10-Q
Table of Contents

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

FORM 10-Q

 

 

(Mark One)

x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended November 30, 2014

OR

 

¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from                 to                 .

Commission File Number: 001-33162

 

 

RED HAT, INC.

(Exact name of registrant as specified in its charter)

 

 

 

Delaware   06-1364380

(State or other jurisdiction of

incorporation or organization)

 

(I.R.S. Employer

Identification No.)

100 East Davie Street, Raleigh, North Carolina 27601

(Address of principal executive offices, including zip code)

(919) 754-3700

(Registrant’s telephone number, including area code)

 

 

Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  x    No  ¨

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes  x    No  ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

 

Large accelerated filer   x    Accelerated filer   ¨
Non-accelerated filer   ¨    Smaller reporting company   ¨

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes  ¨    No  x

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date:

As of January 2, 2015, there were 183,414,508 shares of common stock outstanding.


Table of Contents

RED HAT, INC.

 

         Page  

CAUTIONARY NOTE ON FORWARD-LOOKING STATEMENTS

     2   

PART I

  FINANCIAL INFORMATION:   

ITEM 1:

  FINANCIAL STATEMENTS   
 

Consolidated Balance Sheets at November 30, 2014 (unaudited) and February 28, 2014 (derived from audited financial statements)

     3   
 

Consolidated Statements of Operations for the three months and nine months ended November 30, 2014 (unaudited) and 2013 (unaudited)

     4   
 

Consolidated Statements of Comprehensive Income for the three months and nine months ended November 30, 2014 (unaudited) and 2013 (unaudited)

     5   
 

Consolidated Statements of Cash Flows for the three months and nine months ended November 30, 2014 (unaudited) and 2013 (unaudited)

     6   
  Notes to Consolidated Financial Statements (unaudited)      7   

ITEM 2:

 

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

     32   

ITEM 3:

  QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK      48   

ITEM 4:

  CONTROLS AND PROCEDURES      51   

PART II

  OTHER INFORMATION:   

ITEM 1:

  LEGAL PROCEEDINGS      52   

ITEM 1A:

  RISK FACTORS      52   

ITEM 2:

  UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS      73   

ITEM 6:

  EXHIBITS      74   

SIGNATURES

     75   

 

1


Table of Contents

CAUTIONARY NOTE ON FORWARD-LOOKING STATEMENTS

Certain statements contained in this report and the documents incorporated by reference in this report, including in Management’s Discussion and Analysis of Financial Condition and Results of Operations, constitute “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. Forward-looking statements provide current expectations of future events based on certain assumptions, and any statement that is not strictly a historical statement could be deemed to be a forward-looking statement (for example, statements regarding current or future financial performance, management’s plans and objectives for future operations, product plans and performance, management’s expectations regarding market risk and market penetration, management’s assessment of market factors or strategies, objectives and plans of Red Hat, Inc. together with its subsidiaries (“Red Hat”) and its partners). Words such as “anticipate,” “believe,” “estimate,” “expect,” “intend,” “plan,” “project,” “will,” and similar expressions, may also identify such forward-looking statements. Red Hat may also make forward-looking statements in other filings made with the Securities and Exchange Commission (“SEC”), press releases, materials delivered to stockholders and oral statements made by management. Investors are cautioned that these forward-looking statements are inherently uncertain, are not guarantees of Red Hat’s future performance and are subject to a number of risks and uncertainties that could cause Red Hat’s actual results to differ materially from those found in the forward-looking statements and from historical trends. These risks and uncertainties include the risks and cautionary statements detailed in Part II, Item 1A, “Risk Factors” and elsewhere in this report as well as in Red Hat’s other filings with the SEC, copies of which may be accessed through the SEC’s web site at http://www.sec.gov. Readers are urged to carefully review these risks and cautionary statements. Moreover, Red Hat operates in a rapidly changing and highly competitive environment. It is impossible to predict all risks and uncertainties or assess the impact of any new risk or uncertainty on our business or any forward-looking statement. The forward-looking statements included in this report represent our views as of the date of this report. We specifically disclaim any obligation to update these forward-looking statements in the future. These forward-looking statements should not be relied upon as representing our views as of any date subsequent to the date of this report.

 

2


Table of Contents

RED HAT, INC.

CONSOLIDATED BALANCE SHEETS

(In thousands—except share and per share amounts)

 

     November 30, 2014
(Unaudited)
    February 28,
2014 (1)
 
ASSETS     

Current assets:

    

Cash and cash equivalents

   $ 883,989      $ 646,742   

Investments in debt securities, short-term

     231,420        335,387   

Accounts receivable, net of allowances for doubtful accounts of $2,336 and $1,986, respectively

     354,870        360,594   

Deferred tax assets, net

     106,282        108,264   

Prepaid expenses

     126,827        118,387   

Other current assets

     1,629        1,808   
  

 

 

   

 

 

 

Total current assets

   $ 1,705,017      $ 1,571,182   

Property and equipment, net of accumulated depreciation and amortization of $223,157 and $209,295, respectively

     173,599        173,917   

Goodwill

     939,574        687,430   

Identifiable intangibles, net

     144,176        133,399   

Investments in debt securities, long-term

     531,112        505,300   

Other assets, net

     54,393        35,391   
  

 

 

   

 

 

 

Total assets

   $ 3,547,871      $ 3,106,619   
  

 

 

   

 

 

 
LIABILITIES AND STOCKHOLDERS’ EQUITY     

Current liabilities:

    

Accounts payable and accrued expenses

   $ 229,272      $ 179,468   

Deferred revenue

     941,441        966,832   

Other current obligations

     1,908        1,786   
  

 

 

   

 

 

 

Total current liabilities

   $ 1,172,621      $ 1,148,086   

Long-term deferred revenue

     358,684        322,365   

Convertible notes

     710,844        —     

Other long-term obligations

     71,915        85,003   

Commitments and contingencies (NOTES 12 and 13)

    

Stockholders’ equity:

    

Preferred stock, 5,000,000 shares authorized, none outstanding

     —          —     

Common stock, $0.0001 per share par value, 300,000,000 shares authorized, 232,883,474 and 230,915,589 shares issued, and 183,372,588 and 189,712,211 shares outstanding at November 30, 2014 and February 28, 2014, respectively

     23        23   

Additional paid-in capital

     1,928,179        1,891,848   

Retained earnings

     852,673        720,172   

Treasury stock at cost, 49,510,886 and 41,203,378 shares at November 30, 2014 and February 28, 2014, respectively

     (1,515,288     (1,056,419

Accumulated other comprehensive loss

     (31,780     (4,459
  

 

 

   

 

 

 

Total stockholders’ equity

   $ 1,233,807      $ 1,551,165   
  

 

 

   

 

 

 

Total liabilities and stockholders’ equity

   $ 3,547,871      $ 3,106,619   
  

 

 

   

 

 

 

 

(1) Derived from audited financial statements.

The accompanying notes are an integral part of these consolidated financial statements.

 

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RED HAT, INC.

CONSOLIDATED STATEMENTS OF OPERATIONS

(In thousands—except per share amounts)

(Unaudited)

 

     Three Months Ended     Nine Months Ended  
     November 30,
2014
     November 30,
2013
    November 30,
2014
     November 30,
2013
 

Revenue:

          

Subscriptions

   $ 394,699       $ 342,770      $ 1,156,161       $ 985,279   

Training and services

     61,196         53,766        169,387         148,939   
  

 

 

    

 

 

   

 

 

    

 

 

 

Total subscription and training and services revenue

     455,895         396,536        1,325,548         1,134,218   
  

 

 

    

 

 

   

 

 

    

 

 

 

Cost of subscription and training and services revenue:

          

Cost of subscriptions

     28,574         24,544        84,125         71,437   

Cost of training and services

     42,791         35,883        118,857         100,627   
  

 

 

    

 

 

   

 

 

    

 

 

 

Total cost of subscription and training and services revenue

     71,365         60,427        202,982         172,064   
  

 

 

    

 

 

   

 

 

    

 

 

 

Gross profit

     384,530         336,109        1,122,566         962,154   
  

 

 

    

 

 

   

 

 

    

 

 

 

Operating expense:

          

Sales and marketing

     187,218         153,528        538,576         440,568   

Research and development

     90,613         82,519        275,817         234,619   

General and administrative

     39,502         39,270        125,786         111,807   

Facility exit costs

     —           —          —           2,171   
  

 

 

    

 

 

   

 

 

    

 

 

 

Total operating expense

     317,333         275,317        940,179         789,165   
  

 

 

    

 

 

   

 

 

    

 

 

 

Income from operations

     67,197         60,792        182,387         172,989   

Interest income

     2,196         1,579        6,048         4,608   

Interest expense

     3,441         51        3,591         114   

Other income (expense), net

     1,559         (389     1,777         446   
  

 

 

    

 

 

   

 

 

    

 

 

 

Income before provision for income taxes

     67,511         61,931        186,621         177,929   

Provision for income taxes

     19,578         9,906        54,120         44,705   
  

 

 

    

 

 

   

 

 

    

 

 

 

Net income

   $ 47,933       $ 52,025      $ 132,501       $ 133,224   
  

 

 

    

 

 

   

 

 

    

 

 

 

Basic net income per common share

   $ 0.26       $ 0.27      $ 0.71       $ 0.70   
  

 

 

    

 

 

   

 

 

    

 

 

 

Diluted net income per common share

   $ 0.26       $ 0.27      $ 0.70       $ 0.69   
  

 

 

    

 

 

   

 

 

    

 

 

 

Weighted average shares outstanding

          

Basic

     185,039         189,514        187,533         190,024   

Diluted

     187,674         191,365        190,081         192,049   

The accompanying notes are an integral part of these consolidated financial statements.

 

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RED HAT, INC.

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

(In thousands)

(Unaudited)

 

     Three Months Ended     Nine Months Ended  
     November 30,
2014
    November 30,
2013
    November 30,
2014
    November 30,
2013
 

Net income

   $ 47,933      $ 52,025      $ 132,501      $ 133,224   

Other comprehensive income (loss):

        

Change in foreign currency translation adjustment

     (16,013     5,248        (27,765     3,199   

Available-for-sale securities:

        

Unrealized gain (loss) on available-for-sale securities during the period

     399        2,213        567        (503

Reclassification for (gain) loss realized on available-for-sale securities, reported in Other income (expense), net

     (1     (23     (151     (340

Tax benefit (expense)

     (140     (759     28        368   
  

 

 

   

 

 

   

 

 

   

 

 

 

Net change in available-for-sale securities (net of tax)

     258        1,431        444        (475
  

 

 

   

 

 

   

 

 

   

 

 

 

Total other comprehensive income (loss)

     (15,755     6,679        (27,321     2,724   
  

 

 

   

 

 

   

 

 

   

 

 

 

Comprehensive income

   $ 32,178      $ 58,704      $ 105,180      $ 135,948   
  

 

 

   

 

 

   

 

 

   

 

 

 

The accompanying notes are an integral part of these consolidated financial statements.

 

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RED HAT, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands)

(Unaudited)

 

    Three Months Ended     Nine Months Ended  
    November 30,
2014
    November 30,
2013
    November 30,
2014
    November 30,
2013
 

Cash flows from operating activities:

       

Net income

  $ 47,933      $ 52,025      $ 132,501      $ 133,224   

Adjustments to reconcile net income to net cash provided by operating activities:

       

Depreciation and amortization

    18,651        18,955        57,114        55,326   

Amortization of debt discount and transaction costs

    3,085        —          3,085        —     

Share-based compensation expense

    33,623        30,190        98,942        83,196   

Deferred income taxes

    (780     (1,412     3,125        9,608   

Net amortization of bond premium on debt securities available for sale

    2,407        2,301        6,965        6,637   

Other

    (175     438        (527     485   

Changes in operating assets and liabilities, net of effects of acquisitions:

       

Accounts receivable

    (75,917     (75,330     2,314        (9,249

Prepaid expenses

    (5,922     (1,109     (13,502     (3,503

Accounts payable and accrued expenses

    26,254        12,272        56,175        38,565   

Deferred revenue

    83,912        56,019        57,955        40,999   

Other

    (83     805        1,264        610   
 

 

 

   

 

 

   

 

 

   

 

 

 

Net cash provided by operating activities

    132,988        95,154        405,411        355,898   
 

 

 

   

 

 

   

 

 

   

 

 

 

Cash flows from investing activities:

       

Purchase of investment in debt securities available for sale

    (141,928     (101,636     (461,069     (448,712

Proceeds from sales and maturities of investment in debt securities available for sale

    93,578        118,084        503,110        597,851   

Acquisition of businesses, net of cash acquired

    (78,317     —          (296,121     —     

Purchase of other intangible assets

    (2,160     (682     (3,911     (13,203

Purchase of property and equipment

    (12,201     (13,327     (35,085     (61,833

Other

    482        (150     2,917        (2,084
 

 

 

   

 

 

   

 

 

   

 

 

 

Net cash provided by (used in) investing activities

    (140,546     2,289        (290,159     72,019   
 

 

 

   

 

 

   

 

 

   

 

 

 

Cash flows from financing activities:

       

Excess tax benefits from share-based payment arrangements

    3,488        3,428        4,897        9,071   

Proceeds from exercise of common stock options

    465        223        1,154        1,311   

Payments related to net settlement of share-based compensation awards

    (21,754     (18,307     (39,314     (33,122

Purchase of treasury stock

    (375,000     (40,018     (535,062     (239,363

Proceeds from issuance of convertible notes, net of issuance costs

    790,394        —          790,394        —     

Purchase of convertible note hedges

    (148,040     —          (148,040     —     

Proceeds from issuance of warrants

    79,776        —          79,776        —     

Payments on other borrowings

    (402     (362     (2,392     (979
 

 

 

   

 

 

   

 

 

   

 

 

 

Net cash provided by (used in) financing activities

    328,927        (55,036     151,413        (263,082
 

 

 

   

 

 

   

 

 

   

 

 

 

Effect of foreign currency exchange rates on cash and cash equivalents

    (22,761     2,910        (29,418     (9,808
 

 

 

   

 

 

   

 

 

   

 

 

 

Net increase in cash and cash equivalents

    298,608        45,317        237,247        155,027   

Cash and cash equivalents at beginning of the period

    585,381        596,794        646,742        487,084   
 

 

 

   

 

 

   

 

 

   

 

 

 

Cash and cash equivalents at end of the period

  $ 883,989      $ 642,111      $ 883,989      $ 642,111   
 

 

 

   

 

 

   

 

 

   

 

 

 

The accompanying notes are an integral part of these consolidated financial statements.

 

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Table of Contents

RED HAT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

NOTE 1—Company

Red Hat, Inc., incorporated in Delaware, together with its subsidiaries (“Red Hat” or the “Company”) is 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, the Company does not recognize revenue from the licensing of the code itself. The Company provides value to its customers through the development, aggregation, integration, testing, certification, delivery, maintenance, enhancement and support of its Red Hat enterprise technologies, and by providing a level of performance, reliability, scalability, flexibility, stability and security for the enterprise technologies the Company packages and distributes. Moreover, because communities of developers not employed by the Company assist with the creation of the Company’s open source offerings, opportunities for further innovation of the Company’s offerings are supplemented by these communities.

The Company derives its revenue and generates 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. The arrangements with the Company’s customers that produce this revenue and cash are explained in further detail in NOTE 2—Summary of Significant Accounting Policies to the Consolidated Financial Statements contained in the Company’s Annual Report on Form 10-K for the fiscal year ended February 28, 2014.

NOTE 2—Summary of Significant Accounting Policies

Basis of presentation

The unaudited interim consolidated financial statements as of and for the three months and nine months ended November 30, 2014 have been prepared by the Company pursuant to the rules and regulations of the Securities and Exchange Commission (the “SEC”) for interim financial reporting. These consolidated statements are unaudited and, in the opinion of management, include all adjustments (consisting of normal recurring adjustments and accruals) necessary for a fair statement of the consolidated balance sheets, consolidated operating results, consolidated other comprehensive income and consolidated cash flows for the periods presented in accordance with accounting principles generally accepted in the United States of America. Operating results for the three months and nine months ended November 30, 2014 are not necessarily indicative of the results that may be expected for the fiscal year ending February 28, 2015. Certain information and footnote disclosures normally included in annual financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been omitted in accordance with the SEC’s rules and regulations for interim reporting. For further information, see the Company’s Consolidated Financial Statements, including notes thereto, included in the Company’s Annual Report on Form 10-K for the fiscal year ended February 28, 2014.

There have been no changes to the Company’s significant accounting policies from those described in NOTE 2—Summary of Significant Accounting Policies to the Consolidated Financial Statements contained in the Company’s Annual Report on Form 10-K for the fiscal year ended February 28, 2014. These unaudited financial statements should be read in conjunction with such Annual Report on Form 10-K.

Certain reclassifications have been made to the prior year’s financial statements to conform to the current year’s presentation.

 

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RED HAT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

 

Consolidation policy

The accompanying Consolidated Financial Statements include the accounts of the Company and all of its wholly-owned subsidiaries. All significant inter-company accounts and transactions have been eliminated in consolidation. There are no significant foreign exchange restrictions on the Company’s foreign subsidiaries.

Use of estimates

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the balance sheet dates and the reported amounts of revenue and expenses during the reporting periods. Actual results could differ from such estimates.

Recent accounting pronouncements

In June 2014, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update 2014-12, Accounting for Share-Based Payments When the Terms of an Award Provide That a Performance Target Could Be Achieved after the Requisite Service Period (“ASU 2014-12”). The FASB issued ASU 2014-12 to provide explicit guidance for share-based awards which allow for an employee to vest in an award upon achievement of a performance condition met after completion of a requisite service period regardless of whether the employee is rendering service on the date the performance target is achieved. ASU 2014-12 provides that the performance target should not be reflected in estimating the grant-date fair value of the award but rather compensation cost should be recognized in the period in which it becomes probable that the performance target will be achieved and recognized prospectively over the remaining requisite service period. This guidance is effective for fiscal years and interim periods within those years beginning after December 15, 2015, and is effective for the Company as of the first quarter of the fiscal year ending February 28, 2017. The Company has not issued such share-based awards and does not believe that this updated standard will have a material impact on the Company’s consolidated financial statements.

In May 2014, the FASB issued Accounting Standards Update 2014-09, Revenue from Contracts with Customers (“ASU 2014-09”). The FASB issued ASU 2014-09 to clarify the principles for recognizing revenue and to develop a common revenue standard for generally accepted accounting principles (“GAAP”) and International Financial Reporting Standards. The standard outlines a single comprehensive model for entities to use in accounting for revenue arising from contracts with customers and supersedes the most current revenue recognition guidance. This guidance is effective for fiscal years and interim periods within those years beginning after December 15, 2016, which is effective for the Company as of the first quarter of the fiscal year ending February 28, 2018. The Company is currently evaluating the impact that the implementation of this standard will have on the Company’s consolidated financial statements.

In July 2013, the FASB issued Accounting Standards Update No. 2013-11, Income Taxes (Topic 740)—Presentation of an Unrecognized Tax Benefit When a Net Operating Loss Carryforward, a Similar Tax Loss, or a Tax Credit Carryforward Exists (“ASU 2013-11”), to eliminate diversity in practice of presenting unrecognized tax benefits as a liability or presenting unrecognized tax benefits as a reduction of a deferred tax asset for a net operating loss or tax credit carryforward in certain circumstances by requiring that an unrecognized tax benefit be presented in the financial statements as a reduction to deferred tax assets excluding certain exceptions. ASU 2013-11 became effective for the Company during the three months ended May 31, 2014. The updated standard did not have a material impact on the Company’s consolidated financial statements.

 

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RED HAT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

 

In March 2013, the FASB issued Accounting Standards Update No. 2013-05, Foreign Currency Matters (Topic 830)—Parent’s Accounting for the Cumulative Translation Adjustment upon Derecognition of Certain Subsidiaries or Groups of Assets within a Foreign Entity or of an Investment in a Foreign Entity (“ASU 2013-05”), which requires a parent entity to release a related foreign entity’s cumulative translation adjustment into net income only if its sale or transfer results in the complete or substantially complete liquidation of the foreign entity in which the subsidiary or group of assets had resided. ASU 2013-05 became effective for the Company during the three months ended May 31, 2014. The updated standard did not have a material impact on the Company’s consolidated financial statements.

NOTE 3—Changes in Equity

The following table summarizes the changes in the Company’s stockholders’ equity during the three months ended November 30, 2014 (in thousands):

 

    Common
Stock
    Additional
Paid-In
Capital
    Retained
Earnings
    Treasury
Stock
    Accumulated
Other
Comprehensive
Income (Loss)
    Total
Stockholders’
Equity
 

Balance at August 31, 2014

  $ 23      $ 1,942,659      $ 804,740      $ (1,216,741   $ (16,025   $ 1,514,656   

Net income

    —          —          47,933        —          —          47,933   

Other comprehensive income (loss),
net of tax

    —          —          —          —          (15,755     (15,755

Exercise of common stock options

    —          465        —          —          —          465   

Common stock repurchase (see
NOTE 10)

    —          (75,000     —          (300,000     —          (375,000

Share-based compensation expense

    —          33,623        —          —          —          33,623   

Tax benefits related to share-based awards

    —          2,978        —          —          —          2,978   

Minimum tax withholdings paid by the Company on behalf of employees related to net settlement of employee share-based awards

    —          (21,754     —          —          —          (21,754

Equity component of convertible notes

    —          96,890        —          —          —          96,890   

Equity component of convertible notes issuance cost

    —          (1,833     —          —          —          (1,833

Purchase of convertible note hedges

    —          (148,040     —          —          —          (148,040

Proceeds from issuance of warrants

    —          79,776        —          —          —          79,776   

Deferred taxes related to convertible notes

    —          19,868        —          —          —          19,868   

Other adjustments

    —          (1,453     —          1,453        —          —     
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Balance at November 30, 2014

  $ 23      $ 1,928,179      $ 852,673      $ (1,515,288   $ (31,780   $ 1,233,807   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

 

9


Table of Contents

RED HAT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

 

The following table summarizes the changes in the Company’s stockholders’ equity during the three months ended November 30, 2013 (in thousands):

 

    Common
Stock
    Additional
Paid-In
Capital
    Retained
Earnings
    Treasury
Stock
    Accumulated
Other
Comprehensive
Income (Loss)
    Total
Stockholders’
Equity
 

Balance at August 31, 2013

  $ 23      $ 1,846,825      $ 623,079      $ (1,016,401   $ (11,922   $ 1,441,604   

Net income

    —          —          52,025        —          —          52,025   

Other comprehensive income (loss), net of tax

    —          —          —          —          6,679        6,679   

Exercise of common stock options

    —          223        —          —          —          223   

Common stock repurchase

    —          —          —          (40,018     —          (40,018

Share-based compensation expense

    —          30,190        —          —          —          30,190   

Tax benefits related to share-based awards

    —          (1,193     —          —          —          (1,193

Minimum tax withholdings paid by the Company on behalf of employees related to net settlement of employee share-based awards

    —          (18,307     —          —          —          (18,307
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Balance at November 30, 2013

  $ 23      $ 1,857,738      $ 675,104      $ (1,056,419   $ (5,243   $ 1,471,203   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

 

10


Table of Contents

RED HAT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

 

The following table summarizes the changes in the Company’s stockholders’ equity during the nine months ended November 30, 2014 (in thousands):

 

    Common
Stock
    Additional
Paid-In
Capital
    Retained
Earnings
    Treasury
Stock
    Accumulated
Other
Comprehensive
Income (Loss)
    Total
Stockholders’
Equity
 

Balance at February 28, 2014

  $ 23      $ 1,891,848      $ 720,172      $ (1,056,419   $ (4,459   $ 1,551,165   

Net income

    —          —          132,501        —          —          132,501   

Other comprehensive income (loss), net of tax

    —          —          —          —          (27,321     (27,321

Exercise of common stock options

    —          1,154        —          —          —          1,154   

Common stock repurchase (see NOTE 10)

    —          (75,000     —          (460,062     —          (535,062

Share-based compensation expense

    —          98,942        —          —          —          98,942   

Assumed employee share-based awards from acquisitions

    —          895        —          —          —          895   

Tax benefits related to share-based awards

    —          4,186        —          —          —          4,186   

Minimum tax withholdings paid by the Company on behalf of employees related to net settlement of employee share-based awards

    —          (39,314     —          —          —          (39,314

Equity component of convertible notes

    —          96,890        —          —          —          96,890   

Equity component of convertible notes issuance cost

    —          (1,833     —          —          —          (1,833

Purchase of convertible note hedges

    —          (148,040     —          —          —          (148,040

Proceeds from issuance of warrants

    —          79,776        —          —          —          79,776   

Deferred taxes related to convertible notes

    —          19,868        —          —          —          19,868   

Other adjustments

    —          (1,193     —          1,193        —          —     
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Balance at November 30, 2014

  $ 23      $ 1,928,179      $ 852,673      $ (1,515,288   $ (31,780   $ 1,233,807   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

 

11


Table of Contents

RED HAT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

 

The following table summarizes the changes in the Company’s stockholders’ equity during the nine months ended November 30, 2013 (in thousands):

 

    Common
Stock
    Additional
Paid-In
Capital
    Retained
Earnings
    Treasury
Stock
    Accumulated
Other
Comprehensive
Income (Loss)
    Total
Stockholders’
Equity
 

Balance at February 28, 2013

  $ 23      $ 1,802,899      $ 541,880      $ (816,674   $ (7,967   $ 1,520,161   

Net income

    —          —          133,224        —          —          133,224   

Other comprehensive income (loss), net of tax

    —          —          —          —          2,724        2,724   

Exercise of common stock options

    —          1,311        —          —          —          1,311   

Common stock repurchase

    —          —          —          (239,363     —          (239,363

Share-based compensation expense

    —          83,196        —          —          —          83,196   

Tax benefits related to share-based awards

    —          3,072        —          —          —          3,072   

Minimum tax withholdings paid by the Company on behalf of employees related to net settlement of employee share-based awards

    —          (33,122     —          —          —          (33,122

Other adjustments

    —          382        —          (382     —          —     
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Balance at November 30, 2013

  $ 23      $ 1,857,738      $ 675,104      $ (1,056,419   $ (5,243   $ 1,471,203   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Accumulated other comprehensive loss

The following is a summary of accumulated other comprehensive loss as of November 30, 2014 and February 28, 2014 (in thousands):

 

     As of
November 30, 2014
    As of
February 28, 2014
 

Accumulated loss from foreign currency translation adjustment

   $ (32,588   $ (4,823

Accumulated unrealized gain, net of tax, on available-for-sale securities

     808        364   
  

 

 

   

 

 

 

Accumulated other comprehensive loss

   $ (31,780   $ (4,459
  

 

 

   

 

 

 

NOTE 4—Identifiable Intangible Assets

Identifiable intangible assets consist primarily of trademarks, copyrights and patents, purchased technologies, customer and reseller relationships and covenants not to compete which are amortized over the estimated useful life, generally on a straight-line basis with the exception of customer and reseller relationships which are generally amortized over the greater of straight-line or the related asset’s pattern of economic benefit. Useful lives range from three to ten years. As of November 30, 2014 and February 28, 2014, trademarks with an indefinite estimated useful life totaled $12.1 million and $9.6 million, respectively.

 

12


Table of Contents

RED HAT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

 

The following is a summary of identifiable intangible assets (in thousands):

 

     As of November 30, 2014      As of February 28, 2014  
     Gross
Amount
     Accumulated
Amortization
    Net
Amount
     Gross
Amount
     Accumulated
Amortization
    Net
Amount
 

Trademarks, copyrights and patents

   $ 115,091       $ (40,681   $ 74,410       $ 105,269       $ (34,784   $ 70,485   

Purchased technologies

     89,416         (62,343     27,073         79,433         (55,960     23,473   

Customer and reseller relationships

     101,128         (69,120     32,008         89,992         (63,075     26,917   

Covenants not to compete

     11,286         (7,379     3,907         10,690         (5,977     4,713   

Other intangible assets

     8,909         (2,131     6,778         8,922         (1,111     7,811   
  

 

 

    

 

 

   

 

 

    

 

 

    

 

 

   

 

 

 

Total identifiable intangible assets

   $ 325,830       $ (181,654   $ 144,176       $ 294,306       $ (160,907   $ 133,399   
  

 

 

    

 

 

   

 

 

    

 

 

    

 

 

   

 

 

 

Amortization expense associated with identifiable intangible assets recognized in the Company’s Consolidated Financial Statements for the three months and nine months ended November 30, 2014 and November 30, 2013 is summarized as follows (in thousands):

 

     Three Months Ended      Nine Months Ended  
     November 30,
2014
     November 30,
2013
     November 30,
2014
     November 30,
2013
 

Cost of revenue

   $ 3,339       $ 2,848       $ 9,129       $ 8,360   

Sales and marketing

     1,959         2,244         5,533         6,395   

Research and development

     250         959         2,167         2,877   

General and administrative

     1,438         1,288         4,474         4,028   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total amortization expense

   $ 6,986       $ 7,339       $ 21,303       $ 21,660   
  

 

 

    

 

 

    

 

 

    

 

 

 

NOTE 5—Income Taxes

Income Tax Expense

The following table summarizes the Company’s tax provision for the three months and nine months ended November 30, 2014 and November 30, 2013 (in thousands):

 

    Three Months Ended     Nine Months Ended  
    November 30,
2014
    November 30,
2013
    November 30,
2014
    November 30,
2013
 

Provision for income taxes:

       

Income before provision for income taxes

  $ 67,511      $ 61,931      $ 186,621      $ 177,929   

Estimated annual effective tax rate on current year ordinary income excluding discrete tax items (1)

    29.0     22.8     29.0     27.5

Provision for income taxes

    19,578        14,131        54,120        48,930   

Discrete tax benefit

    —          4,225        —          4,225   
 

 

 

   

 

 

   

 

 

   

 

 

 

Provision for income taxes

  $ 19,578      $ 9,906      $ 54,120      $ 44,705   
 

 

 

   

 

 

   

 

 

   

 

 

 

 

(1) An effective income tax rate, excluding discrete items, of 22.8% for the three months ended November 30, 2013 results from a change in the Company’s estimated annual effective tax rate from 30.0% as of August 31, 2013 to 27.5% as of November 30, 2013.

 

13


Table of Contents

RED HAT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

 

For the nine months ended November 30, 2014, the Company’s estimated annual effective tax rate of 29.0% differed from the U.S. federal statutory rate of 35.0%, principally due to foreign income taxed at lower rates. For the nine months ended November 30, 2013, the Company’s then-estimated annual effective tax rate of 27.5% differed from the U.S. federal statutory rate of 35.0%, principally due to foreign income taxed at lower rates, research tax credits and the domestic production activities deduction. Tax expense for the three months and nine months ended November 30, 2013 includes a discrete tax benefit of $4.2 million primarily from the domestic production activities deduction for U.S. federal income tax purposes.

Deferred Taxes

As of November 30, 2014, deferred tax assets net of deferred tax liabilities (current and non-current) totaled $115.2 million, of which $4.5 million was offset by a valuation allowance. The Company continues to maintain a valuation allowance against its acquired deferred tax assets with respect to certain net operating loss (“NOL”) carryforwards.

As of November 30, 2014, the Company had U.S. federal and state NOL carryforwards of approximately $53.1 million and $145.0 million, respectively. As of November 30, 2014, the Company had U.S. federal and state research tax credit carryforwards of approximately $17.9 million and $12.6 million, respectively. The tax credit carryforwards are scheduled to expire in varying amounts beginning in the fiscal year ending February 28, 2018.

Unrecognized tax benefits

The Company’s unrecognized tax benefits were $58.0 million as of November 30, 2014 and $57.1 million as of February 28, 2014. The Company’s unrecognized tax benefits at November 30, 2014 and February 28, 2014, which, if recognized, would affect the Company’s effective tax rate, were $53.4 million and $49.7 million, respectively.

During the nine months ended November 30, 2014, the amount of unrecognized tax benefits increased by $0.9 million, primarily as a result of increases with respect to tax positions taken during prior periods. The results and timing of the resolution of tax audits is highly uncertain and the Company is unable to estimate the range of possible changes to the balance of unrecognized tax benefits. However, the Company does not anticipate that within the next 12 months the total amount of unrecognized tax benefits will significantly change.

It is the Company’s policy to recognize interest and penalties related to uncertain tax positions as income tax expense. Accrued interest and penalties related to unrecognized tax benefits totaled $8.9 million and $6.0 million as of November 30, 2014 and February 28, 2014, respectively.

The Company or one of its subsidiaries files income tax returns in the U.S. federal jurisdiction and various states and foreign jurisdictions. The following table summarizes the tax years in the Company’s major tax jurisdictions that remain subject to income tax examinations by tax authorities as of November 30, 2014. Due to NOL carryforwards, in some cases the tax years continue to remain subject to examination with respect to such NOLs.

 

Tax Jurisdiction

   Years Subject  to
Income Tax
Examination
 

U.S. federal

     1994 – Present   

North Carolina

     1999 – Present   

Ireland

     2010 – Present   

Japan (1)

     2012 – Present   

 

14


Table of Contents

RED HAT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

 

 

(1) The Company has been examined for income tax for years through February 28, 2011. A tax examination was concluded in fiscal 2012 with no significant adjustments resulting. However, the statute of limitations remains open for five years.

The U.S. Internal Revenue Service recently completed its examination with respect to the Company’s fiscal year ended February 28, 2010 and proposed certain adjustments. The Company believes that it has adequately provided for any reasonably foreseeable outcomes that may result from the proposed adjustments but, depending on the ultimate outcome, the Company could be required to pay additional income taxes. The Company does not believe that such outcome would have a material effect on its consolidated financial condition or consolidated results of operations.

The Company is currently undergoing an income tax examination in India.

The Company believes it has adequately provided for any reasonably foreseeable outcomes related to tax audits.

NOTE 6—Assets and Liabilities Measured at Fair Value on a Recurring Basis

Fair value is defined as the exchange price that would be received for the purchase of an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for such asset or liability in an orderly transaction between market participants on the measurement date. Valuation techniques used to measure fair value should maximize the use of observable inputs and minimize the use of unobservable inputs. To measure fair value, the Company uses the following fair value hierarchy based on three levels of inputs, of which the first two are considered observable and the last unobservable:

Level 1—Quoted prices in active markets for identical assets or liabilities.

Level 2—Inputs other than Level 1 that are observable, either directly or indirectly, such as quoted prices for similar assets or liabilities; quoted prices in markets that are not active; or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the assets or liabilities.

Level 3—Unobservable inputs that are supported by little or no market activity and are significant to the fair value of the assets or liabilities.

The Company’s investments are comprised primarily of debt securities that are classified as available for sale and recorded at their fair market values. Liquid investments purchased with a maturity period of 90 days or less at the date of purchase are classified as cash equivalents. Investments with remaining effective maturities of twelve months or less from the balance sheet date are classified as short-term investments. Investments with remaining effective maturities of more than twelve months from the balance sheet date are classified as long-term investments. The Company’s Level 1 financial instruments are valued using quoted prices in active markets for identical instruments. The Company’s Level 2 financial instruments, including derivative instruments, are valued using quoted prices for identical instruments in less active markets or using other observable market inputs for comparable instruments.

Unrealized gains and temporary losses on investments classified as available for sale are included within accumulated other comprehensive income, net of any related tax effect. Upon realization, such amounts are reclassified from accumulated other comprehensive income to Other income (expense), net. Realized gains and losses and other than temporary impairments, if any, are reflected in the consolidated statements of operations as

 

15


Table of Contents

RED HAT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

 

Other income (expense), net. The Company does not recognize changes in the fair value of its investments in income unless a decline in value is considered other-than-temporary. The vast majority of the Company’s investments are priced with the assistance of pricing vendors. These pricing vendors use the most recent observable market information in pricing these securities or, if specific prices are not available for these securities, use other observable inputs. In the event observable inputs are not available, the Company assesses other factors to determine the security’s market value, including broker quotes or model valuations. Independent price verifications of all holdings are performed by pricing vendors which are then reviewed by the Company. In the event a price fails a pre-established tolerance check, it is researched so that the Company can assess the cause of the variance to determine what the Company believes is the appropriate fair market value.

The Company minimizes its credit risk associated with investments by investing primarily in investment grade, liquid securities. The Company’s policy is designed to limit exposures to any one issuer depending on credit quality. Periodic evaluations of the relative credit standing of those issuers are considered in the Company’s investment strategy.

The following table summarizes the composition and fair value hierarchy of the Company’s financial assets and liabilities at November 30, 2014 (in thousands):

 

    As of
November 30,
2014
    Quoted Prices In
Active  Markets
for Identical
Assets (Level 1)
    Significant
Other
Observable
Inputs (Level 2)
    Significant
Unobservable
Inputs (Level 3)
 

Assets:

       

Money markets (1)

  $ 263,986      $ 263,986      $ —        $ —     

Interest-bearing deposits (1)

    41        —          41        —     

Available-for-sale securities (1):

       

Commercial paper

    26,999        —          26,999        —     

U.S. agency securities

    255,615        —          255,615        —     

Corporate securities

    428,353        —          428,353        —     

Foreign government securities

    78,523        —          78,523        —     

Foreign currency derivatives (2)

    7        —          7        —     

Liabilities:

       

Foreign currency derivatives (3)

    (411     —          (411     —     
 

 

 

   

 

 

   

 

 

   

 

 

 

Total

  $   1,053,113      $         263,986      $         789,127      $                 —     
 

 

 

   

 

 

   

 

 

   

 

 

 

 

(1) Included in Cash and cash equivalents, Investments in debt securities, short-term or Investments in debt securities, long-term in the Company’s Consolidated Balance Sheet at November 30, 2014, in addition to $593.0 million of cash.
(2) Included in Other current assets in the Company’s Consolidated Balance Sheet at November 30, 2014.
(3) Included in Accounts payable and accrued expenses in the Company’s Consolidated Balance Sheet at November 30, 2014.

 

16


Table of Contents

RED HAT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

 

The following table summarizes the composition and fair value hierarchy of the Company’s financial assets and liabilities at February 28, 2014 (in thousands):

 

    As of
February  28,
2014
    Quoted Prices  In
Active Markets
for Identical
Assets (Level 1)
    Significant
Other
Observable
Inputs (Level 2)
    Significant
Unobservable
Inputs (Level 3)
 

Assets:

       

Money markets (1)

  $ 178,280      $ 178,280      $ —        $ —     

Interest-bearing deposits (1)

    86,937        —          86,937        —     

Available-for-sale securities (1):

       

Commercial paper

    37,643        —          37,643        —     

U.S. agency securities

    279,049        —          279,049        —     

Corporate securities

    382,516        —          382,516        —     

Foreign government securities

    79,841        —          79,841        —     

Foreign currency derivatives (2)

    134        —          134        —     

Liabilities:

       

Foreign currency derivatives (3)

    (15     —          (15     —     
 

 

 

   

 

 

   

 

 

   

 

 

 

Total

  $ 1,044,385      $ 178,280      $ 866,105      $                 —     
 

 

 

   

 

 

   

 

 

   

 

 

 

 

(1) Included in Cash and cash equivalents, Investments in debt securities, short-term or Investments in debt securities, long-term in the Company’s Consolidated Balance Sheet at February 28, 2014, in addition to $443.2 million of cash.
(2) Included in Other current assets in the Company’s Consolidated Balance Sheet at February 28, 2014.
(3) Included in Accounts payable and accrued expenses in the Company’s Consolidated Balance Sheet at February 28, 2014.

The following table represents the Company’s investments measured at fair value as of November 30, 2014 (in thousands):

 

                   Balance Sheet Classification  
     Amortized
Cost
     Gross Unrealized     Aggregate
Fair Value
     Cash and
cash
equivalents
     Investments
in debt
securities,
short-term
     Investments
in debt
securities,
long-term
 
            Gains      Losses (1)                             

Money markets

   $ 263,986       $ —         $ —        $ 263,986       $ 263,986       $ —         $ —     

Interest-bearing deposits

     41         —           —          41         —           41         —     

Commercial paper

     26,999         —           —          26,999         26,999         —           —     

U.S. agency securities

     255,784         81         (250     255,615         —           4,998         250,617   

Corporate securities

     427,353         1,309         (309     428,353         —           156,317         272,036   

Foreign government securities

     78,452         74         (3     78,523         —           70,064         8,459   
  

 

 

    

 

 

    

 

 

   

 

 

    

 

 

    

 

 

    

 

 

 

Total

   $ 1,052,615       $ 1,464       $ (562   $ 1,053,517       $ 290,985       $ 231,420       $ 531,112   
  

 

 

    

 

 

    

 

 

   

 

 

    

 

 

    

 

 

    

 

 

 

 

(1) As of November 30, 2014, there were $0.2 million of accumulated unrealized losses related to investments that have been in a continuous unrealized loss position for 12 months or longer.

 

17


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RED HAT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

 

The following table represents the Company’s investments measured at fair value as of February 28, 2014 (in thousands):

 

                   Balance Sheet Classification  
     Amortized
Cost
     Gross Unrealized     Aggregate
Fair Value
     Cash and
cash
equivalents
     Investments
in debt
securities,
short-term
     Investments
in debt
securities,
long-term
 
            Gains      Losses (1)                             

Money markets

   $ 178,280       $ —         $ —        $ 178,280       $ 178,280       $ —         $ —     

Interest-bearing deposits

     86,937         —           —          86,937         —           86,937         —     

Commercial paper

     37,643         —           —          37,643         25,299         12,344         —     

U.S. agency securities

     279,657         12         (620     279,049         —           56,314         222,735   

Corporate securities

     381,446         1,279         (209     382,516         —           131,612         250,904   

Foreign government securities

     79,818         34         (11     79,841         —           48,180         31,661   
  

 

 

    

 

 

    

 

 

   

 

 

    

 

 

    

 

 

    

 

 

 

Total

   $ 1,043,781       $ 1,325       $ (840   $ 1,044,266       $ 203,579       $ 335,387       $ 505,300   
  

 

 

    

 

 

    

 

 

   

 

 

    

 

 

    

 

 

    

 

 

 

 

(1) As of February 28, 2014, there were $0.2 million of accumulated unrealized losses related to investments that have been in a continuous unrealized loss position for 12 months or longer.

NOTE 7—Derivative Instruments

The Company transacts business in various foreign countries and is, therefore, subject to risk of foreign currency exchange rate fluctuations. The Company from time to time enters into forward contracts to economically hedge transactional exposure associated with commitments arising from trade accounts receivable, trade accounts payable and fixed purchase obligations denominated in a currency other than the functional currency of the respective operating entity. All derivative instruments are recorded on the Consolidated Balance Sheets at their respective fair market values. The Company has elected not to prepare and maintain the documentation required to qualify for hedge accounting treatment and, therefore, changes in fair value are recorded in the Consolidated Statements of Operations.

The effects of derivative instruments on the Company’s Consolidated Financial Statements are as follows as of November 30, 2014 and for the three and nine months then ended (in thousands):

 

    As of November 30, 2014         Three Months
Ended
November 30,
2014
    Nine Months
Ended
November 30,
2014
 
     Balance Sheet Location     Fair
Value
    Notional
Value
    Location of Gain
(Loss)  Recognized
in Income on
Derivatives
  Amount of  Gain
(Loss) Recognized
in Income on
Derivatives
 

Assets—foreign currency forward contracts not designated as hedges

    Other current assets      $ 7      $ 1,099      Other income

(expense), net

  $             48      $             312   

Liabilities—foreign currency forward contracts not designated as hedges

   
 
Accounts payable and
accrued expenses
  
  
    (411     20,324      Other income

(expense), net

    (811     (1,352
   

 

 

   

 

 

     

 

 

   

 

 

 

TOTAL

    $ (404   $ 21,423        $ (763   $ (1,040
   

 

 

   

 

 

     

 

 

   

 

 

 

 

18


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RED HAT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

 

The effects of derivative instruments on the Company’s Consolidated Financial Statements are as follows as of November 30, 2013 and for the three and nine months then ended (in thousands):

 

    As of November 30, 2013         Three Months
Ended
November 30,
2013
    Nine Months
Ended
November 30,
2013
 
     Balance Sheet Location     Fair
Value
    Notional
Value
    Location of Gain
(Loss)  Recognized
in Income on
Derivatives
  Amount of  Gain
(Loss) Recognized
in Income on
Derivatives
 

Assets—foreign currency forward contracts not designated as hedges

    Other current assets      $ 58      $ 10,886      Other income

(expense), net

  $             177      $             800   

Liabilities—foreign currency forward contracts not designated as hedges

   
 
Accounts payable and
accrued expenses
  
  
    (278     13,860      Other income

(expense), net

    (389     (2,399
   

 

 

   

 

 

     

 

 

   

 

 

 

TOTAL

    $ (220   $ 24,746        $ (212   $ (1,599
   

 

 

   

 

 

     

 

 

   

 

 

 

NOTE 8—Share-based Awards

The Company measures share-based compensation cost at the grant date, based on the estimated fair value of the award and recognizes the cost over the employee requisite service period, typically on a straight-line basis, net of estimated forfeitures. The Company estimates the fair value of stock options using the Black-Scholes-Merton valuation model. The fair value of nonvested share awards, nonvested share units and performance share units are measured at their underlying closing share price on the day of grant.

The following summarizes share-based compensation expense recognized in the Company’s Consolidated Financial Statements for the three months and nine months ended November 30, 2014 and November 30, 2013 (in thousands):

 

     Three Months Ended      Nine Months Ended  
     November 30, 2014      November 30, 2013      November 30, 2014      November 30, 2013  

Cost of revenue

   $ 3,915       $ 2,922       $ 10,458       $ 8,861   

Sales and marketing

     15,866         10,268         39,794         30,009   

Research and development

     8,129         9,161         28,091         25,100   

General and administrative

     5,713         7,839         20,599         19,226   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total share-based compensation

   $ 33,623       $ 30,190       $ 98,942       $ 83,196   
  

 

 

    

 

 

    

 

 

    

 

 

 

Share-based compensation expense qualifying for capitalization was insignificant for each of the three months and nine months ended November 30, 2014 and November 30, 2013. Accordingly, no share-based compensation expense was capitalized during the three months and nine months ended November 30, 2014 and November 30, 2013.

Estimated annual forfeitures—An estimated forfeiture rate of 10.0% per annum, which approximates the Company’s historical rate, was applied to options and nonvested share units. Awards are adjusted to actual forfeiture rates at vesting. The Company reassesses its estimated forfeiture rate annually or when new information, including actual forfeitures, indicate a change is appropriate.

 

19


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RED HAT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

 

During the three months and nine months ended November 30, 2014, the Company granted the following share-based awards:

 

     Three Months Ended
November 30, 2014
     Nine Months Ended
November 30, 2014
 
     Shares  and
Shares
Underlying
Awards
     Weighted
Average
Per Share
Fair Value
     Shares  and
Shares
Underlying
Awards
     Weighted
Average
Per Share
Fair Value
 

Service-based shares and share units

     1,181,351       $ 54.93         2,766,093       $ 53.23   

Performance share units—target (1)

     —         $ —           695,218       $ 53.24   

Performance share awards (2)

     —         $ —           184,325       $ 50.54   

Assumed (3)

     —         $ —           219,169       $ 48.45   

Restricted shares issued as part of a business combination with continued employment service conditions (4)

     —         $ —           529,057       $ 54.75   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total awards

     1,181,351       $ 54.93         4,393,862       $ 53.06   
  

 

 

    

 

 

    

 

 

    

 

 

 

 

(1) Certain executives and senior management were awarded a target number of performance share units (“PSUs”). PSU grantees may earn up to 200% of the target number of PSUs. Half of the target number of PSUs can be earned by the grantees depending upon the Company’s financial performance measured against the financial performance of specified peer companies during a three-year performance period beginning on March 1, 2014. The remaining target number of PSUs can be earned by the grantees depending upon the Company’s total shareholder return performance measured against the total shareholder return of specified peer companies during a three-year period beginning on March 1, 2014.

 

     During the three months ended August 31, 2014, certain executives were awarded a total of 242,352 PSUs that will pay out only if the Company’s total shareholder return increases by at least 50% within the three-year performance period beginning on August 6, 2014 (“TSR Hurdle PSUs”). If the performance goal is achieved during the performance period and the grantee’s business relationship with the Company has not ceased, 50% of the TSR Hurdle PSUs shall vest upon achievement of the performance goal and the remaining 50% of the TSR Hurdle PSUs shall vest on the last day of the four-year period beginning on August 6, 2014. If the performance goal is not achieved on or before the last day of the performance period, then all TSR Hurdle PSUs are forfeited.
(2) Certain executives were granted restricted stock awards. These shares were awarded subject to the achievement of a specified dollar amount of revenue for FY2015 (the “RSA Performance Goal”). If the Company fails to achieve the RSA Performance Goal for FY2015, then all such shares are forfeited. If the Company achieves the RSA Performance Goal for FY2015, then 25% of the restricted stock vests on July 16, 2015, and the remainder vests ratably on a quarterly basis over the course of the subsequent three–year period, provided that the grantee’s business relationship with the Company has not ceased.
(3) Amount represents partially-vested options assumed as part of a business combination.
(4) As part of the Company’s acquisition of eNovance, a total of 529,057 restricted common shares were issued to certain shareholders of eNovance. These restricted shares are conditioned on continued employment with the Company. The shares effectively vest 25% per year and are being amortized on a straight-line basis to share-based compensation expense in the Company’s Consolidated Statement of Operations.

 

20


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RED HAT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

 

NOTE 9—Earnings Per Share

The Company computes basic net income per common share by dividing net income available to common stockholders by the weighted average number of common shares outstanding. Diluted net income per common share is computed by dividing net income by the weighted average number of common shares and dilutive potential common share equivalents then outstanding. Potential common share equivalents consist of shares issuable upon the exercise of stock options or vesting of share-based awards.

The following table reconciles the numerators and denominators of the earnings per share calculation for the three months and nine months ended November 30, 2014 and November 30, 2013 (in thousands, except per share amounts):

 

     Three Months Ended      Nine Months Ended  
     November 30,
2014
     November 30,
2013
     November 30,
2014
     November 30,
2013
 

Net income, basic and diluted

   $ 47,933       $ 52,025       $ 132,501       $ 133,224   
  

 

 

    

 

 

    

 

 

    

 

 

 

Weighted average common shares outstanding

     185,039         189,514         187,533         190,024   

Incremental shares attributable to assumed vesting or exercise of outstanding equity award shares

     2,635         1,851         2,548         2,025   

Diluted shares

     187,674         191,365         190,081         192,049   
  

 

 

    

 

 

    

 

 

    

 

 

 

Diluted net income per share

   $ 0.26       $ 0.27       $ 0.70       $ 0.69   
  

 

 

    

 

 

    

 

 

    

 

 

 

The weighted average number of shares outstanding used in the computation of basic and diluted earnings per share for the three months and nine months ended November 30, 2014 does not include the effect of common stock potentially issuable in accordance with the terms of the Company’s convertible notes and warrants. The effects of these potentially outstanding shares were not included in the calculation of diluted earnings per share because the effect would have been anti-dilutive.

With respect to the Company’s convertible notes, the Company has the option to pay or deliver, as the case may be, either cash, shares of its common stock or combination of cash and shares of its common stock for the aggregate amount due upon conversion of the notes. The Company’s intent is to settle the principal amount of the notes in cash upon conversion. As a result, upon conversion of the notes, only the amounts payable in excess of the principal amounts of the notes are considered in diluted earnings per share under the treasury stock method. See NOTE 15—Convertible Notes to the Company’s Consolidated Financial Statements for detailed information on the convertible notes.

The following share awards are not included in the computation of diluted earnings per share because the aggregate value of proceeds considered received upon either exercise or vesting was greater than the average market price of the Company’s common stock during the related periods and the effect of including such share awards in the computation would be anti-dilutive (in thousands):

 

     Three Months Ended      Nine Months Ended  
     November 30,
2014
     November 30,
2013
     November 30,
2014
     November 30,
2013
 

Number of shares considered anti-dilutive for calculating diluted EPS

     39         1,430         151         1,514   
  

 

 

    

 

 

    

 

 

    

 

 

 

 

21


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RED HAT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

 

NOTE 10—Share Repurchase Programs

On April 15, 2013, the Company announced that its Board of Directors had authorized the repurchase of up to $300.0 million of Red Hat’s common stock from time to time on the open market or in privately negotiated transactions. The program commenced on April 16, 2013, and will expire on the earlier of (i) March 31, 2015, or (ii) a determination by the Board, Chief Executive Officer or Chief Financial Officer to discontinue the program.

As of November 30, 2014, the amount available under the program for the repurchase of the Company’s common stock was $80.0 million.

Accelerated share repurchase

The Company used $375.0 million of the net proceeds from the issuance of the convertible notes discussed in NOTE 15—Convertible Notes to the Company’s Consolidated Financial Statements during the three months ended November 30, 2014 to repurchase shares of its common stock under an accelerated share repurchase program (the “ASR Agreement”) with Goldman, Sachs & Co. (the “ASR Counterparty”). On October 7, 2014, under the ASR Agreement, the Company paid $375.0 million to the ASR Counterparty and received approximately 5.3 million shares of its common stock from the ASR Counterparty, which represented 80 percent of the shares the Company would have repurchased assuming an average share price of $56.47 (the Company’s closing share price at October 1, 2014). The total number of shares of common stock that the Company will repurchase under the ASR Agreement will be based on the average of the daily volume-weighted average prices of the Company’s common stock during the term of the ASR Agreement, less a discount. At settlement, the ASR Counterparty may be required to deliver additional shares of the Company’s common stock to the Company or, under certain circumstances, the Company may be required to deliver shares of common stock or make a cash payment to the ASR Counterparty. Final settlement of the ASR Agreement is expected to be completed by February 27, 2015, although the settlement may be accelerated at the ASR Counterparty’s option.

The Company accounted for the ASR program as two separate transactions: (i) the approximately 5.3 million shares of common stock initially delivered to the Company were accounted for as a treasury stock transaction with $300.0 million, or 80 percent, of the $375.0 million upfront payment being recorded in Treasury stock in the Company’s Consolidated Balance Sheet at November 30, 2014 and (ii) the unsettled portion of the ASR Agreement of $75.0 million was recorded in Additional paid-in capital on the Company’s Consolidated Balance Sheet as of November 30, 2014. As the remainder of the shares are delivered, which is anticipated to be in the fourth quarter of fiscal year 2015, the associated amounts will be reclassified from Additional paid-in capital to Treasury stock.

 

22


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RED HAT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

 

NOTE 11—Segment Reporting

The following summarizes revenue from unaffiliated customers and income (loss) from operations for the three months and nine months ended November 30, 2014 and November 30, 2013 and total cash, cash equivalents and available-for-sale investment securities and total assets as of November 30, 2014 and November 30, 2013, by geographic segment (in thousands):

 

     Americas      EMEA      Asia Pacific      Corporate (1)     Consolidated  
     Three Months Ended November 30, 2014  

Revenue from unaffiliated customers

   $ 290,525       $ 105,755       $ 59,615       $ —        $ 455,895   

Income (loss) from operations

   $ 68,620       $ 19,805       $ 12,395       $ (33,623   $ 67,197   
     Three Months Ended November 30, 2013  

Revenue from unaffiliated customers

   $ 249,744       $ 93,818       $ 52,974       $ —        $ 396,536   

Income (loss) from operations

   $ 51,638       $ 27,265       $ 12,079       $ (30,190   $ 60,792   
     Nine Months Ended November 30, 2014  

Revenue from unaffiliated customers

   $ 838,757       $ 310,025       $ 176,766       $ —        $ 1,325,548   

Income (loss) from operations

   $ 170,093       $ 70,056       $ 41,180       $ (98,942   $ 182,387   

Total cash, cash equivalents and available-for-sale investment securities

   $ 1,078,060       $ 383,972       $ 184,489       $ —        $ 1,646,521   

Total assets

   $ 2,546,504       $ 717,611       $ 283,756       $ —        $ 3,547,871   
     Nine Months Ended November 30, 2013  

Revenue from unaffiliated customers

   $ 720,818       $ 260,107       $ 153,293       $ —        $ 1,134,218   

Income (loss) from operations

   $ 145,666       $ 72,793       $ 37,726       $ (83,196   $ 172,989   

Total cash, cash equivalents and available-for-sale investment securities

   $ 700,056       $ 445,688       $ 180,905       $ —        $ 1,326,649   

Total assets

   $ 1,995,091       $ 624,269       $ 232,008       $ —        $ 2,851,368   

 

(1) Amounts represent share-based compensation expense for each of the three months and nine months ended November 30, 2014 and November 30, 2013, which was not allocated to geographic segments.

Supplemental information about geographic areas

The following table lists, for each of the three months and nine months ended November 30, 2014 and November 30, 2013, revenue from unaffiliated customers in the United States, the Company’s country of domicile, and revenue from unaffiliated customers from foreign countries (in thousands):

 

     Three Months Ended      Nine Months Ended  
     November 30,
2014
     November 30,
2013
     November 30,
2014
     November 30,
2013
 

United States, the Company’s country of domicile

   $ 264,242       $ 217,653       $ 746,105       $ 628,195   

Foreign

     191,653         178,883         579,443         506,023   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total revenue from unaffiliated customers

   $ 455,895       $ 396,536       $ 1,325,548       $ 1,134,218   
  

 

 

    

 

 

    

 

 

    

 

 

 

 

23


Table of Contents

RED HAT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

 

Total tangible long-lived assets located in the United States, the Company’s country of domicile, and similar tangible long-lived assets held outside the United States are summarized in the following table as of November 30, 2014 and February 28, 2014 (in thousands):

 

     As of
November 30,
2014
     As of
February 28,
2014
 

United States, the Company’s country of domicile

   $ 132,475       $ 137,356   

Foreign

     41,124         36,561   
  

 

 

    

 

 

 

Total tangible long-lived assets

   $ 173,599       $ 173,917   
  

 

 

    

 

 

 

Supplemental information about major customers

For each of the three months and nine months ended November 30, 2014, the U.S. government and its agencies represented approximately 10% of the Company’s total revenue. For the three months and nine months ended November 30, 2013, the U.S. government and its agencies represented approximately 9% and 12% of the Company’s total revenue, respectively.

Supplemental information about products and services

The following table, for each of the three and nine months ended November 30, 2014 and November 30, 2013, provides further detail, by type, of our subscription and services revenues. Infrastructure-related offerings subscription revenue includes subscription revenue generated from Red Hat Enterprise Linux and related technologies such as Red Hat Enterprise Virtualization. Subscription revenue generated from our Application development-related and other emerging technology offerings includes Red Hat JBoss Middleware, Red Hat Storage Server and Red Hat cloud offerings such as OpenStack and OpenShift (in thousands):

 

     Three Months Ended      Nine Months Ended  
     November 30,
2014
     November 30,
2013
     November 30,
2014
     November 30,
2013
 

Subscription revenue:

           

Infrastructure-related offerings

   $ 332,897       $ 300,047       $ 983,915       $ 866,186   

Application development-related and other emerging technology offerings

     61,802         42,723         172,246         119,093   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total subscription revenue

     394,699         342,770         1,156,161         985,279   
  

 

 

    

 

 

    

 

 

    

 

 

 

Training and services revenue:

           

Consulting services

     44,588         38,621         125,578         108,168   

Training

     16,608         15,145         43,809         40,771   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total training and services revenue

     61,196         53,766         169,387         148,939   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total subscription and training and services revenue

   $ 455,895       $ 396,536       $ 1,325,548       $ 1,134,218   
  

 

 

    

 

 

    

 

 

    

 

 

 

 

24


Table of Contents

RED HAT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

 

NOTE 12—Commitments and Contingencies

Operating leases

As of November 30, 2014, the Company leased office space and certain equipment under various non-cancelable operating leases. Rent expense under operating leases for the three months ended November 30, 2014 and November 30, 2013 was $8.0 million and $7.5 million, respectively. Rent expense under operating leases for the nine months ended November 30, 2014 and November 30, 2013 was $23.0 million and $21.8 million, respectively.

Product indemnification

The Company is a party to a variety of agreements pursuant to which it may be obligated to indemnify the other party from losses arising in connection with the Company’s services or products, or from losses arising in connection with certain events defined within a particular contract, which may include litigation or claims relating to intellectual property infringement, certain losses arising from damage to property or injury to persons or other matters. In each of these circumstances, payment by the Company is conditioned on the other party making a claim pursuant to the procedures specified in the particular contract, which procedures typically allow the Company to challenge the other party’s claims. Further, the Company’s obligations under these agreements may in certain cases be limited in terms of time and/or amount, and in some instances, the Company may have recourse against third-parties for certain payments made by the Company.

It is not possible to predict the maximum potential amount of future payments under these or similar agreements due to the conditional nature of the Company’s obligations and the facts and circumstances involved in each particular agreement. The Company does not record a liability for claims related to indemnification unless the Company concludes that the likelihood of a material claim is probable and estimable. Historically, payments pursuant to these indemnifications have been immaterial.

NOTE 13—Legal Proceedings

The Company experiences routine litigation in the normal course of its business, including patent litigation. The Company presently believes that the outcome of this routine litigation will not have a material adverse effect on its financial position, results of operations or cash flows.

NOTE 14—Business Combinations

Acquisition of FeedHenry Ltd.

On October 8, 2014 the Company completed its acquisition of all of the shares of FeedHenry Ltd. (“FeedHenry”). FeedHenry is a provider of cloud-based enterprise mobile application platforms. The acquisition is intended to expand the Company’s portfolio of application development, integration and platform-as-a-service solutions, enabling the Company to support mobile application development in public and private environments.

The cash consideration paid as of the closing date was $80.2 million. Based on management’s provisional assessment of the acquisition date fair value of the assets acquired and liabilities assumed, the total cash consideration transferred of $80.2 million has been allocated to the Company’s assets and liabilities on a preliminary basis as follows: $66.4 million to goodwill, $11.6 million to identifiable intangible assets and the remaining $2.2 million to net working capital.

 

25


Table of Contents

RED HAT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

 

The Company incurred approximately $1.1 million in transaction costs, including legal and accounting fees, relating to the acquisition. These transaction costs have been expensed as incurred and included in general and administrative expense on the Company’s Consolidated Statement of Operations for the three and nine months ended November 30, 2014.

Acquisition of eNovance, SAS

On June 24, 2014, the Company completed its acquisition of all of the shares of eNovance, SAS (“eNovance”), a provider of open source cloud computing services. The acquisition is intended to assist in advancing the Company’s market position in OpenStack, and the addition of eNovance’s systems integration capabilities and engineering talent is expected to help meet growing demand for enterprise OpenStack consulting, design and deployment.

The cash consideration paid was $67.6 million. Based on management’s provisional assessment of the acquisition date fair value of the assets acquired and liabilities assumed, the total cash consideration transferred of $67.6 million has been allocated to the Company’s assets on a preliminary basis as follows: $62.5 million to goodwill, $5.3 million to identifiable intangible assets and to net working capital which totaled a net current liability of $0.2 million.

In addition to the cash consideration transferred, the Company issued a total of 529,057 restricted common shares to certain employee-shareholders. The vesting of these restricted shares is conditioned on continued employment with the Company. As a result of the employment condition, the transfer of these shares has been accounted for separate from the business combination. The shares effectively vest 25% per year, with the closing-date date value of the shares being amortized, on a straight-line basis, to share-based compensation expense in the Company’s Consolidated Statement of Operations.

The Company incurred approximately $0.9 million in transaction costs, including legal and accounting fees, relating to the acquisition. These transaction costs have been expensed as incurred and included in general and administrative expense on the Company’s Consolidated Statement of Operations for the nine months ended November 30, 2014.

Acquisition of Inktank Storage, Inc.

On April 30, 2014, the Company completed its acquisition of all of the shares of Inktank Storage, Inc. (“Inktank”), a provider of scale-out, open source storage systems, whose flagship technology, Inktank Ceph Enterprise, delivers object and block storage software to enterprises deploying public or private clouds. The acquisition is intended to complement the Company’s existing GlusterFS-based storage offering. Under the terms of the purchase agreement, the consideration transferred by the Company totaled $152.5 million. The Company incurred approximately $2.0 million in transaction costs, including legal and accounting fees, relating to the acquisition. These transaction costs have been expensed as incurred and included in general and administrative expense on the Company’s Consolidated Statement of Operations for the nine months ended November 30, 2014.

 

26


Table of Contents

RED HAT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

 

The total consideration transferred by the Company in connection with the acquisition is summarized in the following table (in thousands):

 

     Total
Consideration
Transferred
 

Cash consideration paid to and/or on behalf of holders of Inktank stock and vested options

   $ 151,648   

Fair value of nonvested employee share-based awards assumed and attributed to pre-combination services (1)

     895   
  

 

 

 

Total consideration transferred (2)

   $ 152,543   
  

 

 

 

 

(1) The total fair value, as of April 30, 2014, of all assumed nonvested share-based awards was $10.6 million, of which $0.9 million has been attributed to pre-acquisition employee services and accordingly has been recognized as consideration transferred. The remaining $9.7 million of fair value will be recognized as compensation expense over the remaining vesting period ranging from 1 month to approximately 4 years.
(2) In addition to the consideration transferred of $152.5 million and the assumed nonvested share-based awards with an acquisition-date fair value of $10.6 million, the Company has committed to pay retention incentives totaling $8.4 million in cash (payable 25% annually from the date of acquisition assuming continued employment). The Company has also committed to granting key employees share-based awards with a combined value of $15.0 million which will vest 25% annually from the date of grant.

The table below represents the estimated tangible and identifiable intangible assets and liabilities (in thousands) based on management’s provisional assessment of the acquisition date fair value of the assets acquired and liabilities assumed. The Company expects to finalize its assessment of the acquisition-date fair value of assets acquired and liabilities assumed by the end of its fiscal year 2015:

 

     Total
Consideration
Allocated
 

Identifiable intangible assets (see detail below)

   $         10,770   

Cash

     27   

Accounts receivable

     746   

Deferred tax assets, net

     12,722   

Other assets

     161   

Accrued liabilities

     (1,651

Deferred revenue

     (1,016

Goodwill

     130,784   
  

 

 

 

Total consideration allocated

   $ 152,543   
  

 

 

 

 

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RED HAT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

 

The following table summarizes the allocation of consideration transferred to identifiable intangible assets (in thousands). The fair value of the identifiable intangible assets is being amortized over the estimated useful life of each intangible asset on a straight-line basis which approximates the economic pattern of benefits:

 

     Amortization Expense Type    Estimated  Life
(Years)
     Total  

Customer relationships

   Sales and marketing          5       $ 6,800   

Tradenames and trademarks

   General and administrative      Indefinite         3,300   

Covenants not to compete

   Research and development      3         370   

Developed technology

   Cost of revenue      5         300   
        

 

 

 

Total identifiable intangible assets

         $ 10,770   
        

 

 

 

Pro forma consolidated financial information

The following unaudited pro forma consolidated financial information reflects the results of operations of the Company for the three and nine months ended November 30, 2014 and November 30, 2013 (in thousands, except per share amounts) as if the acquisitions of FeedHenry, eNovance and Inktank had closed on March 1, 2013, after giving effect to certain purchase accounting adjustments. These pro forma results are not necessarily indicative of what the Company’s operating results would have been had the acquisitions actually taken place at the beginning of the period.

 

    Three Months Ended     Nine Months Ended  
    November 30, 2014     November 30, 2013     November 30, 2014     November 30, 2013  

Revenue

  $         456,280      $         401,239      $         1,331,007      $         1,147,536   

Net income

    47,218        46,078        122,163        118,168   

Basic net income per common share

  $ 0.26      $ 0.24      $ 0.65      $ 0.62   

Diluted net income per common share

  $ 0.25      $ 0.24      $ 0.64      $ 0.62   

Post-acquisition financial information

The following is a summary of the combined post-acquisition revenue, expenses and losses of FeedHenry, eNovance and Inktank that are included in the Company’s Consolidated Statement of Operations for the three and nine months ended November 30, 2014 (in thousands):

 

     Three Months Ended
November 30, 2014
    Nine Months Ended
November 30, 2014
 

Revenue

   $         2,994      $         5,711   

Operating expenses

     (11,280     (20,613
  

 

 

   

 

 

 

Operating loss

     (8,286     (14,902

Other income

     297        392   
  

 

 

   

 

 

 

Loss before tax benefit

     (7,989     (14,510

Tax benefit

     2,317        4,208   
  

 

 

   

 

 

 

Net loss

   $ (5,672   $ (10,302
  

 

 

   

 

 

 

 

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RED HAT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

 

Goodwill

The following is a summary of changes in goodwill for the nine months ended November 30, 2014 (in thousands):

 

Balance at February 28, 2014

   $ 687,430   

Acquisition of Inktank

     130,784   

Acquisition of eNovance

     62,499   

Acquisition of FeedHenry

     66,376   

Impact of foreign currency fluctuations

     (7,515
  

 

 

 

Balance at November 30, 2014

   $ 939,574   
  

 

 

 

The excess of purchase price paid for FeedHenry, eNovance and Inktank over the fair value of the net assets acquired was recognized as goodwill. Goodwill comprises the majority of the purchase price paid for each of the acquired businesses because these businesses were focused on emerging technologies such as mobile, cloud-enabling and software-defined storage technologies, which consequently—at the time of acquisition—generated relatively little revenue. However, these acquired businesses, with their assembled, highly-specialized workforces and community of contributors are expected to both expand the Company’s existing technology portfolio and advance the Company’s market position overall in open source enterprise solutions.

NOTE 15—Convertible Notes

Convertible note offering

On October 7, 2014, the Company completed its previously announced offering of $700.0 million aggregate principal amount of its 0.25% Convertible Senior Notes due 2019 (the “Notes”). The Notes were sold in a private placement under a purchase agreement, dated as of October 1, 2014, entered into by and among the Company and Morgan Stanley & Co. LLC, Merrill Lynch, Pierce, Fenner & Smith Incorporated, Citigroup Global Markets Inc. and J.P. Morgan Securities LLC as representatives of the several initial purchasers named therein (collectively, the “Initial Purchasers”), for resale to qualified institutional buyers pursuant to Rule 144A under the Securities Act of 1933, as amended (the “Securities Act”). The Company also granted the Initial Purchasers a right to purchase, within a 30-day period, up to an additional $105.0 million principal amount of Notes on the same terms and conditions, which the Initial Purchasers exercised in full on October 2, 2014 and which additional purchase was also completed on October 7, 2014.

The Company used $148.0 million of the net proceeds from the offering of the Notes to pay the cost of the privately-negotiated convertible note hedge transactions described below. The Company received proceeds of $79.8 million from the sale of warrants pursuant to the warrant transactions described below.

In addition, the Company used $375.0 million of the net proceeds from the offering of the Notes to repurchase shares of its common stock under an accelerated share repurchase program pursuant to an agreement that the Company entered into with one of the Initial Purchasers on October 1, 2014, as described in NOTE 10—Share Repurchase Programs to the Company’s Consolidated Financial Statements.

The Company intends to use the remaining net proceeds from the offering for working capital and other general corporate purposes, which may include capital expenditures, potential acquisitions or strategic transactions.

Indenture

On October 7, 2014, the Company entered into an indenture (the “Indenture”) with respect to the Notes with U.S. Bank National Association, as trustee (the “Trustee”). Under the Indenture, the Notes will be senior

 

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RED HAT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

 

unsecured obligations of the Company and bear interest at a rate of 0.25% per year, payable semiannually in arrears on April 1 and October 1 of each year, beginning on April 1, 2015. The Notes will mature on October 1, 2019, unless previously purchased or converted.

The Notes are convertible into shares of the Company’s common stock at an initial conversion rate of 13.6219 shares per $1,000 principal amount of Notes (which is equivalent to an initial conversion price of approximately $73.41 per share), subject to adjustment upon the occurrence of certain events. The initial conversion price represents a premium of approximately 30% to the $56.47 per share closing price of the Company’s common stock on October 1, 2014. Upon conversion of the Notes, holders will receive cash or shares of the Company’s common stock or a combination thereof, at the Company’s election.

Prior to April 1, 2019, the Notes will be convertible only upon the occurrence of certain circumstances, and will be convertible thereafter at any time until the close of business on the second scheduled trading day immediately preceding the maturity date of the Notes.

The conversion rate is subject to customary anti-dilution adjustments. If certain corporate events described in the Indenture occur prior to the maturity date, the conversion rate will be increased for a holder who elects to convert its Notes in connection with such corporate event in certain circumstances.

The Notes are not redeemable prior to maturity, and no sinking fund is provided for the Notes. If the Company undergoes a “fundamental change,” as defined in the Indenture, subject to certain conditions, holders may require the Company to purchase for cash all or any portion of their Notes. The fundamental change purchase price will be 100% of the principal amount of the Notes to be purchased plus any accrued and unpaid special interest up to but excluding the fundamental change purchase date.

The Indenture contains customary terms and covenants, including that upon certain events of default occurring and continuing, either the Trustee or the holders of at least 25% in principal amount of the outstanding Notes may declare 100% of the principal of, and accrued and unpaid interest, if any, on, all the Notes to be due and payable.

In accounting for the issuance of the Notes, the Company separated the Notes into liability and equity components. The carrying amount of the liability component was calculated by measuring the estimated fair value of a similar liability that does not have an associated convertible feature. The carrying amount of the equity component representing the conversion option was determined by deducting the fair value of the liability component from the face value of the Notes as a whole. The excess of the face value of the Notes as a whole over the carrying amount of the liability component (the “debt discount”) is amortized to interest expense over the term of the Notes using the effective interest method with an effective interest rate of 2.86% per annum. The equity component is not remeasured as long as it continues to meet the conditions for equity classification.

As of November 30, 2014, the Notes consisted of the following (in thousands):

 

     As of
November 30,
2014
 

Liability component

  

Principal

   $ 805,000   

Less: debt discount

     (94,156
  

 

 

 

Net carrying amount

   $ 710,844   
  

 

 

 

Equity component (1)

   $ 96,890   
  

 

 

 

 

(1) Recorded in the Consolidated Balance Sheet in Additional paid-in capital.

 

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RED HAT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

 

In accounting for the transaction costs related to the Note issuance, the Company allocated the total amount incurred of $15.2 million to the liability and equity components based on their relative fair values. Issuance costs attributable to the liability component totaled $13.4 million and are being amortized to interest expense over the term of the Notes using the effective interest method. The remaining $1.8 million of issuance costs have been allocated to the equity component and are included in Additional paid-in capital on the Company’s Consolidated Balance Sheet as of November 30, 2014. Additionally, the Company recorded a deferred tax asset of $0.7 million related to the $1.8 million equity component of transactional costs which are deductible for tax purposes.

The following table includes total interest expense recognized related to the Notes for the three and nine months ended November 30, 2014 (in thousands):

 

     Three Months Ended
November 30, 2014
     Nine Months Ended
November 30, 2014
 

Coupon rate 0.25% per year, payable semiannually

   $         302       $         302   

Amortization of Note issuance costs—liability component

     351         351   

Accretion of debt discount

     2,734         2,734   
  

 

 

    

 

 

 

Total interest expense related to Notes

   $ 3,387       $ 3,387   
  

 

 

    

 

 

 

The fair value of the Notes, which was determined based on inputs that are observable in the market (Level 2), and the carrying value of Notes (the carrying value excludes the equity component of the Notes classified in equity) is as follows (in thousands):

 

     As of
November 30, 2014
     As of
February 28, 2014
 
     Fair Value      Carrying Value      Fair Value      Carrying Value  

Convertible notes

   $   718,810       $   710,844       $   —         $   —     
  

 

 

    

 

 

    

 

 

    

 

 

 

Convertible note hedge transactions and warrant transactions

On October 1, 2014, the Company entered into convertible note hedge transactions and warrant transactions with certain of the Initial Purchasers of the Notes or their respective affiliates (the “Option Counterparties”). In connection with the exercise in full by the Initial Purchasers of their option to purchase up to an additional $105.0 million in aggregate principal amount of the Notes, on October 2, 2014 the Company entered into additional convertible note hedge transactions and additional warrant transactions with the Option Counterparties.

The convertible note hedge transactions, including the additional convertible note hedge transactions, are expected to offset the potential dilution with respect to shares of the Company’s common stock upon any conversion of the Notes and/or offset any cash payments the Company is required to make in excess of the principal amount of the converted Notes, as the case may be. The warrant transactions, including the additional warrant transactions, will have a dilutive effect with respect to the Company’s common stock to the extent that the market price per share of the Company’s common stock, as measured under the terms of the warrant transactions, exceeds the $101.65 strike price of the warrants. However, subject to certain conditions, the Company may elect to settle all of the warrants in cash. The $101.65 strike price of the warrants represents a premium of approximately 80% over the $56.47 per share closing price of the Company’s common stock on October 1, 2014.

The purchase of convertible note hedges and proceeds from issuance of warrants were recorded in stockholders’ equity and will continue to be classified as stockholders’ equity.

 

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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, 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 market our offerings primarily to enterprise customers in the form of annual or multi-year subscriptions, and we recognize revenue over the period of the subscription agreements with our customers. Our enterprise technologies are also offered by cloud providers as a service available on demand, and this revenue is reported to and recognized by us following delivery.

We have focused on introducing and gaining acceptance for Red Hat enterprise technologies that comprise our open source architecture. Red Hat Enterprise Linux (“RHEL”) and Red Hat JBoss Middleware offerings have 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 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, 2014.

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 three months ended November 30, 2014, total revenue increased 15.0%, or $59.4 million, to $455.9 million from $396.5 million for the three months ended November 30, 2013. Subscription revenue increased 15.1%, or $51.9 million, driven primarily by additional subscriptions related to our principal RHEL and Red Hat

 

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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 13.8%, or $7.4 million, for the three months ended November 30, 2014 as compared to the three months ended November 30, 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, hardware original equipment manufacturers, IHVs, ISVs, systems integrators and value added resellers;

 

   

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 and billings proxy

Our deferred revenue, current and long-term, balance at November 30, 2014 was $1.30 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. Revenue derived from cloud providers for the delivery of our enterprise technologies as a service available on demand is recognized by us following delivery and not billed in advance. As a result, such revenue has no associated deferred revenue. Total deferred revenue at November 30, 2014 increased $10.9 million, or 0.8%, as compared to the balance at February 28, 2014 of $1.29 billion.

The increase in deferred revenue reported on our Consolidated Balance Sheets of $10.9 million differs from the increase we reported on our Consolidated Statements of Cash Flows for the nine months ended November 30, 2014 of $58.0 million as the amount reported on our Consolidated Statements of Cash Flows for the nine months ended November 30, 2014 excludes (i) the impact of changes in foreign currency exchange rates used to translate deferred revenue balances from our foreign subsidiaries’ functional currency into U.S. dollars and (ii) deferred revenue acquired as parts of business combinations.

Billings proxy

We approximate our quarterly 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.

For the four-fiscal-quarter period ended November 30, 2014, our rolling average billings proxy increased $79.8 million, or 19.6%, to $487.1 million from $407.3 million for the four-fiscal-quarter period ended November 30, 2013. For information regarding seasonality, see Part II, Item 7 under “Overview” of our Annual Report on Form 10-K for the fiscal year ended February 28, 2014.

 

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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 the first, second and third quarters of fiscal 2015 and for each quarter of fiscal 2014 and fiscal 2013 and is being driven primarily by the increased use of our offerings by enterprise customers and our expansion of sales channels and geographic footprint during these periods.

Revenue by geography

For the three months ended November 30, 2014, approximately $191.7 million, or 42.0%, of our revenue was generated outside the United States compared to approximately $178.9 million, or 45.1%, for the three months ended November 30, 2013. 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 November 30, 2014, we had offices in more than 80 locations throughout the world.

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 the three months ended November 30, 2014 and the three months ended November 30, 2013 was as follows (in thousands):

 

     Americas      EMEA      Asia Pacific      Consolidated  

Three Months Ended November 30, 2014

   $ 290,525       $ 105,755       $ 59,615       $ 455,895   

Three Months Ended November 30, 2013

   $ 249,744       $ 93,818       $ 52,974       $ 396,536   

Year-over-year revenue growth rates in U.S. dollars for our three geographical regions were as follows for the three months ended November 30, 2014 and three months ended November 30, 2013:

 

     Americas     EMEA     Asia Pacific     Consolidated  

Three Months Ended November 30, 2014

     16.3     12.7     12.5     15.0

Three Months Ended November 30, 2013

     13.4     26.5     7.8     15.4

Excluding the impact of foreign currency exchange rates, Americas, EMEA and Asia Pacific revenue grew 17.3%, 20.1% and 19.6%, respectively, for the three months ended November 30, 2014 as compared to the three months ended November 30, 2013.

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

Gross profit margin decreased to 84.3% for the three months ended November 30, 2014 from 84.8% for the three months ended November 30, 2013 primarily due to increased staffing cost to support our emerging cloud offerings, such as OpenStack and OpenShift.

 

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Gross profit margin by geography

Gross profit margins by our geographic regions for the three months ended November 30, 2014 and November 30, 2013 were as follows:

 

     Americas     EMEA     Asia Pacific     Consolidated (1)  

Three Months Ended November 30, 2014

     85.5     86.0     82.4     84.3

Three Months Ended November 30, 2013

     85.0     88.3     82.8     84.8

 

(1) Consolidated gross margin includes corporate (non-allocated) share-based compensation expense for the three months ended November 30, 2014 and November 30, 2013 of $3.9 million and $2.9 million, respectively. For additional information, see NOTE 8—Share-based Awards to our Consolidated Financial Statements.

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.

Income from operations

Operating income was 14.7% and 15.3% of total revenue for the three months ended November 30, 2014 and November 30, 2013, respectively. The decrease in operating income as a percentage of revenue was primarily due to continued investment in new and emerging cloud management technologies and incremental transaction costs related to business combinations. 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 regions for the three months ended November 30, 2014 and the three months ended November 30, 2013 was as follows:

 

     Americas     EMEA     Asia Pacific     Consolidated (1)  

Three Months Ended November 30, 2014

     23.6     18.7     20.8     14.7

Three Months Ended November 30, 2013

     20.7     29.1     22.8     15.3

 

(1) Consolidated operating income as a percentage of revenue includes corporate (non-allocated) share-based compensation expense for the three months ended November 30, 2014 and November 30, 2013 of $33.6 million and $30.2 million, respectively. For additional information, see NOTE 11—Segment Reporting to our Consolidated Financial Statements.

Operating margin for EMEA and Asia Pacific decreased for the three months ended November 30, 2014 as compared to the three months ended November 30, 2013 primarily as a result of increased investments in research and development to support new technologies such as cloud management. The operating margin for EMEA for the three months ended November 30, 2014 also includes incremental expenses resulting from the recent acquisitions of both eNovance and FeedHenry. For further discussion regarding business acquisitions, see NOTE 14—Business Combinations to our Consolidated Financial Statements.

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

 

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Cash, cash equivalents, available-for-sale investments in debt securities and cash flow from operations

Cash, cash equivalents and short-term and long-term available-for-sale investments in debt securities balances at November 30, 2014 totaled $1.65 billion. Cash generated from operating activities for the three months ended November 30, 2014 totaled $133.0 million which represents an increase of 39.8% in operating cash flow as compared to the three months ended November 30, 2013. This increase is due to the timing of billing and collections and the timing of accounts payable settlements 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 42.0% of our revenue for the three months ended November 30, 2014 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 of 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.

Three Months Ended November 30, 2014

Using the average foreign currency exchange rates from the third quarter of our prior fiscal year ended February 28, 2014, our revenue and operating expenses from non-U.S. operations for the three months ended November 30, 2014 would have been higher than we reported by approximately $13.2 million and $9.8 million, respectively, which would have resulted in income from operations being higher by $3.3 million.

Nine Months Ended November 30, 2014

Using the average foreign currency exchange rates for the nine months ended November 30, 2013, our revenue and operating expenses from non-U.S. operations for the nine months ended November 30, 2014 would have been higher than we reported by approximately $12.2 million and $11.3 million, respectively, which would have resulted in income from operations being higher by $0.9 million.

Business combinations

FeedHenry

On October 8, 2014, we completed our acquisition of all of the shares of FeedHenry for approximately $80.2 million. FeedHenry is a provider of cloud-based enterprise mobile application platforms. The acquisition is intended to expand our portfolio of application development, integration and platform-as-a-service solutions, enabling us to support mobile application development in public and private environments. We incurred approximately $1.1 million in transaction costs including legal and accounting fees relating to the acquisition. These transaction costs have been expensed as incurred and included in general and administrative expense on our Consolidated Statement of Operations for the three and nine months ended November 30, 2014.

eNovance

On June 24, 2014, we completed our acquisition of all of the shares of eNovance, a provider of open source cloud computing services, for $67.6 million. The acquisition is intended to assist in advancing our market position in OpenStack, and the addition of eNovance’s systems integration capabilities and engineering

 

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talent is expected to help meet growing demand for enterprise OpenStack consulting, design and deployment. We incurred approximately $0.9 million in transaction costs including legal and accounting fees relating to the acquisition. These transaction costs have been expensed as incurred and included in general and administrative expense on our Consolidated Statement of Operations for the nine months ended November 30, 2014.

Inktank

On April 30, 2014, we completed our acquisition of all of the shares of Inktank, a provider of scale-out, open source storage systems, whose flagship technology, Inktank Ceph Enterprise, delivers object and block storage software to enterprises deploying public or private clouds for consideration of $152.5 million. The acquisition is intended to complement our existing GlusterFS-based storage offering. We incurred approximately $2.0 million in transaction costs, including legal and accounting fees relating to the acquisition. These transaction costs have been expensed as incurred and are included in general and administrative expense on our Consolidated Statement of Operations for the nine months ended November 30, 2014.

As a result of the acquisitions of Inktank, eNovance and FeedHenry, operating expenses, other than acquisition-related expenses described above, increased by approximately $11.3 million and $20.6 million, respectively, for the three months and nine months ended November 30, 2014 as compared to the three months and nine months ended November 30, 2013. For further discussion, see NOTE 14—Business Combinations to our Consolidated Financial Statements.

Convertible note offering

On October 7, 2014, we completed our offering of $700.0 million aggregate principal amount of our 0.25% Convertible Senior Notes due 2019 (the “Notes”). The Notes were sold in a private placement under a purchase agreement, dated as of October 1, 2014, entered into by and among us and Morgan Stanley & Co. LLC, Merrill Lynch, Pierce, Fenner & Smith Incorporated, Citigroup Global Markets Inc. and J.P. Morgan Securities LLC as representatives of the several initial purchasers named therein (collectively, the “Initial Purchasers”), for resale to qualified institutional buyers pursuant to Rule 144A under the Securities Act of 1933, as amended (the “Securities Act”). We also granted the Initial Purchasers a right to purchase, within a 30-day period, up to an additional $105.0 million principal amount of Notes on the same terms and conditions, which the Initial Purchasers exercised in full on October 2, 2014 and was also completed on October 7, 2014.

We used $148.0 million of the net proceeds from the offering of the Notes to pay the cost of the privately-negotiated convertible note hedge transactions described in NOTE 15—Convertible Notes to our Consolidated Financial Statements. Proceeds of $79.8 million were received by us from the sale of warrants pursuant to the warrant transactions also described in NOTE 15—Convertible Notes to our Consolidated Financial Statements.

In addition, we used $375.0 million of the net proceeds from the offering of the Notes to repurchase shares of our common stock under an accelerated share repurchase program pursuant to an agreement that we entered into with one of the Initial Purchasers on October 1, 2014, as described in NOTE 10—Share Repurchase Programs to our Consolidated Financial Statements.

We intend to use the remaining net proceeds from the offering for working capital and other general corporate purposes, which may include capital expenditures, potential acquisitions or strategic transactions.

 

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RESULTS OF OPERATIONS

Three months ended November 30, 2014 and November 30, 2013

The following table is a summary of our results of operations for the three months ended November 30, 2014 and November 30, 2013 (in thousands):

 

    Three Months  Ended
(Unaudited)
             
    November 30,
2014
    November 30,
2013
    $
Change
    %
Change
 

Revenue:

       

Subscriptions

  $ 394,699      $ 342,770      $ 51,929        15.1

Training and services

    61,196        53,766        7,430        13.8   
 

 

 

   

 

 

   

 

 

   

 

 

 

Total subscription and training and services revenue

    455,895        396,536        59,359        15.0   
 

 

 

   

 

 

   

 

 

   

 

 

 

Cost of subscription and training and services revenue:

       

Cost of subscriptions

    28,574        24,544        4,030        16.4   

As a % of subscription revenue

    7.2     7.2    

Cost of training and services

    42,791        35,883        6,908        19.3   

As a % of training and services revenue

    69.9     66.7    
 

 

 

   

 

 

   

 

 

   

 

 

 

Total cost of subscription and training and services revenue

    71,365        60,427        10,938        18.1   

As a % of total revenue

    15.7     15.2    
 

 

 

   

 

 

   

 

 

   

 

 

 

Total gross profit

    384,530        336,109        48,421        14.4   
 

 

 

   

 

 

   

 

 

   

 

 

 

Operating expense:

       

Sales and marketing

    187,218        153,528        33,690        21.9   

Research and development

    90,613        82,519        8,094        9.8   

General and administrative

    39,502        39,270        232        0.6   
 

 

 

   

 

 

   

 

 

   

 

 

 

Total operating expense

    317,333        275,317        42,016        15.3   
 

 

 

   

 

 

   

 

 

   

 

 

 

Income from operations

    67,197        60,792        6,405        10.5   

Interest income

    2,196        1,579        617        39.1   

Interest expense

    3,441        51        3,390        6,647.1   

Other income (expense), net

    1,559        (389     1,948        500.8   
 

 

 

   

 

 

   

 

 

   

 

 

 

Income before provision for income taxes

    67,511        61,931        5,580        9.0   

Provision for income taxes (1)

    19,578        9,906        9,672        97.6   
 

 

 

   

 

 

   

 

 

   

 

 

 

Net income

  $ 47,933      $ 52,025      $ (4,092     (7.9 )% 
 

 

 

   

 

 

   

 

 

   

 

 

 

Gross profit margin-subscriptions

    92.8     92.8    

Gross profit margin-training and services

    30.1     33.3    

Gross profit margin

    84.3     84.8    

As a % of total revenue:

       

Subscription revenue

    86.6     86.4    

Training and services revenue

    13.4     13.6    

Sales and marketing expense

    41.1     38.7    

Research and development expense

    19.9     20.8    

General and administrative expense

    8.7     9.9    

Total operating expenses

    69.6     69.4    

Income from operations

    14.7     15.3    

Income before provision for income taxes

    14.8     15.6    

Net income

    10.5     13.1    

Estimated annual effective income tax rate (1)

    29.0     27.5    

 

(1) Provision for income taxes for the three months ended November 30, 2013 includes a net discrete tax benefit of $4.2 million and the impact of the change in our estimated annual effective tax rate from 30% to 27.5%. See NOTE 5—Income Taxes to our Consolidated Financial Statements for further discussion.

 

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Revenue

Subscription revenue

Subscription revenue, which is primarily comprised of direct and indirect sales of Red Hat enterprise offerings, increased by 15.1%, or $51.9 million, to $394.7 million for the three months ended November 30, 2014 from $342.8 million for the three months ended November 30, 2013.

Revenue derived from the sale of subscriptions supporting our Infrastructure-related offerings increased by 10.9%, or $32.9 million, to $332.9 million for the three months ended November 30, 2014 from $300.0 million for the three months ended November 30, 2013 and is primarily due to increases in volumes sold, including additional subscriptions attributable to geographic expansion and the continued migration of enterprises to our open source Linux platform from proprietary operating systems.

Revenue derived from the sale of subscriptions supporting our Application development-related and other emerging technology offerings increased by 44.7%, or $19.1 million, to $61.8 million for the three months ended November 30, 2014 from $42.7 million for the three months ended November 30, 2013. The increase is primarily due to additional subscriptions for Red Hat JBoss Middleware offerings. We expect the growth rate of revenue derived from our Application development-related and other emerging technology offerings to exceed the growth rate of revenue derived from our Infrastructure-related offerings as our Application development-related and other emerging technology offerings continue to gain broader market acceptance in the enterprise IT environment.

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 13.8%, or $7.4 million, to $61.2 million for the three months ended November 30, 2014 from $53.8 million for the three months ended November 30, 2013. The increase is primarily due to services revenue which increased by 15.5%, or $6.0 million, as a result of an increase in consulting engagements driven by increased demand for our open source solutions. Training revenue increased by 9.7%, or $1.5 million, due to increased training related to the introduction of RHEL 7 and for OpenStack. Combined training and services revenue decreased slightly as a percentage of total revenue to 13.4% for the three months ended November 30, 2014 from 13.6% for the three months ended November 30, 2013.

Cost of revenue

Cost of subscription revenue

The cost of subscription revenue primarily consists of expenses we incur to support, distribute and package Red Hat enterprise offerings. These costs include labor-related costs 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 16.4%, or $4.0 million, to $28.6 million for the three months ended November 30, 2014 from $24.5 million for the three months ended November 30, 2013. The increase is primarily due to the expansion of our technical staff in order to meet the demands of our growing subscriber base for support, security updates and fixes, and includes additional compensation of $2.7 million. The remaining increase is driven primarily by incremental facilities costs and amortization expense related to technology acquisitions. Gross profit margin on subscriptions was 92.8% for each of the three months ended November 30, 2014 and November 30, 2013. 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.

 

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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 19.3%, or $6.9 million, to $42.8 million for the three months ended November 30, 2014 from $35.9 million for the three months ended November 30, 2013. Costs to deliver our services revenue increased by 21.8%, or $6.1 million, and relate to additional employee compensation and travel associated with additions to our emerging technologies staff. Total costs to deliver training and services as a percentage of training and services revenue was 69.9% and 66.7% for each of the three month periods ended November 30, 2014 and November 30, 2013, respectively.

Gross profit

Gross profit margin decreased to 84.3% for the three months ended November 30, 2014 from 84.8% for the three months ended November 30, 2013 primarily due to an increase in staffing costs to support our emerging cloud offerings, such as OpenStack and OpenShift.

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 21.9%, or $33.7 million, to $187.2 million for the three months ended November 30, 2014 from $153.5 million for the three months ended November 30, 2013. This increase was primarily due to a $26.8 million increase in selling costs, which includes $24.3 million of additional employee compensation expense attributable to the expansion of our sales force from the prior year and $1.4 million related to travel. The remaining increase relates to marketing costs, which grew 18.0%, or $6.9 million, for the three months ended November 30, 2014 as compared to the three months ended November 30, 2013. As a result of expanded sales staffing, sales and marketing expense increased as a percentage of revenue to 41.1% for the three months ended November 30, 2014 from 38.7% for the three months ended November 30, 2013.

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 9.8%, or $8.1 million, to $90.6 million for the three months ended November 30, 2014 from $82.5 million for the three months ended November 30, 2013. 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. Employee compensation increased by $8.0 million. Research and development expense was 19.9% and 20.8% of total revenue for the three months ended November 30, 2014 and November 30, 2013, respectively.

General and administrative

General and administrative expense consists primarily of personnel and related costs for general corporate functions, including information systems, finance, accounting, legal, human resources and facilities expense. General and administrative expense increased by 0.6%, or $0.2 million, to $39.5 million for the three months ended November 30, 2014 from $39.3 million for the three months ended November 30, 2013. General and administrative expense decreased as a percentage of revenue to 8.7% for the three months ended November 30, 2014 from 9.9% for the three months ended November 30, 2013. We expect general and administrative costs to decrease as a percentage of total revenue as we continue to realize and leverage benefits from investments made during the prior fiscal year in process and technology infrastructure enhancements to support our corporate functions.

 

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Interest income

Interest income increased by 39.1%, or $0.6 million, for the three months ended November 30, 2014 as compared to the three months ended November 30, 2013. The increase in interest income for the three months ended November 30, 2014 is attributable to slightly higher prevailing yields earned on larger cash and investment balances.

Interest expense

Interest expense increased by $3.4 million, for the three months ended November 30, 2014 as compared to the three months ended November 30, 2013. The increase in interest expense for the three months ended November 30, 2014 is attributable to the issuance of convertible senior notes which are described in NOTE 15—Convertible Notes to our Consolidated Financial Statements.

Other income (expense), net

Other income (expense), net increased by $1.9 million, for the three months ended November 30, 2014 as compared to the three months ended November 30, 2013. The increase is primarily due to both net gains recognized from the settlement of foreign currency transactions and unrealized net gains recognized from the remeasurement of foreign currency transactions not yet settled during the three months ended November 30, 2014.

Income taxes

During the three months ended November 30, 2014, we recorded $19.6 million of income tax expense, which is based on an estimated annual effective tax rate of 29.0%. Our estimated annual effective tax rate of 29.0% is less than the U.S. federal statutory rate of 35.0% primarily due to foreign income taxed at lower rates.

During the three months ended November 30, 2013, we recorded $9.9 million of income tax expense, which is based on an estimated annual effective tax rate of 27.5%, less a net discrete tax benefit of $4.2 million. Our estimated annual effective tax rate of 27.5%, which excludes the impact of the discrete tax benefit, is less than the U.S. federal statutory rate of 35.0% primarily due to foreign income taxed at lower rates, research tax credits and the domestic production activities deduction.

 

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Nine months ended November 30, 2014 and November 30, 2013

The following table is a summary of our results of operations for the nine months ended November 30, 2014 and November 30, 2013 (in thousands):

 

     Nine Months  Ended
(Unaudited)
             
     November  30,
2014
    November 30,
2013
    $
Change
    %
Change
 

Revenue:

        

Subscriptions

   $ 1,156,161      $ 985,279      $ 170,882        17.3

Training and services

     169,387        148,939        20,448        13.7   
  

 

 

   

 

 

   

 

 

   

 

 

 

Total subscription and training and services revenue

     1,325,548        1,134,218        191,330        16.9   
  

 

 

   

 

 

   

 

 

   

 

 

 

Cost of subscription and training and services revenue:

        

Cost of subscriptions

     84,125        71,437        12,688        17.8   

As a % of subscription revenue

     7.3     7.3    

Cost of training and services

     118,857        100,627        18,230        18.1   

As a % of training and services revenue

     70.2     67.6    
  

 

 

   

 

 

   

 

 

   

 

 

 

Total cost of subscription and training and services revenue

     202,982        172,064        30,918        18.0   

As a % of total revenue

     15.3     15.2    
  

 

 

   

 

 

   

 

 

   

 

 

 

Total gross profit

     1,122,566        962,154        160,412        16.7   
  

 

 

   

 

 

   

 

 

   

 

 

 

Operating expense:

        

Sales and marketing

     538,576        440,568        98,008        22.2   

Research and development

     275,817        234,619        41,198        17.6   

General and administrative

     125,786        111,807        13,979        12.5   

Facility exit costs

     —          2,171        (2,171     (100.0
  

 

 

   

 

 

   

 

 

   

 

 

 

Total operating expense

     940,179        789,165        151,014        19.1   
  

 

 

   

 

 

   

 

 

   

 

 

 

Income from operations

     182,387        172,989        9,398        5.4   

Interest income

     6,048        4,608        1,440        31.3   

Interest expense

     3,591        114        3,477        3,050.0   

Other income, net

     1,777        446        1,331        298.4   
  

 

 

   

 

 

   

 

 

   

 

 

 

Income before provision for income taxes

     186,621        177,929        8,692        4.9   

Provision for income taxes (1)

     54,120        44,705        9,415        21.1   
  

 

 

   

 

 

   

 

 

   

 

 

 

Net income

   $ 132,501      $ 133,224      $ (723     (0.5 )% 
  

 

 

   

 

 

   

 

 

   

 

 

 

Gross profit margin-subscriptions

     92.7     92.7    

Gross profit margin-training and services

     29.8     32.4    

Gross profit margin

     84.7     84.8    

As a % of total revenue:

        

Subscription revenue

     87.2     86.9    

Training and services revenue

     12.8     13.1    

Sales and marketing expense

     40.6     38.8    

Research and development expense

     20.8     20.7    

General and administrative expense

     9.5     9.9    

Facility exit costs

     —       0.2    

Total operating expenses

     70.9     69.6    

Income from operations

     13.8     15.3    

Income before provision for income taxes

     14.1     15.7    

Net income

     10.0     11.7    

Estimated annual effective income tax rate (1)

     29.0     27.5    

 

(1) The estimated annual effective tax rate for the nine months ended November 30, 2013 is based on estimated annual ordinary income and excludes a net discrete tax benefit of $4.2 million. See NOTE 5—Income Taxes to our Consolidated Financial Statements for further discussion.

 

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Revenue

Subscription revenue

Subscription revenue increased by 17.3%, or $170.9 million, to $1.16 billion for the nine months ended November 30, 2014 from $985.3 million for the nine months ended November 30, 2013.

Revenue derived from the sale of subscriptions supporting our Infrastructure-related offerings increased by 13.6%, or $117.7 million, to $983.9 million for the nine months ended November 30, 2014 from $866.2 million for the nine months ended November 30, 2013 and is primarily due to increases in volumes sold, including additional subscriptions attributable to geographic expansion and the continued migration of enterprises to our open source Linux platform from proprietary operating systems.

Revenue derived from the sale of subscriptions supporting our Application development-related and other emerging technology offerings increased by 44.6%, or $53.2 million, to $172.2 million for the nine months ended November 30, 2014 from $119.1 million for the nine months ended November 30, 2013. The increase is primarily due to additional subscriptions for Red Hat JBoss Middleware offerings.

Training and services revenue

Total training and services revenue increased by 13.7%, or $20.4 million, to $169.4 million for the nine months ended November 30, 2014 from $148.9 million for the nine months ended November 30, 2013. The increase is primarily due to services revenue which increased by 16.1%, or $17.4 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 12.8% for the nine months ended November 30, 2014 from 13.1% for the nine months ended November 30, 2013.

Cost of revenue

Cost of subscription revenue

Cost of subscription revenue increased by 17.8%, or $12.7 million, to $84.1 million for the nine months ended November 30, 2014 from $71.4 million for the nine months ended November 30, 2013. The increase is primarily due to the expansion of our technical staff in order to meet the demands of our growing subscriber base for support, security updates and fixes, and includes additional compensation of $9.4 million. The remaining increase is driven primarily by incremental facilities costs and amortization expense related to technology acquisitions. Gross profit margin on subscriptions was 92.7% for each of the nine months ended November 30, 2014 and November 30, 2013. 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 increased by 18.1%, or $18.2 million, to $118.9 million for the nine months ended November 30, 2014 from $100.6 million for the nine months ended November 30, 2013. Costs to deliver our services revenue increased by 21.2%, or $16.7 million, and relate to additional employee compensation and travel associated with additions to our emerging technologies staff as a result of both direct hires and business combinations. Total costs to deliver training and services as a percentage of training and services revenue was 70.2% and 67.6% for each of the nine months month periods ended November 30, 2014 and November 30, 2013, respectively.

Gross profit

Gross profit margin was 84.7% and 84.8% for each of the nine months ended November 30, 2014 and November 30, 2013, respectively. A favorable mix shift, which increased subscription sales relative to total sales was offset by an increase in staffing costs to support our emerging cloud offerings, such as OpenStack and OpenShift.

 

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Operating expenses

Sales and marketing

Sales and marketing expense increased by 22.2%, or $98.0 million, to $538.6 million for the nine months ended November 30, 2014 from $440.6 million for the nine months ended November 30, 2013. This increase was primarily due to a $78.7 million increase in selling costs, which includes $65.3 million of additional employee compensation expense attributable to the expansion of our sales force from the prior year and $5.3 million related to travel. The remaining increase relates to marketing costs, which grew 17.7%, or $19.3 million, for the nine months ended November 30, 2014 as compared to the nine months ended November 30, 2013. As a result of expanded sales staffing, sales and marketing expense increased as a percentage of revenue to 40.6% for the nine months ended November 30, 2014 from 38.8% for the nine months ended November 30, 2013.

Research and development

Research and development expense increased by 17.6%, or $41.2 million, to $275.8 million for the nine months ended November 30, 2014 from $234.6 million for the nine months ended November 30, 2013. 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. Employee compensation increased by $32.9 million. The remaining increase in research and development costs relates primarily to process and technology infrastructure enhancements, which increased $4.7 million. Research and development expense was 20.8% and 20.7% of total revenue for the nine months ended November 30, 2014 and November 30, 2013, respectively.

General and administrative

General and administrative expense increased by 12.5%, or $14.0 million, to $125.8 million for the nine months ended November 30, 2014 from $111.8 million for the nine months ended November 30, 2013. The increase in general and administrative expenses results from increased compensation-related expense of $10.3 million. The remaining increase includes $4.0 million of transaction costs related to business combinations. General and administrative expense decreased as a percentage of revenue to 9.5% for the nine months ended November 30, 2014 from 9.9% for the nine months ended November 30, 2013. We expect general and administrative costs to decrease as a percentage of total revenue as we continue to realize and leverage benefits from investments made during the prior fiscal year in process and technology infrastructure enhancements to support our corporate functions.

Interest income

Interest income increased by 31.3%, or $1.4 million, for the nine months ended November 30, 2014 as compared to the nine months ended November 30, 2013. The increase in interest income for the nine months ended November 30, 2014 is attributable to slightly higher yields earned on larger cash and investment balances.

Interest expense

Interest expense increased by $3.5 million, for the nine months ended November 30, 2014 as compared to the nine months ended November 30, 2013. The increase in interest expense for the nine months ended November 30, 2014 is attributable to the issuance of convertible senior notes which are described in NOTE 15—Convertible Notes to our Consolidated Financial Statements.

Other income, net

Other income, net increased by $1.3 million, for the nine months ended November 30, 2014 as compared to the nine months ended November 30, 2013. The increase is primarily due to a gain on the sale of an investment during the nine months ended November 30, 2014.

 

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Income taxes

During the nine months ended November 30, 2014, we recorded $54.1 million of income tax expense, which is based on an estimated annual effective tax rate of 29.0%. Our estimated annual effective tax rate of 29.0% is less than the U.S. federal statutory rate of 35.0% primarily due to foreign income taxed at lower rates.

During the nine months ended November 30, 2013, we recorded $44.7 million of income tax expense, which is based on an estimated annual effective tax rate of 27.5%, less a net discrete tax benefit of $4.2 million. Our estimated annual effective tax rate of 27.5%, which excludes the impact of the net discrete tax benefit, is less than the U.S. federal statutory rate of 35.0% primarily due to foreign income taxed at lower rates, research tax credits and the domestic production activities deduction.

LIQUIDITY AND CAPITAL RESOURCES

We derive our liquidity and operating capital primarily from cash flows from operations. Historically, we also received cash from the sale of equity securities, including private sales of preferred stock and the sale of common stock in our initial and follow-on public offerings, and the issuance of convertible notes, including our recent issuance of convertible senior notes with par value totaling $805.0 million described above, in Overview—Convertible note offering and in detail in NOTE 15—Convertible Notes to our Consolidated Financial Statements. At November 30, 2014, we had total cash and investments of $1.65 billion, which was comprised of $884.0 million in cash and cash equivalents, $231.4 million of short-term, available-for-sale, fixed-income investments and $531.1 million of long-term, available-for-sale fixed-income investments. This compares to total cash and investments of $1.49 billion at February 28, 2014

With $884.0 million in cash and cash equivalents on hand, we believe our cash and cash equivalent balances, together with our ability to generate additional cash from operations, should be sufficient to satisfy our cash requirements for the next twelve months and for the foreseeable future. However, we may take advantage of favorable capital market conditions that may arise from time to time to raise additional capital. We presently do not intend to liquidate our short- and long-term investments in debt securities prior to their scheduled maturity dates. However, in the event that we liquidate these investments prior to their scheduled maturities and there are adverse changes in market interest rates or the overall economic environment, we could be required to recognize a realized loss on those investments when we liquidate those investments. At November 30, 2014 and February 28, 2014, net accumulated unrealized gains on our available-for-sale debt securities totaled $0.9 million and $0.5 million, respectively.

Nine months ended November 30, 2014

Cash flows—overview

At November 30, 2014, cash and cash equivalents totaled $884.0 million, an increase of $237.2 million as compared to February 28, 2014. The increase in cash and cash equivalents for the nine months ended November 30, 2014 is primarily the result of operating cash flows which generated $405.4 million and the issuance of our convertible senior notes which generated $790.4 million, net of issuance costs. Partially offsetting cash generated by operations and the issuance of our convertible senior notes were acquisitions of Inktank, eNovance and FeedHenry, which included net cash consideration of $296.1 million, and the repurchase of 8,355,757 shares of our common stock for $535.1 million.

Cash flows from operations

Cash provided by operations of $405.4 million during the nine months ended November 30, 2014 includes net income of $132.5 million, adjustments to exclude the impact of non-cash revenues and expenses, which totaled a $168.7 million net source of cash, and changes in operating assets and liabilities, which totaled a $104.2

 

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million net source of cash. Cash provided by changes in operating assets and liabilities for the nine months ended November 30, 2014 was primarily due to both the growth in billings, which resulted in incremental operating cash flow from an increase in deferred revenue of $58.0 million and the timing of disbursements settlement which increased accounts payable and accrued expenses by $56.2 million.

Cash flows from investing

Cash used in investing activities of $290.2 million for the nine months ended November 30, 2014 includes net cash of $296.1 million used to acquire Inktank, eNovance and FeedHenry and investments in property and equipment of $35.1 million, primarily related to information technology infrastructure and leasehold improvements. These business, property and equipment acquisitions were partially offset by proceeds from net maturities of available-for-sale debt securities of $42.0 million.

Cash flows from financing

Cash provided by financing activities of $151.4 million for the nine months ended November 30, 2014 includes $790.4 million from the issuance of our convertible senior notes, net of issuance costs, proceeds of $79.8 million from issuance of warrants and proceeds from excess tax benefits related to share-based payment arrangements which totaled $4.9 million. Partially offsetting the cash provided by our convertible senior notes issuance and excess tax benefits is $535.1 million used to repurchase 8,355,757 shares of our common stock and $148.0 million used in note hedge transactions. See NOTE 10—Share Repurchase Programs and NOTE 15—Convertible Notes to our Consolidated Financial Statements for further discussion of our share repurchase program and our issuance of convertible senior notes. Payments made in return for common shares received from employees to satisfy employees’ minimum tax withholding obligations related to restricted share awards vesting during the nine months ended November 30, 2014 totaled $39.3 million.

Investments in debt securities

Our investments are comprised primarily of debt securities that are classified as available for sale and recorded at their fair market values. At November 30, 2014 and February 28, 2014, the vast majority of our investments were priced with the assistance of pricing vendors. These pricing vendors use the most recent observable market information in pricing these securities or, if specific prices are not available for these securities, use other observable inputs. In the event observable inputs are not available, we assess other factors to determine the securities’ market value, including broker quotes or model valuations. Independent price verifications of all of our holdings are performed by the pricing vendors, which we review. In the event a price fails a pre-established tolerance check, it is researched so that we can assess the cause of the variance to determine what we believe is the appropriate fair market value.

Capital requirements

We have experienced a substantial increase in our operating expenses since our inception in connection with the growth of our operations, the development of our enterprise technologies, the expansion of our services operations and our acquisition activity. Our capital requirements during the fiscal year ending February 28, 2015 will depend on numerous factors, including the amount of resources we devote to:

 

   

funding the continued development of our enterprise offerings;

 

   

improving and extending our services and the technologies used to market and deliver these services to our customers and support our business;

 

   

pursuing strategic acquisitions and alliances;

 

   

investing in or acquiring businesses, products and technologies; and

 

   

investing in enhancements to the systems we use to run our business and the expansion of our office facilities.

 

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We have utilized, and will continue from time to time to utilize, cash and investments to fund, among other potential uses, purchases of our common stock, purchases of fixed assets, purchases of intangible assets (primarily patents) and mergers and acquisitions. Given our historically strong operating cash flow and the $1.65 billion of cash and investments held at November 30, 2014, we believe our cash and cash equivalent balances, together with our ability to generate additional cash from operations, should be sufficient to satisfy our cash requirements for the next twelve months and for the foreseeable future. However, we may take advantage of favorable capital market conditions that may arise from time to time to raise additional capital.

We believe that cash flows from operations will continue to improve; however, there can be no assurances that we will improve our cash flows from operations from the current rate or that such cash flows will be adequate to fund other investments or acquisitions that we may choose to make or that cash may be located in or generated in the appropriate geography where we can effectively use such cash. We may choose to accelerate the expansion of our business from our current plans, which may require us to raise additional funds through the sale of equity or debt securities or through other financing means. There can be no assurances that any such financing would occur in amounts or on terms favorable to us, if at all.

As of November 30, 2014, our cash, cash equivalents and available-for-sale investment securities totaled $1.65 billion, of which $613.7 million was held outside the U.S. Our intent is to reinvest the earnings of foreign subsidiaries indefinitely outside the U.S. to fund both organic growth and acquisitions. For further discussion related to geographic segments, see NOTE 11—Segment Reporting to our Consolidated Financial Statements.

With $1.03 billion or 62.7% of our available cash, cash equivalents and available-for-sale investments, as of November 30, 2014, held within the U.S., we do not anticipate a need to repatriate any foreign earnings for the foreseeable future. However, if cash held outside the U.S. were needed to fund our U.S. operations, under current tax law we would be subject to additional taxes on the portion related to repatriated earnings of our foreign subsidiaries. As of February 28, 2014, cumulative undistributed foreign earnings totaled $296.4 million. For further discussion, see NOTE 11—Income Taxes to our Consolidated Financial Statements contained in our Annual Report on Form 10-K for the year ended February 28, 2014.

Off-balance sheet arrangements

As of November 30, 2014 and February 28, 2014, we have no off-balance sheet financing arrangements and do not utilize any “structured debt”, “special purpose” or similar unconsolidated entities for liquidity or financing purposes.

 

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ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

We are exposed to the impact of interest rate changes, foreign currency exchange rate fluctuations and changes in the market value of our investments.

Interest rate risk

Our exposure to market rate risk for changes in interest rates relates primarily to our investment portfolio. The primary objective of our investment activities is to preserve principal and liquidity while at the same time maximizing yields without significantly increasing risk. To achieve this objective, we maintain our portfolio of short-term and long-term investments in a variety of available-for-sale fixed and floating rate debt securities, including both government and corporate obligations and money market funds. Investments in both fixed rate and floating rate interest earning instruments carry a degree of interest rate risk. Fixed rate securities may have their fair market value adversely impacted due to a rise in prevailing interest rates, while floating rate securities may produce less income than expected if interest rates fall. Due in part to these factors, our future investment income related to these securities may fall short of expectations due to changes in interest rates, or we may suffer losses in principal if forced to sell securities which have declined in market value due to changes in interest rates or perceived credit risk related to the securities’ issuers. A hypothetical one-half percentage point change in interest rates, assuming a parallel shift of all interest rates, would result in an approximate $0.4 million change in annual interest income derived from investments in our portfolio as of November 30, 2014. For further discussion related to our investments as of November 30, 2014 and February 28, 2014, see NOTE 6—Assets and Liabilities Measured at Fair Value on a Recurring Basis to our Consolidated Financial Statements.

Investment risk

The fair market value of our available-for-sale investment portfolio is subject to interest rate risk. Based on a sensitivity analysis performed on this investment portfolio, a hypothetical one percentage point increase in prevailing interest rates would result in an approximate $12.9 million decrease in the fair value of our available-for-sale investment securities as of November 30, 2014. For further discussion related to our investments as of November 30, 2014 and February 28, 2014, see NOTE 6—Assets and Liabilities Measured at Fair Value on a Recurring Basis to our Consolidated Financial Statements.

Credit risk

Investments in debt and equity securities

The fair market values of our investment portfolio and cash balances are exposed to counterparty credit risk. Accordingly, while we periodically review our portfolio in an effort to mitigate counterparty risk, the principal values of our cash balances, money market accounts and investments in available-for-sale securities could suffer a loss of value.

Accounts receivable

No individual customer accounted for 10% or more of our total accounts receivable as of November 30, 2014 or February 28, 2014.

Foreign currency risk

Approximately 42.0% of our revenue for the three months ended November 30, 2014 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 of 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

 

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against foreign currencies, the translation of these foreign currency statements results in increased revenue and operating expenses for our non-U.S. operations. Similarly, our revenue and operating expenses for our non-U.S. operations decreases if the U.S. dollar strengthens against foreign currencies.

Using the average foreign currency exchange rates from the third quarter of our prior fiscal year ended February 28, 2014, our revenue and operating expenses from non-U.S. operations for the three months ended November 30, 2014 would have been higher than we reported by approximately $13.2 million and $9.8 million, respectively, which would have resulted in income from operations being higher by $3.3 million.

Using the average foreign currency exchange rates for the nine months ended November 30, 2013, our revenue and operating expenses from non-U.S. operations for the nine months ended November 30, 2014 would have been higher than we reported by approximately $12.2 million and $11.3 million, respectively, which would have resulted in income from operations being higher by $0.9 million.

Convertible Senior Notes

In October 2014, we issued $805.0 million of 0.25% convertible senior notes due 2019. The Notes have a fixed annual interest rate of 0.25%, and therefore we do not have economic interest rate exposure on the Notes. However, the fair market value of the Notes is exposed to interest rate risk. Generally, the fair market value of the Notes will increase as interest rates fall and decrease as interest rates rise. For further discussion regarding the fair value of the Notes, see NOTE 15—Convertible Notes to our Consolidated Financial Statements.

In connection with the offering of the Notes, we entered into convertible note hedge transactions and warrant transactions. The convertible note hedge transactions are expected to offset the potential dilution with respect to shares of our common stock upon any conversion of the Notes and/or offset any cash payments that we are required to make in excess of the principal amount of the converted Notes, as the case may be. The warrant transactions will have a dilutive effect with respect to our common stock to the extent that the market price per share of our common stock, as measured under the terms of the warrant transactions, exceeds the applicable strike price of the warrants. However, subject to certain conditions, we may elect to settle all of the warrants in cash. The initial strike price of the warrants is $101.65 per share. The number of shares of our common stock underlying the warrants is 10,965,630 shares, subject to anti-dilution adjustments. The convertible note hedge and warrants are both considered indexed to our common stock and classified as equity; therefore, the convertible note hedge and warrants are not accounted for as derivative instruments.

Derivative instruments

We transact business in various foreign countries and are, therefore, subject to risk of foreign currency exchange rate fluctuations. From time to time we enter into forward contracts to economically hedge transactional exposure associated with commitments arising from trade accounts receivable, trade accounts payable and fixed purchase obligations denominated in a currency other than the functional currency of the respective operating entity. All derivative instruments are recorded on the Consolidated Balance Sheets at their respective fair market values. We have elected not to prepare and maintain the documentation required to qualify our forward contracts for hedge accounting treatment and, therefore, changes in fair value are recorded in our Consolidated Statements of Operations. For further discussion related to our management of foreign currency risk see NOTE 7—Derivative Instruments to our Consolidated Financial Statements.

The aggregate notional amount of outstanding forward contracts at November 30, 2014 was $21.4 million. The fair value of these outstanding contracts at November 30, 2014 was a gross less than $0.1 million asset and a gross $0.4 million liability, and is recorded in Other current assets and Accounts payable and accrued expenses,

 

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respectively, on our Consolidated Balance Sheets. The forward contracts generally expire within three months of the period ended November 30, 2014. The forward contracts will settle in Australian dollars, Euros, Japanese yen, Norwegian krona, Singapore dollars, Swedish krona, Swiss francs and U.S. dollars.

The aggregate notional amount of outstanding forward contracts at February 28, 2014 was $28.3 million. The fair value of these outstanding contracts at February 28, 2014 was a gross $0.1 million asset and a gross less than $0.1 million liability, and is recorded in Other current assets and Accounts payable and accrued expenses, respectively on our Consolidated Balance Sheets. The forward contracts generally expire within three months of the period ended February 28, 2014. The forward contracts will settle in Argentine pesos, Australian dollars, Chilean pesos, Czech koruna, Danish krone, Euros, Israeli shekels, Japanese yen, Korean won, Norwegian krona, Singapore dollars, Swedish krona, Swiss francs, and U.S. dollars.

RECENT ACCOUNTING PRONOUNCEMENTS

In June 2014, the FASB issued Accounting Standards Update 2014-12, Accounting for Share-Based Payments When the Terms of an Award Provide That a Performance Target Could Be Achieved after the Requisite Service Period (“ASU 2014-12”). The FASB issued ASU 2014-12 to provide explicit guidance for share-based awards which allow for an employee to vest in an award upon achievement of a performance condition met after completion of a requisite service period regardless of whether the employee is rendering service on the date the performance target is achieved. ASU 2014-12 provides that the performance target should not be reflected in estimating the grant-date fair value of the award but rather compensation cost should be recognized in the period in which it becomes probable that the performance target will be achieved and recognized prospectively over the remaining requisite service period. This guidance is effective for fiscal years and interim periods within those years beginning after December 15, 2015, and is effective for us as of the first quarter of the fiscal year ending February 28, 2017. We have not issued such share-based awards and do not believe that this updated standard will have a material impact on our consolidated financial statements.

In May 2014, the FASB issued Accounting Standards Update 2014-09, Revenue from Contracts with Customers (“ASU 2014-09”). The FASB issued ASU 2014-09 to clarify the principles for recognizing revenue and to develop a common revenue standard for GAAP and International Financial Reporting Standards. The standard outlines a single comprehensive model for entities to use in accounting for revenue arising from contracts with customers and supersedes the most current revenue recognition guidance. This guidance is effective for fiscal years and interim periods within those years beginning after December 15, 2016, which is effective for us as of the first quarter of the fiscal year ending February 28, 2018. We are currently evaluating the impact that the implementation of this standard will have on our consolidated financial statements.

In July 2013, the FASB issued Accounting Standards Update No. 2013-11, Income Taxes (Topic 740)—Presentation of an Unrecognized Tax Benefit When a Net Operating Loss Carryforward, a Similar Tax Loss, or a Tax Credit Carryforward Exists (“ASU 2013-11”), to eliminate diversity in practice of presenting unrecognized tax benefits as a liability or presenting unrecognized tax benefits as a reduction of a deferred tax asset for a net operating loss or tax credit carryforward in certain circumstances by requiring that an unrecognized tax benefit be presented in the financial statements as a reduction to deferred tax assets excluding certain exceptions. ASU 2013-11 became effective for us during the three months ended May 31, 2014. The updated standard did not have a material impact on our consolidated financial statements.

In March 2013, the FASB issued Accounting Standards Update No. 2013-05, Foreign Currency Matters (Topic 830)—Parent’s Accounting for the Cumulative Translation Adjustment upon Derecognition of Certain Subsidiaries or Groups of Assets within a Foreign Entity or of an Investment in a Foreign Entity (“ASU 2013-05”), which requires a parent entity to release a related foreign entity’s cumulative translation adjustment into net income only if its sale or transfer results in the complete or substantially complete liquidation of the foreign entity in which the subsidiary or group of assets had resided. ASU 2013-05 became effective for us during the three months ended May 31, 2014. The updated standard did not have a material impact on our consolidated financial statements.

 

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ITEM 4. CONTROLS AND PROCEDURES

Role of Controls and Procedures

Our management, including our chief executive officer and chief financial officer, does not expect that our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934) or our internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) under the Securities Exchange Act of 1934) will prevent all errors and all fraud. A control system, no matter how well designed and operated, can provide only reasonable, not absolute, assurance that the control system’s objectives will be met. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of the controls must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within a company have been detected. These inherent limitations include the realities that judgments in decision-making can be faulty and that breakdowns can occur because of simple error and mistake. Controls can also be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of the controls. The design of any system of controls is based in part on certain assumptions about the likelihood of future events. Because of the inherent limitations in a cost-effective control system, misstatements due to error or fraud may occur and not be detected. Also projections of any evaluation of effectiveness of controls and procedures to future periods are subject to the risk that the controls and procedures may become inadequate because of changes in conditions, or that the degree of compliance with the controls and procedures may have deteriorated.

Evaluation of Disclosure Controls and Procedures

Our management, with the participation of our chief executive officer and chief financial officer, evaluated the effectiveness of our disclosure controls and procedures as of the end of the period covered by this report. Based on this evaluation, our chief executive officer and chief financial officer concluded that, as of the end of the period covered by this report, our disclosure controls and procedures were effective at a reasonable assurance level.

Changes in Internal Control Over Financial Reporting

No changes in our internal control over financial reporting occurred during the fiscal quarter covered by this report that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

 

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PART II

 

ITEM 1. LEGAL PROCEEDINGS

The Company experiences routine litigation in the normal course of its business, including patent litigation. The Company presently believes that the outcome of this routine litigation will not have a material adverse effect on its financial position, results of operations or cash flows.

 

ITEM 1A. RISK FACTORS

Set forth below are certain risks and cautionary statements, which supplement other disclosures in this report. Please carefully consider the following risks and cautionary statements. If any of the following risks occur, our business, financial condition, operating results and cash flows could be materially adversely affected.

RISKS RELATED TO BUSINESS UNCERTAINTY

We face intense competition.

The enterprise software industry is rapidly evolving and intensely competitive, and is subject to changing technologies, shifting customer needs, and frequent introductions of new products and services. We compete based on our ability to provide our customers with enterprise software offerings that best meet their needs at a compelling price. We expect that competition will continue to be intense, and there is a risk that our competitors’ products may provide better performance or include additional features when compared to our offerings. Competitive pressures could also affect the prices we may charge or the demand for our offerings, resulting in reduced profit margins and loss of market share.

Our current and potential competitors range from large and well-established companies to emerging start-ups. Some of our competitors have significantly greater financial resources and name recognition, larger development and sales staffs and more extensive marketing and distribution capabilities. Certain competitors also bundle hardware and software offerings, making it more difficult for us to penetrate their customer bases. As the enterprise software industry evolves, the competitive pressure for the Company to innovate encompasses a wider range of products and services, including new offerings that require different expertise than our current offerings. Some competitors may be able to innovate and provide products and services faster than we can.

Industry consolidation may affect competition by creating larger and potentially stronger competitors in the markets in which we compete. We also compete in certain areas with our partners and potential partners, and this may adversely impact our relationship with an individual partner or a number of partners.

Our efforts to compete effectively may not be sufficient, which may adversely affect our business, financial condition, operating results and cash flows.

Our continued success depends on our ability to adapt to a rapidly changing industry. Investment in new offerings, business strategies and initiatives could disrupt our ongoing business and may present risks not originally contemplated.

We operate in highly competitive markets that are characterized by rapid technological change and frequent new product and service announcements. Our continued success will depend on our ability to adapt to rapidly changing technologies, to adapt our offerings to evolving industry standards, to predict user preferences and industry changes and to improve the performance and reliability of our offerings. Our failure to adapt to such changes could harm our business. In addition, the widespread adoption of other technological changes could require substantial expenditures on our part to modify or adapt our offerings or infrastructure. Delays in developing, completing or delivering new or enhanced offerings and technologies could result in delayed or reduced revenue for those offerings and could also adversely affect customer acceptance of those offerings and technologies. The success of new and enhanced offering introductions depends on several factors, including our

 

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ability to invest significant resources in research and development in order to enhance our existing offerings and introduce new offerings in a timely manner, successfully promote the offerings, manage the risks associated with the offerings, make sufficient resources available to support the offerings and address any quality or other defects in the early stages of introduction.

Moreover, we believe that our continued success depends on our investing in new business strategies or initiatives that complement our strategic direction and technology road map. Such endeavors may involve significant risks and uncertainties, including distraction of management’s attention away from other business operations, and insufficient revenue generation to offset liabilities and expenses undertaken with such strategies and initiatives. Because these endeavors may be inherently risky, no assurance can be given that such endeavors will not adversely affect our business, financial condition, operating results and cash flows.

If we fail to continue to establish and maintain strategic relationships with industry-leading companies, we may not be able to attract and retain a larger customer base.

Our success depends in part on our ability to continue to establish and maintain strategic relationships with industry-leading cloud providers, enterprise solution providers, hardware manufacturers, and software vendors, such as Amazon.com, Inc., Cisco Systems, Inc., Dell Inc., Fujitsu Limited, Hewlett-Packard Co., International Business Machines Corporation, NEC Corporation, Oracle Corporation, SAP AG and others. Many of these strategic partners have engineered and certified that their products and services run on or with our offerings, and in some cases have built their products using our offerings. We may not be able to maintain these relationships or replace them on attractive terms in the future. Some of our strategic partners offer competing products and services. As a result of these factors, many of the companies with which we have strategic alliances may choose to pursue alternative technologies and develop alternative products and services in addition to or in lieu of our offerings, either on their own or in collaboration with others, including our competitors. Moreover, we cannot guarantee that the companies with which we have strategic relationships will market our offerings effectively or continue to devote the resources necessary to provide us with effective sales, marketing and technical support. As our agreements with strategic partners terminate or expire, we may be unable to renew or replace these agreements on comparable terms, or at all.

We rely, to a significant degree, on indirect sales channels for the distribution of our offerings, and disruption within these channels could adversely affect our business, financial condition, operating results and cash flows.

We use a variety of different indirect distribution methods for our offerings, including channel partners, such as certified cloud providers, distributors, hardware original equipment manufacturers (“OEMs”), and resellers. A number of these partners in turn distribute via their own networks of channel partners with whom we have no direct relationship. These relationships allow us to offer our technologies to a much larger customer base than we would otherwise be able through our direct sales and marketing efforts.

We rely, to a significant degree, on each of our channel partners to select, screen and maintain relationships with its distribution network and to distribute our offerings in a manner that is consistent with applicable regulatory requirements and Red Hat’s quality standards. Our channel partners may offer their own products and services that are competitive with our offerings or may not distribute and market our offerings effectively. Moreover, our existing channel partner relationships do not, and any future channel partner relationships may not, afford us any exclusive marketing or distribution rights. In addition, if a channel partner is acquired by a competitor or its business units are reorganized or divested, our revenue derived from that partner may be adversely impacted.

Recruiting and retaining qualified channel partners and training them in the use of our enterprise technologies requires significant time and resources. If we fail to devote sufficient resources to support and expand our network of channel partners, our business may be adversely affected. In addition, because we rely on channel partners for the indirect distribution of our enterprise technologies, we may have little or no contact with

 

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the ultimate end-users of our technologies, thereby making it more difficult for us to establish brand awareness, ensure proper delivery and installation of our software, support ongoing customer requirements, estimate end-user demand, respond to evolving customer needs and obtain subscription renewals from end-users.

If our indirect distribution channel is disrupted, we may be required to devote more resources to distribute our offerings directly and support our customers, which may not be as effective and could lead to higher costs, reduced revenue and growth that is slower than expected.

The duration and extent of economic downturns, regional financial instability, and economic and market conditions generally could adversely affect our business, financial condition, operating results and cash flows.

Economic weakness and uncertainty, tightened credit markets and constrained IT spending from time to time contribute to slowdowns in the technology industry, as well as in the customer segments and geographic regions in which we operate, which may result in reduced demand and increased price competition for our offerings. Our operating results in one or more geographic regions or customer segments may also be affected by uncertain or changing economic conditions within that region or segment. Continuing uncertainty about future economic conditions may, among other things, negatively impact our current and prospective customers and result in delays or reductions in technology purchases or lengthen our sales cycle. Adverse economic conditions also may negatively impact our ability to obtain payment for ou