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RHT > SEC Filings for RHT > Form 10-Q on 5-Jul-2013All Recent SEC Filings

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Form 10-Q for RED HAT INC


5-Jul-2013

Quarterly Report


ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

OVERVIEW

We are a leading global provider of open source software solutions, using a community-powered approach to develop and offer reliable and high-performing operating system, middleware, virtualization, storage and cloud technologies.

Open source software is an alternative to proprietary software and represents a different model for the development and licensing of commercial software code than that typically used for proprietary software. Because open source software code is often freely shared, there are customarily no licensing fees for the use of open source software. Therefore, we do not recognize revenue from the licensing of the code itself. We provide value to our customers through the development, aggregation, integration, testing, certification, delivery, maintenance, enhancement and support of our Red Hat enterprise technologies, and by providing a level of performance, reliability, scalability, flexibility, stability and security for the enterprise technologies we package and distribute. Moreover, because communities of developers not employed by us assist with the creation of our open source offerings, opportunities for further innovation of our offerings are supplemented by these communities.

We primarily offer our enterprise technologies in the form of annual or multi-year subscriptions, and we recognize revenue over the period of the subscription agreements with our customers. We market our offerings primarily to enterprise customers.

We have focused on introducing and gaining acceptance for Red Hat enterprise technologies that comprise our open source architecture. Our operating system, Red Hat Enterprise Linux ("RHEL"), has gained widespread independent software vendor ("ISV") and independent hardware vendor ("IHV") support. We have continued to build our open source architecture by expanding our enterprise operating system and middleware offerings and introducing virtualization, storage, cloud and other offerings.

We derive our revenue and generate cash from customers primarily from two sources: (i) subscription revenue and (ii) training and services revenue. These arrangements typically involve subscriptions to Red Hat enterprise technologies. Our revenue is affected by, among other factors, corporate, government and consumer spending levels. In evaluating the performance of our business, we consider a number of factors, including total revenue, deferred revenue, operating income, operating margin and cash flows from operations.

The arrangements with our customers that produce this revenue and cash are explained in further detail in Part II, Item 7 under "Critical Accounting Policies and Estimates" and in NOTE 2-Summary of Significant Accounting Policies to the Consolidated Financial Statements of our Annual Report on Form 10-K for the fiscal year ended February 28, 2013.

In our fiscal year ended February 28, 2013, we focused and expect in our fiscal year ending February 28, 2014 to continue to focus on, among other things, generating (i) widespread adoption of Red Hat enterprise technologies by enterprise customers globally, (ii) increased revenue from our existing user base by renewing existing subscriptions, converting users of free versions of our enterprise technologies to paying subscribers, providing additional value to our customers and growing the number of open source enterprise technologies we offer, (iii) increased revenue by providing additional consulting and other targeted services and (iv) increased revenue from strategic acquisitions and channel partner relationships, including distributors, original equipment manufacturers ("OEMs"), IHVs, ISVs, cloud computing providers, value-added resellers ("VARs") and system integrators, and from our own international expansion, among other means.

Revenue. For the three months ended May 31, 2013, total revenue increased 15.4% or $48.5 million to $363.3 million from $314.7 million for the three months ended May 31, 2012. Subscription revenue increased


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15.9% or $43.2 million, driven primarily by additional subscriptions related to our principal RHEL technologies, which continue to gain broader market acceptance in mission-critical areas of computing, and our expansion of sales channels and our geographic footprint. The increase is, in part, a result of the continued migration of enterprises in industries such as financial services, government, technology and telecommunications to our open source solutions from proprietary technologies. Training and services revenue increased 12.5% or $5.3 million for the three months ended May 31, 2013 as compared to the three months ended May 31, 2012. The increase is driven primarily by customer interest in new products and technologies.

We believe the success of our business model is influenced by:

the extent to which we can expand the breadth and depth of our technology and service offerings;

our ability to enhance the value of subscriptions for Red Hat enterprise technologies through frequent and continuing innovations to these technologies while maintaining stable platforms over multi-year periods;

our ability to generate increasing revenue from channel partner and other strategic relationships, including distributors, OEMs, IHVs, ISVs, cloud computing providers, VARs and system integrators;

the acceptance and widespread deployment of open source technologies by enterprises and similar institutions, such as government agencies;

our ability to generate new and recurring subscription revenue for Red Hat enterprise technologies; and

our ability to provide customers with consulting and training services that generate additional revenue.

Deferred Revenue. Our deferred revenue, current and long-term, balance at May 31, 2013 was $1.06 billion. Because of our subscription model and revenue recognition policies, deferred revenue improves predictability of future revenue. For example, current deferred revenue provides a baseline for revenue to be recognized over the next twelve months. Similarly, long-term deferred revenue provides a baseline for revenue to be recognized beyond twelve months. Total deferred revenue at May 31, 2013 decreased $30.1 million or 2.8% as compared to the balance at February 28, 2013 of $1.09 billion.

The decrease in deferred revenue reported on our Consolidated Balance Sheets of $30.1 million differs from the $16.9 million decrease in deferred revenue we reported on our Consolidated Statements of Cash Flows for the three months ended May 31, 2013 due to changes in foreign currency exchange rates used to translate deferred revenue balances from our foreign subsidiaries' functional currency into U.S. dollars.

Subscription revenue. Our enterprise technologies are sold under subscription agreements. These agreements typically have a one- or three-year subscription period. A subscription generally entitles a customer to, among other things, a specified level of support, as well as new versions of the software, security updates, fixes, functionality enhancements and upgrades to the technology, if and when available, and compatibility with an ecosystem of certified hardware and software applications. Our customers have the ability to purchase higher levels of subscriptions that increase the level of support the customer is entitled to receive. Subscription revenue increased sequentially for the first quarter of fiscal 2014 and for each quarter of fiscal 2013 and 2012 and is being driven primarily by the increased market acceptance and use of open source software by the enterprise and our expansion of sales channels and geographic footprint during these periods.

Revenue by geography. For the three months ended May 31, 2013, approximately $158.3 million or 43.6% of our revenue was generated outside the United States compared to approximately $136.7 million or 43.4% for the three months ended May 31, 2012. Our international operations are expected to grow as our international sales force and channels become more mature and as we enter new locations or expand our presence in existing locations. As of May 31, 2013, we had offices in more than 80 locations throughout the world.


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We operate our business in three geographic regions: the Americas (U.S., Latin America and Canada); EMEA (Europe, Middle East and Africa); and Asia Pacific (principally Japan, Singapore, India, Australia, South Korea and China). Revenue generated by the Americas, EMEA and APAC for the three months ended May 31, 2013 totaled $233.4 million, $80.1 million and $49.8 million, respectively, which resulted in year-over-year revenue growth in the Americas, EMEA and APAC of 14.4%, 20.2% and 12.8% respectively. Excluding the impact of foreign currency exchange rates, Americas, EMEA and APAC revenue grew 14.8%, 20.9% and 24.1%, respectively for the three months ended May 31, 2013 as compared to the three months ended May 31, 2012. The Americas continued to be affected by the uncertainty in Federal government spending while EMEA continued to perform well against a challenging European backdrop. Japan, which is the largest revenue producing country in our APAC region, also performed well despite a weakened yen.

As we expand further within each region, we anticipate revenue growth rates in local currencies to be similar among our geographic regions due to the similarity of products and services offered and the similarity in customer types or classes.

Gross profit. Overall gross profit margin decreased to 84.6% for the three months ended May 31, 2013 from 85.4% for the three months ended May 31, 2012 as a result of both increased amortization expense related to prior fiscal year's complementary middleware and cloud-management technology acquisitions and increased headcount.

Gross profit margin by geography. Gross profit margins generated by our geographic segments for the three months ended May 31, 2013 were as follows:
Americas-84.6%, EMEA-89.2% and APAC-82.5%. For the three months ended May 31, 2012, gross profit margins generated by our geographic segments were as follows:
Americas-85.5%, EMEA-88.9% and APAC-84.2%. Regional year-over-year variations in gross profit margins are primarily due to slight product mix shifts between subscriptions and services.

As we continue to expand our sales and support services within our geographic segments, we expect gross profit margins to further converge over the long run due to the similarity of products and services offered, similarity in production and distribution methods and the similarity in customer types or classes. These geographic profit margins exclude the impact of share-based compensation expense, which was not allocated to our geographic segments.

Income from operations. Operating income was 15.6% and 16.2% of total revenue for the three months ended May 31, 2013 and May 31, 2012, respectively. The decrease in operating income as a percentage of revenue was due to investments made to expand our sales and marketing and research and development functions as well as costs incurred to update our data processing systems and acquire three businesses. These investments are described further in our analysis of results of operations below.

Income from operations by geography. Operating income as a percentage of revenue generated by our geographic segments for the three months ended May 31, 2013 was as follows: Americas-20.1%, EMEA-25.6% and APAC-24.6%. For the three months ended May 31, 2012, income from operations as a percentage of revenue generated by our geographic segments was as follows: Americas-21.3%, EMEA-27.3% and APAC-26.2%. Operating margin for all of our geographic operating segments decreased for the three months ended May 31, 2013 as compared to the three months ended May 31, 2012 primarily as a result of increased investments in research and development and sales and marketing to support new technologies such as cloud management.

These geographic operating margins exclude the impact of share-based compensation expense, which was not allocated to our geographic segments.

Cash, cash equivalents, investments in debt and equity securities and cash flow from operations. Cash, cash equivalents and short-term and long-term available-for-sale investments in securities balances at May 31, 2013 totaled $1.23 billion. Cash generated from operating activities for the three months ended May 31, 2013 totaled $141.8 million which represents an increase of 14.0% in operating cash flow as compared to the three months


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ended May 31, 2012. This increase is due to increases in subscription and services revenues, billings and collections during the same periods.

Our significant cash and investment balances give us a measure of flexibility to take advantage of opportunities such as acquisitions, increasing investment in international areas and repurchasing our common stock.

Foreign currency exchange rates' impact on results of operations. Approximately 43.6% of our revenue for the three months ended May 31, 2013 was produced by sales outside the United States. We are exposed to significant risks of foreign currency fluctuation primarily from receivables denominated in foreign currency and are subject to transaction gains and losses, which are recorded as a component in determining net income. The income statements of our non-U.S. operations are translated into U.S. dollars at the average exchange rates for each applicable month in a period. To the extent the U.S. dollar weakens against foreign currencies, the translation of these foreign-currency-denominated transactions results in increased revenue and operating expenses from operations for our non-U.S. operations. Similarly, our revenue and operating expenses will decrease for our non-U.S. operations if the U.S. dollar strengthens against foreign currencies.

Using the average foreign currency exchange rates from the first quarter of our prior fiscal year ended February 28, 2013, our revenue and operating expenses from non-U.S. operations for the three months ended May 31, 2013 would have been higher than we reported by approximately $6.2 million and $2.7 million, respectively, which would have resulted in income from operations being higher by $3.5 million.

Business combinations. During the year ended February 28, 2013, we acquired two businesses operating in the middleware space. These acquisitions include technologies that are complementary to our JBoss middleware technology. One acquisition, which included certain assets and related operations acquired from Polymita Technologies S.L., closed on August 28, 2012. The second acquisition closed on September 7, 2012 and included certain assets and related operations acquired from FuseSource, a division of Progress Software Corporation. As a result of these acquisitions, operating expenses increased by approximately $3.8 million for the three months ended May 31, 2013 as compared to the three months ended May 31, 2012.

Also, during the year ended February 28, 2013, we completed the acquisition of ManageIQ, Inc. ("ManageIQ"), a Delaware corporation, for approximately $104.5 million in cash. ManageIQ develops, distributes and provides support for enterprise cloud management and automation software. As a result of the acquisition of ManageIQ, operating expenses increased by approximately $3.0 million for the three months ended May 31, 2013 as compared to the three months ended May 31, 2012.

Facility Exit Costs. In December 2011, we entered into an agreement to sublease a building located in downtown Raleigh, North Carolina in which our headquarters are currently located. In connection with the transition to our new headquarters, we have endeavored to assign, sublease or otherwise dispose of our existing leases related to the two facilities that previously constituted our headquarters in Raleigh, North Carolina. In May 2012, we entered into a sublease agreement with an unrelated third-party to lease one of the two facilities that previously constituted our headquarters. As a result, we recognized a loss of $3.1 million for the three months ended May 31, 2012 which represented the excess of our remaining obligation on the space over the agreed sublease income. We continue to market the remaining facility for sublease in an effort to mitigate further facility exit costs. However, to the extent we are unable to sublease or otherwise dispose of such space and recover the full amount of our remaining obligation, we will be required to recognize a loss at the date we cease using this facility, currently estimated to be during our fiscal second quarter ending August 31, 2013. At that time, our net loss with respect to the remaining facility is expected to be approximately $5.0 million.


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                             RESULTS OF OPERATIONS

Three months ended May 31, 2013 and May 31, 2012

The following table is a summary of our results of operations for the three
months ended May 31, 2013 and May 31, 2012 (in thousands):



                                                Three Months  Ended
                                                    (Unaudited)
                                              May 31,         May 31,           $              %
                                               2013            2012           Change         Change
Revenue:
Subscriptions                                $ 315,817       $ 272,571       $ 43,246           15.9 %
Training and services                           47,442          42,160          5,282           12.5

Total subscription and training and
services revenue                               363,259         314,731         48,528           15.4

Cost of subscription and training and
services revenue:
Cost of subscriptions                           23,375          17,940          5,435           30.3
As a % of subscription revenue                     7.4 %           6.6 %
Cost of training and services                   32,682          28,079          4,603           16.4
As a % of training and services revenue           68.9 %          66.6 %

Total cost of subscription and training
and services revenue                            56,057          46,019         10,038           21.8
As a % of total revenue                           15.4 %          14.6 %

Total gross profit                             307,202         268,712         38,490           14.3

Operating expense:
Sales and marketing                            142,444         120,870         21,574           17.8
Research and development                        73,802          59,880         13,922           23.2
General and administrative                      34,333          33,912            421            1.2
Facility exit costs                                 -            3,142         (3,142 )       (100.0 )

Total operating expense                        250,579         217,804         32,775           15.0

Income from operations                          56,623          50,908          5,715           11.2
Interest income                                  1,502           2,294           (792 )        (34.5 )
Other income (expense), net                       (424 )         1,887         (2,311 )       (122.5 )

Income before provision for income taxes        57,701          55,089          2,612            4.7
Provision for income taxes                      17,310          17,628           (318 )         (1.8 )

Net income                                   $  40,391       $  37,461       $  2,930            7.8 %

Gross profit margin-subscriptions                 92.6 %          93.4 %
Gross profit margin-training and
services                                          31.1 %          33.4 %
Gross profit margin                               84.6 %          85.4 %
As a % of total revenue:
Subscription revenue                              86.9 %          86.6 %
Training and services revenue                     13.1 %          13.4 %
Sales and marketing expense                       39.2 %          38.4 %
Research and development expense                  20.3 %          19.0 %
General and administrative expense                 9.5 %          10.8 %
Facility exit costs                                 -  %           1.0 %
Total operating expenses                          69.0 %          69.2 %
Income from operations                            15.6 %          16.2 %
Income before provision for income taxes          15.9 %          17.5 %
Net income                                        11.1 %          11.9 %
Estimated annual effective income tax
rate                                              30.0 %          32.0 %


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Revenue

Subscription revenue

Subscription revenue, which is primarily comprised of direct and indirect sales of Red Hat enterprise technologies, increased by 15.9% or $43.2 million to $315.8 million for the three months ended May 31, 2013 from $272.6 million for the three months ended May 31, 2012. The increase in subscription revenue is primarily due to increases in volumes sold, including additional subscriptions attributable to geographic expansion, and continuing innovation, which attracts new customers and helps to drive renewals from existing customers.

Training and services revenue

Training revenue includes fees paid by our customers for delivery of educational materials and instruction. Services revenue includes fees received from customers for consulting services regarding our offerings, deployment of Red Hat enterprise technologies and for delivery of added functionality to Red Hat enterprise technologies for our major customers and OEM partners. Total training and services revenue increased by 12.5% or $5.3 million to $47.4 million for the three months ended May 31, 2013 from $42.2 million for the three months ended May 31, 2012. Training revenue increased 7.9% or $1.0 million, as some enterprises increased overall spending on discretionary items such as training despite the current economic environment. Our services revenue increased by 14.4% or $4.3 million as a result of an increase in consulting engagements driven by increased demand for our open source solutions. Combined training and services revenue decreased as a percentage of total revenue to 13.1% for the three months ended May 31, 2013 from 13.4% for the three months ended May 31, 2012.

Cost of revenue

Cost of subscription revenue

The cost of subscription revenue primarily consists of expenses we incur to support, distribute, manufacture, augment and package Red Hat enterprise technologies. These costs include labor related cost to provide technical support, security updates and fixes, as well as costs for fulfillment, physical media, literature, packaging and shipping. Cost of subscription revenue increased by 30.3% or $5.4 million to $23.4 million for the three months ended May 31, 2013 from $17.9 million for the three months ended May 31, 2012. The increase is partially the result of continued additions to our technical support staff to meet the demands of our growing subscriber base for support, security updates and fixes, and includes additional compensation of $2.9 million. The remaining increase is driven primarily by incremental amortization expense of $2.0 million related to technology acquisitions. Gross profit margin on subscriptions decreased to 92.6% for the three months ended May 31, 2013 from 93.4% for the three months ended May 31, 2012. As the number of open source technology subscriptions continues to increase, we expect associated support cost will continue to increase, although we anticipate this will occur at a rate slower than that of subscription revenue growth due to economies of scale.

Cost of training and services revenue

Cost of training and services revenue is mainly comprised of personnel and third-party consulting costs for the design, development and delivery of custom engineering, training courses and professional services provided to various types of customers. Cost of training and services revenue increased by 16.4% or $4.6 million to $32.7 million for the three months ended May 31, 2013 from $28.1 million for the three months ended May 31, 2012. The cost to deliver training increased 4.7% or $0.3 million to $7.1 million for the three months ended May 31, 2013 compared to $6.8 million for the three months ended May 31, 2012. The cost to deliver training as a percentage of training revenue decreased to 54.4% for the three months ended May 31, 2013 from 56.1% for the three months ended May 31, 2012 due to better utilization of both instructors and class room space as we transition from an on-site, employee-based, fixed-cost delivery model to a variable-cost delivery model with a global training partner that provides training services on our behalf. Costs to deliver our services revenue


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increased by 20.1% or $4.3 million and relate to additional employee compensation and travel associated with additions to our staff. Total costs to deliver training and services as a percentage of training and services revenue was 68.9% and 66.6% for each of the three month periods ended May 31, 2013 and May 31, 2012, respectively.

Gross profit

Gross profit margin decreased to 84.6% for the three months ended May 31, 2013 from 85.4% for the three months ended May 31, 2012 as a result of both increased amortization expense related to prior fiscal year's complementary middleware and cloud-management technology acquisitions and increased headcount.

Operating expenses

Sales and marketing

Sales and marketing expense consists primarily of salaries and other related costs for sales and marketing personnel, sales commissions, travel, public relations and marketing materials and trade shows. Sales and marketing expense increased by 17.8% or $21.6 million to $142.4 million for the three months ended May 31, 2013 from $120.9 million for the three months ended May 31, 2012. This increase was primarily due to a $16.1 million increase in selling costs, which includes $13.2 million of additional employee compensation expense attributable to the expansion of our sales force from the prior year and $0.4 million and $1.6 million related to professional services and travel, respectively. The remaining increase relates to marketing costs, which grew $5.5 million or 20.1% for the three months ended May 31, 2013 as compared to the three months ended May 31, 2012. The increase in marketing costs includes $3.3 million and $1.6 million related to increased headcount and advertising expense, respectively, to support our expanding marketing efforts. Sales and marketing expense increased as a percentage of revenue to 39.2% for the three months ended May 31, 2013 from 38.4% for the three months ended May 31, 2012 as we continue to invest in our sales and marketing function to expand the breadth of our global sales coverage and depth of our product sales coverage.

Research and development

Research and development expense consists primarily of personnel and related costs for development of software technologies and systems management offerings. Research and development expense increased by 23.2% or $13.9 million to $73.8 million for the three months ended May 31, 2013 from $59.9 million for the three months ended May 31, 2012. The increase in research and development costs primarily resulted from the expansion of our engineering group as a result of both direct hires and business combinations as we continue investing in cloud management and our other emerging technologies such as Red Hat Open Stack infrastructure-as-a-service ("IaaS") and OpenShift platform-as-a-service . . .

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