10-Q 1 rht-10qq3fy18.htm 10-Q Document

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, 2017
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, a smaller reporting company or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company” and “emerging growth company” in Rule 12b-2 of the Exchange Act.
 
Large accelerated filer
x
 
Accelerated filer
¨
 
 
Non-accelerated filer
¨
 
Smaller reporting company
¨
 
 
 
 
 
Emerging growth company
¨

 
If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ¨
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 29, 2017, there were 177,004,300 shares of common stock outstanding.



RED HAT, INC.
 
 
 
Page
 
 
 
 
 
ITEM 1:
 
 
Consolidated Balance Sheets at November 30, 2017 (unaudited) and February 28, 2017 (derived from audited financial statements)
 
Consolidated Statements of Operations for the three and nine months ended November 30, 2017 (unaudited) and 2016 (unaudited)
 
Consolidated Statements of Comprehensive Income for the three and nine months ended November 30, 2017 (unaudited) and 2016 (unaudited)
 
Consolidated Statements of Cash Flows for the three and nine months ended November 30, 2017 (unaudited) and 2016 (unaudited)
 
 
 
 
ITEM 2:
ITEM 3:
ITEM 4:
 
 
 
 
 
ITEM 1:
ITEM 1A:
ITEM 2:
ITEM 6:
 
 
 




2


CAUTIONARY NOTE ON FORWARD-LOOKING STATEMENTS

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


3


PART I

ITEM 1.
FINANCIAL STATEMENTS

RED HAT, INC.
CONSOLIDATED BALANCE SHEETS
(In thousands—except share and per share amounts)
 
November 30, 2017 (Unaudited)
 
February 28, 2017 (1)
ASSETS
 
 
 
Current assets:
 
 
 
Cash and cash equivalents
$
1,331,172

 
$
1,090,808

Investments in debt and equity securities, short-term
384,717

 
369,983

Accounts receivable, net of allowances for doubtful accounts of $2,398 and $2,791, respectively
531,509

 
634,821

Prepaid expenses
216,036

 
200,609

Other current assets
41,276

 
19,481

Total current assets
2,504,710

 
2,315,702

Property and equipment, net of accumulated depreciation and amortization of $277,411 and $231,533, respectively
201,807

 
189,629

Goodwill
1,120,957

 
1,040,709

Identifiable intangibles, net
151,450

 
137,767

Investments in debt securities, long-term
605,284

 
672,440

Deferred tax assets, net
108,235

 
104,833

Other assets, net
67,041

 
74,105

Total assets
$
4,759,484

 
$
4,535,185

LIABILITIES AND STOCKHOLDERS’ EQUITY
 
 
 
Current liabilities:
 
 
 
Accounts payable and accrued expenses
$
341,596

 
$
376,957

Deferred revenue, short-term
1,482,428

 
1,512,762

Other current obligations
1,022

 
1,354

Total current liabilities
1,825,046

 
1,891,073

Deferred revenue, long-term
623,150

 
557,194

Convertible notes
762,367

 
745,633

Other long-term obligations
115,781

 
93,965

Commitments and contingencies (NOTES 11 and 12)

 

Stockholders’ equity:
 
 
 
Preferred stock, $0.0001 per share par value, 5,000,000 shares authorized, none outstanding

 

Common stock, $0.0001 per share par value, 300,000,000 shares authorized, 238,617,591 and 236,804,594 shares issued, and 177,002,948 and 176,901,936 shares outstanding at November 30, 2017 and February 28, 2017, respectively
24

 
24

Additional paid-in capital
2,350,740

 
2,294,462

Retained earnings
1,624,346

 
1,352,991

Treasury stock at cost, 61,614,643 and 59,902,658 shares at November 30, 2017 and February 28, 2017, respectively
(2,506,075
)
 
(2,311,805
)
Accumulated other comprehensive loss
(35,895
)
 
(88,352
)
Total stockholders’ equity
1,433,140

 
1,247,320

Total liabilities and stockholders’ equity
$
4,759,484

 
$
4,535,185

  
____________________ 
(1)
Derived from audited financial statements.

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

4



RED HAT, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands—except per share amounts)
(Unaudited)
 
 
Three Months Ended
 
Nine Months Ended
 
November 30,
2017
 
November 30,
2016
 
November 30,
2017
 
November 30,
2016
Revenue:
 
 
 
 
 
 
 
Subscriptions
$
656,832

 
$
543,318

 
$
1,890,902

 
$
1,576,192

Training and services
91,146

 
71,942

 
257,227

 
206,771

Total subscription and training and services revenue
747,978

 
615,260

 
2,148,129

 
1,782,963

Cost of subscription and training and services revenue:
 
 
 
 
 
 
 
Cost of subscriptions
47,277

 
40,660

 
137,234

 
116,882

Cost of training and services
64,482

 
49,793

 
181,938

 
145,289

Total cost of subscription and training and services revenue
111,759

 
90,453

 
319,172

 
262,171

Gross profit
636,219

 
524,807

 
1,828,957

 
1,520,792

Operating expense:
 
 
 
 
 
 
 
Sales and marketing
308,388

 
267,080

 
883,395

 
763,583

Research and development
145,580

 
122,469

 
424,552

 
358,750

General and administrative
63,838

 
54,485

 
180,430

 
160,439

Total operating expense
517,806

 
444,034

 
1,488,377

 
1,282,772

Income from operations
118,413

 
80,773

 
340,580

 
238,020

Interest income
4,864

 
3,346

 
13,469

 
10,167

Interest expense
6,180

 
6,009

 
18,346

 
17,820

Other expense, net
(1,187
)
 
(1,392
)
 
(3,033
)
 
(1,860
)
Income before provision for income taxes
115,910

 
76,718

 
332,670

 
228,507

Provision for income taxes
14,604

 
8,775

 
61,315

 
40,607

Net income
$
101,306

 
$
67,943

 
$
271,355

 
$
187,900

Basic net income per common share
$
0.57

 
$
0.38

 
$
1.53

 
$
1.04

Diluted net income per common share
$
0.54

 
$
0.37

 
$
1.48

 
$
1.02

Weighted average shares outstanding:
 
 
 
 
 
 
 
Basic
177,063

 
179,233

 
177,188

 
180,245

Diluted
186,160


182,682


183,397


183,453

 


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

5



RED HAT, INC.
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(In thousands)
(Unaudited)
 
 
Three Months Ended
 
Nine Months Ended
 
November 30,
2017
 
November 30,
2016
 
November 30,
2017
 
November 30,
2016
Net income
$
101,306

 
$
67,943

 
$
271,355

 
$
187,900

Other comprehensive income:
 
 
 
 
 
 
 
Change in foreign currency translation adjustment
(1,371
)
 
(17,630
)
 
53,160

 
(14,185
)
Available-for-sale securities:
 
 
 
 
 
 
 
Unrealized loss on available-for-sale securities during the period
(2,206
)
 
(2,725
)
 
(1,052
)
 
(779
)
Reclassification for gain realized on available-for-sale securities, reported in Other expense, net
(1
)
 
(23
)
 
(1
)
 
(32
)
Tax benefit
859

 
982

 
350

 
327

Net change in available-for-sale securities (net of tax)
(1,348
)
 
(1,766
)
 
(703
)
 
(484
)
Total other comprehensive (loss) income
(2,719
)
 
(19,396
)
 
52,457

 
(14,669
)
Comprehensive income
$
98,587

 
$
48,547

 
$
323,812

 
$
173,231



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

6



RED HAT, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
(Unaudited)
 
 
Three Months Ended
 
Nine Months Ended
 
November 30, 2017
 
November 30, 2016
 
November 30, 2017
 
November 30, 2016
Cash flows from operating activities:
 
 
 
 
 
 
 
Net income
$
101,306

 
$
67,943

 
$
271,355

 
$
187,900

Adjustments to reconcile net income to net cash provided by operating activities:
 
 
 
 
 
 
 
Depreciation and amortization
25,588

 
21,870

 
71,541

 
63,732

Amortization of debt discount and transaction costs
5,630

 
5,453

 
16,740

 
16,211

Share-based compensation expense
52,318

 
54,741

 
142,983

 
141,373

Deferred income taxes
273

 
13,818

 
7,831

 
6,199

Net amortization of bond premium on debt securities available for sale
2,113

 
3,120

 
6,988

 
9,954

Other
(214
)
 
986

 
1,318

 
549

Changes in operating assets and liabilities, net of effects of acquisitions:
 
 
 
 
 
 
 
Accounts receivable
(113,898
)
 
(73,149
)
 
111,899

 
86,496

Prepaid expenses
(6,756
)
 
(18,897
)
 
(26,026
)
 
(19,387
)
Accounts payable and accrued expenses
35,559

 
(4,413
)
 
(17,771
)
 
(14,836
)
Deferred revenue
57,275

 
64,181

 
(29,017
)
 
(8,865
)
Other
1,113

 
706

 
3,234

 
(3,868
)
Net cash provided by operating activities
160,307

 
136,359

 
561,075

 
465,458

Cash flows from investing activities:
 
 
 
 
 
 
 
Purchase of investment in debt securities available for sale
(26,580
)
 
(118,152
)
 
(285,773
)
 
(415,796
)
Proceeds from maturities of investment in debt securities available for sale
130,941

 
108,722

 
348,285

 
378,264

Proceeds from sales of investment in debt securities available for sale
5,293

 
5,037

 
19,617

 
30,205

Acquisition of businesses, net of cash acquired

 

 
(83,965
)
 
(28,667
)
Purchase of developed software and other intangible assets
(3,426
)
 
(2,323
)
 
(12,871
)
 
(8,712
)
Purchase of property and equipment
(16,587
)
 
(17,244
)
 
(68,268
)
 
(50,436
)
Other
84

 
(92
)
 
(105
)
 
(203
)
Net cash provided by (used in) investing activities
89,725

 
(24,052
)
 
(83,080
)
 
(95,345
)
Cash flows from financing activities:
 
 
 
 
 
 
 
Proceeds from exercise of common stock options
711

 
1,205

 
4,541

 
3,273

Proceeds from employee stock purchase program
10,575

 
7,155

 
33,288

 
7,155

Payments related to net settlement of share-based compensation awards
(37,807
)
 
(25,769
)
 
(86,230
)
 
(63,245
)
Purchase of treasury stock
(100,000
)
 
(125,318
)
 
(237,002
)
 
(319,182
)
Payments on other borrowings
(346
)
 
(462
)
 
(1,207
)
 
(1,368
)
Other
(6
)
 
(84
)
 
(6
)
 
829

Net cash used in financing activities
(126,873
)
 
(143,273
)
 
(286,616
)
 
(372,538
)
Effect of foreign currency exchange rates on cash and cash equivalents
(2,295
)
 
(22,925
)
 
48,985

 
(8,675
)
Net increase (decrease) in cash and cash equivalents
120,864

 
(53,891
)
 
240,364

 
(11,100
)
Cash and cash equivalents at beginning of the period
1,210,308

 
970,569

 
1,090,808

 
927,778

Cash and cash equivalents at end of the period
$
1,331,172

 
$
916,678

 
$
1,331,172

 
$
916,678




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

7



RED HAT, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)


NOTE 1—Company
Red Hat, Inc., incorporated in Delaware, together with its subsidiaries (“Red Hat” or the “Company”) is a leading global provider of open source software solutions, using a community-powered approach to develop and offer reliable and high-performing operating system, virtualization, management, middleware, cloud, mobile and storage 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 technologies, and by providing a level of performance, scalability, flexibility, reliability and security for the 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 technologies. The arrangements with the Company’s customers that produce this revenue and cash are explained in further detail in NOTE 2—Summary of Significant Accounting Policies to the Consolidated Financial Statements contained in the Company’s Annual Report on Form 10-K for the fiscal year ended February 28, 2017.

NOTE 2—Summary of Significant Accounting Policies
Basis of presentation
The unaudited interim consolidated financial statements as of and for the three and nine months ended November 30, 2017 have been prepared by the Company pursuant to the rules and regulations of the Securities and Exchange Commission (the “SEC”) for interim financial reporting. These consolidated statements are unaudited and, in the opinion of management, include all adjustments (consisting of normal recurring adjustments and accruals) necessary for a fair statement of the consolidated balance sheets, consolidated operating results, consolidated other comprehensive income and consolidated cash flows for the periods presented in accordance with accounting principles generally accepted in the United States (“U.S. GAAP”). Operating results for the three and nine months ended November 30, 2017 are not necessarily indicative of the results that may be expected for the fiscal year ending February 28, 2018. Certain information and footnote disclosures normally included in annual financial statements prepared in accordance with U.S. GAAP have been omitted in accordance with the SEC’s rules and regulations for interim reporting. These unaudited financial statements should be read in conjunction with 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, 2017. 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, 2017.
Certain amounts for the three and nine months ended November 30, 2016 have been reclassified to conform to the current year presentation.
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 foreign currency exchange restrictions that are significant to the Company’s foreign subsidiaries.
Use of estimates
The preparation of financial statements in conformity with U.S. GAAP 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.

8


RED HAT, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(Unaudited)


Recent accounting pronouncements
Accounting pronouncements adopted
In May 2017, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update 2017-09, Compensation—Stock Compensation (Topic 718): Scope of Modification Accounting (“ASU 2017-09”). The FASB issued ASU 2017-09 to clarify and reduce both (i) diversity in practice and (ii) cost and complexity when applying the guidance in Topic 718, to a change to the terms and conditions of a share-based payment award. The Company has early adopted ASU 2017-09 as of the second quarter of its fiscal year ending February 28, 2018. The adoption of this update did not impact the Company’s Consolidated Financial Statements.
In January 2017, the FASB issued Accounting Standards Update 2017-04, Intangibles—Goodwill and Other (Topic 350): Simplifying the Test for Goodwill Impairment (“ASU 2017-04”). The FASB issued ASU 2017-04 to simplify the subsequent measurement of goodwill by eliminating Step 2 from the goodwill impairment test. Under this updated standard, an entity should recognize an impairment charge for the amount by which the carrying amount exceeds the reporting unit’s fair value, but the loss recognized should not exceed the total amount of goodwill allocated to that reporting unit. An entity also should consider income tax effects from any tax-deductible goodwill on the carrying amount of the reporting unit when measuring the goodwill impairment loss, if any. The FASB also eliminated the requirement for reporting units with a zero or negative carrying amount to first perform a qualitative assessment. The Company adopted ASU 2017-04 during the second quarter of its fiscal year ending February 28, 2018. The adoption of this update did not impact the Company’s Consolidated Financial Statements.
Accounting pronouncements being evaluated
In August 2016, the FASB issued Accounting Standards Update 2016-15, Statement of Cash Flows (Topic 230): Classification of Certain Cash Receipts and Cash Payments (“ASU 2016-15”). In November 2016, the FASB issued Accounting Standards Update 2016-18, Statement of Cash Flows (Topic 230): Restricted Cash (“ASU 2016-18”). The FASB issued ASU 2016-15 and ASU 2016-18 to decrease the diversity in practice in how certain cash receipts and cash payments are presented and classified in the statement of cash flows. The amendments in these updates provide guidance on nine specific cash flow issues. The guidance is effective for the Company as of the first quarter of its fiscal year ending February 28, 2019 and should be applied using the retrospective transition method to each period presented. Early adoption is permitted but all amendments must be adopted in the same period. The Company is currently evaluating the impact that these updated standards will have on its consolidated financial statements.
In February 2016, the FASB issued Accounting Standards Update 2016-02, Leases (Topic 842) (“ASU 2016-02”). The FASB issued ASU 2016-02 to increase transparency and comparability among organizations with respect to accounting for leases. Under ASU 2016-02, lessees will recognize a right-of-use asset and a lease liability for virtually all of their leases (other than leases that meet the definition of a short-term lease). The liability will be equal to the present value of lease payments. The asset will be based on the liability, subject to adjustment, such as for initial direct costs. For income statement purposes, the FASB retained a dual model, requiring leases to be classified as either operating or finance. This guidance is effective for the Company as of the first quarter of its fiscal year ending February 28, 2020. The Company is currently evaluating the impact that this updated standard will have on its consolidated financial statements.
In January 2016, the FASB issued Accounting Standards Update 2016-01, Financial Instruments—Overall (Subtopic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities (“ASU 2016-01”). The FASB issued ASU 2016-01 to require equity investments with readily determinable fair values to be measured at fair value with changes in fair value recognized in net income. Equity investments that do not have readily determinable fair values are allowed to be remeasured upon the occurrence of an observable price change or upon identification of an impairment. This guidance is effective for the Company as of the first quarter of the fiscal year ending February 28, 2019. The Company is currently evaluating the impact that this updated standard will have on its consolidated financial statements.
In May 2014, the FASB issued Accounting Standards Update 2014-09, Revenue from Contracts with Customers, now referred to as Accounting Standards Codification Topic 606 (“ASC 606”). The FASB issued ASC 606 to clarify the principles for recognizing revenue and to develop a common revenue standard for U.S. GAAP and International Financial Reporting Standards. The standard outlines a single comprehensive model for entities to use in accounting for revenue arising from contracts with customers and supersedes the current revenue recognition guidance. This guidance is effective for the Company beginning the first quarter of its fiscal year ending February 28, 2019. The standard must be adopted using either a full retrospective approach for all periods presented in the period of adoption or a modified retrospective approach.

9


RED HAT, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(Unaudited)


The Company has substantially completed its preliminary assessment of the potential impact that the implementation of this updated standard will have on its consolidated financial statements. With respect to the Company’s software subscription offerings, the Company provides value to its customers through continuous aggregation, integration, testing, certification, maintenance, enhancement and support of the open source technologies that it distributes. The Company currently recognizes subscription revenue ratably over the subscription period. Under the updated standard, these subscription attributes represent a series of performance obligations that are delivered over time, primarily on a stand-ready basis (for example, attributes such as updates, upgrades, and support are not forced upon subscribers but rather made available to subscribers). As a result, the Company believes that its subscription revenue meets the criteria for revenue recognition over time and will continue to be recognized ratably under the updated standard.
The Company also offers professional consulting and training services that are designed to help customers derive additional value from Red Hat technologies. Under the updated guidance, revenue from professional consulting and training services that were previously sold on a standalone basis will continue to be recognized over time as the Company satisfies its performance obligations by delivering such services to the customer.
With respect to customer contracts with multiple elements (such as software subscriptions and professional consulting and training services), under the current standard the Company allocates total contract revenue to each element’s relative fair value when the Company can demonstrate sufficient vendor-specific objective evidence (“VSOE”) of the fair value of at least those elements that are undelivered. For multiple-element contracts in which one or more of the undelivered elements lacks VSOE, the Company defers recognition of any revenue until the elements lacking VSOE have been delivered. However, under the updated standard, the Company will be required to allocate total contract revenue to each element (referred to as a distinct performance obligation under the updated standard) based on either an established or estimated standalone selling price. The Company would then recognize the allocated revenue as each element (performance obligation) is delivered. Because the Company has historically established VSOE for most of its offerings and as a result has not been required to defer a significant amount of revenue due to insufficient VSOE, the Company does not anticipate the updated standard’s requirement to establish or estimate a standalone selling price, rather than defer revenues in the absence of VSOE, to have a significant impact on the Company’s financial statements.
The Company continues to assess the impact of the updated guidance, including for example, any potential changes to and investments in the Company’s policies, processes, systems and internal controls over financial reporting that may be required to comply with new guidance related to variable consideration, contract modifications, allocation of discounts and expanded disclosures. The Company currently expects to adopt ASC 606 using the full retrospective method.



10


RED HAT, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(Unaudited)


NOTE 3—Stockholders’ Equity
The following table summarizes the changes in the Company’s stockholders’ equity during the three months ended November 30, 2017 (in thousands): 
 
Common
Stock
 
Additional
Paid-In
Capital
 
Retained
Earnings
 
Treasury
Stock
 
Accumulated
Other
Comprehensive
Loss
 
Total
Stockholders’
Equity
Balance at August 31, 2017
$
24

 
$
2,335,518

 
$
1,523,040

 
$
(2,425,059
)
 
$
(33,176
)
 
$
1,400,347

Net income

 

 
101,306

 

 

 
101,306

Other comprehensive loss, net of tax

 

 

 

 
(2,719
)
 
(2,719
)
Exercise of common stock options

 
711

 

 

 

 
711

Common stock repurchase

 

 

 
(100,000
)
 

 
(100,000
)
Share-based compensation expense

 
52,318

 

 

 

 
52,318

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

 
(37,807
)
 

 

 

 
(37,807
)
Re-issuance of treasury stock under employee stock purchase plan

 

 

 
18,984

 

 
18,984

Balance at November 30, 2017
$
24

 
$
2,350,740

 
$
1,624,346

 
$
(2,506,075
)
 
$
(35,895
)
 
$
1,433,140


The following table summarizes the changes in the Company’s stockholders’ equity during the three months ended November 30, 2016 (in thousands):
 
Common
Stock
 
Additional
Paid-In
Capital
 
Retained
Earnings
 
Treasury
Stock
 
Accumulated
Other
Comprehensive
Loss
 
Total
Stockholders’
Equity
Balance at August 31, 2016
$
24

 
$
2,215,856

 
$
1,219,246

 
$
(2,047,008
)
 
$
(69,722
)
 
$
1,318,396

Net income

 

 
67,943

 

 

 
67,943

Other comprehensive loss, net of tax

 

 

 

 
(19,396
)
 
(19,396
)
Exercise of common stock options

 
1,205

 

 

 

 
1,205

Common stock repurchase

 

 

 
(125,318
)
 

 
(125,318
)
Share-based compensation expense

 
54,741

 

 

 

 
54,741

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

 
(25,769
)
 

 

 

 
(25,769
)
Other adjustments

 
1

 
(1
)
 

 

 

Balance at November 30, 2016
$
24

 
$
2,246,034

 
$
1,287,188

 
$
(2,172,326
)
 
$
(89,118
)
 
$
1,271,802



11


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, 2017 (in thousands): 
 
Common
Stock
 
Additional
Paid-In
Capital
 
Retained
Earnings
 
Treasury
Stock
 
Accumulated
Other
Comprehensive
Loss
 
Total
Stockholders’
Equity
Balance at February 28, 2017
$
24

 
$
2,294,462

 
$
1,352,991

 
$
(2,311,805
)
 
$
(88,352
)
 
$
1,247,320

Net income

 

 
271,355

 

 

 
271,355

Other comprehensive income, net of tax

 

 

 

 
52,457

 
52,457

Exercise of common stock options

 
4,541

 

 

 

 
4,541

Common stock repurchase

 

 

 
(237,002
)
 

 
(237,002
)
Share-based compensation expense

 
142,983

 

 

 

 
142,983

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

 
(86,230
)
 

 

 

 
(86,230
)
Re-issuance of treasury stock under employee stock purchase plan

 

 

 
42,732

 

 
42,732

Other adjustments

 
(5,016
)
 

 

 

 
(5,016
)
Balance at November 30, 2017
$
24

 
$
2,350,740

 
$
1,624,346

 
$
(2,506,075
)
 
$
(35,895
)
 
$
1,433,140


12


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, 2016 (in thousands):
 
Common
Stock
 
Additional
Paid-In
Capital
 
Retained
Earnings
 
Treasury
Stock
 
Accumulated
Other
Comprehensive
Loss
 
Total
Stockholders’
Equity
Balance at February 29, 2016
$
23

 
$
2,162,264

 
$
1,099,738

 
$
(1,853,144
)
 
$
(74,449
)
 
$
1,334,432

Net income

 

 
187,900

 

 

 
187,900

Other comprehensive loss, net of tax

 

 

 

 
(14,669
)
 
(14,669
)
Exercise of common stock options
1

 
3,272

 

 

 

 
3,273

Common stock repurchase

 

 

 
(319,182
)
 

 
(319,182
)
Share-based compensation expense

 
141,373

 

 

 

 
141,373

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

 
(63,245
)
 

 

 

 
(63,245
)
Other adjustments

 
1

 

 

 

 
1

Cumulative-effect adjustment from adoption of ASU 2016-09

 
2,369

 
(450
)
 

 

 
1,919

Balance at November 30, 2016
$
24

 
$
2,246,034

 
$
1,287,188

 
$
(2,172,326
)
 
$
(89,118
)
 
$
1,271,802


Share Repurchase Programs
On June 22, 2016, the Company announced that its Board of Directors authorized the repurchase of up to $1.0 billion of Red Hat’s common stock from time to time on the open market or in privately negotiated transactions. The program commenced on July 1, 2016, and will expire on the earlier of (i) June 30, 2018 or (ii) a determination by the Board, Chief Executive Officer or Chief Financial Officer to discontinue the program. The program replaced the previous $500.0 million repurchase program authorized on March 25, 2015, which was discontinued by the Board effective June 30, 2016.
During the nine months ended November 30, 2017, the Company repurchased 2,318,584 shares of its common stock for $237.0 million under the repurchase program.
From its commencement on July 1, 2016 through November 30, 2017, the Company has repurchased 7,219,233 shares of its common stock under the program. As of November 30, 2017, the amount available under the program for the repurchase of the Company’s common stock was $398.7 million.

Accumulated other comprehensive loss
The following is a summary of accumulated other comprehensive loss as of November 30, 2017 and February 28, 2017 (in thousands):
 
 
As of November 30, 2017
 
As of February 28, 2017
Accumulated loss from foreign currency translation adjustment
 
$
(34,624
)
 
$
(87,784
)
Accumulated unrealized loss, net of tax, on available-for-sale securities
 
(1,271
)
 
(568
)
Accumulated other comprehensive loss
 
$
(35,895
)
 
$
(88,352
)


13


RED HAT, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(Unaudited)


NOTE 4—Identifiable Intangible Assets
Identifiable intangible assets consist primarily of trademarks, copyrights and patents, purchased technologies, customer and reseller relationships and covenants not to compete, all of 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 two to 10 years. As of November 30, 2017 and February 28, 2017, trademarks with an indefinite estimated useful life totaled $11.7 million and $10.9 million, respectively.
See NOTE 13—Business Combinations for information regarding identifiable intangible assets acquired. The following is a summary of identifiable intangible assets (in thousands):
 
As of November 30, 2017
 
As of February 28, 2017
 
Gross
Amount
 
Accumulated
Amortization
 
Net
Amount
 
Gross
Amount
 
Accumulated
Amortization
 
Net
Amount
Trademarks, copyrights and patents
$
162,818

 
$
(67,838
)
 
$
94,980

 
$
148,850

 
$
(59,440
)
 
$
89,410

Purchased technologies
130,235

 
(90,143
)
 
40,092

 
107,078

 
(80,536
)
 
26,542

Customer and reseller relationships
105,810

 
(93,703
)
 
12,107

 
104,438

 
(88,046
)
 
16,392

Covenants not to compete
15,669

 
(14,036
)
 
1,633

 
14,081

 
(12,329
)
 
1,752

Other intangible assets
8,833

 
(6,195
)
 
2,638

 
8,833

 
(5,162
)
 
3,671

Total identifiable intangible assets
$
423,365

 
$
(271,915
)
 
$
151,450

 
$
383,280

 
$
(245,513
)
 
$
137,767

Amortization expense associated with identifiable intangible assets recognized in the Company’s Consolidated Financial Statements for the three and nine months ended November 30, 2017 and November 30, 2016 is summarized as follows (in thousands):
 
Three Months Ended
 
Nine Months Ended
 
November 30, 2017
 
November 30, 2016
 
November 30, 2017
 
November 30, 2016
Cost of revenue
$
4,674

 
$
4,578

 
$
13,524

 
$
12,734

Sales and marketing
1,592

 
1,695

 
4,634

 
5,515

Research and development
34

 
34

 
103

 
103

General and administrative
2,084

 
1,690

 
6,137

 
5,291

Total amortization expense
$
8,384

 
$
7,997

 
$
24,398

 
$
23,643


NOTE 5—Income Taxes
The effective tax rates for the three and nine months ended November 30, 2017 of 12.6% and 18.4%, respectively, differed from the U.S. federal statutory rate of 35% primarily due to excess tax benefits from share-based compensation, foreign income taxed at lower rates, research tax credits and the domestic-production-activities deduction. Tax expense for the three and nine months ended November 30, 2017 included net discrete tax benefits of $15.5 million and $28.5 million, respectively, primarily related to net excess tax benefits from share-based compensation.

14


RED HAT, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(Unaudited)


For the three and nine months ended November 30, 2016, the Company’s then-effective tax rates of 11.4% and 17.8%, respectively, differed from the U.S. federal statutory rate of 35% primarily due to excess tax benefits from share-based compensation, foreign income taxes at lower rates, research tax credits and the domestic-production-activities deduction. Tax expense for the three and nine months ended November 30, 2016, included net discrete tax benefits of $11.9 million and $21.1 million, respectively, primarily related to net excess tax benefits from share-based compensation.
The Company files a consolidated U.S. federal income tax return, as well as separate and combined income tax returns in numerous state and international jurisdictions. The Company is currently subject to examination by various taxing jurisdictions. The Company regularly assesses the potential outcomes of both ongoing and future examinations for the current and prior years, and believes that its provision for income taxes is adequate. The outcome of any one examination is not expected to have a material impact on the Company’s consolidated financial statements. The Company believes that some of these audits and negotiations may conclude during the next 12 months.
As of November 30, 2017, it is reasonably possible that total gross unrecognized tax benefits may be reduced by up to $2.0 million within the next 12 months as a result of statutes of limitations expirations in various tax jurisdictions, all of which would reduce the Company’s effective tax rate.
NOTE 6—Assets and Liabilities Measured at Fair Value on a Recurring Basis
Fair value is defined as the exchange price that would be received for the purchase of an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for such asset or liability in an orderly transaction between market participants on the measurement date. Valuation techniques used to measure fair value should maximize the use of observable inputs and minimize the use of unobservable inputs. To measure fair value, the Company uses the following fair value hierarchy based on three levels of inputs, of which the first two are considered observable and the last unobservable:
Level 1—Quoted prices in active markets for identical assets or liabilities.
Level 2—Inputs other than Level 1 that are observable, either directly or indirectly, such as quoted prices for similar assets or liabilities; quoted prices in markets that are not active; or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the assets or liabilities.
Level 3—Unobservable inputs that are supported by little or no market activity and are significant to the fair value of the assets or liabilities.
The Company’s investments are comprised primarily of debt securities that are classified as available for sale and recorded at their fair values. Liquid investments with effective maturities of three months or less at the date of purchase are classified as cash equivalents. Investments with remaining effective maturities of twelve months or less from the balance sheet date are classified as short-term investments. Investments with remaining effective maturities of more than twelve months from the balance sheet date are classified as long-term investments. The Company’s Level 1 financial instruments are valued using quoted prices in active markets for identical instruments. The Company’s Level 2 financial instruments, including derivative instruments, are valued using quoted prices for identical instruments in less active markets or using other observable market inputs for comparable instruments.
Unrealized gains and temporary losses on investments classified as available for sale are included within accumulated other comprehensive income, net of any related tax effect. Realized gains and losses are recorded using the specific identification method and upon realization, such amounts are reclassified from accumulated other comprehensive income to Other expense, net. Realized gains and losses and other than temporary impairments, if any, are reflected in the Company’s Consolidated Statements of Operations as Other expense, net. The Company does not recognize changes in the fair value of its investments in income unless a decline in value is considered other than temporary. The vast majority of the Company’s investments are priced with the assistance of pricing vendors. These pricing vendors use the most recent observable market information in pricing these securities or, if specific prices are not available for these securities, use other observable inputs. In the event observable inputs are not available, the Company assesses other factors to determine the security’s fair 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 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.

15


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 as of November 30, 2017 (in thousands):
 
As of November 30, 2017
 
Level 1
 
Level 2
 
Level 3
Assets:
 
 
 
 
 
 
 
Money markets (1)
$
217,456

 
$
217,456

 
$

 
$

Interest-bearing deposits (1)
59,312

 

 
59,312

 

Available-for-sale securities (1):
 
 
 
 
 
 
 
Commercial paper
250,794

 

 
250,794

 

U.S. agency securities
309,489

 

 
309,489

 

Corporate securities
620,479

 

 
620,479

 

Equity securities
721

 
721

 

 

Foreign currency derivatives (2)
156

 

 
156

 

Liabilities:
 
 
 
 
 
 
 
Foreign currency derivatives (3)
(174
)
 

 
(174
)
 

Total
$
1,458,233

 
$
218,177

 
$
1,240,056

 
$

__________ 
(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 as of November 30, 2017, in addition to $862.9 million of cash.
(2)
Included in Other current assets in the Company’s Consolidated Balance Sheet as of November 30, 2017.
(3)
Included in Accounts payable and accrued expenses in the Company’s Consolidated Balance Sheet as of November 30, 2017.
The following table summarizes the composition and fair value hierarchy of the Company’s financial assets and liabilities as of February 28, 2017 (in thousands):
 
As of February 28, 2017
 
Level 1
 
Level 2
 
Level 3
Assets:
 
 
 
 
 
 
 
Money markets (1)
$
258,188

 
$
258,188

 
$

 
$

Available-for-sale securities (1):
 
 
 
 
 
 
 
U.S. agency securities
327,430

 

 
327,430

 

Corporate securities
714,993

 

 
714,993

 

Foreign currency derivatives (2)
135

 

 
135

 

Liabilities:
 
 
 
 
 
 
 
Foreign currency derivatives (3)
(160
)
 

 
(160
)
 

Total
$
1,300,586

 
$
258,188

 
$
1,042,398

 
$

__________ 
(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 as of February 28, 2017, in addition to $832.6 million of cash.
(2)
Included in Other current assets in the Company’s Consolidated Balance Sheet as of February 28, 2017.
(3)
Included in Accounts payable and accrued expenses in the Company’s Consolidated Balance Sheet as of February 28, 2017.

16


RED HAT, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(Unaudited)


The following table represents the Company’s investments measured at fair value as of November 30, 2017 (in thousands):
 
 
 
 
 
 
 
 
 
Balance Sheet Classification
 
Amortized
Cost
 
Gross Unrealized
 
Aggregate
Fair Value
 
Cash Equivalent Marketable Securities
 
Investments in debt and equity securities, short-term
 
Investments in debt securities, long-term
 
 
Gains
 
Losses (1)
 
 
 
 
Money markets
$
217,456

 
$

 
$

 
$
217,456

 
$
217,456

 
$

 
$

Interest-bearing deposits
59,312

 

 

 
59,312

 

 
59,312

 

Commercial paper
250,794

 

 

 
250,794

 
250,794

 

 

U.S. agency securities
312,391

 

 
(2,902
)
 
309,489

 

 
78,231

 
231,258

Corporate securities
620,121

 
1,270

 
(912
)
 
620,479

 

 
246,453

 
374,026

Equity securities
650

 
71

 

 
721

 

 
721

 

Total
$
1,460,724

 
$
1,341

 
$
(3,814
)
 
$
1,458,251


$
468,250

 
$
384,717

 
$
605,284

__________ 
(1)
As of November 30, 2017, there were $3.0 million of accumulated unrealized losses related to investments that have been in a continuous unrealized loss position for 12 months or longer. The aggregate related fair value of all investments with unrealized losses was $540.1 million.
The following table summarizes the stated maturities of the Company’s investments in debt securities (in thousands):
 
Total
 
Less than 1 Year
 
1-5 Years
 
More than 5 Years
Maturity of current and long-term investments in debt securities
$
989,280

 
$
383,996

 
$
605,284

 
$

The following table represents the Company’s investments measured at fair value as of February 28, 2017 (in thousands):
 
 
 
 
 
 
 
 
 
Balance Sheet Classification
 
Amortized
Cost
 
Gross Unrealized
 
Aggregate
Fair Value
 
Cash Equivalent Marketable Securities
 
Investments in debt and equity securities, short-term
 
Investments in debt securities, long-term
 
 
Gains
 
Losses (1)
 
 
 
 
Money markets
$
258,188

 
$

 
$

 
$
258,188

 
$
258,188

 
$

 
$

U.S. agency securities
329,617

 
37

 
(2,224
)
 
327,430

 

 
27,593

 
299,837

Corporate securities
714,226

 
1,416

 
(649
)
 
714,993

 

 
342,390

 
372,603

Total
$
1,302,031

 
$
1,453

 
$
(2,873
)
 
$
1,300,611

 
$
258,188

 
$
369,983

 
$
672,440

__________ 
(1)
As of February 28, 2017, there were $0.6 million of accumulated unrealized losses related to investments that have been in a continuous unrealized loss position for 12 months or longer. The aggregate related fair value of all investments with unrealized losses was $605.9 million.



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 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. See NOTE 6—Assets and Liabilities Measured at Fair Value on a Recurring Basis for information regarding the fair value hierarchy of derivative instruments.

17


RED HAT, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(Unaudited)


The effects of derivative instruments on the Company’s Consolidated Financial Statements are as follows as of November 30, 2017 and for the three and nine months then ended (in thousands):
 
As of November 30, 2017
 
Classification of 
Unrealized Gain (Loss)
Recognized in Income on
Derivatives
 
Three Months Ended November 30, 2017
 
Nine Months Ended November 30, 2017
 
Balance Sheet 
Classification
 
Fair
Value
 
Notional
Value
 
 
 
Assets—foreign currency forward contracts not designated as hedges
Other current assets
 
$
156

 
$
20,394

 
Other expense, net
 
$
309

 
$
1,589

Liabilities—foreign currency forward contracts not designated as hedges
Accounts payable and accrued expenses
 
(174
)
 
35,210

 
Other expense, net
 
(678
)
 
(1,261
)
Total
 
 
$
(18
)
 
$
55,604

 
 
 
$
(369
)
 
$
328

The effects of derivative instruments on the Company’s Consolidated Financial Statements are as follows as of November 30, 2016 and for the three and nine months then ended (in thousands):
 
As of November 30, 2016
 
Classification of 
Unrealized Gain (Loss)
Recognized in Income on
Derivatives
 
Three Months Ended November 30, 2016
 
Nine Months Ended November 30, 2016
 
Balance Sheet 
Classification
 
Fair
Value
 
Notional
Value
 
 
 
Assets—foreign currency forward contracts not designated as hedges
Other current assets
 
$
132

 
$
25,849

 
Other expense, net
 
$
555

 
$
2,958

Liabilities—foreign currency forward contracts not designated as hedges
Accounts payable and accrued expenses
 
(902
)
 
15,765

 
Other expense, net
 
(1,182
)
 
(2,181
)
Total
 
 
$
(770
)
 
$
41,614

 
 
 
$
(627
)
 
$
777


NOTE 8—Share-based Awards
The Company measures share-based compensation cost at the grant date, based on the estimated fair value of the award and recognizes the cost over the employee requisite service period, typically on a straight-line basis. 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.

18


RED HAT, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(Unaudited)


The following summarizes share-based compensation expense recognized in the Company’s Consolidated Financial Statements for the three and nine months ended November 30, 2017 and November 30, 2016 (in thousands):
 
Three Months Ended
 
Nine Months Ended
 
November 30, 2017
 
November 30, 2016
 
November 30, 2017
 
November 30, 2016
Cost of revenue
$
4,199

 
$
4,037

 
$
12,408

 
$
12,396

Sales and marketing
23,278

 
26,624

 
64,708

 
65,426

Research and development
14,937

 
13,814

 
42,603

 
38,785

General and administrative
9,904

 
10,266

 
23,264

 
24,766

Total share-based compensation expense (1)
$
52,318

 
$
54,741

 
$
142,983

 
$
141,373

__________ 
(1)
Total share-based compensation expense includes $2.9 million and $2.0 million respectively, of expense related to the Company’s employee stock purchase plan (“ESPP”) for the three months ended November 30, 2017 and November 30, 2016 and $8.8 million and $2.0 million, respectively, for the nine months ended November 30, 2017 and November 30, 2016.
Share-based compensation expense qualifying for capitalization was insignificant for each of the three and nine months ended November 30, 2017 and November 30, 2016. Accordingly, no share-based compensation expense was capitalized during the three and nine months ended November 30, 2017 and November 30, 2016.

19


RED HAT, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(Unaudited)


During the three and nine months ended November 30, 2017 and November 30, 2016, the Company granted the following share-based awards:
 
Three Months Ended
 
November 30, 2017
 
November 30, 2016
 
Shares and
Shares
Underlying Awards
 
Weighted
Average Per Share Award Fair Value
 
Shares and
Shares
Underlying Awards
 
Weighted
Average Per Share Award Fair Value
Service-based shares and share units
699,066

 
$
120.89

 
949,421

 
$
76.19

 
Nine Months Ended
 
November 30, 2017
 
November 30, 2016
 
Shares and
Shares
Underlying Awards
 
Weighted Average Per Share Award Fair Value
 
Shares and Shares Underlying Awards
 
Weighted Average Per Share Award Fair Value
Service-based shares and share units
1,585,904

 
$
101.85

 
2,017,861

 
$
75.62

Performance share units—target
261,760

(1)
$
87.99

 
362,502

 
$
76.68

Performance share awards
104,362

(2)
$
87.99

 
140,182

 
$
76.70

Total awards
1,952,026

 
$
99.25

 
2,520,545

 
$
75.83

__________ 
(1)    Certain executives and senior management were awarded a target number of performance share units (“PSUs”). PSU grantees may earn up to 200% of the target number of PSUs. Half of the target number of PSUs can be earned by the grantees depending upon the Company’s financial performance measured against the financial performance of specified peer companies during a three-year performance period beginning on March 1, 2017. 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 performance of specified peer companies during a three-year period beginning on March 1, 2017.
(2)    Certain executives were granted restricted stock awards. These shares were awarded subject to the achievement of a specified dollar amount of revenue for the fiscal year ending February 28, 2018 (the “RSA Performance Goal”). If the Company fails to achieve the RSA Performance Goal for the fiscal year ending February 28, 2018, then all such shares are forfeited. If the Company achieves the RSA Performance Goal for the fiscal year ending February 28, 2018, then 25% of the restricted stock vests on or about July 16, 2018, 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 (“EPS”) calculation for the three and nine months ended November 30, 2017 and November 30, 2016 (in thousands, except per share amounts):
 
Three Months Ended
 
Nine Months Ended
 
November 30, 2017
 
November 30, 2016
 
November 30, 2017
 
November 30, 2016
Net income, basic and diluted
$
101,306

 
$
67,943

 
$
271,355

 
$
187,900

Weighted average common shares outstanding
177,063

 
179,233

 
177,188

 
180,245

Incremental shares attributable to assumed vesting or exercise of outstanding equity award shares
3,518

 
2,935

 
3,281

 
2,980

Dilutive effect of convertible notes
4,109

 
514

 
2,928

 
228

Dilutive effect of warrants
1,470

 

 

 

Diluted shares
186,160

 
182,682

 
183,397

 
183,453

Diluted net income per share
$
0.54

 
$
0.37

 
$
1.48

 
$
1.02

With respect to the Company’s 0.25% Convertible Senior Notes due 2019 (the “convertible notes”), the Company has the option to pay cash or deliver, as the case may be, either cash, shares of its common stock or a combination of cash and shares of its common stock for the aggregate amount due upon conversion of the convertible notes. The Company’s intent is to settle the principal amount of the convertible notes in cash upon conversion. As a result, upon conversion of the convertible notes, only the amounts payable in excess of the principal amounts of the convertible notes are considered in diluted EPS under the treasury stock method. See NOTE 14—Convertible Notes for detailed information on the convertible notes.
Warrants to purchase 10,965,630 shares of the Company’s common stock at $101.65 per share were outstanding during the three and nine months ended November 30, 2017 and November 30, 2016. For the three months ended November 30, 2017, the warrants were included in the computation of diluted EPS because the warrants’ exercise price was lower than the average market price of the Company’s common stock during the related period. For the nine months ended November 30, 2017, the warrants were not included in the computation of diluted EPS because the warrants’ exercise price was greater than the average market price of the Company’s common stock during the related period.
The following share awards were not included in the computation of diluted EPS because the aggregate value of proceeds considered received upon either exercise or vesting was greater than the average market price of the Company’s common stock during the related periods and the effect of including such share awards in the computation would be anti-dilutive (in thousands): 
 
Three Months Ended
 
Nine Months Ended
 
November 30, 2017
 
November 30, 2016
 
November 30, 2017
 
November 30, 2016
Number of shares considered anti-dilutive for calculating diluted EPS
353

 
71

 
117

 
938


20


RED HAT, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(Unaudited)




NOTE 10—Segment Reporting
The Company is organized primarily on the basis of three geographic business units: the Americas (U.S., Latin America and Canada), Europe, Middle East and Africa (“EMEA”) and Asia Pacific. These business units are aggregated into one reportable segment due to the similarity in nature of products and services provided, financial performance economic characteristics (e.g. revenue growth and gross margin), methods of production and distribution and customer classes (e.g. cloud service providers, distributors, reseller and enterprise).
The following summarizes revenue from unaffiliated customers and income (loss) from operations for the three and nine months ended November 30, 2017 and November 30, 2016 and total cash, cash equivalents and available-for-sale investment securities and total assets as of November 30, 2017 and November 30, 2016, by geographic segment (in thousands):
 
Americas
 
EMEA
 
Asia Pacific
 
Corporate (1)
 
Consolidated
 
 
 
 
 
 
 
 
 
 
 
Three Months Ended November 30, 2017
Revenue from unaffiliated customers
$
471,773

 
$
173,718

 
$
102,487

 
$

 
$
747,978

Income (loss) from operations
$
99,937

 
$
42,086

 
$
28,708

 
$
(52,318
)
 
$
118,413

 
 
 
 
 
 
 
 
 
 
 
Three Months Ended November 30, 2016
Revenue from unaffiliated customers
$
393,589

 
$
132,568

 
$
89,103

 
$

 
$
615,260

Income (loss) from operations
$
87,899

 
$
22,608

 
$
25,007

 
$
(54,741
)
 
$
80,773

 
 
 
 
 
 
 
 
 
 
 
Nine Months Ended November 30, 2017
Revenue from unaffiliated customers
$
1,373,512

 
$
477,110

 
$
297,507

 
$

 
$
2,148,129

Income (loss) from operations
$
284,229

 
$
112,333

 
$
87,001

 
$
(142,983
)
 
$
340,580

Total cash, cash equivalents and available-for-sale investment securities
$
1,071,638

 
$
855,164

 
$
394,371

 
$

 
$
2,321,173

Total assets
$
2,877,183

 
$
1,306,074

 
$
576,227

 
$

 
$
4,759,484

 
 
 
 
 
 
 
 
 
 
 
Nine Months Ended November 30, 2016
Revenue from unaffiliated customers
$
1,144,841

 
$
384,334

 
$
253,788

 
$

 
$
1,782,963

Income (loss) from operations
$
229,251

 
$
76,506

 
$
73,636

 
$
(141,373
)
 
$
238,020

Total cash, cash equivalents and available-for-sale investment securities
$
1,060,721

 
$
611,380

 
$
299,269

 
$

 
$
1,971,370

Total assets
$
2,661,792

 
$
981,044

 
$
442,257

 
$

 
$
4,085,093

 __________
(1)
Amounts represent share-based compensation expense that was not allocated to geographic segments.

21


RED HAT, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(Unaudited)


Supplemental information about geographic areas
The following table lists, for each of the three and nine months ended November 30, 2017 and November 30, 2016, 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, 2017
 
November 30, 2016
 
November 30, 2017
 
November 30, 2016
United States, the Company’s country of domicile
 
$
415,900

 
$
352,109

 
$
1,227,645

 
$
1,024,404

Foreign
 
332,078

 
263,151

 
920,484

 
758,559

Total revenue from unaffiliated customers
 
$
747,978

 
$
615,260

 
$
2,148,129

 
$
1,782,963

Total tangible long-lived assets, net of accumulated depreciation, located in the United States, the Company’s country of domicile, and similar tangible long-lived assets, net of accumulated depreciation, held outside the United States are summarized in the following table as of November 30, 2017 and February 28, 2017 (in thousands):
 
 
November 30, 2017
 
February 28, 2017
United States, the Company’s country of domicile
 
$
134,943

 
$
133,492

Foreign
 
66,864

 
56,137

Total tangible long-lived assets
 
$
201,807

 
$
189,629

Supplemental information about major customers
For each of the three months ended November 30, 2017 and November 30, 2016, the U.S. government and its agencies represented in the aggregate approximately 10% of the Company’s total revenue. For each of the nine months ended November 30, 2017 and November 30, 2016, the U.S. government and its agencies represented in the aggregate approximately 11% and 10% of the Company’s total revenue, respectively.
At November 30, 2017, the Company had one customer whose accounts receivable balance individually represented 11% of total accounts receivable. As of February 28, 2017, no individual customer accounted for 10% or more of the Company’s total accounts receivable.
Supplemental information about products and services
The following table, for each of the three and nine months ended November 30, 2017 and November 30, 2016, provides further detail, by type, of the Company’s subscription and services revenues. Infrastructure-related offerings subscription revenue includes subscription revenue generated from Red Hat Enterprise Linux and related technologies such as Red Hat Satellite and Red Hat Enterprise Virtualization. Subscription revenue generated from the Company’s Application Development-related and other emerging technology offerings includes Red Hat JBoss Middleware, Red Hat Storage, Red Hat Mobile Application Platform and Red Hat cloud offerings such as Red Hat OpenStack Platform, Red Hat OpenShift and Red Hat CloudForms (in thousands):

22


RED HAT, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(Unaudited)


 
Three Months Ended
 
Nine Months Ended
 
November 30, 2017
 
November 30, 2016
 
November 30, 2017
 
November 30, 2016
Subscription revenue:
 
 
 
 
 
 
 
Infrastructure-related offerings
$
494,974

 
$
431,142

 
$
1,440,383

 
$
1,261,359

Application Development-related and other emerging technology offerings
161,858

 
112,176

 
450,519

 
314,833

Total subscription revenue
656,832

 
543,318

 
1,890,902

 
1,576,192

Training and services revenue:
 
 
 
 
 
 
 
Consulting services
69,499

 
53,517

 
196,161

 
155,103

Training
21,647

 
18,425

 
61,066

 
51,668

Total training and services revenue
91,146

 
71,942

 
257,227

 
206,771

Total subscription and training and services revenue
$
747,978

 
$
615,260

 
$
2,148,129

 
$
1,782,963


NOTE 11—Commitments and Contingencies
Operating leases
As of November 30, 2017, the Company had leases of office space and certain equipment under various non-cancellable operating leases. Rent expense under operating leases for the three months ended November 30, 2017 and November 30, 2016 was $12.9 million and $11.8 million, respectively. Rent expense under operating leases for the nine months ended November 30, 2017 and November 30, 2016 was $38.1 million and $32.6 million, respectively.
Product indemnification
The Company is a party to a variety of agreements pursuant to which it may be obligated to indemnify the other party from losses arising in connection with the Company’s services or products, or from losses arising in connection with certain events defined within a particular contract, which may include litigation or claims relating to intellectual property infringement, certain losses arising from damage to property or injury to persons or other matters. In each of these circumstances, payment by the Company is conditioned on the other party making a claim pursuant to the procedures specified in the particular contract, which procedures typically allow the Company to challenge the other party’s claims. Further, the Company’s obligations under these agreements may in certain cases be limited in terms of time and/or amount, and in some instances, the Company may have recourse against third parties for certain payments made by the Company.
It is not possible to predict the maximum potential amount of future payments under these or similar agreements due to the conditional nature of the Company’s obligations and the facts and circumstances involved in each particular agreement. The Company does not record a liability for claims related to indemnification unless the Company concludes that the likelihood of a material claim is probable and estimable. Historically, payments pursuant to these indemnifications have been immaterial.

NOTE 12—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.


23


RED HAT, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(Unaudited)


NOTE 13—Business Combinations
Acquisition of Permabit Technology Corporation
On July 31, 2017, the Company acquired the assets and technology of Permabit Technology Corporation (“Permabit”), a provider of software for data deduplication, compression and thin provisioning. Adding Permabit’s data deduplication and compression capabilities to the Company’s Red Hat Enterprise Linux platform will better enable enterprise digital transformation through more efficient storage options.
The consideration paid was $49.8 million in cash. Based on management’s provisional assessment of the acquisition-date fair value of the assets acquired and liabilities assumed, the total consideration transferred of $49.8 million was allocated to the Company’s assets and liabilities on a preliminary basis as follows: $39.4 million to goodwill, $10.4 million to identifiable intangible assets and a nominal amount to working capital. The goodwill acquired is expected to be deductible for tax purposes.
Acquisition of Codenvy S. A.
On June 1, 2017, the Company completed its acquisition of all of the shares of Codenvy S.A. (“Codenvy”), a provider of cloud-native development tools that enable developers to more easily create modern container-based and cloud-native applications. By adding Codenvy to its existing portfolio of developer tools and application platforms, including Red Hat JBoss Middleware and Red Hat OpenShift, the Company continues its efforts to provide solutions that enable developers to create applications for hybrid cloud environments. The Company plans to make Codenvy an integral part of OpenShift.io, the Company’s recently announced hosted development environment for building hybrid cloud services on OpenShift.
During the three months ended November 30, 2017, the Company completed its assessment of the acquisition-date fair value of the assets acquired and liabilities assumed. As a result of the Company’s completed assessment, the total consideration transferred of $34.2 million was allocated to the Company’s assets and liabilities as follows: $25.4 million to goodwill, $11.3 million to identifiable intangible assets and $2.5 million to working capital as a net current liability.
Transaction costs
The Company incurred approximately $1.3 million in transaction costs, including legal and accounting fees, relating to both the Permabit and Codenvy acquisitions. These transaction costs have been expensed as incurred and included in General and administrative expense on the Company’s Consolidated Statement of Operations for the nine months ended November 30, 2017.
Acquisition of 3scale, Inc.
On June 24, 2016, the Company completed its acquisition of all of the shares of 3scale, Inc. (“3scale”), a provider of application programming interface (“API”) management technology. By adding 3scale to its existing portfolio, including Red Hat JBoss Middleware, Red Hat OpenShift and Red Hat Mobile Application Platform, the Company strengthens its enablement of the API economy with simplified cloud integration and microservices-based architectures.
The consideration paid was $29.1 million in cash. Management has completed its assessment of the acquisition-date fair value of the assets acquired and liabilities assumed. The total consideration transferred of $29.1 million was allocated to the Company’s assets and liabilities as follows: $16.9 million to goodwill, $13.1 million to identifiable intangible assets and $0.9 million to working capital as a net current liability.
Pro forma consolidated financial information
Pro forma consolidated financial information for the three and nine months ended November 30, 2017 and November 30, 2016 have not been provided because the acquisitions of Permabit, Codenvy and 3scale would not have had a significant impact on consolidated operating results if the acquisitions had closed on March 1, 2016.
Goodwill
The following is a summary of changes in goodwill for the nine months ended November 30, 2017 (in thousands):
Balance at February 28, 2017
 
$
1,040,709

Acquisitions
 
64,837

Impact of foreign currency fluctuations
 
15,411

Balance at November 30, 2017
 
$
1,120,957


24


RED HAT, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(Unaudited)


The excess of purchase price paid for Permabit, Codenvy, 3scale and other acquisitions over the fair value of the net assets acquired was recognized as goodwill. Goodwill comprises the majority of the purchase price paid for each of the acquired businesses because these businesses were focused on emerging technologies such as development and operations automation, mobile technologies, cloud-enabling technologies and software-defined storage technologies, which consequently—at the time of acquisition—generated relatively little revenue. However, these acquired businesses, with their assembled, highly-specialized workforces and community of contributors, are expected to both expand the Company’s existing technology portfolio and advance the Company’s market position overall in open source solutions.