10-Q 1 rht-10qq1fy19.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 May 31, 2018
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 July 3, 2018, there were 177,373,891 shares of common stock outstanding.



RED HAT, INC.
 
 
 
Page
 
 
 
 
 
ITEM 1:
 
 
Consolidated Balance Sheets at May 31, 2018 (unaudited) and February 28, 2018 (derived from audited financial statements)
 
Consolidated Statements of Operations for the three months ended May 31, 2018 (unaudited) and 2017 (unaudited)
 
Consolidated Statements of Comprehensive Income for the three months ended May 31, 2018 (unaudited) and 2017 (unaudited)
 
Consolidated Statements of Cash Flows for the three months ended May 31, 2018 (unaudited) and 2017 (unaudited)
 
 
NOTE 1—Company
 
 
NOTE 2—Summary of Significant Accounting Policies
 
 
NOTE 3—Accounts Receivable
 
 
NOTE 4—Identifiable Intangible Assets
 
 
NOTE 5—Deferred Selling Costs
 
 
NOTE 6—Derivative Instruments
 
 
NOTE 7—Income Taxes
 
 
NOTE 8—Convertible Notes
 
 
NOTE 9—Commitments and Contingencies
 
 
NOTE 10—Legal Proceedings
 
 
NOTE 11—Stockholders’ Equity
 
 
NOTE 12—Deferred Revenue and Performance Obligations
 
 
NOTE 13—Earnings Per Share
 
 
NOTE 14—Share-based Awards
 
 
NOTE 15—Assets and Liabilities Measured at Fair Value on a Recurring Basis
 
 
NOTE 16—Segment Reporting
 
 
NOTE 17—Business Combinations
 
 
NOTE 18—Subsequent Events
 
 
 
 
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)
 
May 31, 2018 (Unaudited)
 
February 28, 2018 (1)
ASSETS
 
 
 
Current assets:
 
 
 
Cash, cash equivalents and restricted cash
$
1,768,480

 
$
1,724,132

Investments in debt and equity securities, short-term
329,872

 
318,358

Accounts receivable, net of allowances for doubtful accounts of $2,566 and $2,167, respectively
498,964

 
806,744

Prepaid expenses
247,175

 
267,197

Other current assets
61,123

 
25,666

Total current assets
2,905,614

 
3,142,097

Property and equipment, net of accumulated depreciation and amortization of $281,523 and $269,429, respectively
196,653

 
206,105

Goodwill
1,278,708

 
1,288,830

Identifiable intangibles, net
220,176

 
224,953

Investments in debt securities, long-term
428,777

 
430,442

Deferred tax assets, net
82,826

 
92,606

Other assets, net
78,807

 
89,460

Total assets
$
5,191,561

 
$
5,474,493

LIABILITIES AND STOCKHOLDERS’ EQUITY
 
 
 
Current liabilities:
 
 
 
Accounts payable and accrued expenses
$
359,706

 
$
427,139

Deferred revenue, short-term
1,721,300

 
1,853,719

Other current obligations
685

 
843

Convertible notes
194,544

 
23,806

Total current liabilities
2,276,235

 
2,305,507

Deferred revenue, long-term
723,207

 
741,453

Convertible notes
554,503

 
744,194

Other long-term obligations
205,672

 
205,215

Commitments and contingencies (NOTES 9 and 10)

 

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, 239,779,276 and 238,688,708 shares issued, and 177,472,140 and 177,073,904 shares outstanding, respectively
24

 
24

Additional paid-in capital
2,399,925

 
2,416,080

Retained earnings
1,733,270

 
1,619,688

Treasury stock, at cost, 62,307,136 and 61,614,804 shares, respectively
(2,657,774
)
 
(2,525,072
)
Accumulated other comprehensive loss
(43,501
)
 
(32,596
)
Total stockholders’ equity
1,431,944

 
1,478,124

Total liabilities and stockholders’ equity
$
5,191,561

 
$
5,474,493

  
____________________ 
(1)
Derived from audited financial statements except for line items adjusted by the retrospective application of ASC 606. See NOTE 2—Summary of Significant Accounting Policies for detailed information on adoption of ASC 606.


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
 
 
May 31,
2018
 
May 31,
2017 (1)
Revenue:
 
 
 
 
Subscriptions
 
$
711,521

 
$
596,508

Training and services
 
102,009

 
80,288

Total revenue
 
813,530

 
676,796

Cost of revenue:
 
 
 
 
Subscriptions
 
52,173

 
43,633

Training and services
 
70,526

 
57,063

Total cost of revenue
 
122,699

 
100,696

Gross profit
 
690,831

 
576,100

Operating expense:
 
 
 
 
Sales and marketing
 
348,815

 
294,323

Research and development
 
166,506

 
137,163

General and administrative
 
63,354

 
54,870

Total operating expense
 
578,675

 
486,356

Income from operations
 
112,156

 
89,744

Interest income
 
7,834

 
3,993

Interest expense
 
6,319

 
6,085

Other expense, net
 
(2,194
)
 
(586
)
Income before provision for income taxes
 
111,477

 
87,066

(Benefit) provision for income taxes
 
(1,713
)
 
11,752

Net income
 
$
113,190

 
$
75,314

Net income per share:
 
 
 
 
Basic
 
$
0.64

 
$
0.42

Diluted
 
$
0.59

 
$
0.41

Weighted average shares outstanding:
 
 
 
 
Basic
 
177,302

 
177,243

Diluted

190,739


181,810

____________________ 
(1)
As adjusted to reflect the impact of the retrospective application of ASC 606. See NOTE 2—Summary of Significant Accounting Policies for detailed information on adoption of ASC 606.

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
 
 
May 31,
2018
 
May 31,
2017 (1)
Net income
 
$
113,190

 
$
75,314

Other comprehensive income (loss):
 
 
 
 
Change in foreign currency translation adjustment
 
(10,831
)
 
22,670

Available-for-sale securities:
 
 
 
 
Unrealized gain on available-for-sale securities during the period
 
38

 
164

Reclassification for gain realized on available-for-sale securities, reported in Other expense, net
 
(128
)
 

Tax benefit (expense)
 
16

 
(222
)
Net change in available-for-sale securities (net of tax)
 
(74
)
 
(58
)
Total other comprehensive (loss) income
 
(10,905
)
 
22,612

Comprehensive income
 
$
102,285

 
$
97,926

____________________ 
(1)
As adjusted to reflect the impact of the retrospective application of ASC 606. See NOTE 2—Summary of Significant Accounting Policies for detailed information on adoption of ASC 606.



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
 
May 31, 2018
 
May 31, 2017 (1)
Cash flows from operating activities:
 
 
 
Net income
$
113,190

 
$
75,314

Adjustments to reconcile net income to net cash provided by operating activities:
 
 
 
Depreciation and amortization
27,054

 
21,817

Amortization of debt discount and transaction costs
5,838

 
5,540

Deferred income taxes
(3,395
)
 
7,917

Share-based compensation expense
46,005

 
43,718

Net amortization of bond premium on debt securities available for sale
743

 
2,436

Other
1,097

 
961

Changes in operating assets and liabilities:
 
 
 
Accounts receivable
299,439

 
208,761

Other receivables
(35,160
)
 
(19,397
)
Prepaid expenses
25,382

 
12,024

Accounts payable and accrued expenses
(28,642
)
 
(55,326
)
Deferred revenue
(104,592
)
 
(45,717
)
Other
(800
)
 
(176
)
Net cash provided by operating activities
346,159

 
257,872

Cash flows from investing activities:
 
 
 
Purchase of investment in debt securities available for sale
(108,336
)
 
(149,524
)
Proceeds from maturities of investment in debt securities available for sale
87,004

 
112,041

Proceeds from sales of investment in debt securities available for sale
525

 
14,324

Proceeds from sales of strategic equity investments
1,300

 

Purchase of developed software and other intangible assets
(2,866
)
 
(1,774
)
Purchase of property and equipment
(12,963
)
 
(25,900
)
Other
(986
)
 

Net cash used in investing activities
(36,322
)
 
(50,833
)
Cash flows from financing activities:
 
 
 
Proceeds from exercise of common stock options
875

 
2,968

Proceeds from employee stock purchase program
15,262

 
11,761

Payments related to net settlement of share-based compensation awards
(77,094
)
 
(41,010
)
Purchase of treasury stock
(150,019
)
 
(61,987
)
Payments on other borrowings
(299
)
 
(443
)
Repayments of convertible notes
(25,953
)
 

Net cash used in financing activities
(237,228
)
 
(88,711
)
Effect of foreign currency exchange rates on cash, cash equivalents and restricted cash
(28,261
)
 
21,321

Net increase in cash, cash equivalents and restricted cash
44,348

 
139,649

Cash, cash equivalents and restricted cash at beginning of the period
1,724,132

 
1,090,808

Cash, cash equivalents and restricted cash at end of the period
$
1,768,480

 
$
1,230,457

Restricted cash included in cash, cash equivalents and restricted cash
$
1,137

 
$
3,112

____________________ 
(1)
As adjusted to reflect the impact of the retrospective application of ASC 606. See NOTE 2—Summary of Significant Accounting Policies for detailed information on adoption of ASC 606.

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, generally, is 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.
NOTE 2—Summary of Significant Accounting Policies
Basis of presentation
The unaudited interim consolidated financial statements as of and for the three months ended May 31, 2018 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 U.S. (“U.S. GAAP”). Operating results for the three months ended May 31, 2018 are not necessarily indicative of the results that may be expected for the fiscal year ending February 28, 2019. 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, 2018. Other than the accounting pronouncement adopted during the three months ended May 31, 2018 related to accounting for revenue from contracts with customers as described below, 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, 2018.
The Company adopted Accounting Standards Update 2014-09, Revenue from Contracts with Customers, now commonly referred to as Accounting Standards Codification Topic 606 (“ASC 606”), effective March 1, 2018, using the full retrospective transition method. All amounts and disclosures set forth in this Form 10-Q have been updated to comply with the new standard and such information is designated “as adjusted.”
Certain amounts for the three months ended May 31, 2017 have been reclassified to conform to the current period presentation.
The Company’s fiscal year ends on the last day of February, and the Company identifies fiscal years by the calendar years in which they end. For example, the fiscal year ending February 28, 2019 is referred to as “fiscal 2019.”
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 are eliminated in consolidation. There are no significant foreign exchange restrictions on the Company’s foreign subsidiaries.

8


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


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. Estimates are used for, but not limited to, revenue recognition, goodwill and other long-lived assets, share-based compensation, income taxes and loss contingencies.
Revenue recognition
The Company derives its revenues from subscription contracts and training and service contracts. Revenue is recognized when performance obligations, as stipulated in the contracts, are transferred to a customer for an amount that reflects the consideration the Company expects to receive in exchange for those subscription contracts and training and service contracts.
The Company applies the following five steps to recognize revenue:
1)    Identify the contract with a customer. The Company determines that it has a contract with a customer when the contract is approved, the party’s rights regarding the products and services to be transferred can be identified, the payment terms for the products and services are identified, the customer’s ability and intent to pay can be determined, and the contract has commercial substance. Judgment is used to assess the customer’s ability and intent to pay, which is based upon factors including the customer’s historical payment experience or credit and financial information pertaining to the customer.
2)    Identify the performance obligations in the contract. The Company’s performance obligations are identified based on the products and services that will be transferred to the customer that are both capable of being distinct and are distinct in the context of the contract and consist of (i) subscription offerings, including non-proprietary open-source software code delivered to the customer, software support subscriptions delivered to the customer, software support subscriptions embedded in partner products and learning subscriptions and (ii) training and services, including professional services sold at a fixed fee, professional services sold on a time-and-material-basis, training courses or units, and consulting units. In limited cases, the option to purchase additional subscription offerings or training and services may be offered at a price representing a material right. In such cases, the option to purchase is considered a distinct performance obligation.
3)     Determine the transaction price. The Company determines transaction price based on the consideration expected to be received in exchange for transferring certain performance obligations to the customer. In determining the transaction price, variable consideration, if any, would be considered if, in management’s judgment, it is probable that a significant future reversal of cumulative revenue under the contract will not occur.
The Company’s contracts do not contain significant financing components. Specifically, the Company does not typically extend customer payment terms beyond a standard 30- to 60-day term and as a result the Company has elected the one-year-or-less safe harbor expedient and does not impute any interest.
The Company has elected to exclude all taxes from the transaction price (e.g. sales, use, value-added, etc). Revenue is recognized net of such taxes.
4)     Allocate the transaction price to performance obligations in the contract. When a contract contains a single performance obligation, the entire transaction price is allocated to that one performance obligation. Contracts that contain multiple performance obligations require an allocation of the transaction price to each performance obligation based on a relative standalone selling price (“SSP”). The Company typically determines SSP based on the observable price when the Company sells the subscriptions or training and services separately, taking into consideration the geographical region of the customer, type of offering and sales channel. In instances where SSP is not directly observable, the Company determines SSP either from the renewal rate paid for the performance obligation to the extent it is the same rate as stipulated in the initial customer contract or by using the expected-cost-plus-margin approach.
5)     Recognize revenue when or as the performance obligation is satisfied. Revenue is recognized at the time the related performance obligation is satisfied by transferring the promised subscription offerings and training and services to a customer. For each performance obligation, a determination is made as to whether the control is transferred over time or at a point in time. For performance obligations satisfied over time, a method to measure progress toward complete satisfaction is selected, based upon the most faithful depiction of performance. The selected method for each performance obligation type is applied consistently to similar contracts.

9


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


Subscription revenue
Subscription revenue is comprised of direct and indirect sales of subscriptions relating to Red Hat technologies. Accounts receivable and deferred revenue are recorded at the time a customer enters into a binding and non-cancellable subscription agreement for the purchase of a subscription, subscription services are made available to the customer and the customer is billed. The deferred revenue amount is recognized as revenue ratably over the subscription period. Red Hat technologies are generally offered with either one- or three-year base subscription periods; the majority of the Company’s subscriptions have one-year terms. Under these subscription agreements, renewal rates are generally specified for one or three-year renewal terms. Subscriptions generally entitle the end user to the technology itself and post-contract customer support, generally consisting of varying levels of support services as well as access to security updates, fixes, functionality enhancements, upgrades to the technologies, each on an if and when available basis, and compatibility with an ecosystem of certified hardware and software, during the term of the subscription. The Company sells its offerings through two principal channels: (1) direct, which includes sales by the Company’s sales force as well as web store sales, and (2) indirect, which includes certified cloud and service providers (“CCSPs”), distributors, original equipment manufacturers (“OEMs”), systems integrators and value added resellers.
The Company recognizes revenue from the sale of Red Hat technologies ratably over the period of the subscription beginning on the commencement date of the subscription agreement. The Company has determined that the delivery of software code underlying the subscription is a distinct performance obligation as it is both capable of being distinct and is distinct within the context of a customer contract. The Company uses a non-proprietary open-source development and licensing model to provide its software technologies to customers and therefore the amount of transaction price allocated to the underlying software code is negligible. The Company derives a portion of its revenue from CCSPs that provide public clouds with, and allow users to consume, computing resources as a service. The Company earns revenue based on subscription units consumed by the CCSP or its end users. The Company uses its historical cloud-usage data to estimate the amount of revenue earned and recognized each month and adjusts to actual amounts earned upon receipt of usage reports from the CCSPs in the following month. The differences between actual amounts earned and estimates made have generally been insignificant.
Training and services revenue
Training and services revenue is comprised of revenue for consulting, engineering and customer training courses or units and education services. Consulting services consist of time-based units or fixed-fee arrangements. For time-based arrangements, revenue is recognized over time as these services are performed and for fixed-fee arrangements, revenue is recognized based on the proportion of services performed. Engineering services represent revenue earned under fixed-fee arrangements with the Company’s OEM partners and other customers to provide for significant modification and customization of Red Hat technologies. The Company recognizes revenue for these fixed-fee engineering services based on a proportional performance basis using actual costs incurred to date over the estimated total projected costs along with a representative profit margin. A representative profit margin is determined based on analysis of a population of similar contracts by region. Revenue for customer training and education services is recognized on the dates the services are performed.
See NOTE 16—Segment Reporting for further information, including revenue by geographic area and significant product and service offerings.
Contract Balances
Timing of revenue recognition may differ from the timing of invoicing to customers. The Company records a receivable when revenue is recognized prior to invoicing, or deferred revenue when revenue is recognized subsequent to invoicing. For multi-year arrangements, the Company will generally invoice customers upfront or annually at the beginning of each annual coverage period. See below for the accounting policy related to receivables and see NOTE 12—Deferred Revenue and Performance Obligations for further information on deferred revenue balances.
Accounts receivable and allowance for doubtful accounts
Trade accounts receivable are recorded at the invoiced amount and do not bear interest. The allowance for doubtful accounts is the Company’s estimate of the amount of probable credit losses in the Company’s existing accounts receivable. The Company determines the allowance based on historical write-off experience and other qualitative factors. The Company reviews its allowance for doubtful accounts monthly. Past due balances over 90 days and over a specified amount are reviewed individually for collectability. All other balances are reviewed on a pooled basis by type of receivable. Account balances are charged off against the allowance when the Company determines it is probable the receivable will not be recovered. The Company does not have off-balance sheet credit exposure related to its customers. Unbilled receivables related to subscription and training and services contracts are included in accounts receivable.
See NOTE 3—Accounts Receivable for further information on accounts receivable balances.

10


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


Deferred selling costs
Deferred commissions are the incremental costs that are directly associated with non-cancellable subscription contracts with customers and consist of sales commissions and certain related fringe benefits earned by the Company’s sales force. The commissions are deferred and amortized on a straight-line basis over a period that approximates the subscription period. In determining the period that approximates the subscription period, the Company utilizes a portfolio approach that allows for the analysis of customer contracts with similar characteristics. The Company has determined that the effects on the financial statements of the portfolio approach would not differ materially from an individual customer contract analysis approach. The commission payments are paid in full subsequent to the month in which the customer’s service commences. The deferred commission amounts are recoverable through the future revenue streams under the non-cancellable customer contracts. In addition, the Company has the ability and intent under the commission plans with its sales force to recover commissions previously paid to its sales force in the event that customers breach the terms of their subscription agreements and do not fully pay for their subscription agreements.
See NOTE 5—Deferred Selling Costs for further information on deferred commissions and the related amortization of deferred commissions.
Recent accounting pronouncements
Accounting pronouncements adopted
In January 2016, the Financial Accounting Standards Board (“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. Along with ASU 2016-01, the Company evaluated the Accounting Standards Update 2018-03, Technical Corrections and Improvements to Financial Instruments Overall (Subtopic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities (“ASU 2018-03”), which was issued in February 2018, and Accounting Standards Update 2018-04, Investments—Debt Securities (Topic 320) and Regulated Operations (Topic 980): Amendments to SEC Paragraphs Pursuant to SEC Staff Accounting Bulletin No. 117 and SEC Release No. 33-9273 (“ASU 2018-04”), which was issued in March 2018. The Company adopted ASU 2016-01, ASU 2018-03 and ASU 2018-04 as of March 1, 2018. The adoption of these standards did not significantly impact the Company’s Consolidated Financial Statements.
In May 2014, the FASB issued Accounting Standards Update 2014-09, Revenue from Contracts with Customers, now commonly 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. The standard outlines a single comprehensive model for entities to use in accounting for revenue arising from contracts with customers and supersedes the most current revenue recognition guidance. ASC 606 requires the recognition of revenue when control of performance obligations as stipulated in the contracts, is transferred to a customer for an amount that reflects the consideration the entity expects to receive in exchange promised goods and services. The standard also includes Subtopic 340-40, Other Assets and Deferred Costs—Contracts with Customers, which requires the deferral of incremental costs of obtaining a contract with a customer. Collectively, ASC 606 and Subtopic 340-40 are referred to as “ASC 606.”
The Company adopted ASC 606 as of March 1, 2018, utilizing the full retrospective method of transition, which requires a restatement of each prior reporting period presented. In adopting ASC 606, the Company used the practical expedient where the transaction price allocated to the remaining performance obligations before the date of the initial application is not disclosed. The Company implemented new policies, processes and systems to enable both the preparation of financial information and internal controls over financial reporting in connection with its adoption of ASC 606. The impact of adopting ASC 606 on the Company’s fiscal 2018 and fiscal 2017 revenue was not material. The primary impact of adopting the standard related to the deferral of incremental commission and other costs of obtaining contracts with customers. Previously, the Company deferred direct and incremental commission costs to obtain a contract and amortized those costs on a straight-line basis over a period that approximated the subscription period, and under ASC 606, the Company now also defers related fringe benefit costs.

11


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


Select adjusted unaudited financial statement information, which reflects the Company’s adoption of ASC 606, is set forth below.
Consolidated balance sheets (in thousands):
 
February 28, 2018
 
As Reported
 
Adjustments
 
As Adjusted
Prepaid expenses
$
260,092

 
$
7,105

 
$
267,197

Deferred tax assets, net
$
93,300

 
$
(694
)
 
$
92,606

Other assets, net
$
87,924

 
$
1,536

 
$
89,460

Accounts payable and accrued expenses
$
427,086

 
$
53

 
$
427,139

Retained earnings
$
1,611,794

 
$
7,894

 
$
1,619,688

Consolidated statements of operations (in thousands, except per share amounts):
 
Three Months Ended May 31, 2017
 
As Reported
 
Adjustments
 
As Adjusted
Operating expense:


 


 


Sales and marketing
$
296,459

 
$
(2,136
)
 
$
294,323

Net income
$
73,190

 
$
2,124

 
$
75,314

Net income per share:


 


 


Basic
$
0.41

 
$
0.01

 
$
0.42

Diluted
$
0.40

 
$
0.01

 
$
0.41

The Company’s adoption of ASC 606 had no impact on net cash provided by or used in operating, investing or financing activities for any of the periods reported.
Accounting pronouncements being evaluated
In February 2018, the FASB issued Accounting Standards Update 2018-02, Income Statement-Reporting Comprehensive Income (Topic 220): Reclassification of Certain Tax Effects from Accumulated Other Comprehensive Income (“ASU 2018-02”). The FASB issued ASU 2018-02 to give entities the option to reclassify tax effects stranded in accumulated other comprehensive income as a result of the enactment of the Tax Cuts and Jobs Act (the “Tax Act”) to retained earnings. The guidance is effective for the Company as of the first quarter of its fiscal year ending February 28, 2020, with early adoption permitted. The Company is currently evaluating the impact that this updated standard 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 continues to assess the impact of ASU 2016-02, 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 the new guidance related to identifying and measuring right-of-use assets and lease liabilities.

12


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


NOTE 3—Accounts Receivable
Accounts receivable are presented net of an allowance for doubtful accounts. Activity in the Company’s allowance for doubtful accounts is presented in the following table (in thousands):
As of
 
Balance at
beginning
of period
 
Charged to (recovery of)
expense
 
Adjustments (1)
 
Balance at
end of
period
February 28, 2018
 
$
2,791

 
172

 
(796
)
 
$
2,167

May 31, 2018
 
$
2,167

 
562

 
(163
)
 
$
2,566

_______________ 
(1) 
Represents foreign currency translation adjustments and amounts written-off as uncollectible accounts receivable.
Included in accounts receivable, net of allowance for doubtful accounts, are unbilled receivables of $28.6 million and $25.8 million as of May 31, 2018 and February 28, 2018, respectively.
As of May 31, 2018 and February 28, 2018, no individual customer accounted for 10% or more of the Company’s accounts receivable.
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 over the estimated useful life or the related asset’s pattern of economic benefit. Useful lives range from two to 10 years. As of May 31, 2018 and February 28, 2018, trademarks with an indefinite estimated useful life totaled $11.6 million and $12.0 million, respectively. The following is a summary of identifiable intangible assets (in thousands):
 
May 31, 2018
 
February 28, 2018
 
Gross
Amount
 
Accumulated
Amortization
 
Net
Amount
 
Gross
Amount
 
Accumulated
Amortization
 
Net
Amount
Trademarks, copyrights and patents
$
169,385

 
$
(73,732
)
 
$
95,653

 
$
167,005

 
$
(70,749
)
 
$
96,256

Purchased technologies
210,714

 
(98,336
)
 
112,378

 
208,096

 
(93,748
)
 
114,348

Customer and reseller relationships
105,665

 
(96,735
)
 
8,930

 
106,076

 
(95,558
)
 
10,518

Covenants not to compete
15,565

 
(14,300
)
 
1,265

 
15,861

 
(14,324
)
 
1,537

Other intangible assets
8,833

 
(6,883
)
 
1,950

 
8,833

 
(6,539
)
 
2,294

Total identifiable intangible assets
$
510,162

 
$
(289,986
)
 
$
220,176

 
$
505,871

 
$
(280,918
)
 
$
224,953

Amortization expense associated with identifiable intangible assets recognized in the Company’s Consolidated Financial Statements is summarized as follows (in thousands):
 
 
Three Months Ended
 
 
May 31, 2018
 
May 31, 2017
Cost of revenue
 
$
6,485

 
$
4,180

Sales and marketing
 
1,362

 
1,459

Research and development
 
34

 
34

General and administrative
 
2,373

 
1,826

Total amortization expense
 
$
10,254

 
$
7,499



13


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


NOTE 5—Deferred Selling Costs
Deferred selling costs include commissions paid to the Company’s sales associates that are the incremental costs incurred to obtain contracts with customers. The commissions are deferred and amortized over a period to approximate the period of the subscription term. For further discussion on deferred commissions, see NOTE 2—Summary of Significant Accounting Policies. Current and non-current deferred commissions are included in Prepaid expenses and Other assets, respectively, on the Company’s Consolidated Balance Sheets and are as follows (in thousands):
 
May 31, 2018
 
February 28, 2018 (1)
Deferred commissions, current
$
181,901

 
$
188,944

Deferred commissions, non-current
39,295

 
48,653

Total deferred commissions
$
221,196

 
$
237,597

____________________ 
(1)
As adjusted to reflect the impact of the retrospective application of ASC 606. See NOTE 2—Summary of Significant Accounting Policies for detailed information on adoption of ASC 606.
Amortization of deferred commissions is included in Sales and marketing expense on the Company’s Consolidated Statements of Operations. Amortization expense related to deferred commissions totaled $56.2 million and $44.1 million for the three months ended May 31, 2018 and May 31, 2017, respectively. There was no impairment loss in relation to the costs capitalized for the periods presented.
NOTE 6—Derivative Instruments
The Company transacts business in various foreign countries and is, therefore, subject to risk of foreign currency exchange rate fluctuations. From time to time, the Company 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 15—Assets and Liabilities Measured at Fair Value on a Recurring Basis for information regarding the fair value hierarchy of derivative instruments.
The effects of derivative instruments on the Company’s Consolidated Financial Statements are as follows (in thousands):
 
May 31, 2018
 
Classification of 
Gain (Loss)
Recognized in Income on
Derivatives
 
Three Months Ended May 31, 2018
 
Balance Sheet 
Classification
 
Fair
Value
 
Notional
Value
 
 
Assets—foreign currency forward contracts not designated as hedges
Other current assets
 
$
111

 
$
21,554

 
Other expense, net
 
$
289

Liabilities—foreign currency forward contracts not designated as hedges
Accounts payable and accrued expenses
 
(790
)
 
28,112

 
Other expense, net
 
(1,136
)
Total
 
 
$
(679
)
 
$
49,666

 
 
 
$
(847
)
 
May 31, 2017
 
Classification of 
Gain (Loss)
Recognized in Income on
Derivatives
 
Three Months Ended May 31, 2017
 
Balance Sheet 
Classification
 
Fair
Value
 
Notional
Value
 
 
Assets—foreign currency forward contracts not designated as hedges
Other current assets
 
$
278

 
$
18,901

 
Other expense, net
 
$
605

Liabilities—foreign currency forward contracts not designated as hedges
Accounts payable and accrued expenses
 
(137
)
 
27,053

 
Other expense, net
 
(320
)
Total
 
 
$
141

 
$
45,954

 
 
 
$
285


14


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



NOTE 7—Income Taxes
On December 22, 2017, the Tax Cuts and Jobs Act (“Tax Act”) was enacted into law. This new law includes significant changes to the U.S. corporate income tax system, including a permanent reduction in the corporate income tax rate from 35% to 21%, limitations on the deductibility of interest expense and executive compensation, elimination of the domestic production activities deduction and the transition of U.S. international taxation from a worldwide tax system to a territorial tax system.
In December 2017, the SEC staff issued Staff Accounting Bulletin 118 (“SAB 118”), which provides guidance on accounting for the tax effects of the Tax Act. SAB 118 provides a measurement period that should not extend beyond one year from the Tax Act enactment date for companies to complete the accounting under ASC Topic 740—Income Taxes (“ASC 740”). The Company has calculated as final its re-measurement of deferred taxes and uncertain tax positions. While the Company has substantially completed its provisional analysis of the income tax effects of the Tax Act and recorded a reasonable estimate of such effects, the Company regards as provisional the transition tax, withholding and other taxes on future repatriation of cash, and the accounting for compensation accruals. These provisional tax effects may differ during the measurement period, possibly materially, due to further refinement of the calculations, changes in interpretations and assumptions made, and additional guidance that may be issued by the Department of the U.S. Treasury, the Internal Revenue Service, and other regulatory and standard setting bodies. The Company will complete its analysis within fiscal 2019 consistent with the guidance provided in SAB 118, and any adjustments during this measurement period will be included in net earnings from continuing operations as an adjustment to income tax expense in the reporting period when such adjustments are determined. No such adjustments were included in income tax expense for the three months ended May 31, 2018.
The effective tax rate for the three months ended May 31, 2018 of (1.5)%, differed from the U.S. federal statutory rate of 21% primarily due to excess tax benefits from share-based compensation, research tax credits and the impact from the Tax Act. Tax expense for the three months ended May 31, 2018 included net discrete tax benefits of $26.8 million, primarily related to net excess tax benefits from share-based compensation.
For the three months ended May 31, 2017, the Company’s then-effective tax rate of 13.5% (1), 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 and research tax credits. Tax expense for the three months ended May 31, 2017 included net discrete tax benefits of $11.6 million, 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 May 31, 2018, it is reasonably possible that total unrecognized tax benefits may be reduced by up to $0.1 million within the next 12 months primarily as a result of statutes of limitations expirations in various tax jurisdictions, all of which would affect the Company’s effective tax rate.
____________________ 
(1)
As adjusted to reflect the impact of the retrospective application of ASC 606. See NOTE 2—Summary of Significant Accounting Policies for detailed information on adoption of ASC 606.
NOTE 8—Convertible Notes
Convertible note offering
On October 7, 2014, the Company completed its offering of $805.0 million aggregate principal amount of the convertible notes. The convertible notes were sold in a private placement under a purchase agreement, dated as of October 1, 2014, entered into by and among the Company and the initial purchasers, for resale to qualified institutional buyers pursuant to Rule 144A under the Securities Act of 1933, as amended. For additional information, see NOTE 11—Convertible Notes to the Consolidated Financial Statements contained in the Company’s Annual Report on Form 10-K for the fiscal year ended February 28, 2018.

15


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


Indenture
On October 7, 2014, the Company entered into an indenture (the “Indenture”) with respect to the convertible notes with U.S. Bank National Association, as trustee (the “Trustee”). Under the Indenture, the convertible notes are senior unsecured obligations of the Company and bear interest at a rate of 0.25% per year, payable semiannually in arrears on April 1 and October 1 of each year, beginning on April 1, 2015. The convertible notes will mature on October 1, 2019, unless previously purchased or converted.
The convertible notes are convertible into shares of the Company’s common stock at an initial conversion rate of 13.6219 shares per $1,000 principal amount of the convertible notes (which is equivalent to an initial conversion price of approximately $73.41 per share), subject to adjustment upon the occurrence of certain events. Upon conversion of the convertible notes, holders will receive cash or shares of the Company’s common stock or a combination thereof, at the Company’s election.
At their option, holders may convert their convertible notes prior to the close of business on the business day immediately preceding April 1, 2019, only upon the occurrence of certain circumstances. For example, during any fiscal quarter commencing after the fiscal quarter ended on November 30, 2014 (and only during such fiscal quarter), if the last reported sale price of the Company’s common stock for at least 20 trading days (whether or not consecutive) during the period of 30 consecutive trading days ending on the last trading day of the immediately preceding fiscal quarter is greater than or equal to 130% of the conversion price, the convertible notes become convertible at the holders’ option. The price of the Company’s common stock was greater than or equal to 130% of the conversion price, which is $95.43, for at least 20 trading days during the 30 consecutive trading days ending on the last trading day of each of the fiscal quarters ended August 31, 2017 through May 31, 2018. Therefore, as of May 31, 2018, the convertible notes remain convertible at the holders’ option until August 31, 2018.
On and after April 1, 2019, holders may convert their convertible notes at any time until the close of business on the second scheduled trading day immediately preceding the maturity date of the convertible notes.
During the first quarter of the fiscal year ending February 28, 2019, the Company settled notices of conversion with respect to $26.0 million aggregate principal amount of the convertible notes and elected to settle such conversions by paying cash for the principal amount and issuing 185,252 shares of common stock for the excess conversion value. During the three months ended May 31, 2018, the Company recognized a loss on settled conversions of $0.3 million. Total settled conversions as of May 31, 2018 amounted to $26.0 million aggregate principal amount of the convertible notes. The Company expects to settle conversions of $202.3 million in principal amount of the convertible notes in the second quarter of the fiscal year ending February 28, 2019 by paying cash for the principal amount and issuing shares of common stock for the excess conversion value. The Company continues to receive conversion requests and as of July 6, 2018, such incremental requests totaled $45.3 million in principal amount of the convertible notes. The aggregate principal amount of the convertible notes remaining is expected to be $531.4 million after the expected conversion settlements as discussed above and the incremental conversion requests received as of July 6, 2018.
Based on the closing price of the Company’s common stock of $162.42 on the last trading day of the first quarter of the fiscal year ending February 28, 2019, the if-converted value of the convertible notes as of May 31, 2018 exceeded their principal amount by approximately $944.5 million.
The Company continues to classify the net carrying amount of the convertible notes as a long-term liability, except for $194.5 million, classified as current and expected to be cash-settled within the next fiscal quarter. The equity component of the convertible notes will continue to be classified as additional paid-in capital because the Company has the option to settle the principal amount in shares and the convertible notes’ maturity date is more than 12 months away. However, it is the Company’s intent to settle the principal amount of the convertible notes in cash.
The conversion rate is subject to customary anti-dilution adjustments. If certain corporate events described in the Indenture occur prior to the maturity date, the conversion rate will be increased for a holder who elects to convert its convertible notes in connection with such corporate event in certain circumstances.
The convertible notes are not redeemable prior to maturity, and no sinking fund is provided for the notes. If the Company undergoes a “fundamental change,” as defined in the Indenture, subject to certain conditions, holders may require the Company to purchase for cash all or any portion of their convertible notes. The fundamental change purchase price will be 100% of the principal amount of the convertible notes to be purchased plus any accrued and unpaid special interest up to but excluding the fundamental change purchase date.

16


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


The Indenture contains customary terms and covenants, including that upon certain events of default occurring and continuing, either the Trustee or the holders of at least 25% in principal amount of the outstanding convertible notes may declare 100% of the principal of, and accrued and unpaid interest, if any, on, all the convertible notes to be due and payable.
In accounting for the issuance of the convertible notes, the Company separated the convertible notes into liability and equity components. The Company allocated the total transaction costs incurred to the liability and equity components based on their relative fair values. Issuance costs attributable to the liability component are being amortized to interest expense over the term of the convertible notes. The excess of the face value of the convertible notes as a whole over the carrying amount of the liability component (the “debt discount”) is being amortized to interest expense over the term of the convertible notes. The convertible notes consisted of the following (in thousands):
 
May 31, 2018
 
February 28, 2018
Liability component:
 
 
 
Principal
$
779,013

 
$
804,966

Less: debt issuance costs
(3,864
)
 
(4,695
)
Less: debt discount
(26,102
)
 
(32,271
)
Net carrying amount
$
749,047

 
$
768,000

Equity component (1)
$
96,051

 
$
96,890

__________
 
 
 
(1)   Recognized in the Consolidated Balance Sheets in Additional paid-in capital.
The following table includes total interest expense recognized related to the convertible notes (in thousands):
 
Three Months Ended
 
May 31, 2018
 
May 31, 2017
Coupon rate 0.25% per year, payable semiannually
$
471

 
$
503

Amortization of convertible note issuance costs — liability component
831

 
673

Accretion of debt discount
5,007

 
4,867

Total interest expense related to convertible notes
$
6,309

 
$
6,043

The fair value of the convertible notes, which was determined based on inputs that are observable in the market (Level 2), and the carrying value of convertible notes (the carrying value excludes the equity component of the convertible notes classified in equity) is as follows (in thousands):
 
May 31, 2018
  
Fair Value
 
Carrying Value
Convertible notes
$
753,518

 
$
749,047

Convertible note hedge transactions and warrant transactions
On October 1, 2014, the Company entered into convertible note hedge transactions and warrant transactions with certain of the initial purchasers of the convertible notes or their respective affiliates. In connection with the conversions of the convertible notes that settled in the first quarter of the fiscal year ending February 28, 2019, the Company exercised a portion of the options that are part of the convertible note hedge transactions for 185,239 shares of the Company’s common stock.

17


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


The convertible note hedge transactions are expected to offset, to the extent the Company’s common stock per share price does not exceed $101.65, the potential dilution with respect to shares of the Company’s common stock upon any conversion of the convertible notes and/or offset any cash payments the Company is required to make in excess of the principal amount of the converted notes, as the case may be. To partially offset the $148.0 million cost of the convertible note hedge transactions, the Company issued warrants and received proceeds of $79.8 million. The number of shares of the Company’s common stock underlying the warrants total 10,965,630, the number of shares originally underlying the convertible notes and the convertible note hedge transactions. The combination of the convertible note hedge transactions and the warrant transactions effectively increases the initial conversion price of the convertible notes from $73.41 per share to $101.65 per share. As a result, the warrant transactions will have a dilutive effect with respect to the Company’s common stock to the extent that the market price per share of the Company’s common stock, as measured under the terms of the warrant transactions, exceeds the $101.65 strike price of the warrants. For the three months ended May 31, 2018, the warrants were included in the computation of diluted shares outstanding because the warrants’ exercise price was less than the average market price of the Company’s common stock during the related period. However, subject to certain conditions, the Company may elect to settle all of the warrants in cash.
NOTE 9—Commitments and Contingencies
Operating leases
As of May 31, 2018, the Company leased office space and certain equipment under various non-cancellable operating leases. Rent expense under operating leases for the three months ended May 31, 2018 and May 31, 2017 was $13.4 million and $12.5 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. Payments pursuant to these indemnification claims during the three months ended May 31, 2018 and May 31, 2017 were, in the aggregate, immaterial.
NOTE 10—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.


18


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


NOTE 11—Stockholders’ Equity
The following table summarizes the changes in the Company’s stockholders’ equity during the three months ended May 31, 2018 (in thousands): 
 
Common
Stock
 
Additional
Paid-In
Capital
 
Retained
Earnings
(1)
 
Treasury
Stock
 
Accumulated
Other
Comprehensive
Loss
 
Total
Stockholders’
Equity
Balance at February 28, 2018
$
24

 
$
2,416,080

 
$
1,619,688

 
$
(2,525,072
)
 
$
(32,596
)
 
$
1,478,124

Net income

 

 
113,190

 

 

 
113,190

Other comprehensive loss, net of tax

 

 

 

 
(10,905
)
 
(10,905
)
Vest and exercise of share-based awards

 
875

 

 

 

 
875

Common stock repurchase

 
(17,175
)
 

 
(132,844
)
 

 
(150,019
)
Share-based compensation expense

 
46,005

 

 

 

 
46,005

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

 
(77,094
)
 

 

 

 
(77,094
)
Re-issuance of treasury stock under employee stock purchase plan

 
18,471

 

 
13,740

 

 
32,211

Convertible note conversions

 
(835
)
 

 

 

 
(835
)
Exercises of convertible note hedges

 
13,598

 

 
(13,598
)
 

 

Cumulative-effect adjustment from adoption of ASU 2016-01


 

 
392

 

 

 
392

Balance at May 31, 2018
$
24

 
$
2,399,925

 
$
1,733,270

 
$
(2,657,774
)
 
$
(43,501
)
 
$
1,431,944

____________________ 
(1)
As adjusted to reflect the impact of the retrospective application of ASC 606. See NOTE 2—Summary of Significant Accounting Policies for detailed information on adoption of ASC 606.


19


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


The following table summarizes the changes in the Company’s stockholders’ equity during the three months ended May 31, 2017 (in thousands):
 
Common
Stock
 
Additional
Paid-In
Capital
 
Retained
Earnings
(1)
 
Treasury
Stock
 
Accumulated
Other
Comprehensive
Loss
 
Total
Stockholders’
Equity
Balance at February 28, 2017
$
24

 
$
2,294,462

 
$
1,357,837

 
$
(2,311,805
)
 
$
(88,352
)
 
$
1,252,166

Net income

 

 
75,314

 

 

 
75,314

Other comprehensive income, net of tax

 

 

 

 
22,612

 
22,612

Vest and exercise of share-based awards

 
2,968

 

 

 

 
2,968

Common stock repurchase

 

 

 
(61,987
)
 

 
(61,987
)
Share-based compensation expense

 
43,718

 

 

 

 
43,718

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

 
(41,010
)
 

 

 

 
(41,010
)
Re-issuance of treasury stock under employee stock purchase plan

 

 

 
23,748

 

 
23,748

Other adjustments

 
(5,015
)
 

 

 

 
(5,015
)
Balance at May 31, 2017
$
24

 
$
2,295,123

 
$
1,433,151

 
$
(2,350,044
)
 
$
(65,740
)
 
$
1,312,514

____________________ 
(1)
As adjusted to reflect the impact of the retrospective application of ASC 606. See NOTE 2—Summary of Significant Accounting Policies for detailed information on adoption of ASC 606.
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 expired on June 30, 2018.
During the three months ended May 31, 2018, the Company repurchased 948,638 shares of its common stock at an aggregate cost of $150.0 million under this repurchase program. These amounts are recognized in Treasury stock on the Company’s Consolidated Balance Sheets except for $17.2 million, representing 103,744 shares, recognized in Additional paid-in capital. The $17.2 million, representing 103,744 shares, will be reclassified to Treasury stock in the quarter ending August 31, 2018.
From its commencement on July 1, 2016 through May 31, 2018, the Company repurchased 8,167,871 shares of its common stock for $751.3 million under this program. As of May 31, 2018, the amount available under this program for the repurchase of the Company’s common stock was $248.7 million.
On June 21, 2018, the Company announced that its Board authorized a new repurchase program effective July 1, 2018, replacing the repurchase program described above that expired on June 30, 2018. See NOTE 18—Subsequent Events for additional information regarding the Company’s new share repurchase program.


20


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


Accumulated other comprehensive loss
Accumulated other comprehensive loss was comprised of the following (in thousands):
 
 
May 31, 2018
 
February 28, 2018
Accumulated loss from foreign currency translation adjustment
 
$
(40,510
)
 
$
(29,679
)
Accumulated unrealized loss, net of tax, on available-for-sale securities
 
(2,991
)
 
(2,917
)
Accumulated other comprehensive loss
 
$
(43,501
)
 
$
(32,596
)
NOTE 12—Deferred Revenue and Performance Obligations
Activity in the Company’s deferred revenue accounts is presented in the following table (in thousands):
 
 
February 28, 2018
 
Revenue recognized from opening balance
 
Deferred revenue, net (1)
 
May 31, 2018
Deferred revenue, short-term
 
$
1,853,719

 
$
(611,353
)
 
$
478,934

 
$
1,721,300

Deferred revenue, long-term
 
741,453

 

 
(18,246
)
 
723,207

Total deferred revenue
 
$
2,595,172

 
$
(611,353
)
 
$
460,688

 
$
2,444,507

_______________ 
(1) 
Includes revenue recognized from current period customer contracts and the impact from foreign currency exchange rate fluctuations.
As of May 31, 2018, the value of customer contracts allocated to performance obligations not yet satisfied, including $2.44 billion of total deferred revenue, was approximately $3.20 billion, of which approximately 60% is expected to be recognized as revenue within the next 12 months and the remainder thereafter.
In addition to the approximately $3.20 billion of customer contract value allocated to performance obligations not yet satisfied, as of May 31, 2018, the Company has offered customers options to purchase additional services at an agreed-upon price per hour that total approximately $122.8 million.
The summation of the customer contract value allocated to performance obligations not yet satisfied and the options to purchase additional services equals approximately $3.33 billion, which the Company considers as its total backlog.
NOTE 13—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, vesting of share-based awards, settlement of convertible notes, or exercise of warrants.
The following table reconciles the numerators and denominators of the earnings per share (“EPS”) calculation (in thousands, except per share amounts):
 
Three Months Ended
 
May 31, 2018
 
May 31, 2017 (1)
Net income, basic and diluted
$
113,190

 
$
75,314

Weighted average common shares outstanding
177,302

 
177,243

Incremental shares attributable to assumed vesting or exercise of outstanding equity award shares
3,833

 
2,974

Dilutive effect of convertible notes
5,686

 
1,593

Dilutive effect of warrants
3,918

 

Diluted shares
190,739

 
181,810

Diluted net income per share
$
0.59

 
$
0.41

____________________ 
(1)
As adjusted to reflect the impact of the retrospective application of ASC 606. See NOTE 2—Summary of Significant Accounting Policies for detailed information on adoption of ASC 606.

21


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


With respect to the Company’s 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 8—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 months ended May 31, 2018 and May 31, 2017. For the three months ended May 31, 2018, the warrants were included in the computation of diluted EPS because the warrants’ exercise price was less than the average market price of the Company’s common stock during the related period.
The following share awards are 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
 
May 31, 2018
 
May 31, 2017
Number of shares considered anti-dilutive for calculating diluted EPS

 
14

NOTE 14—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.
The following summarizes share-based compensation expense recognized in the Company’s Consolidated Financial Statements (in thousands):
 
 
Three Months Ended
 
 
May 31, 2018
 
May 31, 2017
Cost of revenue
 
$
5,128

 
$
3,948

Sales and marketing
 
19,520

 
20,612

Research and development
 
14,782

 
13,447

General and administrative
 
6,575

 
5,711

Total share-based compensation expense (1)
 
$
46,005

 
$
43,718

__________ 
(1)
Total share-based compensation expense included $4.0 million and $2.9 million, respectively, of expense related to the Company’s employee stock purchase plan (“ESPP”) for the three months ended May 31, 2018 and May 31, 2017.
Share-based compensation expense qualifying for capitalization was insignificant for each of the three months ended May 31, 2018 and May 31, 2017. Accordingly, no share-based compensation expense was capitalized during these periods.

22


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


The following table summarizes the Company’s share-based awards granted, by type:
 
Three Months Ended
 
May 31, 2018
 
May 31, 2017
 
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
669,450

 
$
160.53

 
838,395

 
$
86.17

Performance share units—target
173,014

(1) 
$
163.56

 
261,760

 
$
87.99

Performance share awards
64,219

(2) 
$
163.56

 
104,362

 
$
87.99

Total share-based awards
906,683

 
$
161.32

 
1,204,517

 
$
86.72

__________ 
(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, 2018. 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, 2018.
(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, 2019 (the “RSA Performance Goal”). If the Company fails to achieve the RSA Performance Goal then all such shares are forfeited. If the Company achieves the RSA Performance Goal then 25% of the restricted stock vests on or about July 16, 2019, 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 15—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.

23


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


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 by 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 that 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.
The following table summarizes the composition and fair value hierarchy of the Company’s financial assets and liabilities at May 31, 2018 (in thousands):
 
May 31, 2018
 
Level 1
 
Level 2
 
Level 3
Assets:
 
 
 
 
 
 
 
Money markets (1)
$
349,062

 
$
349,062

 
$

 
$

Interest-bearing deposits (1)
87,494

 

 
87,494

 

Available-for-sale securities (1):
 
 
 
 
 
 
 
Commercial paper
609,776

 

 
609,776

 

U.S. agency securities
303,837

 

 
303,837

 

Corporate securities
357,380

 

 
357,380

 

Foreign currency derivatives (2)
111

 

 
111

 

Liabilities:
 
 
 
 
 
 
 
Foreign currency derivatives (3)
(790
)
 

 
(790
)
 

Total
$
1,706,870

 
$
349,062

 
$
1,357,808

 
$

__________ 
(1) 
Included in Cash, cash equivalents and restricted cash, Investments in debt and equity securities, short-term or Investments in debt securities, long-term in the Company’s Consolidated Balance Sheet at May 31, 2018, in addition to $819.6 million of cash.
(2) 
Included in Other current assets in the Company’s Consolidated Balance Sheet at May 31, 2018.
(3) 
Included in Accounts payable and accrued expenses in the Company’s Consolidated Balance Sheet at May 31, 2018.

24


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


The following table summarizes the composition and fair value hierarchy of the Company’s financial assets and liabilities at February 28, 2018 (in thousands):
 
February 28, 2018
 
Level 1
 
Level 2
 
Level 3
Assets:
 
 
 
 
 
 
 
Money markets (1)
$
334,665

 
$
334,665

 
$

 
$

Interest-bearing deposits (1)
61,125

 

 
61,125

 

Available-for-sale securities (1):
 
 
 
 
 
 
 
Commercial paper
615,043

 

 
615,043

 

U.S. agency securities
308,267

 

 
308,267

 

Corporate securities
381,514

 

 
381,514

 

Equity securities
1,166

 
1,166

 

 

Foreign currency derivatives (2)
298

 

 
298

 

Liabilities:
 
 
 
 
 
 
 
Foreign currency derivatives (3)
(312
)
 

 
(312
)
 

Total
$
1,701,766

 
$
335,831

 
$
1,365,935

 
$

__________ 
(1) 
Included in Cash, cash equivalents and restricted cash, 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, 2018, in addition to $771.2 million of cash.
(2) 
Included in Other current assets in the Company’s Consolidated Balance Sheet at February 28, 2018.
(3) 
Included in Accounts payable and accrued expenses in the Company’s Consolidated Balance Sheet at February 28, 2018.
The following table represents the Company’s investments measured at fair value as of May 31, 2018 (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
$
349,062

 
$

 
$

 
$
349,062

 
$
349,062

 
$

 
$

Interest-bearing deposits
87,494

 

 

 
87,494

 

 
87,494

 

Commercial paper
609,776

 

 

 
609,776

 
599,838

 
9,938

 

U.S. agency securities
307,704

 
6

 
(3,873
)
 
303,837

 

 
99,685

 
204,152

Corporate securities
358,340

 
540

 
(1,500
)
 
357,380

 

 
132,755

 
224,625

Total
$
1,712,376

 
$
546

 
$
(5,373
)
 
$
1,707,549

 
$
948,900

 
$
329,872

 
$
428,777

__________ 
(1) 
As of May 31, 2018, there were $4.1 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 investments with unrealized losses was $528.4 million.
The following table summarizes the stated maturities of the Company’s investment in available-for-sale securities (in thousands):
 
As of May 31, 2018
 
Less than 1 Year
 
1-5 Years
 
More than 5 Years
Maturity of available-for-sale debt securities
$
671,155

 
$
242,378

 
$
428,777

 
$


25


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


The following table represents the Company’s investments measured at fair value as of February 28, 2018 (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
$
334,665

 
$

 
$

 
$
334,665

 
$
334,665

 
$

 
$

Interest-bearing deposits
61,125

 

 

 
61,125

 

 
61,125

 

Commercial paper
615,043

 

 

 
615,043

 
615,043

 

 

U.S. agency securities
312,537

 

 
(4,270
)
 
308,267

 

 
93,175

 
215,092

Corporate securities
382,497

 
696

 
(1,679
)
 
381,514

 
3,272

 
162,892

 
215,350

Equity securities
650

 
516

 

 
1,166

 

 
1,166

 

Total
$
1,706,517

 
$
1,212

 
$
(5,949
)
 
$
1,701,780

 
$
952,980

 
$
318,358

 
$
430,442

__________ 
(1) 
As of February 28, 2018, there were $4.4 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 investments with unrealized losses was $515.4 million.
NOTE 16—Segment Reporting
The Company is organized primarily on the basis of three geographic business units: the Americas (U.S., Canada and Latin America), 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; income (loss) from operations; total cash, cash equivalents and available-for-sale investment securities and total assets by geographic segment (in thousands):
 
Americas
 
EMEA
 
Asia Pacific
 
Corporate (1)
 
Consolidated
 
Three Months Ended May 31, 2018
Revenue from unaffiliated customers
$
500,306

 
$
195,148

 
$
118,076

 
$

 
$
813,530

Income (loss) from operations
$
71,864

 
$
48,860

 
$
37,437

 
$
(46,005
)
 
$
112,156

Total cash, cash equivalents, restricted cash and available-for-sale investment securities
$
1,524,311

 
$
576,171

 
$
426,647

 
$

 
$
2,527,129

Total assets
$
3,559,900

 
$
1,015,187

 
$
616,474

 
$

 
$
5,191,561

 
Three Months Ended May 31, 2017
Revenue from unaffiliated customers
$
438,380

 
$
143,671

 
$
94,745

 
$

 
$
676,796

Income (loss) from operations (2)
$
74,591

 
$
30,923

 
$
27,948

 
$
(43,718
)
 
$
89,744

Total cash, cash equivalents, restricted cash and available-for-sale investment securities
$
1,186,481

 
$
779,346

 
$
343,754

 
$

 
$
2,309,581

Total assets (2)
$
2,864,857

 
$
1,135,329

 
$
519,263

 
$

 
$
4,519,449

 __________
(1) 
Amounts represent share-based compensation expense that was not allocated to geographic segments.
(2) 
As adjusted from retrospective adoption of ASC 606. See NOTE 2—Summary of Significant Accounting Policies for detailed information on adoption of ASC 606.

26


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


Supplemental information about geographic areas
The Company approximates its geographic sources of revenue based on the country of origin of its non-cancellable subscription and service agreements initiated during the year (commonly referred to as bookings). The following table lists revenue from unaffiliated customers in the U.S., the Company’s country of domicile, and revenue from foreign countries (in thousands):
 
Three Months Ended
 
May 31, 2018
 
May 31, 2017
U.S., the Company’s country of domicile
$
442,421

 
$
394,542

Foreign
371,109

 
282,254

Total revenue from unaffiliated customers
$
813,530

 
$
676,796

Total tangible long-lived assets located in the U.S., the Company’s country of domicile, and similar tangible long-lived assets held outside the U.S. are summarized in the following table (in thousands):
 
May 31, 2018
 
February 28, 2018
U.S., the Company’s country of domicile
$
132,328

 
$
137,112

Foreign
64,325

 
68,993

Total tangible long-lived assets
$
196,653

 
$
206,105

Supplemental information about major customers
For each of the three months ended May 31, 2018 and May 31, 2017, the U.S. government and its agencies represented in the aggregate approximately 10% and 11% of the Company’s total revenue, respectively.
Supplemental information about products and services
The following table provides further detail, by type, of the Company’s subscription and services revenues. Subscription revenue for infrastructure-related offerings includes subscription revenue generated from Red Hat Enterprise Linux and related technologies such as Red Hat Satellite and Red Hat Virtualization. Subscription revenue generated from the Company’s Application Development-related and other emerging technology offerings includes Red Hat JBoss Middleware, Red Hat OpenShift, Red Hat Cloud Infrastructure, Red Hat OpenStack Platform, Red Hat Ansible Automation, Red Hat CloudForms, Red Hat Storage technologies and Red Hat Mobile Application Platform (in thousands):
 
Three Months Ended
 
May 31, 2018
 
May 31, 2017
Subscription revenue:
 
 
 
Infrastructure-related offerings
$
522,402

 
$
457,961

Application Development-related and other emerging technology offerings
189,119

 
138,547

Total subscription revenue
711,521

 
596,508

Training and services revenue:
 
 
 
Consulting services
79,147

 
61,488

Training
22,862

 
18,800

Total training and services revenue
102,009

 
80,288

Total revenue
$
813,530

 
$
676,796



27


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


NOTE 17—Business Combinations
Acquisition of CoreOS, Inc.
On January 30, 2018, the Company completed the acquisition of all of the shares of CoreOS, Inc. (“CoreOS”). The addition of CoreOS, a provider of Kubernetes and container-native solutions, is expected to further enable the Company’s customers to build any application and deploy them in any environment with the flexibility afforded by open source. By combining CoreOS’s complementary capabilities with the Company’s Kubernetes and container-based portfolio, including Red Hat OpenShift, the Company aims to further accelerate adoption and development of its hybrid cloud platform for modern application workloads.
The consideration paid was $238.7 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 $238.7 million was allocated to the Company’s assets and liabilities on a preliminary basis as follows: $160.7 million to goodwill, $81.7 million to identifiable intangible assets and $3.7 million to working capital as a net current liability.
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 technology. 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.
During the three months ended February 28, 2018, the Company completed its 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 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 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. 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.

28


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 (in thousands, except per share amounts) as if the acquisitions of CoreOS, Permabit and Codenvy had occurred as of the beginning of the fiscal year prior to the fiscal year of acquisition, 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 fiscal year prior to the fiscal year of acquisition.
 
Three Months Ended May 31, 2017
Revenue
$
679,373

Net income
$
66,852

Basic net income per common share
$
0.38

Diluted net income per common share
$
0.37

Goodwill and other business combinations
The following is a summary of goodwill (in thousands):
Balance at February 28, 2018
$
1,288,830

Impact of foreign currency fluctuations
(7,589
)
Other adjustments
(2,533
)
Balance at May 31, 2018
$
1,278,708

The excess of purchase price paid for CoreOS, Permabit, Codenvy 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.
NOTE 18—Subsequent Events
On June 21, 2018, the Company announced that its Board 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 new program commenced on July 1, 2018, and will expire on the earlier of (i) June 30, 2020 or (ii) a determination by the Board, Chief Executive Officer or Chief Financial Officer to discontinue the program.
The new program replaced the previous $1.0 billion repurchase program, which expired on June 30, 2018.


29


ITEM 2.
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
OVERVIEW
We are a leading global provider of open source software solutions, using a community-powered approach to develop and offer reliable and high-performing operating system, virtualization, 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 ,generally, is 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 technologies, and by providing a level of performance, scalability, flexibility, reliability and security for the technologies we package and distribute. Moreover, because communities of developers not employed by us assist with the creation of our open source offerings, opportunities for further innovation of our offerings are supplemented by these communities.
We market our offerings primarily to customers in the form of annual or multi-year subscriptions, and we recognize revenue over the period of the subscription agreements with our customers. Our technologies are also offered by certified cloud and service providers (“CCSPs”) as a service available on demand, and this revenue is recognized by us upon delivery.
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 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 Note 2—Summary of Significant Accounting Policies to our Consolidated Financial Statements in Part I, Item 1 of this Quarterly Report on Form 10-Q. We adopted ASC 606, effective March 1, 2018, using the full retrospective transition method. All amounts and disclosures set forth in this Form 10-Q have been updated to comply with the new standard and such information is designated “as adjusted.”
We believe our success is influenced by: (i) our ability to utilize the innovation derived from software developed by an open source community and make it consumable for enterprise customers, (ii) the extent to which we can expand the breadth and depth of our offerings, (iii) strategic business combinations and acquisitions of technical talent and technologies, (iv) our ability to enhance the value of our offerings through frequent and continuing innovation while maintaining platforms designed to be stable and secure over multi-year periods, (v) the extent to which adoption of our emerging technology offerings and software development processes such as CI/CD (continuous integration and continuous deployment) and DevOps increases, (vi) our involvement and leadership in key open source communities and projects, which enable us to develop, enhance and maintain our offerings, (vii) our corporate culture, which we believe fosters innovation, creativity and collaboration, (viii) our ability to generate increasing revenue directly and through partners and other strategic relationships, including CCSPs, distributors, embedded technology partners, independent hardware vendors (“IHVs”), independent software vendors (“ISVs”), OEMs, systems integrators and value added resellers, (ix) our ability to generate new and recurring revenue for our offerings, (x) the widespread and increasing deployment of open source technologies by enterprises and similar institutions, (xi) our software, hardware, application and cloud service certification programs, which are intended to create an ecosystem of technologies that are compatible with our offerings and supported by us, (xii) our ability to provide customers with consulting and training services that generate additional subscription revenue, and (xiii) our ability to provide greater subscription value, enhance the experience of our customers and promote customer loyalty by focusing on ways in which we can help our customers succeed.
In fiscal 2019, we expect to focus on, among other things: (i) driving the widespread adoption of our offerings, (ii) investing in the development of open source technologies and promoting the use of our technologies by software developers globally, (iii) pursuing strategic acquisitions and alliances, and (iv) promoting a range of services to help our customers derive additional value.

30


Non-GAAP disclosures
In accordance with U.S. GAAP, the income statements of our non-U.S. operations are translated into U.S. dollars using the average exchange rates for each month in an applicable period. To the extent the U.S. dollar weakens against foreign currencies, the translation of transactions denominated in foreign currencies results in increased revenue, as stated in U.S. dollars, for our non-U.S. operations. Similarly, revenue, as stated in U.S. dollars, for our non-U.S. operations decreases if the U.S. dollar strengthens against foreign currencies. In this Part I, Item 2, we disclose non-GAAP amounts and growth rates that exclude the impact of foreign currency exchange rate fluctuations for the three months ended May 31, 2018 in an effort to provide a comparable framework for assessing how our business performed when compared to the three months ended May 31, 2017. To compute the non-GAAP impact of foreign currency exchange rate fluctuations, we translate amounts from our non-U.S. operations for the three months ended May 31, 2018 using the average foreign currency exchange rate for the three months ended May 31, 2017.
Revenue
For the three months ended May 31, 2018, total revenue increased 20.2%, or $136.7 million, to $813.5 million from $676.8 million for the three months ended May 31, 2017. Excluding the impact of foreign currency exchange rate fluctuations, total revenue increased by 16.9% for the three months ended May 31, 2018, as detailed in the following table.
The growth rates of subscription revenue by offering type, training and services revenue and total revenue, as reported and excluding the impact of foreign currency exchange rate fluctuations, for the three months ended May 31, 2018 versus the three months ended May 31, 2017 are as follows (in thousands):
 
Three Months Ended
 
May 31, 2018
 
May 31, 2017
 
Year-Over-Year Growth Rate
Infrastructure-related subscription revenue, as reported
$
522,402

 
$
457,961

 
14.1%
Adjustment for foreign currency exchange rates
(13,938
)
 

 
 
Infrastructure-related subscription revenue, excluding foreign currency impact
508,464

 
457,961

 
11.0%
 
 
 
 
 
 
Application Development-related and other emerging technology subscription revenue, as reported
189,119

 
138,547

 
36.5%
Adjustment for foreign currency exchange rates
(6,130
)
 

 
 
Application Development-related and other emerging technology subscription revenue, excluding foreign currency impact
182,989

 
138,547

 
32.1%
 
 
 
 
 
 
Total subscription revenue, as reported
711,521

 
596,508

 
19.3%
Adjustment for foreign currency exchange rates
(20,068
)
 

 
 
Total subscription revenue, excluding foreign currency impact
691,453

 
596,508

 
15.9%
 
 
 
 
 
 
Total training and services revenue, as reported
102,009

 
80,288

 
27.1%
Adjustment for foreign currency exchange rates
(2,450
)
 

 
 
Total training and services revenue, excluding foreign currency impact
99,559

 
80,288

 
24.0%
 
 
 
 
 
 
Total revenue, as reported
813,530

 
676,796

 
20.2%
Adjustment for foreign currency exchange rates
(22,518
)
 

 
 
Total revenue, excluding foreign currency impact
$
791,012

 
$
676,796

 
16.9%

31


Subscription revenue
Our enterprise technologies are delivered primarily under subscription agreements. These agreements typically have a one- or three-year subscription period. A subscription generally entitles a customer to, among other things, a specified level of support, as well as security updates, fixes, functionality enhancements, upgrades to the technologies, each if and when available, and compatibility with an ecosystem of certified hardware and software. Subscription revenue increased sequentially for the first quarter of fiscal 2019 and for each quarter of fiscal 2018 and fiscal 2017 and was driven primarily by the increased use of our offerings by customers and our expansion of sales channels and geographic footprint during these periods.
Subscription revenue increased 19.3%, or $115.0 million, for the three months ended May 31, 2018 as compared to the three months ended May 31, 2017. Excluding the impact of foreign currency exchange rate fluctuations, subscription revenue increased by 15.9% for the three months ended May 31, 2018. The increase in subscription revenue is driven primarily by additional subscriptions related to our Red Hat Enterprise Linux, Red Hat JBoss Middleware and certain emerging technology offerings: Ansible, OpenShift and OpenStack. The increase is, in part, a result of the continued migration of enterprises in industries such as financial services, government and telecommunications to our open source solutions from proprietary technologies. Revenue growth in our Middleware portfolio has moderated as customers shift their workloads from traditional Java deployments to containerized environments with middleware-as-a-service on OpenShift. We believe this transition will impact the revenue growth of the Middleware portfolio throughout fiscal 2019.
Training and services revenue
Training and services revenue increased 27.1%, or $21.7 million, for the three months ended May 31, 2018 as compared to the three months ended May 31, 2017. Excluding the impact of foreign currency exchange rate fluctuations, training and services revenue increased by 24.0%. The increase is driven primarily by customer interest in new products and increased demand for consulting projects supporting Ansible, OpenShift and OpenStack solutions.
Deferred revenue and billings proxy
Year-to-date deferred revenue
Our deferred revenue, current and long-term, balance at May 31, 2018 was $2.44 billion. Total deferred revenue at May 31, 2018 decreased 5.8%, or $150.7 million, as compared to the balance of $2.60 billion at February 28, 2018. Excluding the impact of foreign currency exchange rate fluctuations, total deferred revenue decreased by 4.0%, or $104.6 million, from February 28, 2018 to May 31, 2018, which is the change in deferred revenue reported on our Consolidated Statements of Cash Flows. The decrease in deferred revenue is primarily attributable to our typically lower seasonal first quarter billings.
Below is a summary of our deferred revenue, as reported and excluding the impact of foreign currency exchange rate fluctuations for May 31, 2018 and February 28, 2018 (in thousands):
 
May 31, 2018
 
February 28, 2018
 
Year-to-Date Growth Rate
Current deferred revenue, as reported
$
1,721,300

 
$
1,853,719

 
(7.1)%
Adjustment for foreign currency exchange rates
28,639

 

 
 
Current deferred revenue, excluding foreign currency impact
$
1,749,939

 
$
1,853,719

 
(5.6)%
 
 
 
 
 
 
Long-term deferred revenue, as reported
$
723,207

 
$
741,453

 
(2.5)%
Adjustment for foreign currency exchange rates
17,434

 

 
 
Long-term deferred revenue, excluding foreign currency impact
$
740,641

 
$
741,453

 
(0.1)%
 
 
 
 
 
 
Total deferred revenue, as reported
$
2,444,507

 
$
2,595,172

 
(5.8)%
Adjustment for foreign currency exchange rates
46,073

 

 
 
Total deferred revenue, excluding foreign currency impact
$
2,490,580

 
$
2,595,172

 
(4.0)%

32


Year-over-year deferred revenue
Total deferred revenue increased by 19.0%, or $390.3 million, to $2.44 billion at May 31, 2018 from $2.05 billion at May 31, 2017. Excluding the impact of foreign currency exchange rate fluctuations, total deferred revenue increased by 18.2%, or $374.2 million, from May 31, 2017 to May 31, 2018. This increase in deferred revenue of $374.2 million is the summation of the changes in deferred revenue reported on our Consolidated Statements of Cash Flows for each quarter of the four-fiscal-quarter period ended May 31, 2018, which includes an insignificant amount of deferred revenue acquired from business combinations.