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RED HAT INC - 10-Q - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS(Edgar Glimpses Via Acquire Media NewsEdge) 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 August 31, 2014, total revenue increased 19.1%, or $71.5 million, to $445.9 million from $374.4 million for the three months ended August 31, 2013. Subscription revenue increased 19.2%, 27-------------------------------------------------------------------------------- Table of Contents or $62.8 million, driven primarily by additional subscriptions related to our principal Red Hat Enterprise Linux and Red Hat JBoss Middleware offerings, which continue to gain broader market acceptance in mission-critical areas of computing, and our expansion of sales channels and our geographic footprint. The increase is, in part, a result of the continued migration of enterprises in industries such as financial services, government, technology and telecommunications to our open source solutions from proprietary technologies. Training and services revenue increased 18.2%, or $8.7 million, for the three months ended August 31, 2014 as compared to the three months ended August 31, 2013. The increase is driven primarily by customer interest in new products and increased demand for our open source solutions. We believe our success is influenced by: • the extent to which we can expand the breadth and depth of our enterprise offerings; • our ability to enhance the value of Red Hat enterprise offerings through frequent and continuing innovation while maintaining stable platforms over multi-year periods; • our ability to generate increasing revenue from channel partner and other strategic relationships, including cloud computing providers, distributors, IHVs, ISVs, hardware original equipment manufacturers, 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 August 31, 2014 was $1.25 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 August 31, 2014 decreased $37.4 million, or 2.9%, as compared to the balance at February 28, 2014 of $1.29 billion. The decrease in deferred revenue reported on our Consolidated Balance Sheets of $37.4 million differs from the decrease we reported on our Consolidated Statements of Cash Flows for the six months ended August 31, 2014 of $26.0 million as the amount reported on our Consolidated Statements of Cash Flows for the six months ended August 31, 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 August 31, 2014 our rolling average billings proxy increased $76.4 million, or 19.6%, to $465.3 million from $388.9 million for the four-fiscal-quarter period ended August 31, 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. 28-------------------------------------------------------------------------------- Table of Contents 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 and second 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 the enterprise and our expansion of sales channels and geographic footprint during these periods. Revenue by geography For the three months ended August 31, 2014, approximately $198.3 million, or 44.5%, of our revenue was generated outside the United States compared to approximately $166.0 million, or 44.3%, for the three months ended August 31, 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 August 31, 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 August 31, 2014 and the three months ended August 31, 2013 was as follows (in thousands): Americas EMEA Asia Pacific Consolidated Three Months Ended August 31, 2014 $ 282,138 $ 103,496 $ 60,265 $ 445,899 Three Months Ended August 31, 2013 $ 237,647 $ 86,239 $ 50,537 $ 374,423 Year-over-year revenue growth rates in U.S. dollars for our three geographical regions were as follows for the three months ended August 31, 2014 and three months ended August 31, 2013: Americas EMEA Asia Pacific Consolidated Three Months Ended August 31, 2014 18.7 % 20.0 % 19.2 % 19.1 % Three Months Ended August 31, 2013 13.6 % 29.0 % 8.4 % 16.1 % Excluding the impact of foreign currency exchange rates, Americas, EMEA and Asia Pacific revenue grew 19.5%, 17.4% and 19.9%, respectively, for the three months ended August 31, 2014 as compared to the three months ended August 31, 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 84.9% for the three months ended August 31, 2014 from 85.2% for the three months ended August 31, 2013 primarily due to increased staffing cost to support our emerging cloud offerings, such as OpenStack and OpenShift. 29 -------------------------------------------------------------------------------- Table of Contents Gross profit margin by geography Gross profit margins by our geographic regions for the three months ended August 31, 2014 and August 31, 2013 were as follows: Americas EMEA Asia Pacific Consolidated (1) Three Months Ended August 31, 2014 85.1 % 88.1 % 84.3 % 84.9 % Three Months Ended August 31, 2013 85.1 % 89.7 % 83.7 % 85.2 % (1) Consolidated gross margin includes corporate (non-allocated) share-based compensation expense for the three months ended August 31, 2014 and August 31, 2013 of $3.4 million and $3.1 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 14.4% and 14.8% of total revenue for the three months ended August 31, 2014 and August 31, 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 August 31, 2014 and the three months ended August 31, 2013 was as follows: Americas EMEA Asia Pacific Consolidated (1) Three Months Ended August 31, 2014 21.3 % 25.2 % 24.4 % 14.4 % Three Months Ended August 31, 2013 19.8 % 29.0 % 26.5 % 14.8 % (1) Consolidated operating income as a percentage of revenue includes corporate (non-allocated) share-based compensation expense for the three months ended August 31, 2014 and August 31, 2013 of $36.6 million and $29.9 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 August 31, 2014 as compared to the three months ended August 31, 2013 primarily as a result of increased investments in research and development to support new technologies such as cloud management. These geographic operating margins exclude the impact of share-based compensation expense, which was not allocated to our geographic segments. Cash, cash equivalents, 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 August 31, 2014 totaled $1.32 billion. Cash generated from operating activities for the three months ended August 31, 2014 totaled $107.7 million which represents a decrease of 9.4% in operating cash flow as 30 -------------------------------------------------------------------------------- Table of Contents compared to the three months ended August 31, 2013. This decrease 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 44.5% of our revenue for the three months ended August 31, 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 August 31, 2014 Using the average foreign currency exchange rates from the second 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 August 31, 2014 would have been lower than we reported by approximately $0.1 million and higher than we reported by approximately $0.5 million, respectively, which would have resulted in income from operations being lower by $0.6 million. Six Months Ended August 31, 2014 Using the average foreign currency exchange rates for the six months ended August 31, 2013, our revenue and operating expenses from non-U.S. operations for the six months ended August 31, 2014 would have been lower and higher than we reported by approximately $0.7 million and $1.7 million, respectively, which would have resulted in income from operations being lower by $2.4 million. Business combinations eNovance On June 24, 2014, we completed our acquisition of all of the shares of eNovance, a provider of open source cloud computing services. The acquisition is intended to assist in advancing our 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. 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 three and six months ended August 31, 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. The acquisition is intended to complement our existing GlusterFS-based storage offering. We incurred approximately $2.0 million in acquisition-related expenses, including legal and accounting fees. These costs have been expensed as incurred and are included in general and administrative expense on our Consolidated Statement of Operations for the six months ended August 31, 2014. 31-------------------------------------------------------------------------------- Table of Contents As a result of the acquisitions of Inktank and eNovance, operating expenses, other than acquisition-related expenses described above, increased by approximately $7.5 million and $9.3 million, respectively, for the three months and six months ended August 31, 2014 as compared to the three months and six months ended August 31, 2013. For further discussion, see NOTE 14-Business Combinations to our Consolidated Financial Statements. On September 18, 2014, we announced the signing of a definitive agreement to acquire all of the shares of FeedHenry for approximately 63.5 million Euros. 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 (PaaS) solutions, enabling us to support mobile application development in public and private environments. The acquisition is expected to close in the third quarter of fiscal 2015. 32-------------------------------------------------------------------------------- Table of Contents RESULTS OF OPERATIONSThree months ended August 31, 2014 and August 31, 2013 The following table is a summary of our results of operations for the three months ended August 31, 2014 and August 31, 2013 (in thousands): Three Months Ended (Unaudited) August 31, August 31, $ % 2014 2013 Change Change Revenue: Subscriptions $ 389,495 $ 326,692 $ 62,803 19.2 % Training and services 56,404 47,731 8,673 18.2 Total subscription and training and services revenue 445,899 374,423 71,476 19.1 Cost of subscription and training and services revenue: Cost of subscriptions 27,791 23,518 4,273 18.2 As a % of subscription revenue 7.1 % 7.2 % Cost of training and services 39,383 32,062 7,321 22.8 As a % of training and services revenue 69.8 % 67.2 % Total cost of subscription and training and services revenue 67,174 55,580 11,594 20.9 As a % of total revenue 15.1 % 14.8 % Total gross profit 378,725 318,843 59,882 18.8 Operating expense: Sales and marketing 174,520 144,596 29,924 20.7 Research and development 95,265 78,299 16,966 21.7 General and administrative 44,713 38,203 6,510 17.0 Facility exit costs - 2,171 (2,171 ) (100.0 ) Total operating expense 314,498 263,269 51,229 19.5 Income from operations 64,227 55,574 8,653 15.6 Interest income 2,010 1,527 483 31.6 Other income (expense), net (289 ) 1,196 (1,485 ) (124.2 ) Income before provision for income taxes 65,948 58,297 7,651 13.1 Provision for income taxes 19,125 17,489 1,636 9.4 Net income $ 46,823 $ 40,808 $ 6,015 14.7 % Gross profit margin-subscriptions 92.9 % 92.8 % Gross profit margin-training and services 30.2 % 32.8 % Gross profit margin 84.9 % 85.2 % As a % of total revenue: Subscription revenue 87.4 % 87.3 % Training and services revenue 12.6 % 12.7 % Sales and marketing expense 39.1 % 38.6 % Research and development expense 21.4 % 20.9 % General and administrative expense 10.0 % 10.2 % Facility exit costs - % 0.6 % Total operating expenses 70.5 % 70.3 % Income from operations 14.4 % 14.8 % Income before provision for income taxes 14.8 % 15.6 % Net income 10.5 % 10.9 % Estimated annual effective income tax rate 29.0 % 30.0 % 33 -------------------------------------------------------------------------------- Table of Contents Revenue Subscription revenue Subscription revenue, which is primarily comprised of direct and indirect sales of Red Hat enterprise offerings, increased by 19.2%, or $62.8 million, to $389.5 million for the three months ended August 31, 2014 from $326.7 million for the three months ended August 31, 2013. Revenue derived from the sale of subscriptions supporting our Infrastructure-related offerings increased by 15.7%, or $45.1 million, to $332.0 million for the three months ended August 31, 2014 from $286.9 million for the three months ended August 31, 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 44.5%, or $17.7 million, to $57.5 million for the three months ended August 31, 2014 from $39.8 million for the three months ended August 31, 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 18.2%, or $8.7 million, to $56.4 million for the three months ended August 31, 2014 from $47.7 million for the three months ended August 31, 2013. The increase is primarily due to services revenue which increased by 19.3%, or $6.8 million, as a result of an increase in consulting engagements driven by increased demand for our open source solutions. Training revenue increased by 15.1%, or $1.9 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 12.6% for the three months ended August 31, 2014 from 12.7% for the three months ended August 31, 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 cost to provide technical support, security updates and fixes, as well as costs for fulfillment, physical media, literature, packaging and shipping. Cost of subscription revenue increased by 18.2%, or $4.3 million, to $27.8 million for the three months ended August 31, 2014 from $23.5 million for the three months ended August 31, 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 $3.4 million. The remaining increase is driven primarily by incremental facilities costs and amortization expense related to technology acquisitions. Gross profit margin on subscriptions increased slightly to 92.9% for the three months ended August 31, 2014 from 92.8% for the three months ended August 31, 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 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 34-------------------------------------------------------------------------------- Table of Contents to various types of customers. Cost of training and services revenue increased by 22.8%, or $7.3 million, to $39.4 million for the three months ended August 31, 2014 from $32.1 million for the three months ended August 31, 2013. Costs to deliver our services revenue increased by 26.1%, or $6.6 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 69.8% and 67.2% for each of the three month periods ended August 31, 2014 and August 31, 2013, respectively. Gross profit Gross profit margin decreased to 84.9% for the three months ended August 31, 2014 from 85.2% for the three months ended August 31, 2013 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 20.7%, or $29.9 million, to $174.5 million for the three months ended August 31, 2014 from $144.6 million for the three months ended August 31, 2013. This increase was primarily due to a $28.1 million increase in selling costs, which includes $23.8 million of additional employee compensation expense attributable to the expansion of our sales force from the prior year and $1.1 million related to travel. The remaining increase relates to marketing costs, which grew 4.9%, or $1.8 million, for the three months ended August 31, 2014 as compared to the three months ended August 31, 2013. As a result of expanded sales staffing, sales and marketing expense increased as a percentage of revenue to 39.1% for the three months ended August 31, 2014 from 38.6% for the three months ended August 31, 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 21.7%, or $17.0 million, to $95.3 million for the three months ended August 31, 2014 from $78.3 million for the three months ended August 31, 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 $13.2 million. The remaining increase in research and development costs relates primarily to process and technology infrastructure enhancements, which increased $1.7 million. Research and development expense was 21.4% and 20.9% of total revenue for the three months ended August 31, 2014 and August 31, 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 17.0%, or $6.5 million, to $44.7 million for the three months ended August 31, 2014 from $38.2 million for the three months ended August 31, 2013. The increase in general and administrative expenses results from increased compensation-related expense of $3.9 million. The remaining increase includes $0.9 million of transaction costs related to business combinations. General and administrative expense decreased as a percentage of revenue to 10.0% for the three months ended August 31, 2014 from 10.2% for the three months ended August 31, 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. 35 -------------------------------------------------------------------------------- Table of Contents Interest income Interest income increased by 31.6%, or $0.5 million, for the three months ended August 31, 2014 as compared to the three months ended August 31, 2013. The increase in interest income for the three months ended August 31, 2014 is attributable to slightly higher prevailing yields earned on larger cash and investment balances. Other income (expense), net Other income (expense), net decreased by 124.2%, or $1.5 million, for the three months ended August 31, 2014 as compared to the three months ended August 31, 2013. The decrease is primarily due to both realized net losses recognized from the settlement of foreign currency transactions and the unrealized net losses recognized from the remeasurement of foreign currency transactions not yet settled during the three months ended August 31, 2014. Income taxes During the three months ended August 31, 2014, we recorded $19.1 million of income tax expense, which is based on an estimated annual effective tax rate of 29%. Our estimated annual effective tax rate of 29% is less than the U.S. federal statutory rate of 35% primarily due to foreign income taxed at lower rates. During the three months ended August 31, 2013, we recorded $17.5 million of income tax expense, which was based on a then estimated annual effective tax rate of 30%. Our estimated annual effective tax rate of 30% was less than the U.S. federal statutory rate of 35% primarily due to foreign income taxed at lower rates and research tax credits. 36-------------------------------------------------------------------------------- Table of Contents Six months ended August 31, 2014 and August 31, 2013 The following table is a summary of our results of operations for the six months ended August 31, 2014 and August 31, 2013 (in thousands): Six Months Ended (Unaudited) August 31, August 31, $ % 2014 2013 Change Change Revenue: Subscriptions $ 761,462 $ 642,509 $ 118,953 18.5 % Training and services 108,191 95,173 13,018 13.7 Total subscription and training and services revenue 869,653 737,682 131,971 17.9 Cost of subscription and training and services revenue: Cost of subscriptions 55,551 46,893 8,658 18.5 As a % of subscription revenue 7.3 % 7.3 % Cost of training and services 76,066 64,744 11,322 17.5 As a % of training and services revenue 70.3 % 68.0 % Total cost of subscription and training and services revenue 131,617 111,637 19,980 17.9 As a % of total revenue 15.1 % 15.1 % Total gross profit 738,036 626,045 111,991 17.9 Operating expense: Sales and marketing 351,358 287,040 64,318 22.4 Research and development 185,204 152,100 33,104 21.8 General and administrative 86,284 72,537 13,747 19.0 Facility exit costs - 2,171 (2,171 ) (100.0 ) Total operating expense 622,846 513,848 108,998 21.2 Income from operations 115,190 112,197 2,993 2.7 Interest income 3,852 3,029 823 27.2 Other income, net 68 772 (704 ) (91.2 ) Income before provision for income taxes 119,110 115,998 3,112 2.7 Provision for income taxes 34,542 34,799 (257 ) (0.7 ) Net income $ 84,568 $ 81,199 $ 3,369 4.1 % Gross profit margin-subscriptions 92.7 % 92.7 % Gross profit margin-training and services 29.7 % 32.0 % Gross profit margin 84.9 % 84.9 % As a % of total revenue: Subscription revenue 87.6 % 87.1 % Training and services revenue 12.4 % 12.9 % Sales and marketing expense 40.4 % 38.9 % Research and development expense 21.3 % 20.6 % General and administrative expense 9.9 % 9.8 % Facility exit costs - % 0.3 % Total operating expenses 71.6 % 69.7 % Income from operations 13.2 % 15.2 % Income before provision for income taxes 13.7 % 15.7 % Net income 9.7 % 11.0 % Estimated annual effective income tax rate 29.0 % 30.0 % 37 -------------------------------------------------------------------------------- Table of Contents Revenue Subscription revenue Subscription revenue increased by 18.5%, or $119.0 million, to $761.5 million for the six months ended August 31, 2014 from $642.5 million for the six months ended August 31, 2013. Revenue derived from the sale of subscriptions supporting our Infrastructure-related offerings increased by 15.0%, or $84.9 million, to $651.0 million for the six months ended August 31, 2014 from $566.1 million for the six months ended August 31, 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 $34.1 million, to $110.4 million for the six months ended August 31, 2014 from $76.4 million for the six months ended August 31, 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 $13.0 million, to $108.2 million for the six months ended August 31, 2014 from $95.2 million for the six months ended August 31, 2013. The increase is primarily due to services revenue which increased by 16.5%, or $11.4 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 12.4% for the six months ended August 31, 2014 from 12.9% for the six months ended August 31, 2013. Cost of revenue Cost of subscription revenue Cost of subscription revenue increased by 18.5%, or $8.7 million, to $55.6 million for the six months ended August 31, 2014 from $46.9 million for the six months ended August 31, 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 $6.7 million. The remaining increase is driven primarily by incremental facilities costs and amortization expense related to technology acquisitions. Gross profit margin on subscriptions was 92.7% for each of the six months ended August 31, 2014 and August 31, 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 17.5%, or $11.3 million, to $76.1 million for the six months ended August 31, 2014 from $64.7 million for the six months ended August 31, 2013. Costs to deliver our services revenue increased by 20.9%, or $10.6 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 70.3% and 68.0% for each of the six month periods ended August 31, 2014 and August 31, 2013, respectively. Gross profit Gross profit margin was 84.9% for each of the six months ended August 31, 2014 and August 31, 2013 . 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. 38-------------------------------------------------------------------------------- Table of Contents Operating expenses Sales and marketing Sales and marketing expense increased by 22.4%, or $64.3 million, to $351.4 million for the six months ended August 31, 2014 from $287.0 million for the six months ended August 31, 2013. This increase was primarily due to a $51.9 million increase in selling costs, which includes $41.0 million of additional employee compensation expense attributable to the expansion of our sales force from the prior year and $3.9 million related to travel. The remaining increase relates to marketing costs, which grew 17.6%, or $12.4 million, for the six months ended August 31, 2014 as compared to the six months ended August 31, 2013. As a result of expanded sales staffing, sales and marketing expense increased as a percentage of revenue to 40.4% for the six months ended August 31, 2014 from 38.9% for the six months ended August 31, 2013. Research and development Research and development expense increased by 21.8%, or $33.1 million, to $185.2 million for the six months ended August 31, 2014 from $152.1 million for the six months ended August 31, 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 $24.9 million. The remaining increase in research and development costs relates primarily to process and technology infrastructure enhancements, which increased $4.4 million. Research and development expense was 21.3% and 20.6% of total revenue for the six months ended August 31, 2014 and August 31, 2013, respectively. General and administrative General and administrative expense increased by 19.0%, or $13.7 million, to $86.3 million for the six months ended August 31, 2014 from $72.5 million for the six months ended August 31, 2013. The increase in general and administrative expenses results from increased compensation-related expense of $5.2 million. The remaining increase includes $2.9 million of transaction costs related to business combinations and $4.2 million related to increased facilities costs. Primarily as a result of the incremental costs related to facilities and business combinations, general and administrative expense increased as a percentage of revenue to 9.9% for the six months ended August 31, 2014 from 9.8% for the six months ended August 31, 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 27.2%, or $0.8 million, for the six months ended August 31, 2014 as compared to the six months ended August 31, 2013. The increase in interest income for the six months ended August 31, 2014 is attributable to slightly higher yields earned on larger cash and investment balances. Other income Other income decreased by 91.2%, or $0.7 million, for the six months ended August 31, 2014 as compared to the six months ended August 31, 2013. The decrease is primarily due to both realized net losses recognized from the settlement of foreign currency transactions and unrealized net losses recognized from the remeasurement of foreign currency transactions not yet settled during the six months ended August 31, 2014. Income taxes During the six months ended August 31, 2014, we recorded $34.5 million of income tax expense, which is based on an estimated annual effective tax rate of 29%. Our estimated annual effective tax rate of 29% is less than the U.S. federal statutory rate of 35% primarily due to foreign income taxed at lower rates. 39-------------------------------------------------------------------------------- Table of Contents During the six months ended August 31, 2013, we recorded $34.8 million of income tax expense, which was based on a then estimated annual effective tax rate of 30%. Our estimated annual effective tax rate of 30% was less than the U.S. federal statutory rate of 35% primarily due to foreign income taxed at lower rates and research tax credits. 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 debentures. At August 31, 2014, we had total cash and investments of $1.32 billion, which was comprised of $585.4 million in cash and cash equivalents, $217.6 million of short-term, available- for-sale, fixed-income investments and $513.9 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 $585.4 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 August 31, 2014 and February 28, 2014, net accumulated unrealized gains on our available-for-sale debt securities totaled $0.5 million. Six months ended August 31, 2014 Cash flows-overview At August 31, 2014, cash and cash equivalents totaled $585.4 million, a decrease of $61.4 million as compared to February 28, 2014. The decrease in cash and cash equivalents for the six months ended August 31, 2014 is primarily the result of the acquisitions of Inktank and eNovance, which included net cash consideration of $217.8 million, and the repurchase of 3,043,202 shares of our common stock for $160.1 million. Partially offsetting cash used in investing and financing activities was cash provided by operations which generated $272.4 million for the six months ended August 31, 2014. Net cash generated by operating activities and used for investing and financing activities is further described below. Cash flows from operations Cash provided by operations of $272.4 million during the six months ended August 31, 2014 includes net income of $84.6 million, adjustments to exclude the impact of non-cash revenues and expenses, which totaled a $111.9 million net source of cash, and changes in operating assets and liabilities, which totaled a $76.0 million net source of cash. Cash provided by changes in operating assets and liabilities for the six months ended August 31, 2014 was primarily the result of collections on our prior quarters' billings which generated operating cash flow of $78.2 million. These collections were partially offset by a reduction in deferred revenue of $26.0 million for the six months ended August 31, 2014 which corresponds to our typical, seasonal first and second quarter reduction in billings. Cash flows from investing Cash used in investing activities of $149.6 million for the six months ended August 31, 2014 includes net cash of $217.8 million used to acquire Inktank and eNovance and investments in property and equipment of 40-------------------------------------------------------------------------------- Table of Contents $22.9 million, primarily related to leasehold improvements. These business, property and equipment acquisitions were partially offset by proceeds from net maturities of available-for-sale debt securities of $90.4 million. Cash flows from financing Cash used in financing activities of $177.5 million for the six months ended August 31, 2014 includes $160.1 million used to repurchase 3,043,202 shares of our common stock. See NOTE 10-Share Repurchase Program to our Consolidated Financial Statements for further discussion of our share repurchase program. 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 six months ended August 31, 2014 totaled $17.6 million. Partially offsetting financing activities using cash were proceeds from excess tax benefits related to share-based employee compensation which totaled $1.4 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 August 31, 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. 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 $1.32 billion of cash and investments held at August 31, 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 41 -------------------------------------------------------------------------------- Table of Contents 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 August 31, 2014, our cash, cash equivalents and available-for-sale investment securities totaled $1.32 billion, of which $739.2 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 $577.8 million or 43.9% of our available cash, cash equivalents and available-for-sale investments, as of August 31, 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 August 31, 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. 42 -------------------------------------------------------------------------------- Table of Contents |