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, 2013

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 December 31, 2013, there were 189,538,365 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, 2013 (unaudited) and February 28, 2013 (derived from audited financial statements)

     3   
 

Consolidated Statements of Operations for the three months and nine months ended November 30, 2013 (unaudited) and 2012 (unaudited)

     4   
 

Consolidated Statements of Comprehensive Income for the three months and nine months ended November 30, 2013 (unaudited) and 2012 (unaudited)

     5   
 

Consolidated Statements of Cash Flows for the three months and nine months ended November 30, 2013 (unaudited) and 2012 (unaudited)

     6   
  Notes to Consolidated Financial Statements (unaudited)      7   

ITEM 2:

 

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

     25   

ITEM 3:

  QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK      40   

ITEM 4:

  CONTROLS AND PROCEDURES      43   

PART II

  OTHER INFORMATION:   

ITEM 1:

  LEGAL PROCEEDINGS      44   

ITEM 1A:

  RISK FACTORS      44   

ITEM 2:

  UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS      61   

ITEM 6:

  EXHIBITS      62   

SIGNATURES

     63   

 

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. (“Red Hat”) and its partners). Words such as “anticipates,” “believes,” “expects,” “estimates,” “intends,” “plans,” “projects,” 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


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RED HAT, INC.

CONSOLIDATED BALANCE SHEETS

(In thousands—except share and per share amounts)

 

     November 30, 2013
(Unaudited)
    February 28,
2013 (1)
 
ASSETS     

Current assets:

    

Cash and cash equivalents

   $ 642,111      $ 487,084   

Investments in debt and equity securities, short-term

     324,424        392,381   

Accounts receivable, net of allowances for doubtful accounts of $1,495 and $1,339, respectively

     309,753        302,942   

Deferred tax assets, net

     93,711        88,765   

Prepaid expenses

     96,142        94,421   

Other current assets

     2,459        3,156   
  

 

 

   

 

 

 

Total current assets

   $ 1,468,600      $ 1,368,749   

Property and equipment, net of accumulated depreciation and amortization of $218,565 and $189,985, respectively

     168,604        141,586   

Goodwill

     687,490        690,911   

Identifiable intangibles, net

     136,073        142,243   

Investments in debt securities, long-term

     360,114        438,908   

Other assets, net

     30,487        31,263   
  

 

 

   

 

 

 

Total assets

   $ 2,851,368      $ 2,813,660   
  

 

 

   

 

 

 
LIABILITIES AND STOCKHOLDERS’ EQUITY     

Current liabilities:

    

Accounts payable and accrued expenses

   $ 190,868      $ 154,202   

Deferred revenue

     833,671        830,486   

Other current obligations

     1,007        1,024   
  

 

 

   

 

 

 

Total current liabilities

   $ 1,025,546      $ 985,712   

Long-term deferred revenue

     289,622        259,466   

Other long-term obligations

     64,997        48,321   

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, 230,728,912 and 229,210,961 shares issued, and 189,525,534 and 193,021,226 shares outstanding at November 30, 2013 and February 28, 2013, respectively

     23        23   

Additional paid-in capital

     1,857,738        1,802,899   

Retained earnings

     675,104        541,880   

Treasury stock at cost, 41,203,378 and 36,189,735 shares at November 30, 2013 and February 28, 2013, respectively

     (1,056,419     (816,674

Accumulated other comprehensive loss

     (5,243     (7,967
  

 

 

   

 

 

 

Total stockholders’ equity

   $ 1,471,203      $ 1,520,161   
  

 

 

   

 

 

 

Total liabilities and stockholders’ equity

   $ 2,851,368      $ 2,813,660   
  

 

 

   

 

 

 

 

(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,
2013
    November 30,
2012
    November 30,
2013
     November 30,
2012
 

Revenue:

         

Subscriptions

   $ 342,770      $ 294,186      $ 985,279       $ 845,557   

Training and services

     53,766        49,420        148,939         135,375   
  

 

 

   

 

 

   

 

 

    

 

 

 

Total subscription and training and services revenue

     396,536        343,606        1,134,218         980,932   
  

 

 

   

 

 

   

 

 

    

 

 

 

Cost of subscription and training and services revenue:

         

Cost of subscriptions

     24,544        21,153        71,437         57,939   

Cost of training and services

     35,883        31,965        100,627         89,056   
  

 

 

   

 

 

   

 

 

    

 

 

 

Total cost of subscription and training and services revenue

     60,427        53,118        172,064         146,995   
  

 

 

   

 

 

   

 

 

    

 

 

 

Gross profit

     336,109        290,488        962,154         833,937   
  

 

 

   

 

 

   

 

 

    

 

 

 

Operating expense:

         

Sales and marketing

     153,528        133,792        440,568         378,240   

Research and development

     82,519        68,655        234,619         191,901   

General and administrative

     39,270        38,122        111,807         109,847   

Facility exit costs (NOTE 12)

     —          —          2,171         3,142   
  

 

 

   

 

 

   

 

 

    

 

 

 

Total operating expense

     275,317        240,569        789,165         683,130   
  

 

 

   

 

 

   

 

 

    

 

 

 

Income from operations

     60,792        49,919        172,989         150,807   

Interest income

     1,579        1,936        4,608         6,384   

Other income (expense), net

     (440     (730     332         502   
  

 

 

   

 

 

   

 

 

    

 

 

 

Income before provision for income taxes

     61,931        51,125        177,929         157,693   

Provision for income taxes

     9,906        16,360        44,705         50,462   
  

 

 

   

 

 

   

 

 

    

 

 

 

Net income

   $ 52,025      $ 34,765      $ 133,224       $ 107,231   
  

 

 

   

 

 

   

 

 

    

 

 

 

Basic net income per common share

   $ 0.27      $ 0.18      $ 0.70       $ 0.56   
  

 

 

   

 

 

   

 

 

    

 

 

 

Diluted net income per common share

   $ 0.27      $ 0.18      $ 0.69       $ 0.55   
  

 

 

   

 

 

   

 

 

    

 

 

 

Weighted average shares outstanding

         

Basic

     189,514        193,374        190,024         193,127   

Diluted

     191,365        195,666        192,049         195,898   

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,
2013
    November 30,
2012
    November 30,
2013
    November 30,
2012
 

Net income

   $ 52,025      $ 34,765      $ 133,224      $ 107,231   

Other comprehensive income (loss):

        

Change in foreign currency translation adjustment

     5,248        5,485        3,199        (2,593

Available-for-sale securities:

        

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

     2,213        849        (503     2,578   

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

     (23     (399     (340     (778

Tax (expense) benefit

     (759     (144     368        (576
  

 

 

   

 

 

   

 

 

   

 

 

 

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

     1,431        306        (475     1,224   
  

 

 

   

 

 

   

 

 

   

 

 

 

Total other comprehensive income (loss)

     6,679        5,791        2,724        (1,369
  

 

 

   

 

 

   

 

 

   

 

 

 

Comprehensive income

   $ 58,704      $ 40,556      $ 135,948      $ 105,862   
  

 

 

   

 

 

   

 

 

   

 

 

 

 

 

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,
2013
    November 30,
2012
    November 30,
2013
    November 30,
2012
 

Cash flows from operating activities:

       

Net income

  $ 52,025      $ 34,765      $ 133,224      $ 107,231   

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

       

Depreciation and amortization

    18,955        16,126        55,326        44,773   

Share-based compensation expense

    30,190        26,678        83,196        72,743   

Deferred income taxes

    2,016        6,686        18,679        29,749   

Excess tax benefits from share-based payment arrangements

    (3,428     (8,100     (9,071     (27,900

Net amortization of bond premium on debt securities available for sale

    2,301        1,675        6,637        5,094   

Other

    438        (552     485        (2,393

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

       

Accounts receivable

    (75,330     (35,291     (9,249     534   

Prepaid expenses

    (1,109     2,652        (3,503     (4,314

Accounts payable and accrued expenses

    12,272        19,879        38,565        42,809   

Deferred revenue

    56,019        35,207        40,999        56,515   

Other

    805        431        610        3,572   
 

 

 

   

 

 

   

 

 

   

 

 

 

Net cash provided by operating activities

    95,154        100,156        355,898        328,413   
 

 

 

   

 

 

   

 

 

   

 

 

 

Cash flows from investing activities:

       

Purchase of investment in debt securities available for sale

    (101,636     (123,318     (448,712     (631,087

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

    118,084        169,743        597,851        587,522   

Acquisition of business, net of cash acquired

           (21,188            (31,239

Purchase of other intangible assets

    (682     (5,577     (13,203     (32,440

Purchase of property and equipment

    (13,327     (28,309     (61,833     (64,552

Other

    (150     (66     (2,084     264   
 

 

 

   

 

 

   

 

 

   

 

 

 

Net cash provided by (used in) investing activities

    2,289        (8,715     72,019        (171,532
 

 

 

   

 

 

   

 

 

   

 

 

 

Cash flows from financing activities:

       

Excess tax benefits from share-based payment arrangements

    3,428        8,100        9,071        27,900   

Proceeds from exercise of common stock options

    223        4,294        1,311        10,810   

Payments related to net settlement of share-based compensation awards

    (18,307     (22,924     (33,122     (45,612

Purchase of treasury stock

    (40,018     (52,018     (239,363     (84,900

Payments on other borrowings

    (362     (205     (979     (682
 

 

 

   

 

 

   

 

 

   

 

 

 

Net cash used in financing activities

    (55,036     (62,753     (263,082     (92,484
 

 

 

   

 

 

   

 

 

   

 

 

 

Effect of foreign currency exchange rates on cash and cash equivalents

    2,910        5,647        (9,808     (7,703
 

 

 

   

 

 

   

 

 

   

 

 

 

Net increase in cash and cash equivalents

    45,317        34,335        155,027        56,694   

Cash and cash equivalents at beginning of the period

    596,794        571,576        487,084        549,217   
 

 

 

   

 

 

   

 

 

   

 

 

 

Cash and cash equivalents at end of the period

  $ 642,111      $ 605,911      $ 642,111      $ 605,911   
 

 

 

   

 

 

   

 

 

   

 

 

 

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, middleware, virtualization, storage and cloud technologies.

Open source software is an alternative to proprietary software and represents a different model for the development and licensing of commercial software code than that typically used for proprietary software. Because open source software code is often freely shared, there are customarily no licensing fees for the use of open source software. Therefore, 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 contained in the Company’s Annual Report on Form 10-K for the fiscal year ended February 28, 2013.

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, 2013 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 to present fairly 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, 2013 are not necessarily indicative of the results that may be expected for the fiscal year ending February 28, 2014. 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, 2013.

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, 2013. 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 July 2013, the Financial Accounting Standards Board (“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 is effective prospectively for the Company in the first quarter of its fiscal year ending February 28, 2015. The Company does not believe that this updated standard will have a material impact on its 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 is effective prospectively for the Company in the first quarter of its fiscal year ending February 28, 2015. The Company does not believe that this updated standard will have a material impact on its consolidated financial statements.

 

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RED HAT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

 

NOTE 3—Changes in Equity

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 (see NOTE 10)

    —          —          —          (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   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

The following table summarizes the changes in the Company’s stockholders’ equity during the three months ended November 30, 2012 (in thousands):

 

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

Balance at August 31, 2012

  $         23      $ 1,761,524      $ 464,142      $ (728,894   $ (13,112   $ 1,483,683   

Net income

    —          —          34,765        —          —          34,765   

Other comprehensive income (loss), net of tax

    —          —          —          —          5,791        5,791   

Exercise of common stock options

    —          4,294        —          —          —          4,294   

Common stock repurchase

    —          —          —          (52,018     —          (52,018

Share-based compensation expense

    —          26,678        —          —          —          26,678   

Tax benefits related to share-based awards

    —          953        —          —          —          953   

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

    —          (22,924     —          —          —          (22,924
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Balance at November 30, 2012

  $ 23      $ 1,770,525      $ 498,907      $ (780,912   $ (7,321   $ 1,481,222   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

 

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 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 (see NOTE 10)

    —          —          —          (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   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

The following table summarizes the changes in the Company’s stockholders’ equity during the nine months ended November 30, 2012 (in thousands):

 

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

Balance at February 29, 2012

  $         23      $ 1,709,082      $ 391,676      $ (696,012   $ (5,952   $ 1,398,817   

Net income

    —          —          107,231        —          —          107,231   

Other comprehensive income (loss), net of tax

    —          —          —          —          (1,369     (1,369

Exercise of common stock options

    —          10,810        —          —          —          10,810   

Common stock repurchase

    —          —          —          (84,900     —          (84,900

Share-based compensation expense

    —          72,743        —          —          —          72,743   

Tax benefits related to share-based awards

    —          23,502        —          —          —          23,502   

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

    —          (45,612     —          —          —          (45,612
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Balance at November 30, 2012

  $ 23      $ 1,770,525      $ 498,907      $ (780,912   $ (7,321   $ 1,481,222   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

 

10


Table of Contents

RED HAT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

 

Accumulated other comprehensive loss

The following is a summary of accumulated other comprehensive loss as of November 30, 2013 and February 28, 2013 (in thousands):

 

     As of
November  30,
2013
    As of
February  28,
2013
 

Accumulated loss from foreign currency translation adjustment

   $ (5,569   $ (8,768

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

     326        801   
  

 

 

   

 

 

 

Accumulated other comprehensive loss

   $ (5,243   $ (7,967
  

 

 

   

 

 

 

NOTE 4—Identifiable Intangible Assets

Identifiable intangible assets consist primarily of purchased technologies, customer and reseller relationships, trademarks, copyrights and patents 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, 2013 and February 28, 2013, trademarks with an indefinite estimated useful life totaled $9.6 million and $9.3 million, respectively.

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

 

     As of November 30, 2013      As of February 28, 2013  
     Gross
Amount
     Accumulated
Amortization
    Net
Amount
     Gross
Amount
     Accumulated
Amortization
    Net
Amount
 

Trademarks, copyrights and patents

   $ 100,420       $ (33,011   $ 67,409       $ 94,020       $ (27,412   $ 66,608   

Purchased technologies

     79,388         (53,614     25,774         79,201         (46,507     32,694   

Customer and reseller relationships

     89,985         (60,394     29,591         89,959         (53,391     36,568   

Covenants not to compete

     10,656         (5,513     5,143         10,516         (4,143     6,373   

Other intangible assets

     8,927         (771     8,156         —           —          —     
  

 

 

    

 

 

   

 

 

    

 

 

    

 

 

   

 

 

 

Total identifiable intangible assets

   $ 289,376       $ (153,303   $ 136,073       $ 273,696       $ (131,453   $ 142,243   
  

 

 

    

 

 

   

 

 

    

 

 

    

 

 

   

 

 

 

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, 2013 and November 30, 2012 is summarized as follows (in thousands):

 

     Three Months Ended      Nine Months Ended  
     November 30,
2013
     November 30,
2012
     November 30,
2013
     November 30,
2012
 

Cost of revenue

   $ 2,848       $ 1,433       $ 8,360       $ 3,252   

Sales and marketing

     2,244         2,076         6,395         6,272   

Research and development

     959         959         2,877         2,877   

General and administrative

     1,288         1,476         4,028         3,800   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total amortization expense

   $ 7,339       $ 5,944       $ 21,660       $ 16,201   
  

 

 

    

 

 

    

 

 

    

 

 

 

 

11


Table of Contents

RED HAT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

 

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, 2013 and November 30, 2012 (in thousands):

 

     Three Months Ended     Nine Months Ended  
     November 30,
2013
    November 30,
2012
    November 30,
2013
    November 30,
2012
 

Provision for income taxes:

        

Income before provision for income taxes

   $ 61,931      $ 51,125      $ 177,929      $ 157,693   

Estimated effective tax rate excluding discrete tax items (1)

     22.8     32.0     27.5     32.0
  

 

 

   

 

 

   

 

 

   

 

 

 

Provision for income taxes

     14,131        16,360        48,930        50,462   

Discrete tax benefit

     4,225        —          4,225        —     
  

 

 

   

 

 

   

 

 

   

 

 

 

Provision for income taxes

   $ 9,906      $ 16,360      $ 44,705      $ 50,462   
  

 

 

   

 

 

   

 

 

   

 

 

 

 

(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% as of August 31, 2013 to 27.5% as of November 30, 2013.

For the three months and nine months ended November 30, 2013, the Company recorded income tax expense of $9.9 million and $44.7 million, respectively. 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. Excluding the impact of the discrete tax benefit, the Company’s estimated annual effective tax rate was 27.5%. The estimated annual effective tax rate of 27.5% differs from the U.S. federal statutory rate of 35% principally due to foreign income taxed at lower rates, research tax credits and the domestic production activities deduction.

For the three months and nine months ended November 30, 2012, the Company’s estimated annual effective tax rate of 32% differed from the U.S. federal statutory rate of 35% principally due to foreign income taxed at lower rates.

Deferred Taxes

As of November 30, 2013, deferred tax assets net of deferred tax liabilities (current and non-current) totaled $91.6 million, of which $0.4 million was offset by a valuation allowance. The Company continues to maintain a valuation allowance against its deferred tax assets with respect to certain net operating loss (“NOL”) carryforwards.

As of November 30, 2013, the Company had U.S. federal and state NOL carryforwards of approximately $27.2 million and $97.4 million, respectively. As of November 30, 2013, the Company had U.S. federal and state research tax credit carryforwards of approximately $31.7 million and $9.7 million, respectively. The tax credit carryforwards are scheduled to expire in varying amounts beginning in the fiscal year ending February 28, 2019.

 

12


Table of Contents

RED HAT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

 

Unrecognized tax benefits

The Company’s unrecognized tax benefits were $56.8 million as of November 30, 2013 and $48.3 million as of February 28, 2013. The Company’s unrecognized tax benefits at November 30, 2013 and February 28, 2013, which, if recognized, would affect the Company’s effective tax rate were $47.5 million and $45.3 million, respectively.

During the nine months ended November 30, 2013, the amount of unrecognized tax benefits increased $7.3 million, primarily as a result of increases with respect to tax positions taken during prior periods. It is reasonably possible that the balance of unrecognized tax benefits may change within the next 12 months upon a conclusion of an income tax examination by the U.S. Internal Revenue Service. However, the Company is unable to estimate the range of potential change at this time.

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 $5.2 million and $4.2 million as of November 30, 2013 and February 28, 2013, 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, 2013. 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

     2008 – Present   

Japan

     2012 – Present   

With respect to Japan, 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 Company is currently undergoing an income tax examination by the U.S. Internal Revenue Service with respect to its fiscal year ended February 28, 2010. The Company is also 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

 

13


Table of Contents

RED HAT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

 

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 with effective original maturities of 90 days or less from the balance sheet date 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, net. Realized gains and losses and other than temporary impairments, if any, are reflected in the statements of operations as other income, 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.

 

14


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 November 30, 2013 (in thousands):

 

    As of
November 30,
2013
    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)

  $ 249,311      $ 249,311      $ —        $ —     

Interest-bearing deposits (1)

    59,039        —          59,039        —     

Available-for-sale securities (1):

       

Commercial paper

    4,000        —          4,000        —     

U.S. agency securities

    199,472        —          199,472        —     

Corporate securities

    357,313        —          357,313        —     

Foreign government securities

    68,714        —          68,714        —     

Foreign currency derivatives (2)

    58        —          58        —     

Liabilities:

       

Foreign currency derivatives (3)

    (278     —          (278     —     
 

 

 

   

 

 

   

 

 

   

 

 

 

Total

  $     937,629      $         249,311      $         688,318      $                 —     
 

 

 

   

 

 

   

 

 

   

 

 

 

 

(1) Included in Cash and cash equivalents, Investments in debt and equity securities, short-term or Investments in debt securities, long-term in the Company’s Consolidated Balance Sheet at November 30, 2013, in addition to $388.8 million of cash.
(2) Included in Other current assets in the Company’s Consolidated Balance Sheet at November 30, 2013.
(3) Included in Accounts payable and accrued expenses in the Company’s Consolidated Balance Sheet at November 30, 2013.

The following table summarizes the composition and fair value hierarchy of the Company’s financial assets and liabilities at February 28, 2013 (in thousands):

 

    As of
February 28,
2013
    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)

  $ 143,680      $ 143,680      $ —        $ —     

Interest-bearing deposits (1)

    123,518        —          123,518        —     

Available-for-sale securities (1):

       

Commercial paper

    54,483        —          54,483        —     

U.S. agency securities

    359,993        —          359,993        —     

Corporate securities

    312,691        —          312,691        —     

Foreign government securities

    26,869        —          26,869        —     

Equity securities (1)

    274        274        —          —     

Foreign currency derivatives (2)

    280        —          280        —     

Liabilities:

       

Foreign currency derivatives (3)

    (219     —          (219     —     
 

 

 

   

 

 

   

 

 

   

 

 

 

Total

  $ 1,021,569      $ 143,954      $ 877,615      $                 —     
 

 

 

   

 

 

   

 

 

   

 

 

 

 

15


Table of Contents

RED HAT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

 

 

(1) Included in Cash and cash equivalents, Investments in debt and equity securities, short-term or Investments in debt securities, long-term in the Company’s Consolidated Balance Sheet at February 28, 2013, in addition to $296.9 million of cash.
(2) Included in Other current assets in the Company’s Consolidated Balance Sheet at February 28, 2013.
(3) Included in Accounts payable and accrued expenses in the Company’s Consolidated Balance Sheet at February 28, 2013.

The following table represents the Company’s investments measured at fair value as of November 30, 2013 (in thousands):

 

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

Money markets

   $ 249,311       $ —         $ —        $ 249,311       $ 249,311       $ —         $ —     

Interest-bearing deposits

     59,039         —           —          59,039         —           59,039         —     

Commercial paper

     4,000         —           —          4,000         4,000         —           —     

U.S. agency securities

     200,127         45         (700     199,472         —           45,808         153,664   

Corporate securities

     356,203         1,227         (117     357,313         —           150,863         206,450   

Foreign government securities

     68,709         7         (2     68,714         —           68,714         —     
  

 

 

    

 

 

    

 

 

   

 

 

    

 

 

    

 

 

    

 

 

 

Total

   $ 937,389       $ 1,279       $ (819   $ 937,849       $ 253,311       $ 324,424       $ 360,114   
  

 

 

    

 

 

    

 

 

   

 

 

    

 

 

    

 

 

    

 

 

 

 

(1) As of November 30, 2013, there were less than $0.1 million of accumulated unrealized losses related to investments that have been in a continuous unrealized loss position for 12 months or longer.

The following table represents the Company’s investments measured at fair value as of February 28, 2013 (in thousands):

 

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

Money markets

   $ 143,680       $ —         $ —        $ 143,680       $ 143,680       $ —         $ —     

Interest-bearing deposits

     123,518         —           —          123,518         —           123,518         —     

Commercial paper

     54,483         —           —          54,483         39,498         14,985         —     

U.S. agency securities

     360,060         136         (203     359,993         7,041         54,485         298,467   

Corporate securities

     311,561         1,262         (132     312,691         —           172,250         140,441   

Foreign government securities

     26,902         2         (35     26,869         —           26,869         —     

Equity securities

     6         268         —          274         —           274         —     
  

 

 

    

 

 

    

 

 

   

 

 

    

 

 

    

 

 

    

 

 

 

Total

   $ 1,020,210       $ 1,668       $ (370   $ 1,021,508       $ 190,219       $ 392,381       $ 438,908   
  

 

 

    

 

 

    

 

 

   

 

 

    

 

 

    

 

 

    

 

 

 

 

(1) As of February 28, 2013, there were less than $0.1 million of accumulated unrealized losses related to investments that have been in a continuous unrealized loss position for 12 months or longer.

 

16


Table of Contents

RED HAT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

 

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, 2013 and for the three months 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
   

 

 

   

 

 

     

 

 

   

 

 

 

The effects of derivative instruments on the Company’s Consolidated Financial Statements are as follows as of November 30, 2012 and for the three months and nine months then ended (in thousands):

 

    As of November 30, 2012         Three Months
Ended
November 30,
2012
    Nine Months
Ended
November 30,
2012
 
     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      $ 51      $ 11,417      Other income

(expense), net

  $             226      $             800   

Liabilities—foreign currency forward contracts not designated as hedges

   
 
Accounts payable and
accrued expenses
  
  
  $ (78   $ 30,705      Other income

(expense), net

  $ (281   $ (1,423
   

 

 

   

 

 

     

 

 

   

 

 

 

TOTAL

    $ (27   $ 42,122        $ (55   $ (623
   

 

 

   

 

 

     

 

 

   

 

 

 

The aggregate notional amount of outstanding forward contracts at February 28, 2013 was $65.5 million. The fair value of these outstanding contracts at February 28, 2013 was a gross $0.3 million asset and a gross $0.2 million liability, and is recorded in Other current assets and Accounts payable and accrued expenses, respectively, on the Consolidated Balance Sheets.

 

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RED HAT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

 

NOTE 8—Share-based Awards

The Company measures share-based compensation cost at 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, 2013 and November 30, 2012 (in thousands):

 

     Three Months Ended      Nine Months Ended  
     November 30,
2013
     November 30,
2012
     November 30,
2013
     November 30,
2012
 

Cost of revenue

   $ 2,922       $ 2,444       $ 8,861       $ 6,777   

Sales and marketing

     10,268         8,875         30,009         23,962   

Research and development

     9,161         7,935         25,100         22,040   

General and administrative

     7,839         7,424         19,226         19,964   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total share-based compensation

   $ 30,190       $ 26,678       $ 83,196       $ 72,743   
  

 

 

    

 

 

    

 

 

    

 

 

 

Share-based compensation expense qualifying for capitalization was insignificant for each of the three months and nine months ended November 30, 2013 and November 30, 2012. Accordingly, no share-based compensation expense was capitalized during the three months nor nine months ended November 30, 2013 and November 30, 2012.

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.

During the three months and nine months ended November 30, 2013, the Company granted the following share-based awards:

 

     Three Months Ended
November 30, 2013
     Nine Months Ended
November 30, 2013
 
     Shares and
Shares
Underlying
Awards
     Weighted
Average
Per Share
Fair Value
     Shares and
Shares
Underlying
Awards
     Weighted
Average
Per Share
Fair Value
 

Stock options

     76,728       $ 11.70         128,537       $ 12.51   

Service-based shares and share units

     1,158,304       $ 43.60         2,197,391       $ 47.16   

Performance share units—target (1)

     —         $ —           335,724       $ 47.86   

Performance share awards (2)

     93,875       $ 42.61         232,205       $ 45.74   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total awards

     1,328,907       $ 41.69         2,893,857       $ 45.59   
  

 

 

    

 

 

    

 

 

    

 

 

 

 

(1)

Certain executive officers 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

 

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RED HAT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

 

  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. 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 thirty-six month period beginning on March 1, 2013.
(2) Certain executives and senior management were granted restricted stock awards. These shares were awarded subject to the achievement of a specified dollar amount of revenue for FY2014 (the “RSA Performance Goal”). If the Company fails to achieve the RSA Performance Goal for FY2014, then all such shares are forfeited. If the Company achieves the RSA Performance Goal for FY2014, then 25% of the restricted stock vests on July 16, 2014, 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.

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, 2013 and November 30, 2012 (in thousands, except per share amounts):

 

     Three Months Ended      Nine Months Ended  
     November 30,
2013
     November 30,
2012
     November 30,
2013
     November 30,
2012
 

Net income, basic and diluted

   $ 52,025       $ 34,765       $ 133,224       $ 107,231   
  

 

 

    

 

 

    

 

 

    

 

 

 

Weighted average common shares outstanding

     189,514         193,374         190,024         193,127   

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

     1,851         2,292         2,025         2,771   
  

 

 

    

 

 

    

 

 

    

 

 

 

Diluted shares

     191,365         195,666         192,049         195,898   
  

 

 

    

 

 

    

 

 

    

 

 

 

Diluted net income per share

   $ 0.27       $ 0.18       $ 0.69       $ 0.55   
  

 

 

    

 

 

    

 

 

    

 

 

 

The following shares 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 were 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,
2013
     November 30,
2012
     November 30,
2013
     November 30,
2012
 

Number of shares considered anti-dilutive for calculating diluted EPS

                 1,430                     920                     1,514                     68   
  

 

 

    

 

 

    

 

 

    

 

 

 

 

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RED HAT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

 

NOTE 10—Share Repurchase Program

Between March 1, 2013, and April 15, 2013, the Company repurchased an aggregate of 3,648,575 shares of its common stock for $179.3 million. These repurchases were made pursuant to the Company’s repurchase program previously announced on March 28, 2012, and completed the repurchases authorized under such program.

On April 15, 2013, the Company announced that its Board of Directors has 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, 2013, the Company had repurchased 1,358,004 shares of its common stock for $60.0 million under this program. As of November 30, 2013, the amount available under the program for the repurchase of the Company’s common stock was $240.0 million.

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, 2013 and November 30, 2012 and total cash, cash equivalents and available-for-sale investment securities and total assets as of November 30, 2013 and November 30, 2012 by geographic segment (in thousands):

 

     Americas      EMEA      Asia Pacific      Corporate (1)     Total  
     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   
     Three Months Ended November 30, 2012  

Revenue from unaffiliated customers

   $ 220,277       $ 74,188       $ 49,141       $ —        $ 343,606   

Income (loss) from operations

   $ 47,250       $ 17,924       $ 11,423       $ (26,678   $ 49,919   
     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   

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   
     Nine Months Ended November 30, 2012  

Revenue from unaffiliated customers

   $ 633,404       $ 207,670       $ 139,858       $ —        $ 980,932   

Income (loss) from operations

   $ 132,739       $ 55,854       $ 34,957       $ (72,743   $ 150,807   

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

   $ 882,744       $ 328,411       $ 138,742       $ —        $ 1,349,897   

Total assets

   $ 1,984,289       $ 473,455       $ 204,155       $ —        $ 2,661,899   

 

(1) Amounts represent share-based compensation expense for each of the three months and nine months ended November 30, 2013 and November 30, 2012, which was not allocated to geographic segments.

 

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RED HAT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

 

Supplemental information about geographic areas

The following table lists, for each of the three months and nine months ended November 30, 2013 and November 30, 2012, 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,
2013
     November 30,
2012
     November 30,
2013
     November 30,
2012
 

United States, the Company’s country of domicile

   $ 217,653       $ 193,592       $ 628,195       $ 556,675   

Foreign

     178,883         150,014         506,023         424,257   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total revenue from unaffiliated customers

   $ 396,536       $ 343,606       $ 1,134,218       $ 980,932   
  

 

 

    

 

 

    

 

 

    

 

 

 

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, 2013 and February 28, 2013 (in thousands):

 

     As of
November 30,
2013
     As of
February 28,
2013
 

United States, the Company’s country of domicile

   $ 134,074       $ 105,029   

Foreign

     34,530         36,557   
  

 

 

    

 

 

 

Total tangible long-lived assets

   $ 168,604       $ 141,586   
  

 

 

    

 

 

 

Supplemental information about major customers

For the three months ended November 30, 2013 and November 30, 2012, the U.S. government and its agencies generated approximately 9% and 12% of the Company’s total revenue from unaffiliated customers, respectively. For the nine months ended November 30, 2013 and November 30, 2012, the U.S. government and its agencies generated approximately 9% and 11% of the Company’s total revenue from unaffiliated customers, respectively.

NOTE 12—Commitments and Contingencies

Operating Leases

As of November 30, 2013, the Company leased office space and certain equipment under various non-cancelable operating leases. Rent expense under operating leases was $7.5 million and $6.8 million for the three months ended November 30, 2013 and November 30, 2012, respectively. For the nine months ended November 30, 2013 and November 30, 2012, rent expense under operating leases was $21.8 million and $19.8 million, respectively.

Facility Exit Costs

In December 2011, the Company entered into an agreement to sublease a building located in downtown Raleigh, North Carolina in which the Company’s headquarters are currently located. In connection with the

 

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RED HAT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

 

transition to the Company’s new headquarters, the Company has assigned or subleased its existing leases related to the two facilities that previously constituted the Company’s headquarters in Raleigh, North Carolina.

In May 2012, the Company entered into a sublease agreement with an unrelated third-party to lease one of the two facilities. As a result, the Company recognized a loss of $3.1 million for the three months ended May 31, 2012 which represented the excess of the Company’s remaining obligation on the space over the agreed sublease income.

The Company ceased using the remaining facility during the three months ended August 31, 2013 and, as a result, recognized a loss of $2.2 million which represents the remaining costs associated with the Company’s exit from the facility. In September 2013, the Company agreed to assign, to an unrelated third party, its lease related to the remaining facility.

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 ManageIQ, Inc.

On December 21, 2012, the Company completed its acquisition of ManageIQ, Inc. (“ManageIQ”), a provider of enterprise cloud management and automation solutions that enable organizations to deploy, manage and optimize private clouds, public clouds and virtualized infrastructures. Under the terms of the purchase agreement, the consideration transferred by the Company totaled $104.5 million. The Company incurred approximately $0.5 million in transaction costs including legal and accounting fees relating to the acquisition. These costs have been expensed as incurred and included in general and administrative expense on the Consolidated Statement of Operations for the year ended February 28, 2013.

 

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Table of Contents

RED HAT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

 

The table below represents the tangible and identifiable intangible assets and liabilities (in thousands) based on management’s assessment of the acquisition date fair value of the assets acquired and liabilities assumed:

 

     Total
Consideration
Allocated
 

Estimated identifiable intangible assets (see detail below)

   $         17,340   

Cash

     222   

Accounts receivable

     570   

Fixed assets

     69   

Deferred tax assets, net

     6,610   

Other assets

     155   

Accrued liabilities

     (262

Deferred revenue

     (132

Goodwill

     79,910   
  

 

 

 

Total consideration allocated

   $ 104,482   
  

 

 

 

The following table summarizes the allocation of identifiable intangible assets resulting from the acquisition. For purposes of this allocation, the Company has assessed a fair value of ManageIQ’s identifiable intangible assets related to developed technology, employee covenants not to compete, customer relationships and tradenames and trademarks based on the net present value of the projected income stream of these identifiable intangible assets. 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 (in thousands):

 

     Amortization Expense Type      Estimated Life
(Years)
     Total  

Developed technology

     Cost of revenue             5       $ 13,500   

Employee covenants not to compete

     Research and development         4         2,800   

Customer relationships

     Sales and marketing         5         1,000   

Tradenames and trademarks

     General and administrative         2         40   
        

 

 

 

Total identifiable intangible assets

         $ 17,340   
        

 

 

 

Other acquisitions in fiscal 2013

During the fiscal year ended February 28, 2013, the Company entered into agreements to acquire two businesses operating in the middleware space. These acquisitions include technologies that are complementary to the Company’s JBoss Middleware technology. One acquisition, which included certain assets and related operations acquired from Polymita Technologies S.L. (“Polymita”), closed on August 28, 2012. The second acquisition closed on September 7, 2012 and included certain assets and related operations acquired from FuseSource, a division of Progress Software Corporation (“FuseSource”). The total cash consideration for these two acquisitions was $31.2 million. The total cash consideration transferred of $31.2 million has been allocated to the Company’s assets as follows: $17.5 million to goodwill, $13.2 million to identifiable intangible assets and the remaining $0.5 million to other current assets.

 

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RED HAT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

 

Pro forma consolidated financial information

The following unaudited pro forma consolidated financial information reflects the results of operations of the Company for the three months and nine months ended November 30, 2012 (in thousands, except per share amounts) as if the acquisitions of Polymita, FuseSource and ManageIQ had closed on March 1, 2012, 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
November 30, 2012
     Nine Months Ended
November 30, 2012
 

Revenue

   $         343,784       $         981,807   

Net income

     32,361         94,647   

Basic net income per common share

   $ 0.17       $ 0.49   

Diluted net income per common share

   $ 0.17       $ 0.48   

Goodwill

The following is a summary of changes in goodwill for the nine months ended November 30, 2013 (in thousands):

 

Balance at February 28, 2013

   $ 690,911   

Final purchase price allocation adjustment for ManageIQ (1)

     (3,164

Impact of foreign currency fluctuations

     (257
  

 

 

 

Balance at November 30, 2013

   $ 687,490   
  

 

 

 

 

(1) The final measurement period adjustment of $3.2 million was not significant relative to the total consideration paid for ManageIQ and, therefore, the final adjustment has not been retrospectively applied to the Company’s Consolidated Balance Sheet as of February 28, 2013. If the Company had applied the adjustment retrospectively, the Deferred tax assets, net balance on the Company’s Consolidated Balance Sheet for the fiscal year ended February 28, 2013 would have been $3.2 million higher and the Goodwill balance on its Consolidated Balance Sheet for the fiscal year ended February 28, 2013 would have been $3.2 million lower.

 

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Table of Contents
ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

OVERVIEW

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

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

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

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

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

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

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

 

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Table of Contents

Revenue

For the three months ended November 30, 2013, total revenue increased 15.4% or $52.9 million to $396.5 million from $343.6 million for the three months ended November 30, 2012. Subscription revenue increased 16.5% or $48.6 million, driven primarily by additional subscriptions related to our principal RHEL and middleware technologies, which continue to gain broader market acceptance in mission-critical areas of computing, and our expansion of sales channels and our geographic footprint. The increase is, in part, a result of the continued migration of enterprises in industries such as financial services, government, technology and telecommunications to our open source solutions from proprietary technologies. Training and services revenue increased 8.8% or $4.3 million for the three months ended November 30, 2013 as compared to the three months ended November 30, 2012. The increase is driven primarily by customer interest in new products and technologies.

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

 

   

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

 

   

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

 

   

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

 

   

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

 

   

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

 

   

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

Deferred Revenue

Our deferred revenue, current and long-term, balance at November 30, 2013 was $1.12 billion. Because of our subscription model and revenue recognition policies, deferred revenue improves predictability of future revenue. For example, current deferred revenue provides a baseline for revenue to be recognized over the next twelve months. Similarly, long-term deferred revenue provides a baseline for revenue to be recognized beyond twelve months. Total deferred revenue at November 30, 2013 increased $33.3 million or 3.1% as compared to the balance at February 28, 2013 of $1.09 billion.

The increase in deferred revenue reported on our Consolidated Balance Sheets of $33.3 million differs from the $41.0 million increase in deferred revenue we reported on our Consolidated Statements of Cash Flows for the nine months ended November 30, 2013 due to changes in foreign currency exchange rates used to translate deferred revenue balances from our foreign subsidiaries’ functional currency into U.S. dollars.

The increase in deferred revenue of $41.0 million reported on our Consolidated Statement of Cash Flows for the nine months ended November 30, 2013 was driven primarily by the strengthening of our U.S. federal government and European businesses, both of which have faced challenging economic environments in prior quarters.

Subscription revenue

Our enterprise technologies are sold under subscription agreements. These agreements typically have a one- or three-year subscription period. A subscription generally entitles a customer to, among other things, a specified level of support, as well as new versions of the software, security updates, fixes, functionality enhancements and upgrades to the technology, if and when available, and compatibility with an ecosystem of certified hardware and software applications. Our customers have the ability to purchase higher levels of subscriptions that increase the level of support the customer is entitled to receive. Subscription revenue increased sequentially for the first,

 

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second and third quarters of fiscal 2014 and for each quarter of fiscal 2013 and 2012 and is being driven primarily by the increased use of open source software by the enterprise and our expansion of sales channels and geographic footprint during these periods.

Revenue by geography

For the three months ended November 30, 2013, approximately $178.9 million or 45.1% of our revenue was generated outside the United States compared to approximately $150.0 million or 43.7% for the three months ended November 30, 2012. Our international operations are expected to grow as our international sales force and channels become more mature and as we enter new locations or expand our presence in existing locations. As of November 30, 2013, 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 APAC for the three months ended November 30, 2013 totaled $249.7 million, $93.8 million and $53.0 million, respectively, which resulted in year-over-year revenue growth in the Americas, EMEA and APAC of 13.4%, 26.5% and 7.8% respectively. Excluding the impact of foreign currency exchange rates, Americas, EMEA and APAC revenue grew 14.1%, 20.7% and 23.9%, respectively for the three months ended November 30, 2013 as compared to the three months ended November 30, 2012. As a result of our subscription-based revenue recognition model, revenue from the Americas continued to be affected by prior quarters’ U.S. federal government spending while Japan, which is the largest revenue-producing country in our APAC region, performed well despite a weakened yen.

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

Gross profit

Gross profit margin increased to 84.8% for the three months ended November 30, 2013 from 84.5% for the three months ended November 30, 2012 due to a favorable mix shift, which increased subscription revenue relative to total revenue. The favorable mix shift was was partially offset by an increase in investments to expand our technical consulting staff.

Gross profit margin by geography

Gross profit margins generated by our geographic segments for the three months ended November 30, 2013 were as follows: Americas—85.0%, EMEA—88.3% and APAC—82.8%. For the three months ended November 30, 2012, gross profit margins generated by our geographic segments were as follows: Americas—84.3%, EMEA—88.4% and APAC—84.9%. Regional year-over-year variations in gross profit margins are primarily due to slight product mix shifts between subscriptions and services.

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

Income from operations

Operating income was 15.3% and 14.5% of total revenue for the three months ended November 30, 2013 and November 30, 2012, respectively. The increase in operating income as a percentage of revenue was due primarily to savings realized from our general and administrative functions as we continue to realize and leverage benefits from investments made during the prior fiscal year in process and technology infrastructure to support

 

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our corporate functions. Such savings were partially offset by our continued investment in new and emerging cloud management technologies resulting in increased research and development costs relative to revenue. These investments are described further in our analysis of results of operations below.

Income from operations by geography

Operating income as a percentage of revenue generated by our geographic segments for the three months ended November 30, 2013 was as follows: Americas—20.7%, EMEA—29.1% and APAC—22.8%. For the three months ended November 30, 2012, income from operations as a percentage of revenue generated by our geographic segments was as follows: Americas—21.5%, EMEA—24.2% and APAC—23.2%. Operating margin for the Americas and APAC decreased for the three months ended November 30, 2013 as compared to the three months ended November 30, 2012 primarily as a result of increased investments in research and development to support new technologies such as cloud management. The increase in operating margin for EMEA from 24.2% for the three months ended November 30, 2012, to 29.1% for the three months ended November 30, 2013 was due to reduced operating expense which included the impact of government incentives attributable to hiring in the region.

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

Cash, cash equivalents, investments in debt and equity securities and cash flow from operations

Cash, cash equivalents and short-term and long-term available-for-sale investments in securities balances at November 30, 2013 totaled $1.33 billion. Cash generated from operating activities for the nine months ended November 30, 2013 totaled $355.9 million which represents an increase of 8.4% in operating cash flow as compared to the nine months ended November 30, 2012. This increase is due to increases in subscription and services revenues, billings and collections during the same periods.

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

Foreign currency exchange rates’ impact on results of operations

Approximately 45.1% of our revenue for the three months ended November 30, 2013 was produced by sales outside the United States. We are exposed to significant risks of foreign currency fluctuation primarily from receivables denominated in foreign currency and are subject to transaction gains and losses, which are recorded as a component in determining net income. The income statements of our non-U.S. operations are translated into U.S. dollars at the average exchange rates for each applicable month in a period. To the extent the U.S. dollar weakens against foreign currencies, the translation of these foreign-currency-denominated transactions results in increased revenue and operating expenses from operations for our non-U.S. operations. Similarly, our revenue and operating expenses will decrease for our non-U.S. operations if the U.S. dollar strengthens against foreign currencies.

Three Months Ended November 30, 2013

Using the average foreign currency exchange rates from the third quarter of our prior fiscal year ended February 28, 2013, our revenue and operating expenses from non-U.S. operations for the three months ended November 30, 2013 would have been higher than we reported by approximately $5.2 million and $2.8 million, respectively, which would have resulted in income from operations being higher by $2.5 million.

Nine Months Ended November 30, 2013

Using the average foreign currency exchange rates for the nine months ended November 30, 2012, our revenue and operating expenses from non-U.S. operations for the nine months ended November 30, 2013 would have been higher than we reported by approximately $14.8 million and $6.3 million, respectively, which would have resulted in income from operations being higher by $8.4 million.

 

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Business combinations

During the year ended February 28, 2013, we acquired two businesses operating in the middleware space. These acquisitions include technologies that are complementary to our JBoss Middleware technology. One acquisition, which included certain assets and related operations acquired from Polymita Technologies S.L., closed on August 28, 2012. The second acquisition closed on September 7, 2012 and included certain assets and related operations acquired from FuseSource, a division of Progress Software Corporation.

Also, during the year ended February 28, 2013, we completed the acquisition of ManageIQ, Inc. (“ManageIQ”), a Delaware corporation, for approximately $104.5 million in cash. Our acquisition of ManageIQ closed on December 21, 2012. ManageIQ develops, distributes and provides support for enterprise cloud management and automation software. As a result of the acquisition of ManageIQ, operating expenses increased by approximately $2.6 million for the three months ended November 30, 2013 as compared to the three months ended November 30, 2012.

Facility Exit Costs

In December 2011, we entered into an agreement to sublease a building located in downtown Raleigh, North Carolina in which our headquarters are currently located. In connection with the transition to our new headquarters, we have assigned or subleased our existing leases related to the two facilities that previously constituted our headquarters in Raleigh, North Carolina.

In May 2012, we entered into a sublease agreement with an unrelated third-party to lease one of the two facilities that previously constituted our headquarters. As a result, we recognized a loss of $3.1 million for the three months ended May 31, 2012 which represented the excess of our remaining obligation on the space over the agreed sublease income.

We ceased using the remaining facility during the three months ended August 31, 2013 and, as a result, recognized a loss of $2.2 million which represents the remaining costs associated with our exit from the facility. In September 2013, we agreed to assign, to an unrelated third party, our lease related to the remaining facility.

 

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RESULTS OF OPERATIONS

Three months ended November 30, 2013 and November 30, 2012

The following table is a summary of our results of operations for the three months ended November 30, 2013 and November 30, 2012 (in thousands):

 

     Three Months  Ended
(Unaudited)
             
     November 30,
2013
    November 30,
2012
    $
Change
    %
Change
 

Revenue:

        

Subscriptions

   $ 342,770      $ 294,186      $ 48,584        16.5

Training and services

     53,766        49,420        4,346        8.8   
  

 

 

   

 

 

   

 

 

   

 

 

 

Total subscription and training and services revenue

     396,536        343,606        52,930        15.4   
  

 

 

   

 

 

   

 

 

   

 

 

 

Cost of subscription and training and services revenue:

        

Cost of subscriptions

     24,544        21,153        3,391        16.0   

As a % of subscription revenue

     7.2     7.2    

Cost of training and services

     35,883        31,965        3,918        12.3   

As a % of training and services revenue

     66.7     64.7    
  

 

 

   

 

 

   

 

 

   

 

 

 

Total cost of subscription and training and services revenue

     60,427        53,118        7,309        13.8   

As a % of total revenue

     15.2     15.5    
  

 

 

   

 

 

   

 

 

   

 

 

 

Total gross profit

     336,109        290,488        45,621        15.7   
  

 

 

   

 

 

   

 

 

   

 

 

 

Operating expense:

        

Sales and marketing

     153,528        133,792        19,736        14.8   

Research and development

     82,519        68,655        13,864        20.2   

General and administrative

     39,270        38,122        1,148        3.0   
  

 

 

   

 

 

   

 

 

   

 

 

 

Total operating expense

     275,317        240,569        34,748        14.4   
  

 

 

   

 

 

   

 

 

   

 

 

 

Income from operations

     60,792        49,919        10,873        21.8   

Interest income

     1,579        1,936        (357     (18.4

Other income (expense), net

     (440     (730     290        39.7   
  

 

 

   

 

 

   

 

 

   

 

 

 

Income before provision for income taxes

     61,931        51,125        10,806        21.1   

Provision for income taxes (1)

     9,906        16,360        (6,454     (39.4
  

 

 

   

 

 

   

 

 

   

 

 

 

Net income

   $ 52,025      $ 34,765      $ 17,260        49.6
  

 

 

   

 

 

   

 

 

   

 

 

 

Gross profit margin-subscriptions

     92.8     92.8    

Gross profit margin-training and services

     33.3     35.3    

Gross profit margin

     84.8     84.5    

As a % of total revenue:

        

Subscription revenue

     86.4     85.6    

Training and services revenue

     13.6     14.4    

Sales and marketing expense

     38.7     38.9    

Research and development expense

     20.8     20.0    

General and administrative expense

     9.9     11.1    

Total operating expenses

     69.4     70.0    

Income from operations

     15.3     14.5    

Income before provision for income taxes

     15.6     14.9    

Net income

     13.1     10.1    

Estimated annual effective income tax rate (1)

     27.5     32.0    

 

(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 technologies, increased by 16.5% or $48.6 million to $342.8 million for the three months ended November 30, 2013 from $294.2 million for the three months ended November 30, 2012. The increase in subscription revenue is primarily due to increases in volumes sold, including additional subscriptions attributable to geographic expansion, and continuing innovation, which attracts new customers and helps to drive renewals from existing customers.

Training and services revenue

Training revenue includes fees paid by our customers for delivery of educational materials and instruction. Services revenue includes fees received from customers for consulting services regarding our offerings, deployment of Red Hat enterprise technologies and for delivery of added functionality to Red Hat enterprise technologies for our major customers and OEM partners. Total training and services revenue increased by 8.8% or $4.3 million to $53.8 million for the three months ended November 30, 2013 from $49.4 million for the three months ended November 30, 2012. The increase is due to services revenue which increased by 12.5% or $4.3 million as a result of an increase in consulting engagements driven by increased demand for our open source solutions. Combined training and services revenue decreased as a percentage of total revenue to 13.6% for the three months ended November 30, 2013 from 14.4% for the three months ended November 30, 2012.

Cost of revenue

Cost of subscription revenue

The cost of subscription revenue primarily consists of expenses we incur to support, distribute, manufacture, augment and package Red Hat enterprise technologies. These costs include labor related cost to provide technical support, security updates and fixes, as well as costs for fulfillment, physical media, literature, packaging and shipping. Cost of subscription revenue increased by 16.0% or $3.4 million to $24.5 million for the three months ended November 30, 2013 from $21.2 million for the three months ended November 30, 2012. The increase is partially the result of continued additions to our technical support staff to meet the demands of our growing subscriber base for support, security updates and fixes, and includes additional compensation of $2.7 million. The remaining increase is driven primarily by incremental amortization expense of $1.5 million related to technology acquisitions. Gross profit margin on subscriptions remained unchanged at 92.8% for the three months ended November 30, 2013 and November 30, 2012. As the number of open source technology subscriptions continues to increase, we expect associated support cost will continue to increase, although we anticipate this will occur at a rate slower than that of subscription revenue growth due to economies of scale.

Cost of training and services revenue

Cost of training and services revenue is mainly comprised of personnel and third-party consulting costs for the design, development and delivery of custom engineering, training courses and professional services provided to various types of customers. Cost of training and services revenue increased by 12.3% or $3.9 million to $35.9 million for the three months ended November 30, 2013 from $32.0 million for the three months ended November 30, 2012. Costs to deliver our services revenue increased by 15.4% or $3.7 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 66.7% and 64.7% for each of the three month periods ended November 30, 2013 and November 30, 2012, respectively.

 

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Gross profit

Gross profit margin increased to 84.8% for the three months ended November 30, 2013 from 84.5% for the three months ended November 30, 2012 due to a favorable mix shift, which increased subscription sales relative to total sales. The favorable mix shift was partially offset by an increase in investments to expand our technical consulting staff.

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 14.8% or $19.7 million to $153.5 million for the three months ended November 30, 2013 from $133.8 million for the three months ended November 30, 2012. This increase was primarily due to a $15.9 million increase in selling costs, which includes $11.6 million of additional employee compensation expense attributable to the expansion of our sales force from the prior year and $1.7 million related to travel. The remaining increase relates to marketing costs, which grew $3.8 million or 11.1% for the three months ended November 30, 2013 as compared to the three months ended November 30, 2012. The increase in marketing costs includes $2.0 million and $2.5 million related to increased headcount and advertising expense, respectively, to support our expanding marketing efforts. Sales and marketing expense decreased as a percentage of revenue to 38.7% for the three months ended November 30, 2013 from 38.9% for the three months ended November 30, 2012 as we began to realize some scale economies from prior investments made in our sales and marketing function to expand the breadth of our global sales coverage and depth of our product sales coverage.

Research and development

Research and development expense consists primarily of personnel and related costs for development of software technologies and systems management offerings. Research and development expense increased by 20.2% or $13.9 million to $82.5 million for the three months ended November 30, 2013 from $68.7 million for the three months ended November 30, 2012. The increase in research and development costs primarily resulted from the expansion of our engineering group as a result of both direct hires and business combinations as we continue investing in cloud management and our other emerging technologies such as RHEL OpenStack Platform infrastructure-as-a-service (“IaaS”) and OpenShift platform-as-a-service (“PaaS”) among others. Employee compensation increased by $9.6 million. The remaining increase in research and development costs relates primarily to process and technology infrastructure enhancements, which increased $2.3 million. Research and development expense was 20.8% and 20.0% of total revenue for the three months ended November 30, 2013 and November 30, 2012, 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 3.0% or $1.1 million to $39.3 million for the three months ended November 30, 2013 from $38.1 million for the three months ended November 30, 2012. The increase in general and administrative expenses results from increased compensation-related expense of $3.4 million which was partially offset by a reduction in professional service fees. General and administrative expense decreased as a percentage of revenue to 9.9% for the three months ended November 30, 2013 from 11.1% for the three months ended November 30, 2012 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 decreased by $0.4 million or 18.4% for the three months ended November 30, 2013 as compared to the three months ended November 30, 2012. The decrease in interest income for the three months ended November 30, 2013 is attributable to prevailing lower yields earned on our cash and investment balances.

Other income (expense), net

Other income (expense), net increased $0.3 million for the three months ended November 30, 2013 as compared to the three months ended November 30, 2012. The increase is primarily due to an increase in net gains of $0.6 million realized on settlement of foreign currency transactions as a result of changes in foreign currency exchange rates for the three months ended November 30, 2013.

Income taxes

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% primarily due to foreign income taxed at lower rates, research tax credits and the domestic production activities deduction.

During the three months ended November 30, 2012, we recorded $16.4 million of income tax expense, which was based on a then estimated annual effective tax rate of 32%. Our estimated annual effective tax rate of 32% was less than the U.S. federal statutory rate of 35% primarily due to foreign income taxed at lower rates.

 

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Nine months ended November 30, 2013 and November 30, 2012

The following table is a summary of our results of operations for the nine months ended November 30, 2013 and November 30, 2012 (in thousands):

 

     Nine Months  Ended
(Unaudited)
             
     November 30,
2013
    November 30,
2012
    $
Change
    %
Change
 

Revenue:

        

Subscriptions

   $ 985,279      $ 845,557      $ 139,722        16.5

Training and services

     148,939        135,375        13,564        10.0   
  

 

 

   

 

 

   

 

 

   

 

 

 

Total subscription and training and services revenue

     1,134,218        980,932        153,286        15.6   
  

 

 

   

 

 

   

 

 

   

 

 

 

Cost of subscription and training and services revenue:

        

Cost of subscriptions

     71,437        57,939        13,498        23.3   

As a % of subscription revenue

     7.3     6.9    

Cost of training and services

     100,627        89,056        11,571        13.0   

As a % of training and services revenue

     67.6     65.8    
  

 

 

   

 

 

   

 

 

   

 

 

 

Total cost of subscription and training and services revenue

     172,064        146,995        25,069        17.1   

As a % of total revenue

     15.2     15.0    
  

 

 

   

 

 

   

 

 

   

 

 

 

Total gross profit

     962,154        833,937        128,217        15.4   
  

 

 

   

 

 

   

 

 

   

 

 

 

Operating expense:

        

Sales and marketing

     440,568        378,240        62,328        16.5   

Research and development

     234,619        191,901        42,718        22.3   

General and administrative

     111,807        109,847        1,960        1.8   

Facility exit costs

     2,171        3,142        (971     (30.9
  

 

 

   

 

 

   

 

 

   

 

 

 

Total operating expense

     789,165        683,130        106,035        15.5   
  

 

 

   

 

 

   

 

 

   

 

 

 

Income from operations

     172,989        150,807        22,182        14.7   

Interest income

     4,608        6,384        (1,776     (27.8

Other income (expense), net

     332        502        (170     (33.9
  

 

 

   

 

 

   

 

 

   

 

 

 

Income before provision for income taxes

     177,929        157,693        20,236        12.8   

Provision for income taxes

     44,705        50,462        (5,757     (11.4
  

 

 

   

 

 

   

 

 

   

 

 

 

Net income

   $ 133,224      $ 107,231      $ 25,993        24.2
  

 

 

   

 

 

   

 

 

   

 

 

 

Gross profit margin-subscriptions

     92.7     93.1    

Gross profit margin-training and services

     32.4     34.2    

Gross profit margin

     84.8     85.0    

As a % of total revenue:

        

Subscription revenue

     86.9     86.2    

Training and services revenue

     13.1     13.8    

Sales and marketing expense

     38.8     38.6    

Research and development expense

     20.7     19.6    

General and administrative expense

     9.9     11.2    

Facility exit costs

     0.2     0.3    

Total operating expenses

     69.6     69.6    

Income from operations

     15.3     15.4    

Income before provision for income taxes

     15.7     16.1    

Net income

     11.7     10.9    

Estimated annual effective income tax rate (1)

     27.5     32.0    

 

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

 

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Revenue

Subscription revenue

Subscription revenue increased by 16.5% or $139.7 million to $985.3 million for the nine months ended November 30, 2013 from $845.6 million for the nine months ended November 30, 2012. The increase in subscription revenue is primarily due to increases in volumes sold, including additional subscriptions attributable to geographic expansion, and continuing innovation, which attracts new customers and helps to drive renewals from existing customers.

Training and services revenue

Total training and services revenue increased by 10.0% or $13.6 million to $148.9 million for the nine months ended November 30, 2013 from $135.4 million for the nine months ended November 30, 2012. Training revenue increased 2.3% or $0.9 million, as some enterprises increased overall spending on such discretionary items. Our services revenue increased by 13.2% or $12.6 million as a result of an increase in consulting engagements driven by increased demand for our open source solutions. Combined training and services revenue decreased as a percentage of total revenue to 13.1% for the nine months ended November 30, 2013 from 13.8% for the nine months ended November 30, 2012.

Cost of revenue

Cost of subscription revenue

Cost of subscription revenue increased by 23.3% or $13.5 million to $71.4 million for the nine months ended November 30, 2013 from $57.9 million for the nine months ended November 30, 2012. The increase is partially the result of continued additions to our technical support staff to meet the demands of our growing subscriber base for support, security updates and fixes, and includes additional compensation of $8.8 million. The remaining increase is driven primarily by incremental amortization expense of $5.2 million related to technology acquisitions. Gross profit margin on subscriptions decreased to 92.7% for the nine months ended November 30, 2013 from 93.1% for the nine months ended November 30, 2012. As the number of open source technology subscriptions continues to increase, we expect associated support cost will continue to increase, although we anticipate this will occur at a rate slower than that of subscription revenue growth due to economies of scale.

Cost of training and services revenue

Cost of training and services revenue increased by 13.0% or $11.6 million to $100.6 million for the nine months ended November 30, 2013 from $89.1 million for the nine months ended November 30, 2012. The cost to deliver training increased 2.5% or $0.5 million to $21.8 million for the nine months ended November 30, 2013 compared to $21.3 million for the nine months ended November 30, 2012. Costs to deliver our services revenue increased by 16.3% or $11.0 million and relate to additional employee compensation and travel associated with additions to our technical staff to support our emerging technologies. Total costs to deliver training and services as a percentage of training and services revenue was 67.6% and 65.8% for each of the nine months ended month periods ended November 30, 2013 and November 30, 2012, respectively.

Gross profit

Gross profit margin decreased to 84.8% for the nine months ended November 30, 2013 from 85.0% for the nine months ended November 30, 2012 as a result of both increased amortization expense related to prior fiscal year’s complementary middleware and cloud-management technology acquisitions and increased headcount.

 

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Operating expenses

Sales and marketing

Sales and marketing expense increased by 16.5% or $62.3 million to $440.6 million for the nine months ended November 30, 2013 from $378.2 million for the nine months ended November 30, 2012. This increase was primarily due to a $46.6 million increase in selling costs, which includes $37.8 million of additional employee compensation expense attributable to the expansion of our sales force from the prior year and $4.3 million related to travel. The remaining increase relates to marketing costs, which grew $15.7 million or 16.9% for the nine months ended November 30, 2013 as compared to the nine months ended November 30, 2012. The increase in marketing costs includes $7.7 million and $8.7 million related to increased headcount and advertising expense, respectively, to support our expanding marketing efforts. Sales and marketing expense increased as a percentage of revenue to 38.8% for the nine months ended November 30, 2013 from 38.6% for the nine months ended November 30, 2012 as we continue to invest in our sales and marketing function to expand the breadth of our global sales coverage and depth of our product sales coverage.

Research and development

Research and development expense increased by 22.3% or $42.7 million to $234.6 million for the nine months ended November 30, 2013 from $191.9 million for the nine months ended November 30, 2012. The increase in research and development costs primarily resulted from the expansion of our engineering group as a result of both direct hires and business combinations as we continue investing in cloud management and our other emerging technologies such as RHEL OpenStack Plaform IaaS and OpenShift PaaS among others. Employee compensation increased by $32.3 million. The remaining increase in research and development costs relates primarily to process and technology infrastructure enhancements, which increased $6.1 million. Research and development expense was 20.7% and 19.6% of total revenue for the nine months ended November 30, 2013 and November 30, 2012, respectively.

General and administrative

General and administrative expense increased by 1.8% or $2.0 million to $111.8 million for the nine months ended November 30, 2013 from $109.8 million for the nine months ended November 30, 2012. The increase in general and administrative expenses results from increased compensation-related expense of $7.7 million and increased facility and infrastructure enhancements of $2.4 million and were partially offset by a reduction in professional service fees, which decreased $8.7 million. General and administrative expense decreased as a percentage of revenue to 9.9% for the nine months ended November 30, 2013 from 11.2% for the nine months ended November 30, 2012 as we begin 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 decreased by $1.8 million or 27.8% for the nine months ended November 30, 2013 as compared to the nine months ended November 30, 2012. The decrease in interest income for the nine months ended November 30, 2013 is attributable to prevailing lower yields earned on our cash and investment balances.

Other income (expense), net

Other income (expense), net decreased $0.2 million for the nine months ended November 30, 2013 as compared to the nine months ended November 30, 2012. The decrease is primarily due to our share of a nonrecurring gain of $2.0 million we recognized in our prior fiscal year related to a strategic investment we account for under the equity method. The absence of such a gain in our current year results was partially offset by net gains realized on settlement of foreign currency transactions during the nine months ended November 30, 2013.

 

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Income taxes

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% primarily due to foreign income taxed at lower rates, research tax credits and the domestic production activities deduction.

During the nine months ended November 30, 2012, we recorded $50.5 million of income tax expense, which was based on a then estimated annual effective tax rate of 32%. Our estimated annual effective tax rate of 32% was less than the U.S. federal statutory rate of 35% primarily due to foreign income taxed at lower rates.

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 November 30, 2013, we had total cash and investments of $1.33 billion, which was comprised of $642.1 million in cash and cash equivalents, $265.4 million of short-term, available-for-sale, fixed-income investments, $59.0 million in interest-bearing deposit accounts with maturity dates greater than 30 days and $360.1 million of long-term, available-for-sale fixed-income investments. This compares to total cash and investments of $1.32 billion at February 28, 2013.

With $642.1 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. 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. At November 30, 2013, net accumulated unrealized gains on our available-for-sale debt securities totaled $0.5 million. At February 28, 2013, net accumulated unrealized gains on our available-for-sale debt securities totaled $1.0 million.

Nine months ended November 30, 2013

Cash flows—overview

At November 30, 2013, cash and cash equivalents totaled $642.1 million, an increase of $155.0 million as compared to February 28, 2013. The increase in cash and cash equivalents for the nine months ended November 30, 2013 is primarily the result of cash provided by operations which generated $355.9 million and cash provided by investing activities which includes net proceeds from available-for-sale debt securities of $149.1 million. Cash provided by operations and investing activities was partially offset by financing activities which included the repurchase of 5,006,579 shares of our common stock at a total cost of $239.4 million and investments in property and equipment which totaled $61.8 million for the nine months ended November 30, 2013. Net cash generated by operating and investing activities and used for financing activities is further described below.

Cash flows from operations

Cash provided by operations of $355.9 million during the nine months ended November 30, 2013 includes net income of $133.2 million, adjustments to exclude the impact of non-cash revenues and expenses, which totaled a $155.3 million net source of cash, and changes in operating assets and liabilities, which totaled a $67.4 million net source of cash. Cash provided by changes in operating assets and liabilities for the nine months ended

 

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November 30, 2013 was primarily the result of growth in billings which generated incremental operating cash flow of $31.8 million composed of an increase in deferred revenue of $41.0 million offset by an increase in accounts receivable of $9.2 million for the nine months ended November 30, 2013 and timing of disbursements settlement and growth in operating expenses which increased accounts payable and accrued expenses by $38.6 million.

Adjustments to exclude the impact of non-cash revenues and expenses related to deferred income taxes of $18.7 million was primarily due to research tax credits and share-based compensation deductions which were in excess of amounts originally recognized as expense in our consolidated statements of operations. Excess tax benefits from share-based compensation, which totaled $9.1 million, are considered a financing source of cash.

Cash flows from investing

Cash provided by investing activities of $72.0 million for the nine months ended November 30, 2013 includes proceeds from net sales and maturities of available-for-sale securities of $149.1 million, which were partially offset by investments in property and equipment of $61.8 million, primarily related to leasehold improvements. Investments in other intangible assets, which include patents and software license fees, totaled $13.2 million for the nine months ended November 30, 2013.

Cash flows from financing

Cash used in financing activities of $263.1 million for the nine months ended November 30, 2013 includes $239.4 million used to repurchase 5,006,579 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 nine months ended November 30, 2013 totaled $33.1 million. Partially offsetting financing activities using cash were proceeds from excess tax benefits related to share-based employee compensation which totaled $9.1 million and proceeds from employees’ exercise of common stock options which totaled $1.3 million. Payments on other borrowings totaled $1.0 million for the nine months ended November 30, 2013.

Investments in debt and equity 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, 2013 and February 28, 2013, 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, 2014 will depend on numerous factors, including the amount of resources we devote to:

 

   

funding the continued development of our enterprise technology offerings;

 

   

accelerating the development of our systems management offerings;

 

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

 

   

pursuing strategic acquisitions and alliances;

 

   

investing in businesses, products and technologies; and

 

   

investing in enhancements to the systems we use to run our business and the expansion of our office facilities, including capital expenditures related to our current headquarters facility.

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 intellectual property and mergers and acquisitions. Given our historically strong operating cash flow and the $1.33 billion of cash and investments held at November 30, 2013, we do not presently anticipate the need to raise cash to fund our operations, either through the sale of additional equity or through the issuance of debt, in the foreseeable future. However, we may take advantage of favorable capital market situations 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. 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, 2013, our cash, cash equivalents and available-for-sale investment securities totaled $1.33 billion, of which $657.5 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 $669.2 million or 50.4% of our available cash, cash equivalents and available-for-sale investments, as of November 30, 2013, 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, 2013, undistributed foreign earnings totaled $200.5 million. For further discussion, see NOTE 11—Income Taxes contained in our Annual Report on Form 10-K for the year ended February 28, 2013.

Based on our expected utilization of NOL and tax credit carryforwards, we currently anticipate that we will be paying U.S. federal income tax beginning in the fourth quarter of our fiscal year ending February 28, 2014.

Off-balance sheet arrangements

As of November 30, 2013 and February 28, 2013, 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 investments in available-for-sale securities. 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. 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. For example, a hypothetical one-half percentage point change in interest rates, assuming a parallel shift of all interest rates, would result in an approximate $0.6 million change in annual interest income derived from available-for-sale investments in our portfolio as of November 30, 2013. For further discussion related to our investments as of November 30, 2013 and February 28, 2013, 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 $8.6 million decrease in the fair value of our available-for-sale investment securities as of November 30, 2013. For further discussion related to our investments as of November 30, 2013 and February 28, 2013, 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

As of November 30, 2013 and February 28, 2013, no individual customer accounted for 10% or more of the Company’s accounts receivable.

Foreign Currency Risk

Approximately 45.1% of our revenue for the three months ended November 30, 2013 was produced by sales outside the United States. We are exposed to significant risks of foreign currency fluctuation primarily from receivables denominated in foreign currency and are subject to transaction gains and losses, which are recorded as a component in determining net income. The income statements of our non-U.S. operations are translated into

 

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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 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, 2013, our revenue and operating expenses from non-U.S. operations for the three months ended November 30, 2013 would have been higher than we reported by approximately $5.2 million and $2.8 million, respectively, which would have resulted in income from operations being higher by $2.5 million.

Using the average foreign currency exchange rates for the nine months ended November 30, 2012, our revenue and operating expenses from non-U.S. operations for the nine months ended November 30, 2013 would have been higher than we reported by approximately $14.8 million and $6.3 million, respectively, which would have resulted in income from operations being higher by $8.4 million.

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 in accordance with FASB ASC Section 815. 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, 2013 was $24.7 million. The fair value of these outstanding contracts at November 30, 2013 was a gross $0.1 million asset and a gross $0.3 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 November 30, 2013. The forward contracts will settle in Australian dollars, Euros, Hong Kong dollars, Japanese yen, Malaysian ringgit, Mexican pesos, Norwegian krona, Singapore dollars, Swedish krona, Swiss francs, Taiwanese dollars and U.S. dollars.

The aggregate notional amount of outstanding forward contracts at February 28, 2013 was $65.5 million. The fair value of these outstanding contracts at February 28, 2013 was a gross $0.3 million asset and a gross $0.2 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 expired within three months of the period ended February 28, 2013. The forward contracts settled 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 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

 

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presented in the financial statements as a reduction to deferred tax assets excluding certain exceptions. ASU 2013-11 is effective prospectively for us in the first quarter of our fiscal year ending February 28, 2015. We do not believe that this updated standard will 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 is effective prospectively for us in the first quarter of our fiscal year ending February 28, 2015. We do not believe that this updated standard will 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 Exchange Act) or our internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) 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

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 specific 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 outstanding debts owed to us by our customers or other parties with whom we do business. In addition, these conditions may impact our investment portfolio, and we could determine that some of our investments have experienced an other-than-temporary decline in fair value, requiring an impairment charge that could adversely impact our financial condition and operating results. Also, these conditions may make it more difficult to forecast operating results. If global economic conditions, or economic conditions in the United States, Europe, Asia or in other key geographic regions or customer segments, remain uncertain or persist, spread or deteriorate further, current and prospective customers may delay or reduce their IT spending, which could 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 hardware manufacturers, software vendors, cloud providers and enterprise solutions providers such as Amazon.com, Inc. (“Amazon”), Cisco Systems, Inc., Dell Inc., Fujitsu Limited, Hewlett-Packard Co. (“HP”), International Business Machines Corporation (“IBM”), NEC Corporation, Oracle Corporation (“Oracle”), 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.

 

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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 OEMs, distributors 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 revenues 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 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.

We have entered into and may continue to enter into or seek to enter into business combinations and acquisitions, which may be difficult to complete and integrate, disrupt our business, divert management’s attention, adversely affect our business, financial condition, operating results and cash flows and dilute stockholder value.

As part of our business strategy, we have in the past entered into business combinations and acquisitions, and we may continue to do so in the future. These types of transactions can increase the expense of running our business and present significant challenges and risks, including:

 

   

Integrating the acquired business’ accounting, financial reporting, management, information and information security, human resource and other administrative systems to permit effective management, and the lack of control if such integration is delayed or not implemented;

 

   

Gathering full information regarding a business or technology prior to a transaction, including the identification and assessment of liabilities, claims or other circumstances that could result in litigation or regulatory exposure, unfavorable accounting treatment, unexpected tax implications and other adverse effects on our business;

 

   

Increased operating expenses related to the acquired business or technology;

 

   

Maintaining or establishing acceptable standards, controls, procedures and policies;

 

   

Disruption of our ongoing business and distraction of management;

 

   

Impairment of relationships with our employees, partners or customers as a result of any integration of new management and other personnel, products or technology or as a result of the changes in the competitive landscape affected by the transaction;

 

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Maintaining good relationships with customers or business partners of the acquired business;

 

   

Effective evaluation of talent at an acquired business or cultural challenges associated with integrating employees from the acquired business into our organization;

 

   

Loss of key employees of the acquired business;

 

   

Incorporating and further developing acquired products or technology into our offerings and maintaining quality standards consistent with our brands;

 

   

Achieving the expected benefits of the transaction;

 

   

Expenses related to the transaction;

 

   

Claims and liabilities we may assume from the acquired business or technology, or that are otherwise related to the transaction;

 

   

Entering into new markets in which we have little or no experience or in which competitors may have stronger market positions;

 

   

Impairment of intangible assets and goodwill acquired in transactions; and

 

   

For foreign transactions, additional risks related to the integration of operations across different cultures and languages, and the economic, political, compliance and regulatory risks associated with specific countries.

There can be no assurance that we will manage these challenges and risks successfully. Moreover, if we are not successful in completing transactions that we have pursued or may pursue, our business may be adversely affected, and we may incur substantial expenses and divert significant management time and resources. In addition, in pursuing and completing such transactions, we could use substantial portions of our available cash as all or a portion of the purchase price for these transactions or as retention incentives to employees of the acquired business, or we may incur substantial debt. We could also issue additional securities as all or a portion of the purchase price for these transactions or as retention incentives to employees of the acquired business, which could cause our stockholders to suffer significant dilution. Any transaction may not generate additional revenue or profit for us, or may take longer to do so than expected, which may adversely affect our business, financial condition, operating results and cash flows.

If we fail to effectively manage our growth, our business, financial condition, operating results and cash flows could be adversely affected.

We have expanded our operations rapidly in recent years. For example, our total revenue increased from $1.13 billion for the fiscal year ended February 29, 2012 to $1.33 billion for the fiscal year ended February 28, 2013. Moreover, the total number of our employees increased from over 4,500 as of February 29, 2012 to approximately 5,600 as of February 28, 2013 and is expected to generally increase in the foreseeable future. In addition, we continue to explore ways to extend our offerings and geographic reach. Our growth has placed and will likely continue to place a strain on our management systems, information systems, resources and internal controls. Our ability to successfully provide our offerings and implement our business plan requires adequate information systems and resources, internal controls and oversight from our senior management.

As we expand in international markets, these challenges increase as a result of the need to support a growing business in an environment of multiple languages, cultures, customs, legal systems, dispute resolution systems, regulatory systems and commercial practices. As we grow, we must also continue to hire, train, supervise and manage new employees. We may not be able to adequately screen and hire or adequately train, supervise and manage sufficient personnel or develop management, or effectively manage and develop our controls and oversight functions and information systems to adequately manage our growth effectively. If we are unable to effectively manage our growth, our business, financial condition, operating results and cash flows could be adversely affected.

 

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Industry consolidation may lead to increased competition and may adversely affect our business, financial condition, operating results and cash flows.

There has been a trend of consolidation in the technology industry. We expect this trend to continue as companies attempt to strengthen or hold their market positions in an evolving industry. For example, as the computing, networking, storage, and software technologies that comprise the enterprise data center converge, many companies seek to position themselves as key or single-source vendors providing end-to-end technology solutions for the data center. Also, some of our current and potential competitors have made acquisitions or announced new strategic alliances designed to position them as a key or single-source vendor. As a result of these developments, we face greater competition, including competition from entities that are among our key business partners. This increased competition could adversely affect our business, financial condition, operating results and cash flows.

Because of the characteristics of open source software, there are few technology barriers to entry into the open source market by new competitors and it may be relatively easy for competitors, some of which may have greater resources than we have, to enter our markets and compete with us.

One of the characteristics of open source software is that anyone may modify and redistribute the existing open source software and use it to compete with us. Such competition can develop without the degree of overhead and lead time required by traditional proprietary software companies. It is possible for competitors with greater resources than ours to develop their own open source solutions, potentially reducing the demand for, and putting price pressure on, our offerings. In addition, some competitors make their open source software available for free download and use on an ad hoc basis or may position their open source software as a loss leader. We cannot guarantee that we will be able to compete successfully against current and future competitors or that competitive pressure and/or the availability of open source software will not result in price reductions, reduced operating margins and loss of market share, any one of which could adversely affect our business, financial condition, operating results and cash flows.

We may not be able to continue to attract and retain capable management.

Our future success depends on the continued services and effectiveness of a number of key management personnel, including our CEO. The loss of these individuals, particularly to a competitor, some of which may be in a position to offer greater compensation, could adversely affect our business or stock price.

Our ability to retain key management personnel or hire capable new management personnel as we grow may be challenged to the extent the technology sector performs well and/or if companies with more generous compensation packages or greater perceived growth opportunities compete for the same personnel. In addition, historically we have used share-based compensation as a key component of our compensation packages. Changes in the accounting for share-based compensation could adversely affect our earnings or force us to use more cash compensation to attract and retain capable personnel. If the price of our common stock falls, the value of our share-based awards to recipients is reduced. Such events, or if we are unable to secure shareholder approval for increases in the number of shares eligible for share-based compensation grants, could adversely affect our ability to successfully attract and retain key management personnel. Effective succession planning is also important to our long-term success. Failure to ensure effective transfer of knowledge and smooth transitions involving key management personnel could hinder our strategic planning and execution.

We depend on our key non-management employees, the loss of which could adversely affect our business or diminish our brands.

Competition in our industry for qualified employees, especially technical employees, is intense and from time to time our competitors directly target our employees. The loss of key employees could hinder our influence in open source projects and seriously impede our success. Moreover, the loss of these individuals, particularly to a competitor, some of which may be in a position to offer greater compensation, and any resulting loss of customers could reduce our market share and diminish our brands. We have from time to time in the past experienced, and we may experience in the future, difficulty in hiring and retaining highly skilled employees with appropriate qualifications.

 

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A number of our key employees have become, or will become, vested in a significant amount of their equity compensation awards. Employees may be more likely to leave us after a significant portion of their equity compensation awards fully vest, especially if the shares underlying the equity awards have significantly appreciated in value. If we do not succeed in retaining and motivating our key employees and attracting new key personnel, our business, financial performance, operating results and cash flows may be adversely affected.

Our corporate culture has contributed to our success, and if we cannot maintain this culture as we grow, we could lose the innovation, creativity and collaboration fostered by our culture, and our business may be adversely affected.

We believe that a critical contributor to our success has been our corporate culture, which we believe fosters innovation, creativity and collaboration. As our organization grows, and we are required to implement more complex organizational management structures, we may find it increasingly difficult to maintain these beneficial aspects of our corporate culture. If we are unable to maintain our corporate culture, we may find it difficult to attract and retain motivated employees.

Our subscription-based business model may encounter customer resistance or we may experience a decline in the demand for our offerings.

We provide Red Hat enterprise technologies under annual or multi-year subscriptions. 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. While we believe this practice complies with the requirements of the GNU General Public License, and while we have reviewed this practice with the Free Software Foundation, the organization that maintains and provides interpretations of the GNU General Public License, we may still encounter customer resistance to this distribution model or customers may fail to honor the terms of our subscription agreements. To the extent we are unsuccessful in promoting or defending this distribution model, our business, financial condition, operating results and cash flows could be adversely affected.

In addition, our customers generally undertake a significant evaluation process that may result in a lengthy sales cycle. We spend substantial time, effort, and money on our sales efforts, including developing and implementing appropriate go-to-market strategies and training our sales force and channel partners in order to effectively market new offerings, without any assurance that our efforts will produce any sales. As technologies and the markets for our enterprise offerings change, our subscription-based business model may no longer meet the needs of our customers. For example, a business model based on annual or multi-year subscriptions may no longer be competitive in an environment where disruptive technologies (such as virtualization and cloud) enable customers to consume computing resources on an hourly basis or for free.

An increased focus on developing and providing virtualization, storage and cloud computing offerings may require a greater focus on marketing more holistic solutions, rather than individual offerings. Consequently, we may need to develop appropriate marketing and pricing strategies for our offerings, our customers’ purchasing decisions may become more complex and require additional levels of approval and the duration of sales cycles for our offerings may increase.

If we are unable to adapt our business model to changes in the marketplace, our business, financial condition, operating results and cash flows could be adversely affected.

If our customers do not renew their subscription agreements with us, our business, financial results, operating results and cash flows may be adversely affected.

Our customers may not renew their subscriptions after the expiration of their subscription agreements and in fact, some customers elect not to do so. In addition, our customers may opt for a lower-priced edition of our offerings or for fewer subscriptions. We have limited historical data with respect to rates of customer subscription renewals, so we cannot accurately predict customer renewal rates. Our customers’ renewal rates may

 

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decline or fluctuate as a result of a number of factors, including their level of satisfaction with our services and their ability to continue their operations and spending levels. Government contracts could be subject to future funding that may affect the extension or termination of programs and generally are subject to the right of the government to terminate for convenience or non-appropriation. If we experience a decline in the renewal rates for our customers or they opt for lower-priced editions of our offerings or fewer subscriptions, our business, financial condition, operating results and cash flows may be adversely affected.

If third-party enterprise hardware and software providers do not continue to make their products and services compatible with our offerings, our software may cease to be competitive and our business, financial condition, operating results and cash flows may be adversely affected.

The competitive position of our offerings is dependent on their compatibility with products and services of third-party enterprise hardware and software companies. To the extent that a software or hardware vendor might have or develop products and services that compete with ours, the vendor may have an incentive to seek to limit the performance, functionality or compatibility of our offerings when used with one or more of the vendor’s offerings. In addition, these vendors may fail to support or issue statements of compatibility or certification of our offerings when used with their offerings. We intend to encourage the development of additional applications that operate on both current and new versions of our offerings by, among other means, attracting third-party developers to our offerings, providing open source tools to create these applications and maintaining our existing developer relationships through marketing and technical support. We intend to encourage the compatibility of our software with various third-party hardware and software offerings by maintaining and expanding our relationships, both business and technical, with relevant independent hardware and software vendors. If we are not successful in achieving these goals, however, our offerings may not be competitive and our business, financial condition, operating results and cash flows may be adversely affected.

If open source software programmers, most of whom we do not employ, do not continue to develop and enhance open source technologies, we may be unable to develop new technologies, adequately enhance our existing technologies or meet customer requirements for innovation, quality and price.

We rely to a significant degree on a number of largely informal communities of independent open source software programmers to develop and enhance our enterprise technologies. For example, Linus Torvalds, a prominent open source software developer, and a relatively small group of software engineers, many of whom are not employed by us, are primarily responsible for the development and evolution of the Linux kernel, which is the heart of the Red Hat Enterprise Linux operating system. If these groups of programmers fail to adequately further develop and enhance open source technologies, we would have to rely on other parties to develop and enhance our offerings or we would need to develop and enhance our offerings with our own resources. We cannot predict whether further developments and enhancements to these technologies would be available from reliable alternative sources. In either event, our development expenses could be increased and our technology release and upgrade schedules could be delayed. Moreover, if third-party software programmers fail to adequately further develop and enhance open source technologies, the development and adoption of these technologies could be stifled and our offerings could become less competitive. Delays in developing, completing or delivering new or enhanced offerings could result in delayed or reduced revenue for those offerings and could also adversely affect customer acceptance of those offerings.

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 to modify or adapt our offerings or infrastructure. Delays in developing,

 

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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 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.

Our offerings may contain defects that may be costly to correct, delay market acceptance of our enterprise technologies and expose us to claims and litigation.

Despite our testing procedures, errors have been and may continue to be found in our offerings after deployment. This risk is increased by the fact that much of the code in our offerings is developed by independent parties over whom we exercise no supervision or control. If errors are discovered, we may have to make significant expenditures of capital and devote significant technical resources to analyze, correct, eliminate or work around them and may not be able to successfully do so in a timely manner or at all. Errors and failures in our offerings could result in a loss of, or delay in, market acceptance of our enterprise technologies, loss of existing or potential customers and delayed or lost revenue and could damage our reputation and our ability to convince enterprise users of the benefits of our technologies.

In addition, errors in our technologies could cause system failures, loss of data or other adverse effects for our customers who may assert warranty and other claims for substantial damages against us. Although our agreements with our customers often contain provisions which seek to limit our exposure to potential product liability claims, it is possible that these provisions may not be effective or enforceable under the laws of some jurisdictions. In addition, our insurance policies may not adequately limit our exposure to this type of claim. These claims, even if unsuccessful, could be costly and time consuming to defend and could adversely affect our business, financial conditions, operating results and cash flows.

Our virtualization, storage and cloud computing offerings are based on emerging technologies and business models, and the potential market for these offerings remains uncertain.

Our virtualization, storage and cloud computing offerings are based on emerging technologies and business models, the success of which will depend on the perceived technological and operational benefits and cost savings associated with the adoption of these technologies. The virtualization, storage and cloud computing technologies are rapidly evolving. We expect competition to remain intense and, as with many emerging IT sectors, these technologies may be subject to a “first mover” effect pursuant to which certain product offerings rapidly capture a significant portion of market share and developer attention. Moreover, we may make errors in reacting to relevant business trends and predicting which technologies are successful or otherwise develop into industry standards.

Adoption of virtualization, storage and cloud computing offerings may occur more slowly or less pervasively than we expect and the revenue growth associated with these offerings may be slower than currently expected. Moreover, even if virtualization, storage and cloud computing are adopted widely by enterprises, our offerings in these areas may not attract a sufficient number of users or generate attractive financial results. We incur expenses associated with these offerings in advance of our ability to generate associated revenues. Demand for our virtualization, storage and cloud computing offerings may unfavorably impact demand for our other

 

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products and services including software subscriptions and related professional services. If the market for our virtualization, storage and cloud computing offerings fails to develop adequately it could have an adverse effect on our business, financial condition, operating results and cash flows.

Our continued success depends on our ability to maintain and enhance strong brands.

We believe that the brand identities that we have developed have contributed significantly to the success of our business. We also believe that maintaining and enhancing our brands is important to expanding our customer base and attracting talented employees. In order to maintain and enhance our brands, we may be required to make substantial investments that may not be successful. Maintaining our brands will depend in part on our ability to remain a leader in open source technology and our ability to continue to provide high-quality offerings. If we fail to promote and maintain our brands, or if we incur excessive costs in doing so, our business, financial condition, operating results and cash flows may be adversely affected.

If our growth rate slows, our stock price could be adversely affected.

As the markets for our offerings mature and the scale of our business increases, our rate of revenue growth will likely be lower than the growth rates we experienced in earlier periods. In addition, to the extent that the adoption of our offerings occurs more slowly or is less pervasive than we expect, our revenue growth rates may slow or our revenue may decline, which could adversely affect our stock price.

Security breaches and data loss may expose us to liability, harm our reputation and adversely affect our business.

Our business involves the production and distribution of enterprise software technologies, as well as hosting applications. As part of our business we receive and process information about our employees, customers and partners, and we may store and process (or contract with third parties to store and process) our customers’ data. While we take security and testing measures relating to our offerings and operations, those measures may not prevent security breaches and data loss that could harm our business. Advances in computer capabilities, new discoveries in the field of cryptography, inadequate technology or facility security measures or other factors may result in data loss or a compromise or breach of our systems and the data we store and process (or the systems and data stored and processed by third parties on our behalf). These security measures may be breached or data lost as a result of actions by third parties or employee error or malfeasance. A party who is able to circumvent security measures or exploit inadequacies in security measures, could, among other things, misappropriate proprietary information (including information about our employees, customers and partners and our customers’ information), cause the loss or disclosure of some or all of this information, cause interruptions in our or our customers’ operations or expose customers (and their customers) to computer viruses or other disruptions or vulnerabilities. A compromise to these systems could remain undetected for an extended period of time, exacerbating the impact of that compromise. Actual or perceived vulnerabilities may lead to claims against us by customers, partners or other third parties, which could be material. While our customer agreements typically contain provisions that seek to limit our liability, there is no assurance these provisions will be enforceable and effective under applicable law. In addition, the cost and operational consequences of implementing further data protection measures could be significant. Any loss of data or compromise of our systems or the data we store or process (or the systems and data stored and processed by third parties on our behalf) could result in a loss of confidence in the security of our offerings, damage our reputation, lead to legal liability and adversely affect our business, financial condition, operating results and cash flows.

We are vulnerable to technology infrastructure failures, which could harm our reputation and adversely affect our business.

We rely on our technology infrastructure, and the technology infrastructure of third parties, for many functions, including selling our offerings, supporting our partners, fulfilling orders and billing, collecting and making payments. This technology infrastructure may be vulnerable to damage or interruption from natural disasters, power loss, telecommunication failures, terrorist attacks, computer intrusions and viruses, software

 

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errors, computer denial-of-service attacks and other events. A significant number of the systems making up this infrastructure are not redundant, and our disaster recovery planning may not be sufficient for every eventuality. This technology infrastructure may fail or be vulnerable to damage or interruption because of actions by third parties or employee error or malfeasance. We do not carry business interruption insurance sufficient to protect us from all losses that may result from interruptions in our services as a result of technology infrastructure failures or to cover all contingencies. Any interruption in the availability of our websites and on-line interactions with customers and partners would create a large volume of questions and complaints that would need to be addressed by our support personnel. If our support personnel cannot meet this demand, customer and partner satisfaction levels may fall, which in turn could cause additional claims, reduced revenue or loss of customers. Despite any precautions we may take, such problems could result in, among other consequences, a loss of data, loss of confidence in the stability and reliability of our offerings, damage to our reputation, legal liability, all of which may adversely affect our business, financial condition, operating results and cash flows interruptions.

A decline in or reprioritization of funding in the U.S. government budget or delays in the budget process could adversely affect our business, financial condition, operating results and cash flows.

We derive, and expect to continue to derive, a portion of our revenue from U.S. government agencies. Government deficit reduction and austerity measures, along with continued economic challenges, continue to place pressure on U.S. government spending. The termination of, or delayed or reduced funding for, government-sponsored programs and contracts from which we derive revenue could adversely affect our business, financial condition, operating results and cash flows.

We may be unable to predict the future course of open source technology development, which could reduce the market appeal of our offerings, damage our reputation and adversely affect our business, financial condition, operating results and cash flows.

We do not exercise control over many aspects of the development of open source technology. Different groups of open source software programmers compete with one another to develop new technology. Typically, the technology developed by one group will become more widely used than that developed by others. If we acquire or adopt new technology and incorporate it into our offerings but competing technology becomes more widely used or accepted, the market appeal of our offerings may be reduced and that could harm our reputation, diminish our brands and adversely affect our business, financial condition, operating results and cash flows.

We include software licensed from other parties in our offerings, the loss of which could increase our costs and delay availability of our offerings.

We utilize various types of software licensed from unaffiliated third parties in our offerings. Aspects of our business could be disrupted if any of the software we license from others or functional equivalents of this software were no longer available to us, no longer offered to us on commercially reasonable terms or changed in ways or included defects that made the third-party software unsuitable for our use. In these cases, we would be required to either redesign our technologies to function with software available from other parties, develop these components ourselves or eliminate the functionality, which could result in increased costs, the need to mitigate customer issues, delays in delivery of our offerings and the release of new offerings and limit the features available in our current or future offerings.

 

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RISKS RELATED TO LEGAL UNCERTAINTY

If our technologies are found or alleged to infringe third-party intellectual property rights, we could be required to redesign our offerings, replace components of our offerings, enter into license agreements with third parties and provide infringement indemnification.

We regularly commit to our subscription customers that if portions of our offerings are found to infringe any third-party intellectual property rights we will, at our expense and option: (i) obtain the right for the customer to continue to use the technology consistent with their subscription agreement with us; (ii) modify the technology so that it is non-infringing; or (iii) replace the infringing component with a non-infringing component, and indemnify them against specified infringement claims. Although we cannot predict whether we will need to satisfy these commitments and often have limitations on these commitments, satisfying the commitments could be costly and time consuming and could adversely affect our business, financial condition, operating results and cash flows. In addition, our insurance policies would likely not adequately cover our exposure to this type of claim.

We are vulnerable to claims that our technologies infringe third-party intellectual property rights because our technologies are comprised of software components, many of which are developed by numerous independent parties, and an adverse legal decision affecting our intellectual property could adversely affect our business.

We are vulnerable to claims that our technologies infringe third-party intellectual property rights, including patent, copyright and trade secrets because our technologies are comprised of software components, many of which are developed by numerous independent parties. Moreover, because the scope of software patent protection is often not well defined or readily determinable, patent applications in the United States are not publicly disclosed at the time of filing, and the number of software patents that are issued each year is significant and growing, among other concerns, we are unlikely to be able to assess adequately the relevance of patents to our technologies, and may be unable to take appropriate responsive action, in a timely or economic manner. Our exposure to risks associated with the use of intellectual property may increase as a result of acquisitions. In addition, third parties may make infringement and similar or related claims after we have acquired technology that had not been asserted prior to our acquisition.

In the past, our technologies have been subject to intellectual property infringement claims. Some of these claims have been brought by entities that do not design, manufacture, or distribute products or services or that acquire intellectual property like patents for the sole purpose of monetizing their acquired intellectual property through asserting claims of infringement. As these entities do not have operating businesses of their own and therefore have limited risk of counterclaims for damages or injunctive relief, it may be difficult to deter them from bringing intellectual property infringement claims. We expect to face the possibility of more intellectual property infringement claims as our prominence increases, business activities expand, market share and revenues grow, the number of products and competitors in our industry grows and the functionality of products in different portions of the industry overlap. We may not be able to accurately assess the risk related to these suits, and we may be unable to accurately assess our level of exposure.

Defending patent and other intellectual property claims, even claims without significant merit, can be time consuming, costly and can divert the attention of technical and management personnel. We may receive unfavorable preliminary or interim rulings in the course of litigation, and there can be no assurances that favorable final outcomes will be obtained in all cases. We may decide to settle certain lawsuits and disputes on terms that are unfavorable to us. Similarly, if any litigation to which we are a party is resolved adversely, we may be subject to an unfavorable judgment that may not be reversed upon appeal. The terms of such a settlement or judgment may require us to cease offering certain of our technologies or pay substantial amounts to the other party. In addition, we may have to seek a license to continue offering technologies found to be in violation of a third party’s rights, which may not be available on reasonable terms, or at all, and may significantly increase our operating costs and expenses. As a result, we may also be required to develop alternative non-infringing technology or practices or discontinue the practices. The development of alternative non-infringing technology or practices could require significant effort and expense or may not be feasible.

 

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An adverse legal decision regarding the intellectual property in and to our technology and other offerings could adversely affect our business, financial condition, operating results and cash flows. See “Legal Proceedings” for additional information.

Our activities, or the activities of our partners, may violate anti-corruption laws and regulations that apply to us.

In many foreign countries, particularly in certain developing economies, it is not uncommon to engage in business practices that are prohibited by regulations that may apply to us, such as the U.S. Foreign Corrupt Practices Act and similar laws. Although we have policies and procedures designed to help promote compliance with these laws, our employees, contractors, partners and agents, as well as those companies to which we outsource certain of our business operations, may take actions in violation of our policies and procedures. Any violation of these laws and regulations could result in fines, criminal sanctions against us, our officers, or our employees, prohibitions on the conduct of our business, and damage to our reputation.

We could be prevented from selling or developing our software if the GNU General Public License and similar licenses under which our technologies are developed and licensed are not enforceable or are modified so as to become incompatible with other open source licenses.

A number of our offerings, including Red Hat Enterprise Linux, have been developed and licensed under the GNU General Public License and similar open source licenses. These licenses state that any program licensed under them may be liberally copied, modified and distributed. It is possible that a court would hold these licenses to be unenforceable or that someone could assert a claim for proprietary rights in a program developed and distributed under them. Any ruling by a court that these licenses are not enforceable, or that open source components of our offerings may not be liberally copied, modified or distributed, may have the effect of preventing us from distributing or developing all or a portion of our offerings. In addition, licensors of open source software employed in our offerings may, from time to time, modify the terms of their license agreements in such a manner that those license terms may no longer be compatible with other open source licenses in our offerings or our end user license agreement, and thus could, among other consequences, prevent us from continuing to distribute the software code subject to the modified license.

Our efforts to protect our trademarks may not be adequate to prevent third parties from misappropriating our intellectual property rights in our trademarks.

Our collection of trademarks is valuable and important to our business. The protective steps we have taken in the past have been, and may in the future continue to be, inadequate to protect and deter misappropriation of our trademark rights. We may be unable to detect the unauthorized use of, or take appropriate steps to enforce, our trademark rights in a timely manner. We have registered some of our trademarks in countries in North America, South America, Europe, Asia, Africa and Australia and have other trademark applications pending in various countries around the world. Effective trademark protection may not be available in every country in which we offer or intend to distribute our offerings. We may be unable to prevent third parties from acquiring domain names that are similar to, infringe upon, or diminish the value of our trademarks and other proprietary rights. Failure to adequately protect our trademark rights could damage or even destroy one or more of our brands and impair our ability to compete effectively. Furthermore, defending or enforcing our trademark rights could result in the expenditure of significant financial and managerial resources.

Efforts to assert intellectual property ownership rights in our technologies could impact our standing in the open source community, which could limit our technology innovation capabilities and adversely affect our business.

When we undertake actions to protect and maintain ownership and control over our intellectual property, including patents, copyrights and trademark rights, our standing in the open source community could be adversely affected, which in turn could limit our ability to continue to rely on this community, upon which we are dependent, as a resource to help develop and improve our technologies and further our research and development efforts, and could adversely affect our business.

 

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We are, and may become, involved in disputes and lawsuits that could adversely affect our business.

Lawsuits or legal proceedings may be commenced against us. These disputes and proceedings may involve significant expense and divert the attention of management and other employees. If we do not prevail in these matters, we could be required to pay substantial damages or settlement costs, which could adversely affect our business, financial condition, operating results and cash flows. See “Legal Proceedings” for additional information.

Our business is subject to a variety of U.S. and international laws regarding data privacy and protection.

Our business is subject to federal, state and international laws regarding privacy and protection of user data. We post, on our website, our privacy policies and practices concerning the use and disclosure of user data. As Internet commerce continues to evolve, increasing regulation by federal, state or foreign agencies becomes more likely. The introduction of new product and service offerings by us may cause new and different regulations to apply to our business. Increased regulation in the area of data privacy and protection is expected, and laws and regulations applying to the solicitation, collection, processing, protection or use of information could affect our ability to use and share data, or the adoption of our cloud offerings by customers.

It is possible that these laws may be interpreted and applied in a manner that is inconsistent with our data practices. If so, in addition to the possibility of fines and penalties, a governmental order could require that we change our data practices. Compliance with these regulations may involve significant costs or require changes in business practices that result in reduced revenue. Noncompliance could result in penalties being imposed on us or orders that we cease conducting the noncompliant activity.

Any failure by us to comply with our posted privacy policies or other federal, state or international privacy-related or data protection laws and regulations or a requirement to change our data practices could have an adverse effect on our business, financial condition, operating results and cash flows.

If we fail to comply with our customer contracts or government contracting regulations, our business could be adversely affected.

Our contracts with our customers may include specialized performance requirements. In particular, our contracts with federal, state, provincial and local governmental customers are subject to various procurements regulations, contract provisions and other requirements relating to their formation, administration and performance. Any failure by us to comply with the specific provisions in our customer contracts or any violation of government contracting regulations could result in the imposition of various civil and criminal penalties, which may include termination of contracts, forfeiture of profits, suspension of payments and, in the case of our government contracts, fines and suspension from future government contracting. In addition, we may be subject to qui tam litigation, the process by which a private individual sues or prosecutes on behalf of the government relating to government contracts and shares in the proceeds of any successful litigation or settlement, which could include claims for up to treble damages. Further, any negative publicity related to our customer contracts or any proceedings surrounding them, regardless of its accuracy, may damage our business and affect our ability to compete for new contracts. There is increased pressure for governments and their agencies, both domestically and internationally, to reduce spending. If our customer contracts are terminated, if we are suspended from government work, or if our ability to compete for new contracts is adversely affected, we could suffer an adverse effect on our business, financial condition, operating results and cash flows.

 

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RISKS RELATED TO FINANCIAL UNCERTAINTY

Our quarterly and annual operating results may not be a reliable indicator of our future financial performance.

Due to the unpredictability of the technology spending environment, among other reasons, our revenue and operating results have fluctuated and may continue to fluctuate. We base our current and projected future expense levels, in part, on our estimates of future revenue. Our expenses are, to a large extent, fixed in the short term. Accordingly, we may not be able to adjust our spending quickly enough to protect our projected operating results for a quarter if our revenue in that quarter falls short of our expectations. If, among other considerations, our future financial performance falls below the expectations of securities analysts or investors or we are unable to increase or maintain profitability, the market price of our common stock may decline.

Our stock price has been volatile historically and may continue to be volatile. Further, the sale of our common stock by significant stockholders may cause the price of our common stock to decrease.

The trading price of our common stock has been and may continue to be subject to wide fluctuations. Our stock price may fluctuate in response to a number of events and factors, such as quarterly variations in operating results, announcements of technological innovations or new products by us or our competitors, announcements relating to strategic decisions, announcements related to key personnel, customer purchase delays, service disruptions, changes in financial estimates and recommendations by securities analysts, the operating and stock price performance of other companies that investors may deem comparable to us, news reports relating to trends in our markets, general economic conditions and other risks listed herein.

In addition, several of our stockholders own significant portions of our common stock. If these stockholders were to sell all or a portion of their holdings of our common stock, then the market price of our common stock could be negatively impacted. The effect of such sales, or of significant portions of our stock being offered or made available for sale, could result in strong downward pressure on our stock price. Investors should be aware that they could experience significant short-term volatility in our stock if such stockholders decide to sell all or a portion of their holdings of our common stock at once or within a short period of time.

We may lack the financial and operational resources needed to increase our market share and compete effectively.

We compete with a number of large and well-established companies that have significantly greater financial resources and name recognition, larger development staffs and more extensive marketing and distribution capabilities. Some of these competitors also bundle hardware and software offerings, making it more difficult for us to penetrate their customer bases. No assurance can be given that our efforts to compete effectively will be sufficient.

In the market for operating systems, we face significant competition from competitors which offer hardware-independent multi-user operating systems for Intel platforms and/or Linux and UNIX-based operating systems, including HP, IBM, Microsoft Corporation (“Microsoft”), Oracle and Unisys Corporation. With respect to Linux operating systems, our chief competitor has historically been Attachmate Corporation (“Attachmate”), with its SUSE brand of Linux. Canonical Ltd. and Oracle also sell support for their versions of the Linux operating system. We also compete with freely available Linux distributions, such as Fedora, CentOS and Debian.

In the market for middleware offerings, our competitors include, but are not limited to, IBM, Microsoft, Oracle and VMware, Inc. (“VMware”) all of which offer portfolios of enterprise Java and non-Java middleware products. Our middleware offering is heavily dependent on the Java programming language, which is controlled by Oracle.

In the market for virtualization our competitors include, but are not limited to, Attachmate, Citrix Systems, Inc. (“Citrix”), Microsoft, Oracle and VMware.

 

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With respect to our storage offerings we compete with companies that provide software-based storage products, such as EMC Corporation and NetApp, Inc. Public cloud providers such as Amazon and Rackspace Hosting, Inc. (“Rackspace”) also offer storage capabilities.

With our cloud technologies we compete with companies that provide tools for enterprises to create private clouds, such as Citrix, Microsoft and VMware, as well as with companies that provide public clouds, such as Amazon, Google Inc., Microsoft and Rackspace.

With respect to our management offerings our competitors include Attachmate, BMC Software, Inc., CA, Inc., HP, IBM, Microsoft and Oracle, all of which offer support for heterogeneous operating system environments, such as Linux, Solaris, AIX, HP-UX and Windows.

We face competition in the market for services related to the development, deployment and integration of enterprise technologies. Our competitors in the market include Accenture plc, HP, IBM and Tata Consultancy Services Limited, as well as other technology consulting companies. Some of these competitors may be able to leverage their existing service organizations and provide higher levels of support, consulting and training on a more cost-effective basis than we can.

We may lack the resources needed to compete successfully with our current competitors as well as potential new competitors. Moreover, we 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. Competitive pressures could affect prices or demand for our offerings, resulting in reduced profit margins and loss of market opportunity. We may have to lower the prices of our offerings to stay competitive, which could adversely affect our margins and financial condition. In addition, if our pricing and other factors are not sufficiently competitive, we may lose market share. Industry consolidation may also effect competition by creating larger and potentially stronger competitors in the markets in which we compete, which may adversely affect our business.

We may not be able to meet the financial and operational challenges that we will encounter as our international operations, which represented approximately 43.3% of our total revenue for the fiscal year ended February 28, 2013, continue to expand.

Our international operations accounted for approximately 43.3% of total revenue for the fiscal year ended February 28, 2013. As we expand our international operations, we may have difficulty managing and administering a globally dispersed business and we may need to expend additional funds to, among other activities, reorganize our sales force and technical support services team, outsource or supplement general and administrative functions, staff key management positions, obtain additional information technology infrastructure and successfully localize offerings for a significant number of international markets, which may adversely affect our operating results.

Additional challenges associated with the conduct of our business overseas that may adversely affect our operating results include:

 

   

Fluctuations in exchange rates;

 

   

Pricing environments;

 

   

Longer payment cycles and less financial stability of customers;

 

   

Economic, political, compliance and regulatory risks associated with specific countries;

 

   

Difficulty selecting and monitoring channel partners outside of the United States;

 

   

Lower levels of availability or use of the Internet, through which our software is often delivered;

 

   

Difficulty protecting our intellectual property rights overseas due to, among other reasons, the uncertainty of laws and enforcement in certain countries relating to the protection of intellectual property rights;

 

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Difficulty in staffing, developing and managing foreign operations as a result of distance, language, legal, cultural and other differences;

 

   

Difficulty maintaining quality standards consistent with the our brands;

 

   

Export and import laws and regulations could prevent us from delivering our offerings into and from certain countries;

 

   

Public health risks and natural disasters, particularly in areas in which we have significant operations;

 

   

Limitations on the repatriation and investment of funds and foreign currency exchange restrictions;

 

   

Changes in import/export duties, quotas or other trade barriers could affect the competitive pricing of our offerings and reduce our market share in some countries; and

 

   

Economic or political instability or terrorist acts in some international markets could adversely affect our business in those markets or result in the loss or forfeiture of some foreign assets and the loss of sums spent developing and marketing those assets and the revenue associated with them.

Any failure by us to effectively manage the challenges associated with the international expansion of our operations could adversely affect our business, financial condition, operating results and cash flows.

A substantial portion of our revenues is derived from our Red Hat Enterprise Linux platform.

During our fiscal year ended February 28, 2013, a substantial portion of our subscription revenues was derived from our Red Hat Enterprise Linux technologies. Although we are continuing to develop other offerings, we expect that revenue from Red Hat Enterprise Linux will constitute a majority of our revenue for the foreseeable future. Declines and variability in demand for Red Hat Enterprise Linux could occur as a result of:

 

   

competitive products and pricing;

 

   

failure to release new or enhanced versions of Red Hat Enterprise Linux on a timely basis, or at all;

 

   

technological change that we are unable to address with Red Hat Enterprise Linux; or

 

   

future economic conditions.

Additionally, as more customers and potential customers virtualize their data centers and move computing projects to cloud environments, demand for operating systems such as Red Hat Enterprise Linux may decline. Due to the concentration of our revenues from Red Hat Enterprise Linux, our business, financial condition, operating results and cash flows could be adversely affected by a decline in demand for Red Hat Enterprise Linux.

We may be subject to greater tax liabilities.

We are subject to income and other taxes in the U.S. and in numerous foreign jurisdictions. Our domestic and foreign tax liabilities are subject to the allocation of revenue and expenses in different jurisdictions. Additionally, the amount of taxes paid is subject to our interpretation of applicable tax laws in the jurisdictions in which we operate. Significant judgment is required in determining our worldwide provision for income taxes. In the ordinary course of our business, there are many transactions and calculations where the ultimate tax determination is uncertain. We are regularly subject to audits by tax authorities. Although we believe our tax estimates are reasonable, the final determination of tax audits and any related litigation could be materially different from our historical income tax provisions and accruals. The results of an audit or litigation could adversely affect our financial statements in the period or periods for which that determination is made.

We earn a significant amount of our operating income from outside the U.S., and any repatriation of funds currently held in foreign jurisdictions may result in higher effective tax rates for the company. In addition, there have been proposals to change U.S. tax laws that would significantly impact how U.S. multinational corporations are taxed on foreign earnings. Although we cannot predict whether or in what form this proposed legislation may pass, if enacted it could adversely affect our tax expense and cash flows.

 

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Because we recognize revenue from subscriptions for our service over the term of the subscription, downturns or upturns in sales may not be immediately reflected in our operating results.

We generally recognize subscription revenue from customers ratably over the term of their subscription agreements, which are generally 12 to 36 months. As a result, much of the revenue we report in each quarter is deferred revenue from subscription agreements entered into during previous quarters. Consequently, a decline in subscriptions in any one quarter will not necessarily be fully reflected in the revenue in that quarter and will negatively affect our revenue in future quarters. In addition, we may be unable to adjust our cost structure to reflect this reduced revenue. Accordingly, the effect of significant downturns in sales and market acceptance of our service, and potential changes in our rate of renewals, may not be fully reflected in our operating results until future periods. Our subscription model also makes it difficult for us to rapidly increase our revenue through additional sales in any period, as revenue from new customers must be recognized over the applicable subscription term.

If our goodwill or amortizable intangible assets become impaired, we may be required to record a significant charge to earnings.

Under generally accepted accounting principles, we review our amortizable intangible assets for impairment when events or changes in circumstances indicate the carrying value may not be recoverable. Goodwill is required to be tested for impairment at least annually. Factors that may be considered a change in circumstances indicating that the carrying value of our goodwill or amortizable intangible assets may not be recoverable include a decline in stock price and market capitalization, reduced future cash flow estimates and slower growth rates in our industry. We may be required to record a significant charge to earnings in our financial statements during the period in which any impairment of our goodwill or amortizable intangible assets is determined which could adversely affect our operating results.

We may be exposed to potential risks if we do not have an effective system of disclosure controls or internal controls.

We must comply, on an on-going basis, with the requirements of the Sarbanes-Oxley Act of 2002, including those provisions that establish the requirements for both management and auditors of public companies with respect to reporting on internal control over financial reporting. We cannot be certain that measures we have taken, and will take, will be sufficient or timely completed to meet these requirements on an on-going basis, or that we will be able to implement and maintain adequate disclosure controls and controls over our financial processes and reporting in the future, particularly in light of our rapid growth, international expansion and changes in our offerings, which are expected to result in on-going changes to our control systems and areas of potential risk.

If we fail to maintain an effective system of disclosure controls or internal control over financial reporting, including satisfaction of the requirements of the Sarbanes-Oxley Act, we may not be able to accurately or timely report on our financial results or adequately identify and reduce fraud. As a result, the financial position of our business could be adversely affected; current and potential future shareholders could lose confidence in us and/or our reported financial results, which may cause a negative effect on our trading price; and we could be exposed to litigation or regulatory proceedings, which may be costly or divert management attention.

Changes in accounting principles and guidance, or their interpretation, could result in unfavorable accounting charges or effects, including changes to previously filed financial statements, which could cause our stock to decline.

We prepare our consolidated financial statements in accordance with accounting principles generally accepted in the U.S. These principles are subject to interpretation by the Securities and Exchange Commission and various bodies formed to interpret and create appropriate accounting principles and guidance. A change in these principles or guidance, or in their interpretations, may have a significant effect on our reported results and may retroactively affect previously reported results.

 

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Our investment portfolio is subject to credit and illiquidity risks and fluctuations in the market value of our investments and interest rates. These risks may result in an impairment of or the loss of all or a portion of the value of our investments, an inability to sell our investments or a decline in interest income.

We maintain an investment portfolio of various holdings, types and maturities. Our portfolio as of February 28, 2013 consisted primarily of money market funds, U.S. government and agency securities, German sovereign securities, certificates of deposit, corporate securities and equity securities. Although we follow an established investment policy and seek to minimize the risks associated with our investments by investing primarily in investment grade, highly liquid securities and by limiting the amounts invested with any one institution, type of security or issuer, we cannot give assurances that the assets in our investment portfolio will not lose value or become impaired, or that our interest income will not decline.

A significant part of our investment portfolio consists of U.S. government and agency securities. If global credit and equity markets experience prolonged periods of decline, or if there is a default or downgrade of U.S. government or agency debt, our investment portfolio may be adversely impacted and we could determine that some of our investments have experienced an other-than-temporary decline in fair value, requiring impairment charges that could adversely affect our financial condition and operating results.

Future fluctuations in economic and market conditions could adversely affect the market value of our investments, and we could record additional impairment charges and lose some or all of the principal value of investments in our portfolio. A total loss of an investment or a significant decline in the value of our investment portfolio could adversely affect our financial condition and operating results. For information regarding the sensitivity of and risks associated with the market value of portfolio investments and interest rates, see “Quantitative and Qualitative Disclosures About Market Risk”.

Our investments in private companies are subject to risk of loss of investment capital. Some of these investments may have been made to further our strategic objectives and support our key business initiatives. Our investments in private companies are inherently risky because the markets for the technologies they have under development are typically in the early stages and may never materialize. We could lose the value of our entire investment in these companies.

We are subject to risks of currency fluctuations and related hedging operations.

A portion of our business is conducted in currencies other than the U.S. dollar. Changes in exchange rates among other currencies and the U.S. dollar will affect our net revenue, operating expenses and operating margins. We cannot predict the impact of future exchange rate fluctuations. As we expand international operations, our exposure to exchange rate fluctuations increases. We use financial instruments, primarily forward purchase contracts, to economically hedge U.S. dollar and other currency commitments arising from trade accounts receivable, trade accounts payable and fixed purchase obligations. If these hedging activities are not successful or we change or reduce these hedging activities in the future, we may experience significant unexpected expenses from fluctuations in exchange rates. For information regarding our hedging activity, see “Quantitative and Qualitative Disclosures About Market Risk”.

Natural disasters and geo-political events could adversely affect our business, financial condition, operating results and cash flows.

The occurrence of one or more epidemics, natural disasters or geo-political events, such as civil unrest or terrorist attacks, in a country in which we operate or in which technology industry suppliers or our customers are located, could adversely affect our business, financial condition, operating results and cash flows. Such events could result in physical damage to, or the complete loss of, one or more of our facilities, the lack of an adequate work force in a market, the inability of our associates to reach or have transportation to our facilities directly affected by such events, the evacuation of the populace from areas in which our facilities are located, changes in the purchasing patterns of our customers, the temporary or long-term disruption in the supply of computer hardware and related components, the disruption or delay in the manufacture and transport of goods overseas, the disruption of utility services to our facilities or to suppliers, partners or customers, and disruption in our communications with our customers.

 

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ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

Issuer Purchases of Equity Securities

The table below sets forth information regarding the Company’s purchases of its common stock during its third fiscal quarter ended November 30, 2013:

Issuer Purchases of Equity Securities

 

Period

   Total Number
of Shares
Purchased (1)
     Weighted
Average
Price Paid
per Share
     Total Number of
Shares Purchased
as Part of Publicly
Announced  Plans
or Programs (2)
     Maximum Number (or
Approximate Dollar
Value) of Shares that
May Yet Be Purchased
Under the Plans  or
Programs (2)
 

September 1, 2013—September 30, 2013

     —         $ —           —         $ 280.0 million   

October 1, 2013—October 31, 2013

     1,340,855       $ 43.50         920,226       $ 240.0 million   

November 1, 2013—November 30, 2013

     —         $ —           —         $ 240.0 million   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total

         1,340,855       $     43.50                 920,226       $         240.0 million   
  

 

 

    

 

 

    

 

 

    

 

 

 

 

(1) During the three months ended November 30, 2013, the Company withheld an aggregate of 420,629 shares of its common stock from employees to satisfy minimum tax withholding obligations relating to the vesting of restricted share awards. These shares were not withheld pursuant to the program described in Note (2) below.
(2) On April 15, 2013, the Company announced that its Board of Directors has 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. See NOTE 10—Share Repurchase Program to the Consolidated Financial Statements for information regarding the Company’s $300.0 million stock repurchase program announced on April 15, 2013.

 

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ITEM 6. EXHIBITS

(a) List of Exhibits

 

Exhibit No.

  

Exhibit

10.1*

   Cash Retention Agreement, dated October 16, 2013, between Red Hat, Inc. and Brian Stevens

31.1

   Certification of the registrant’s Chief Executive Officer pursuant to Rule 13a-14(a)/Rule 15d-14(a) under the Securities Exchange Act of 1934, as amended, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

31.2

   Certification of the registrant’s Chief Financial Officer pursuant to Rule 13a-14(a)/Rule 15d-14(a) under the Securities Exchange Act of 1934, as amended, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

32.1

   Certification of the registrant’s principal executive officer and principal financial officer pursuant to 18 U.S.C. Section 1350

101.INS

   XBRL Instance Document

101.SCH

   XBRL Taxonomy Extension Schema

101.CAL

   XBRL Taxonomy Extension Calculation Linkbase

101.DEF

   XBRL Taxonomy Extension Definition Linkbase

101.LAB

   XBRL Taxonomy Extension Label Linkbase

101.PRE

   XBRL Taxonomy Extension Presentation Linkbase

 

 

* Indicates a management contract or compensatory plan, contract or arrangement.

 

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SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

 

    RED HAT, INC.

Date: January 9, 2014

  By:  

/S/ JAMES M. WHITEHURST  

   

James M. Whitehurst  

President and Chief Executive Officer  

(Duly Authorized Officer on Behalf of the Registrant)  

    RED HAT, INC.

Date: January 9, 2014

  By:  

/S/ CHARLES E. PETERS, JR.

   

Charles E. Peters, Jr.

Executive Vice President and

Chief Financial Officer

(Principal Financial Officer)

    RED HAT, INC.

Date: January 9, 2014

  By:  

/S/ MARK E. COOK

   

Mark E. Cook

Vice President Finance and Controller

(Principal Accounting Officer)

 

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