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RHT > SEC Filings for RHT > Form 10-K on 24-Apr-2014All Recent SEC Filings

Show all filings for RED HAT INC

Form 10-K for RED HAT INC


24-Apr-2014

Annual Report


ITEM 7. 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, virtualization, middleware, 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 provide our enterprise offerings 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. Red Hat Enterprise Linux and Red Hat JBoss Middleware offerings have gained widespread ISV and 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 Estimates" and in NOTE 2-Summary of Significant Accounting Policies to our Consolidated Financial Statements.

In our fiscal year ended February 28, 2014, we focused on and expect in our fiscal year ending February 28, 2015 to continue to focus on, among other things, (i) promoting the widespread adoption of Red Hat enterprise offerings by enterprise customers globally, (ii) expanding our virtualization, storage, cloud and other enterprise offerings, (iii) investing in the development of open source technologies, (iv) increasing revenue from our existing customer base,
(v) increasing revenue by promoting a range of services to help our customers derive additional value, (vi) expanding routes to market, (vii) growing our presence in international markets, and (viii) pursuing strategic acquisitions and alliances.

Revenue

For the year ended February 28, 2014, total revenue increased 15.5%, or $205.8 million, to $1.53 billion from $1.33 billion for the year ended February 28, 2013. Subscription revenue increased 16.4%, or $188.4


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million, driven primarily by additional subscriptions related to our principal Red Hat Enterprise Linux and Red Hat JBoss Middleware offerings, 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 9.6%, or $17.4 million, for the year ended February 28, 2014 as compared to the year ended February 28, 2013. The increase is driven primarily by customer interest in new products and increased demand for our open source solutions.

We believe our success is influenced by:

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

our ability to enhance the value of Red Hat enterprise offerings through frequent and continuing innovation while maintaining stable platforms over multi-year periods;

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

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

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

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

Deferred revenue, billings proxy, seasonality and backlog

Deferred revenue

Our deferred revenue, current and long-term, balance at February 28, 2014 was $1.29 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 February 28, 2014 increased 18.3%, or $199.2 million, as compared to the balance at February 28, 2013 of $1.09 billion.

The change in deferred revenue reported on our Consolidated Balance Sheets of $199.2 million differs from the $205.4 million change in deferred revenue we reported on our Consolidated Statements of Cash Flows for the year ended February 28, 2014 due to changes in foreign currency exchange rates used to translate deferred revenue balances from our foreign subsidiaries' functional currency into U.S. dollars.

Billings proxy

We approximate our annual billings by adding revenue recognized on our Consolidated Statements of Operations to the change in total deferred revenue reported on our Consolidated Statements of Cash Flows. We use the change in deferred revenue as reported on our Consolidated Statements of Cash Flows because the amount has been adjusted for the impact of changes in foreign currency exchange rates used to translate deferred revenue balances from our foreign subsidiaries' functional currencies into U.S. dollars.

Our billings proxy increased by 16.7%, or $248.6 million, to $1.74 billion for the year ended February 28, 2014 from $1.49 billion for the year ended February 28, 2013.

Seasonality

Our fourth fiscal quarter has historically been our strongest quarter for new billings and renewals. This pattern has become more pronounced over time as the number of customers with renewal dates occurring in the last half of our fiscal year has continued to increase. Furthermore, our quarterly sales cycles are frequently


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weighted toward the end of the quarter, with an increased volume of sales completed in the last few weeks of each quarter. The year-over-year compounding effect of this seasonality in billing patterns and overall new business and renewal activity causes the value of invoices making up our billings that we generate in the last half of our fiscal year to continually increase in proportion to the value of our invoices making up our billings in the first half of our fiscal year. Below is a summary of our billings (approximated as described above by adding revenue for the period with the change in deferred revenue as reported on our Consolidated Statements of Cash Flows for the same period) by quarter for fiscal 2014, fiscal 2013, fiscal 2012, fiscal 2011 and fiscal 2010 (in thousands):

                                      First quarter                   Second quarter                    Third quarter                   Fourth quarter
                               Billings       % of fiscal       Billings       % of fiscal       Billings       % of fiscal       Billings       % of fiscal
                                 proxy        year total          proxy        year total          proxy        year total          proxy        year total
Year ended February 28, 2014   $ 346,359              19.9 %    $ 376,303              21.6 %    $ 452,555              26.0 %    $ 564,755              32.5 %
Year ended February 28, 2013   $ 309,609              20.8 %    $ 349,025              23.4 %    $ 378,813              25.4 %    $ 453,944              30.4 %
Year ended February 29, 2012   $ 266,016              20.3 %    $ 304,171              23.2 %    $ 322,072              24.6 %    $ 417,699              31.9 %
Year ended February 28, 2011   $ 208,086              20.4 %    $ 233,200              22.8 %    $ 262,379              25.7 %    $ 318,336              31.1 %
Year ended February 28, 2010   $ 176,749              21.3 %    $ 193,788              23.3 %    $ 217,792              26.2 %    $ 242,532              29.2 %

We also have historically experienced a seasonal decline in our services revenue during our fiscal fourth quarter as compared to our fiscal third quarter.

Backlog

Our backlog as of February 28, 2014 totaled approximately $1.56 billion and includes amounts billed to customers and recognized as current and long-term deferred revenue on our Consolidated Balance Sheet of $966.8 million and $322.4 million, respectively, plus the value of non-cancellable subscription and services agreements to be billed in the future and not reflected in our financial results, which was in excess of $270.0 million. Our total backlog as of February 28, 2013 was approximately $1.37 billion and included off-balance sheet backlog in excess of $280.0 million. The increase in backlog from approximately $1.37 billion as of February 28, 2013 to $1.56 billion as of February 28, 2014 demonstrates increased customer commitment to our open source technologies.

We report our off-balance sheet backlog as a conservative approximation, often describing the amount as "in excess of", primarily because the value of underlying contracts is derived from data not yet subjected to the complete application of our revenue recognition policies. We endeavor to derive the value of our off-balance sheet backlog in a consistent manner year over year and therefore believe the amounts are comparable.

Subscription revenue

Our enterprise technologies are sold primarily 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. Subscription revenue increased sequentially for each quarter of fiscal 2014, fiscal 2013 and fiscal 2012 and is being driven primarily by the increased use of our offerings by the enterprise and our expansion of sales channels and geographic footprint during these periods.

Revenue by geography

In the year ended February 28, 2014, approximately 44.7%, or $686.6 million, of our revenue was generated outside the U.S. compared to approximately 43.3%, or $574.9 million, for the year ended February 28, 2013. Our international operations are expected to continue to grow as our international sales force and channels become more mature and as we enter new locations outside the U.S. or expand our presence in existing international locations. As of February 28, 2014, 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 Australia, China, India, Japan, Singapore and South Korea). Revenue generated by the Americas, EMEA and Asia Pacific for fiscal 2014, fiscal 2013 and fiscal 2012 was as follows (in thousands):

                                 Americas        EMEA         Asia Pacific         Total
  Year ended February 28, 2014   $ 974,655     $ 352,935     $      207,025     $ 1,534,615
  Year ended February 28, 2013   $ 855,214     $ 284,922     $      188,681     $ 1,328,817
  Year ended February 29, 2012   $ 716,033     $ 257,603     $      159,467     $ 1,133,103

Year-over-year revenue growth rates in U.S. dollars for our three geographical regions were as follows for fiscal 2014, fiscal 2013 and fiscal 2012:

                                    Americas        EMEA        Asia Pacific       Total
    Year ended February 28, 2014         14.0 %      23.9 %               9.7 %      15.5 %
    Year ended February 28, 2013         19.4 %      10.6 %              18.3 %      17.3 %
    Year ended February 29, 2012         22.7 %      29.0 %              26.7 %      24.6 %

Excluding the impact of changes in foreign currency exchange rates, revenue from the Americas, EMEA and Asia Pacific grew approximately 14.7%, 19.7% and 23.9%, respectively, for the year ended February 28, 2014. Excluding the impact of changes in foreign currency exchange rates, total revenue grew by 17.1% for the year ended February 28, 2014.

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

Gross profit margin

Gross profit margin decreased slightly to 84.8% for the year ended February 28, 2014 from 84.9% for the year ended February 28, 2013 as a result of increased amortization related to the prior fiscal year's complementary middleware and cloud-management technology acquisitions and increased staffing to support our emerging cloud offerings, such as OpenStack and OpenShift. These incremental amortization and staffing costs were partially offset by a slight product mix shift from services to subscriptions due to the higher gross profit margins for subscriptions.

Gross profit margin by geography

Gross profit margins by geographic region for fiscal 2014, fiscal 2013 and fiscal 2012 were as follows:

                                    Americas        EMEA        Asia Pacific       Total
    Year ended February 28, 2014         85.0 %      88.8 %              83.2 %      84.8 %
    Year ended February 28, 2013         84.9 %      88.9 %              83.9 %      84.9 %
    Year ended February 29, 2012         84.4 %      87.7 %              82.7 %      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 regions, we expect gross profit margins across geographic regions 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 regions.


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Income from operations

Operating income was 15.1% of total revenue for each of the years ended February 28, 2014 and February 28, 2013. Operating expenses as a percent of revenue decreased to 69.7% for the year ended February 28, 2014 from 69.8% for the year ended February 28, 2013 as savings realized from our general and administrative functions offset the increase in costs from investments made in our sales and marketing and research and development functions.

Income from operations by geography

Operating income as a percentage of revenue generated by our geographic regions for fiscal 2014, fiscal 2013 and fiscal 2012 was as follows:

                                 Americas        EMEA        Asia Pacific        Total (1)
 Year ended February 28, 2014         20.4 %      26.9 %              25.1 %           15.1 %
 Year ended February 28, 2013         21.2 %      25.4 %              24.5 %           15.1 %
 Year ended February 29, 2012         23.1 %      29.0 %              24.7 %           17.6 %

(1) Total operating income as a percentage of revenue includes corporate (non-allocated) share-based compensation expense for the years ended February 28, 2014, February 28, 2013 and February 29, 2012 of $113.8 million, $98.7 million and $79.3 million, respectively. For additional information, see NOTE 20-Segment Reporting to our Consolidated Financial Statements.

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 February 28, 2014 totaled $1.49 billion. Cash generated from operating activities for the year ended February 28, 2014 totaled $540.6 million, which represents an increase of 16.2% in operating cash flow as compared to the year ended February 28, 2013. This increase is due to an increase in subscription and services revenues, billings and collections during the same period.

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 44.7% of our revenue for the year ended February 28, 2014 came from sales outside the U.S. 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 our prior fiscal year ended February 28, 2013, our revenue and operating expenses from non-U.S. operations for the fiscal year ended February 28, 2014 would have been higher than we reported by approximately $21.4 million and $12.1 million, respectively, which would have resulted in income from operations being higher by $9.3 million.


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Business combinations

During the year ended February 28, 2013, we completed the acquisition of ManageIQ, Inc. ("ManageIQ") for approximately $104.5 million in cash. ManageIQ is a provider of enterprise cloud management and automation solutions that enable organizations to deploy, manage and optimize private clouds, public clouds and virtualized infrastructures. As a result of the acquisition of ManageIQ, operating expenses increased by approximately $3.0 million for the year ended February 28, 2013.

Also 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 Red Hat JBoss Middleware technology. One acquisition, which included certain assets and related operations acquired from Polymita Technologies S.L. ("Polymita"), 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 ("FuseSource"). Transaction fees related to these two acquisitions totaled approximately $1.0 million for the year ended February 28, 2013 and are included in general and administrative expense on our Consolidated Statement of Operations for the year ended February 28, 2013. As a result of these two acquisitions, operating expenses increased by approximately $8.0 million for the year ended February 28, 2013.

During the year ended February 29, 2012, we acquired Gluster, Inc. ("Gluster"). Gluster develops, distributes and provides support for open-source, scale-out storage software. The acquisition expands our enterprise software offerings to include management of unstructured data. Total consideration transferred as part of the acquisition was $137.2 million and includes cash consideration of $135.9 million and equity consideration related to assumed, nonvested employee share-based awards of $1.2 million. The total fair value, as of October 7, 2011, of all assumed nonvested awards was $14.5 million, of which $1.2 million has been attributed to pre-acquisition employee services and accordingly has been recognized as consideration transferred. The remaining $13.3 million of fair value will be recognized as compensation expense over the remaining vesting period.

For further discussion related to our acquisitions, see NOTE 3-Business Combinations to our Consolidated Financial Statements.

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 is currently located. In connection with the transition to our new headquarters, we have subleased or entered into agreements to assign 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 year ended February 28, 2013, which represented the excess of our remaining obligation on the space over the agreed sublease income.

We ceased using the remaining facility in June 2013 and, as a result, recognized a loss of $2.2 million which represented the remaining costs associated with our exit from the facility. In August 2013, we agreed to assign our lease related to the remaining facility to an unrelated third party effective September 2014.


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CRITICAL ACCOUNTING ESTIMATES

We prepare our consolidated financial statements in accordance with accounting principles generally accepted in the U.S. ("U.S. GAAP"). Our significant accounting policies are disclosed in NOTE 2-Summary of Significant Accounting Policies to our Consolidated Financial Statements and describe our methods for applying U.S. GAAP in areas such as revenue recognition, deferred selling costs, fair value measurements, and foreign currency translation among other areas deemed significant. In applying certain significant accounting policies, we have to make estimates and assumptions that affect our reported amounts of assets, liabilities, revenue, and expenses, as well as related disclosure of contingent assets and liabilities. In some cases, changes in the accounting estimates are reasonably likely to occur from period to period. Accordingly, actual results could differ materially from our estimates. To the extent that there are material differences between these estimates and actual results, our financial condition, results of operations or cash flows could be adversely affected. We base our estimates on past experience and other assumptions that we believe are reasonable under the circumstances, and we evaluate these estimates on an ongoing basis. We refer to accounting estimates of this type as critical accounting estimates, which we discuss further below. Critical accounting estimates are applied in the following areas:

Revenue recognition;

Goodwill and other long-lived assets;

Share-based compensation;

Income taxes; and

Loss contingencies.

Revenue recognition

Application of accounting principles related to the measurement and recognition of revenue requires judgment. For example, in transactions that include multiple elements, we must exercise judgment in determining whether adequate vendor-specific objective evidence ("VSOE") of fair value exists for each undelivered element. Changes to the elements in a transaction, the ability to identify VSOE for those elements, and changes in the fair value of the respective elements could materially impact the amount of earned and unearned revenue.

In addition, complex arrangements with nonstandard terms and conditions may require significant contract interpretation to determine appropriate accounting, including whether the deliverables specified in a multiple element transaction should be treated as separate units of accounting.

Goodwill and other long-lived assets

We make judgments about the recoverability of goodwill, identifiable intangible assets and other long-lived assets, including capitalized software purchased or developed for internal use. The assumptions and estimates used to determine recoverability of goodwill, identifiable intangible assets and other long-lived assets are complex and subjective. They can be affected by various factors, including external factors, such as industry and economic trends, and internal factors, such as changes in our business strategy and our internal, multi-year forecasts for our subscription and services offerings, which often include emerging technologies. Changes in any of these various factors could materially impact our financial condition and results of operations.

Share-based compensation

We are required to make estimates and assumptions with regards to the number of share-based awards that we expect will ultimately vest and the amount of tax benefits we expect will ultimately be realized, among other things.


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Share-based awards expected to vest

We currently apply an estimated annual forfeiture rate of 10% to the service-based share awards we grant to our employees. Our estimated forfeiture rate is based on recent historical experience as well as qualitative considerations about management's expectations for attrition rates over the vesting periods. Actual attrition rates could vary significantly from our expectations resulting in material quarterly adjustments to our financial results. During the year ended February 28, 2014 we granted service-based share . . .

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