I would like to turn it back over to management for any additional or closing comments.

Tom McCallum

Thank you again for joining us today and we look forward to seeing many of your at our Analyst Day in October.

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Source: Red Hat, Inc. F2Q09 (Qtr End 08/31/08) Earnings Call Transcript
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