Red Hat, Inc. Q1 2011 Earnings Call Transcript

123jump.com Staff
28 Jun, 2010
New York City

Revenues rose 20% to $209.1 million & net income rose 30.3% to $24.1 million or 12 cents a share. Operating cash flow of $61 million was in line with Q1 last year. Non-GAAP operating expense came in at $126 million up 3% sequentially and 16% year-over-year. Non-GAAP operating income was $52 million.

Red Hat, Inc. ((RHT))
Q1 2011 Earnings Call Transcript
June 22, 2010 5:00 p.m. ET

Executives

Tom McCallum – Vice President, Investor Relations
James M. Whitehurst – President and Chief Executive Officer
Charles E. Peters Jr. – Executive Vice President and Chief Financial Officer

Analysts

Kevin Rune – Morgan Stanley
Mark Murphy – Piper Jaffray
Tim Klasell – Thomas Weisel Partners
Heather Bellini – ISI Group
Trip Chowdhry – Global Equities
Katherine Egbert – Jefferies and Company
Todd Raker – Deutsche Bank
John DiFucci – J.P. Morgan
Michael Turits – Raymond James
Nabil Elsheshai – Pacific Crest Securities
Tatyana Yamaida – Robert W. Baird
Brent Williams – Benchmark Company
Brent Thill – UBS
Richard Williams – Cross Research
Brad Whitt – Gleacher & Company
Bhavan Suri – William Blair
Matthew Hedberg – RBC Capital
Stephanie Withers – Goldman Sachs
Brad Reback – Oppenheimer & Company

Presentation

Operator

Good afternoon, ladies and gentlemen. My name is Gerald and I will be your conference Operator. At this time, I would like to welcome everyone to Red Hat''s Q1 2011 Earnings Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers’ remark, there will be a question-and-answer session. If you would like to ask your question during this time, simply press star then the number one on your telephone keypad. If you would like to withdraw your question, press the pound key. Thank you. I would now like to introduce Mr. Tom McCallum, Vice President of Investor Relations. Sir, you may begin.

Tom McCallum

Thank you. Hello everyone. Welcome to Red Hat''s earnings call for Q1 fiscal 2011. Speakers for today''s call will be Jim Whitehurst, President and CEO and Charlie Peters, Executive Vice President and CFO. Our earnings press release was issued after the market closed today and may be downloaded from RedHat.com on the Investor Relations page. Also, on this page you will be able to find a historic reconciliation schedule of GAAP to non-GAAP financial metrics as well as a schedule on currency rates.

Various remarks that we may make about the company''s future expectations, plans and prospects, including the statements containing the words believe, anticipate, plan, project, estimate, expect, intend or will constitute forward-looking statements for the purposes of the Safe Harbor provisions under the Private Securities Litigation Reform Act of 1995. Actual results may differ materially from those indicated by these forward-looking statements as a result of various important factors, including those discussed in the company''s most recent quarterly report on Form 10-Q filed with the SEC.

In addition, any forward-looking statements represent our estimates or views only as of today, June 22, 2010 and these estimates or views may change. While the company may elect to update forward-looking statements at some point in the future, we specifically disclaim any obligation to do so, even if our estimates or views do change. And therefore, you should not rely on these forward-looking statements as representing our estimates or views at any date subsequent to today.

As a final note, we will be holding an analyst meeting on Wednesday, June 23 here in Boston at our Summit JBoss World Event. The webcast of the presentations will also be available on our Investor Relations page. With that, I would like to turn the call over to Jim.

James M. Whitehurst

Thank you, Tom. And let me add my welcome to all of you joining us on today''s call. I am pleased to announce another quarter of strong execution by our Red Hat Associates, which has led to financial results that are above our expectations. The demand for our subscriptions remain strong and demand for our services has rebounded.

Here are a few highlights. First, sales execution was strong for Q1. We experienced solid demand in all major geographies and across all our products suites. This demand was further highlighted by winning the largest deal in our history in the past quarter, an eight-figure deal with a mainstream customer which was primarily middleware. Second, we saw consistent traction with our free to paid initiative, with one of the largest deals in the quarter being a free to paid win.

Yesterday, we also announced a major win with the NYSE Euronext. After evaluating the free dot org version of JBoss in their test and development environments versus proprietary solutions, the NYSE Euronext looked to Red Hat to provide enterprise class support for production workloads on Enterprise JBoss. As they migrated production workloads to paid JBoss subscriptions, they continue to reap major benefits, including cost savings of up to 50% to 60% from the simplicity and flexibility of the architecture. As with RHEL, the NYSE has now standardized on JBoss.

A third driver, this quarter is the fact that our cloud and virtualization offerings continued to make early traction with cloud providers. In addition to the RHEL and RHEV public cloud wins announced earlier this quarter with NTT and IBM, we closed a multimillion dollar deal with a global cloud provider, who is recognized as a top leader in cloud services. Internationally, we also announced wins with a hosting and cloud service provider in the Netherlands and a RHEV virtualization win with a mobile provider in Southeast Asia.

Finally, from the renewals perspective, I am pleased to report that all of our top 25 deals that were up for renewal in the quarter renewed and not only renewed, but they did so with a total value at over 120% of the original value. This further validates the level of value customers are receiving through their Red Hat subscriptions. In addition to strong topline growth, we grew non-GAAP operating income by 28% in the first quarter. At the same time, we continued to invest in new growth opportunities like virtualization, cloud and middleware.

Let me preview some of the exciting events and announcements that will take place over the next few days at the Red Hat Summit and JBoss World, our premier open source user and partner event, which begins today in Boston. Attendance is over 2,200 people, with registration still coming in and attendees are coming from around the globe. We will be showcasing Red Hat''s leadership with innovators, customers and partners, including IBM, Cisco and Accenture.

At the summit, we will officially launch several new portals and programs to further strengthen our relationship with customers, developers, partners and cloud providers. First, we launched globally the Red Hat Partner Center, which includes a partner portal, tools and resources to enable partners to scale their business with Red Hat.

Second, we will further enhance the value our customers receive through Red Hat subscriptions with a new customer portal designed to empower customers with tools that provide greater capabilities to troubleshoot and collaborate. We work closely with many of our customers to drive enhanced functionality across the portal.

And we are pleased to provide our global customers with an even better customer experience with Red Hat. Cloud Computing will be a major theme at the Red Hat Summit and JBoss World this week.

With focus on leveraging our broad ecosystem enabling developers and providing improved service delivery, we will announce initiatives that are designed to make Cloud Computing more consumable for the enterprise. We will also take this opportunity to update everyone on our latest product innovations and technology roadmap, including the latest version of our operating system, Red Hat Enterprise Linux 6, which is currently in beta. We anticipate that RHEL 6 will be one of our most ambitious, important platform releases to date.

The architecture of RHEL 6 is designed to address in the shift in the modern IT environment, whether physical, virtual or cloud. The major themes of a future release include pervasive virtualization, improved scalability and availability, increased power efficiency and delivery of some of the latest software technology. RHEL 6 will be an ideal foundation for customers seeking to fully -- seeking fully integrated, secure virtualization and cloud deployments.

We will also be discussing our virtualization offerings that include the KVM hypervisor technology and a comprehensive set of server virtualization tools. In addition to new capabilities, our virtualization offerings are designed to support both server virtualization and virtual desktop environments using Red Hat VDI solutions, all from the same management platform. Our middleware team will be discussing new developments and technologies.

With more enterprises looking to expand open source middleware use within their infrastructures, we expect that there''ll be great interest from our attendees this week on what’s new on the JBoss front and how JBoss will play an integral role in Red Hat''s cloud strategy.

As a final note around summit, BusinessWeek has recognized Red Hat as one of the BusinessWeek Top 50 in their annual report. This ranking represents an evaluation of best-in-class corporate performers from the S&P 500 Index.

We are ranked number 22, and as a top technology company along with Google, salesforce.com and Amazon.com. I want to thank Red Hat Associates for their passion and energy that they bring each day to their jobs and in their support of our customers. I can tell you that everyone at Red Hat is working together to deliver on and enhance the value our customers expect from us, and it shows in our results.

In summary, we are pleased with our execution, as we continue to win business from our competitors. We are optimistic on the renewed demand for large projects and on our pipeline. Over the next few days, you will hear more about solutions and programs which place us in a strong position for future growth. With that, let me turn the call over to Charlie.

Charles E. Peters Jr.

Thank you, Jim. Here are some of the highlights of our first quarter, which include growing first quarter revenue by 20% on a year-over-year basis, growing bookings faster than revenue and growing backlog, both unusual for a first quarter. Expanding non-GAAP operating margin by 140 basis points year-over-year, growing non-GAAP earnings per share by 20% year-over-year, generating operating cash flow of $61 million, and repurchasing 2.5 million shares of our common stock.

As Jim mentioned earlier, we experienced significant growth in a number of large deals year-over-year. The top 30 deals in the quarter included 11 deals at approximately $1 million or greater, more than double Q1 last year. One deal in excess of $5 million and one eight-figure deal, which was the largest in our history.

Approximately one-third of these deals included a middleware component, with two being standalone middleware deals. In fact, the largest deal was almost entirely a middleware deal and it was with a new mainstream customer.

In addition, a number of our largest deals contained an initial consulting component, which we believe is a positive signal for new project spending and future subscription billings. However, these deals generally have lower upfront invoicing, which impacts the presentation of our billings and deferred revenue.

As an example, we invoiced less than 5% of the eight-figure deal that I referenced a moment ago, since we are in the beginning of the implementation. Off-balance-sheet backlog is the beneficiary and as a result, it has grown since Q4.

Now, let''s talk about our financial performance. First-quarter revenue was $209 million, an increase of 20% year-over-year, 7% sequentially and well above our guidance range. This sequential growth rate is the highest in two years. The drivers to our total revenue growth were both subscription revenue and service revenue.

Subscription revenue was again up over 20% year-over-year and 6% sequentially to $179 million. Subscription revenue, which is renewable, constituted 86% of total revenue.

The training and services component of revenue was $30 million, up 18% from last year and up 13% sequentially. This strong performance included the anticipated seasonal boost, but more importantly, we saw renewed demand for new projects as IT spending appears to be in the early stages of recovering.

Bookings were up strongly compared to Q1 last year. The channel generated 54% of our Q1 bookings and 46% came from direct sales versus a 56%/44% split in Q4. This split reflects the strong execution by our direct sales force, even while the channel business continues to perform well.

In terms of geography, 62% of bookings came from the Americas, 22% from EMEA and 16% from Asia-Pacific. Our billings proxy for the quarter was $208 million, up 18% in U.S. dollars from last year, or $31 million, reflecting the normal pattern which we experience between Q4 and Q1 each year.

The billings proxy is calculated by adding revenue plus the change in deferred revenue on the cash flow statement, which eliminated -- which eliminates most foreign currency exchange impact. Our billings proxy was also influenced somewhat this quarter by the percentage of deals that contained an upfront service component, which is billed as work progresses, as I mentioned before.

Importantly, we continue to sign a significant level of new and renewal-based business and our renewal rates on larger deals remains very high. The combination of these factors led to record Q1 bookings performance.

So now let''s shift back to the income statement. On a non-GAAP basis, excluding stock compensation and amortization expense, overall gross margin was 85% for Q1. Subscription gross margin was 93.6%, while training and services gross margin was 34%.

Moving on to non-GAAP operating expenses, we remain focused on managing discretionary costs, while continuing to invest in growth opportunities such as middleware, virtualization and Cloud Computing.

Q1 non-GAAP operating expense came in at $126 million, up 3% sequentially and 16% year-over-year. Spending was appropriately focused on sales and engineering, while G&A declined from higher Q4 levels. Q1 non-GAAP operating income was $52 million, producing an operating margin of 24.8%, up 100 basis points sequentially and 140 basis points year-over-year and better than our guidance.

Net interest income was less than last year and slightly less than the $2 million which we had guided, due mainly to lower interest rates. Investment and foreign currency gains added another $1 million to other income.

Our estimated annual effective tax rate is 35% for both GAAP and non-GAAP results. Non-GAAP diluted earnings per share came to $0.18, which is at the high end of our guidance, up 20% compared to last year.

Now, let''s turn to the balance sheet and the cash flow statement. We ended the quarter with cash and investments of $968 million, nearly unchanged from last quarter after the repurchase of 2.5 million shares of our common stock for $74 million.

Operating cash flow of $61 million was in line with Q1 last year. However, compared to a year-ago quarter we reduced payables and grew Accounts Receivable, which use cash. Quarterly cash flow varies as a result of these differences, which will normalize over time. Foreign-exchange adjusted days sales outstanding were 53 days compared to 56 days in Q4 and 54 days in Q1 last year.

As a reminder, since days sales outstanding is traditionally a measure of receivables versus billings, our DSO calculation includes revenue plus the change in deferred revenue from the cash flow statement. Total deferred revenue at quarter end was $626 million, an increase of $58 million or 10% over the same quarter a year ago. Current deferred revenue grew 17% in U.S. dollar terms, while long-term deferred revenue declined 5% from a year ago.

It is important to note that the percentage of deferred -- of current deferred revenue have continued to increase even as the total grows, improving our visibility on near-term revenue. Deferred revenue decreased approximately $20 million from last quarter but would have been essentially flat without the sharp drop in the quarter-end euro rate. Let me break this down further for you. Short-term deferred revenues ended Q4 at $481 million had real growth in Q1 of $1 million but was reduced by $13 million as a result of changes in foreign exchange spot rates and ended Q1 at $469 million.

Long-term deferred revenue, which ended Q4 at $165 million, had a real decline in Q1 of $3 million and was further reduced by changes in the foreign exchange spot rates by $5 million, ending Q1 at $157 million. Currency rates have continued to be volatile, especially the euro, which depreciated approximately 10% during the quarter. If the first quarter had been at the same foreign exchange rates as Q1 last year, both revenue and expenses would have been about $3 million lower, with no net change in operating income.

Now, I would like to turn to guidance, which assumes currency rates approximately where they were yesterday. To be clear, this means that the assumed average euro and pound rates, which are approximately 9% lower than in Q1.

Additionally, compensation costs will increase in Q2 after we grant July merit increases to our employees since it has been 18 months since the last increase for most of them. With these assumptions in mind, I offer the following. Q2 revenue is estimated to be approximately $210 million to $212 million. Operating margin is estimated to be around 24% and non-GAAP earnings-per-share is estimated to be approximately $0.18, assuming the same 35% tax rate.

Full-year guidance for both the P&L and cash flow remains unchanged, implying that we have had meaningful strengthening in our business on a local currency basis. One should note that given the recent changes in foreign exchange, our revenue outlook would have been approximately $10 million to $15 million higher than our original guidance if rates remained unchanged from the original planning assumption when the euro was at $1.35.

In summary, the company continues to execute well and we are managing for growth. We are managing costs while investing in innovation, efficiencies and additional commercial capabilities that will enable us to further distance ourself from our competition. Operator, I would now like to turn it back over to you for the first question.

Question-and-Answer Session

Operator

At this time, ladies and gentlemen, if you would like to ask a question, please press star then number one on your telephone keypad. We’ll pause for just a moment to compile a Q&A roster. And your first question comes from Adam Holt with Morgan Stanley. Mr. Holt, your line is open, sir.

Kevin Rune – Morgan Stanley

Hi. This is Kevin Rune [ph] on behalf of Adam. You had mentioned a few big deals on JBoss. And I was wondering if, in the past you have mentioned a benchmark of JBoss growing at around twice the rate of the core. Could you give us a bit more color on that and what drove the recovery in JBoss this quarter?

James M. Whitehurst

I would say that middleware was strong, both in services and subscriptions this quarter and did in fact grow at more than twice the rate of the base business. I think, partly as we discussed the first quarter a year ago when the recession was probably at its worst, many people were cutting back on consulting and services. We are seeing that come back and middleware is very much a services led sales. So I think that is leading to some of this.

Kevin Rune – Morgan Stanley

Thank you.

James M. Whitehurst

Next question.

Operator

Your next question comes from Mark Murphy with Piper Jaffray.

James M. Whitehurst

Hey, Mark.

Mark Murphy – Piper Jaffray

You had noted an eight-figure win that was mostly middleware. And I am curious if that was a competitive replacement? And also, Charlie, is the eight figures -- I guess I am assuming that that is a three-year bookings amount. Then I have a quick follow-up.

Charles E. Peters Jr.

The eight-figure deal was in fact a greenfield opportunity that we won after significant amount of proof of concept work. It is a multiyear deal. Is there a quick follow-up?

Mark Murphy – Piper Jaffray

Yes. I am wondering, Charlie, can you estimate the billings impact from the upfront services mix in terms of how different were the billings number have looked, is it perhaps a couple or a few million dollars there?

Charles E. Peters Jr.

Well, I guess the other thing I can probably add to clarify that, just to reiterate what I said, that bookings grew faster than revenue. And we also had an off balance sheet backlog build in the first quarter and this is the first time in my memory that that has happened, which means there is future billing events that will happen. But I don''t have any dollars to put on that.

Mark Murphy – Piper Jaffray

Thank you.

Operator

Your next question comes from Tim Klasell with Thomas Weisel Partners.

Tim Klasell – Thomas Weisel Partners

Yeah. Just a question on the pipeline, it seems like you closed a lot of large deals this quarter and maybe some other revenue is going to be recognized in later quarters. Last year, you changed some sales force compensation to drive certain behavior. Did you do anything different this year to drive all the large deal strength and the billings profile?

Charles E. Peters Jr.

It sounds a good question. Not at all. I think our sales team has simply come together better. In the first quarter of last year, our teams were, I would say, forming. We had a number of changes in North America. The team has come together well and is really performing at a high level, but there has been nothing on the compensation side that has been changed.

James M. Whitehurst

Tim, I think one same thing you are seeing is more new deals or new functionality being added. And we get a very high share of greenfield functionality. And so now with some bigger projects are coming back, you''re starting to see some bigger opportunities for us.

Tim Klasell – Thomas Weisel Partners

Right. Thank you.

Operator

Your next question comes from Heather Bellini with ISI Group.

Heather Bellini – ISI Group

Hi. Good afternoon, guys. I had two quick questions. I guess the first was, Charlie, if you could give us any update on penetration of advanced platform and what you are seeing from your client base in terms of that product. The second was just a quick follow-up on the large deal, the eight-figure deal that you mentioned. You mentioned you''re only able to invoice less than 5%. What is the typical implementation period for a deal such as that?

Charles E. Peters Jr.

Okay. So the first question on AP. I will give you a little more color now and then a teaser, so you will all come to analyst day tomorrow. 19 of the top 30 deals has an AP component. So fairly consistent with where we have been on that metric and I will share more details about AP penetration tomorrow at analyst day. The second…

Heather Bellini – ISI Group

Implementation period for the large deal, just in general how do we think about that, and how it impacts the deferred balance?

Charles E. Peters Jr.

Yeah. I think the services part of the deal, it will probably take about a year. And some subscriptions will begin rolling out during that period of time. And it is, as I said in response to Tim''s question, it will be a long-term subscription arrangement.

Heather Bellini – ISI Group

Okay. Great. Thank you.

James M. Whitehurst

Thank you.

Operator

Your next question comes from Trip Chowdhry with Global Equities.

Trip Chowdhry – Global Equities

Thank you. Two quick questions. First is regarding your growth strategy. I was just wondering like if we -- when I talk to various CIOs, the biggest concern they mention is application portability that is an application written for one cloud should be able to migrate to another cloud. I was wondering, are you thinking like JBoss could be a platform which provides application portability, like application that is billion on salesforce.com could be migrated to Amazon.com or any other platform, any thoughts on it? Then I have a follow-up question.

James M. Whitehurst

Sure, absolutely. That is at the heart of what we do. We have done it for years just bare metal with the ability to have choice at the hardware level and we are doing it now on the cloud side.

If you come to analyst day tomorrow, we will talk a lot more about it. But just one example is our Certified Cloud Program, where clouds like Amazon, IBM, NTT, if they are running a stack that we have certified, we are certifying an application that will run on Red Hat -- that is certified for Red Hat, will run on those clouds, certified and we will tech support you on it. So we are working very hard to bring choice into cloud.

Cloud has the potential to be the mother of all lock-in if we are not careful. So it is a core source of value that we are bringing. And you will hear a lot more about that tomorrow.

Trip Chowdhry – Global Equities

Perfect. Another question I had was on RHEV virtualization platform. What only search is showing you have very strong strength in the financial sector versus the other sector. Are there something in technology or in your marketing that is gravitating your success rate to more in financial versus other sector? But probably I haven''t covered enough ground. Thank you and all the best.

James M. Whitehurst

Yeah. I think it''s the same thing that started with Linux, right. Our first major wins with Linux got started were in financial services. These are people who are looking for scalability and performance. And we have that high-performance hypervisor and so those are the people you''re going to see interested first.

Charles E. Peters Jr.

Thanks Trip.

Operator

Your next question comes from Katherine Egbert with Jefferies.

Katherine Egbert – Jefferies & Company

Hi. Can you hear me?

Charles E. Peters Jr.

Yes.

Katherine Egbert – Jefferies & Company

Okay. Great. Quickly, can you tell us what the average contract length was in the quarter?

Charles E. Peters Jr.

Sure, the average contract length is still around 22 months. The split was about 72% or 73% were single-year bookings, the balance being the longer-term bookings.

Katherine Egbert – Jefferies & Company

Okay. Then with respect to the consulting contracts and the leading indicator, isn''t this kind of a one-quarter phenomenon because of the large deal or is this something that you expect -- is this a new strategy? I mean, how should we -- what perspective should we put this in?

Charles E. Peters Jr.

I don''t think it is necessarily a one-quarter phenomenon. If you recall, going back even a couple of years, when we acquired Amentra, we said the purpose of that was that we believed, in particular, middleware and services led sale and that is an important part of what we do. Last year, when the economy got weak, I think we and everyone else had a little bit of softness is in consulting and we are seeing it coming back. So I think, hopefully, we will see more of it.

James M. Whitehurst

Especially with JBoss. As you are seeing more greenfield or new projects happening, you will see growth in the consulting business, because it is a services led sale.

Katherine Egbert – Jefferies & Company

Okay. Great job.

Charles E. Peters Jr.

Thanks.

Operator

Your next question comes from Todd Raker with Deutsche Bank.

Todd Raker – Deutsche Bank

Hi guys, nice quarter.

James M. Whitehurst

Thank you.

Charles E. Peters Jr.

Thank you.

Todd Raker – Deutsche Bank

Two quick questions for you. First, just cycling back to last quarter, there was one of your top 25 deals that did not renew and you guys commented that you were in active negotiations. Did that deal get renewed this quarter?

Charles E. Peters Jr.

I think what we said on the one last quarter was that we -- it was a multi-divisional company. We did not get a renewal on one division, at the same time we signed up another. So I think the answer is, still working on the errant division.

Todd Raker – Deutsche Bank

Okay. And then on the cloud front, you guys have announced some very nice wins with some cloud service providers. Can you say that on -- are these exclusive transactions where they are kind of putting all of their eggs in the RHEL basket or are they going to go with multiple flavors of OS to service their end customers?

James M. Whitehurst

They are generally going with RHEV as the hypervisor substrate but certainly they will use Windows, RHEL, other operating systems as guests on top of that. I mean, obviously, Windows is certified on RHEV. And so there will certainly be demand for RHEV on there -- Windows on there, but these are RHEV deals.

Todd Raker – Deutsche Bank

So diving into that, are these guys then not going to offer ESX or VMware flavor, or they''re going to offer multiple flavors to their end customers?

Charles E. Peters Jr.

That is something that I don''t think that we could -- that we would necessarily know.

Todd Raker – Deutsche Bank

Okay. I''m just trying to get a sense for -- clearly you are starting to drive significant revenue, but do you think you can drive revenue from every large cloud service provider out there or have some of the cloud providers, kind of, stimulate on VMware and therefore your opportunity is relatively limited in those environments?

Charles E. Peters Jr.

I will see -- I think we all have the lion''s share of cloud operators running Red Hat. The performance and scalability for technically sophisticated customers, we will see that. And secondly, the economics of open source, I feel very confident that that is a market that we will do very well in.

Operator

And your next question comes from John DiFucci with J.P. Morgan.

John DiFucci – J.P. Morgan

Thank you. Charlie, you said that backlog is up in the first quarter, which is, as you point out, surprising but deferred revenue is flattish and excluding foreign exchange and is down significantly if you don''t exclude it. Is it fair to say that the increase in backlog was entirely due to that eight-figure dealer or was a more than just that?

Charles E. Peters Jr.

No. It was definitely more than that. It was -- we had a strong quarter overall. That was a contributor, but only part of it.

John DiFucci – J.P. Morgan

Okay. So even excluding that, backlog would have been up?

Charles E. Peters Jr.

Yes.

John DiFucci – J.P. Morgan

Okay. Just a quick follow-up. Are you seeing anything different in Europe? That is -- I think a lot of people are wondering what is happening over there. We all read the paper, and we are wondering if you are seeing any impact on end demand, other than foreign exchange?

Charles E. Peters Jr.

It’s been pretty consistent and I would say growing. The European business was good in Q1. They reported a good pipeline for Q2. The one metric that I gave that might cause you to ask that question was the percentage by region and I would say the high percentage in the Americas would be largely driven by the large deal that I talked about. That was a North American deal but other than that, all the regions performed well, including EMEA.

James M. Whitehurst

Yeah. I just got back from a couple of weeks in EMEA. I traveled around the region visiting customers. We see a lot of strength there. In fact, this quarter was the fastest bookings growth in EMEA since I have been at Red Hat.

John DiFucci – J.P. Morgan

Thanks a lot guys.

James M. Whitehurst

Thanks.

Operator

Your next question comes from Michael Turits with Raymond James.

Michael Turits – Raymond James

A couple of things. One, just a clarification, you said that you saw bookings grow faster than revs, but you had that down deferred revenue. Just was that -- that bookings growth, did that include the off balance sheet stuff, that sounds same calculation again?

Charles E. Peters Jr.

I would just give you the definition again, bookings, billings and revenue because a lot of times there is a definitional problem. Bookings is the total value of a contract, whether we bill it or not. Billing is what it sounds like if we sent the bill. It is a billing. And then revenue is obviously what you report for GAAP purposes. And what gets in the backlog is anything that is a booking that has not yet been billed. So I did say -- yes, I did say that bookings grew faster than revenue. I also said the backlog grew. As the backlog grew would tell you that bookings were also higher than billings. That is how backlog grows.

Michael Turits – Raymond James

Another thing, Charlie, how is this playing out in terms of the way licensing works around virtualization? As people are implementing virtual instances of RHEL, they can put up to four on an enterprise license or subscription, but then you''re charging for AP. How is that netting out? Are you -- in virtualized implementations are you getting it net more or net less, given those pluses and minuses?

Charles E. Peters Jr.

I think one of the best indicator of that would be to go to our comments about our bookings and billings and revenue. We grew by 20% revenue. Our bookings were higher than revenue and so we are still growing at a nice clip.

Operator

And your next question comes from Nabil Elsheshai with Pacific Crest Securities.

Nabil Elsheshai – Pacific Crest Securities

Hey, this is a real quick question on VMware and SUSE. I was wondering if you guys could comment on the competitive -- your thoughts on the competitive dynamics there with bundling of free version of SUSE?

James M. Whitehurst

Yeah. I think it just further validates Red Hat''s strategy of having tight integration between the hypervisor and the operating system.

Nabil Elsheshai – Pacific Crest Securities

Okay. Then real quick, just on the large steel. You had mentioned it was middleware. Was that primarily JBoss or did it include all the merged and all the other middleware tools?

Charles E. Peters Jr.

It was all the other middleware tools.

Nabil Elsheshai – Pacific Crest Securities

Did it include JBoss?

Charles E. Peters Jr.

Yes, there was some JBoss.

Nabil Elsheshai – Pacific Crest Securities

Okay. All right. Thank you guys

Charles E. Peters Jr.

Thanks

Operator

Your next question comes from Steve Ashley with Robert W. Baird.

Tatyana Yamaida – Robert W. Baird

Hi, this is Tatyana Yamaida [ph] for Steve Ashley. I am just wondering how you think about timing for new product releases? It has been over 39 months since the RHEL 5 release. So I am wondering how we should think about the timing of your release going forward.

Charles E. Peters Jr.

I think you may hear more about that at the analyst day tomorrow. But I think it is widely known that RHEL 6 is in beta and so the actual general availability of RHEL 6 is in the not-too-distant future. And the actual amount of time between releases is really not so important as the functionality to deliver in the quarterly updates along the way. We provide value to our customers through the subscription by adding value every single quarter. That is why they keep coming back and renewing.

James M. Whitehurst

Just to emphasize on the economics, because this is an important point that I talk about with our customers every day. When we come out with a new release, it does not generate incremental revenue for us. If you are a subscriber, you have access to that. So new releases aren''t a revenue event for us, so it really is driven by the technology and when it is really time to do the full update.

Tatyana Yamaida – Robert W. Baird

That''s helpful. Thank you.

Operator

Your next question comes from Brent Williams with Benchmark Company.

Brent Williams – Benchmark Company

Thanks for taking the question. I wanted to look at -- when you talk about RHEL 6 feature is a virtualization cloud, power management and new technologies, how do you -- I mean, obviously, there is a huge number of things and there is going to be something in there that appeals to everybody.

But based on the tone of business right now and I am thinking in terms of greenfield opportunities, which do you see? I mean, power management I was a little surprised to see in there. Is that more important than I might think? And is there something that you can do sitting on top of the same hardware that other operating systems can do -- or that they cannot do rather, to give better power on the same -- essentially the same hardware?

James M. Whitehurst

Please come tomorrow. We will give you a lot more discussion around that but let me just succinctly say, green IT is a massive topic in data centers around the world today. The power of the open source model and having intelligence and our own hardware enablement in chips, I do think puts us in an extraordinary position to deliver a whole set of features like power management that it is hard for others to match. But we will go into more of that tomorrow.

Brent Williams – Benchmark Company

Okay. And what type vertical industry was the eight-figure deal from?

Charles E. Peters Jr.

It is not one of the ones that you would typically have in our top four. Let me just leave it at that.

Brent Williams – Benchmark Company

Okay. Thanks.

Operator

Your next question comes from Brent Thill with UBS.

Brent Thill – UBS

Thanks. Just in terms of the comment, Charlie, you made on the strengthening in the core business, can you give us a sense -- you know, with the server unit growth now reaccelerating and I know in the downturn you said that didn''t hurt you, but I am assuming that is now helping you. Is there anything else you are singing just in general that is really contributing now to seeing this material strengthening that you highlighted?

Charles E. Peters Jr.

I do intend tomorrow to share the information about where we stand in terms of the OEM billings, the percentage of total billings and kind of update what I did at last analyst day. I can tell you that we have seen nice growth from the OEMs. But as a percentage of the total what you will see is it is not a whole lot different than it was a year ago because the base business is growing nicely. So I will lay that out for everybody tomorrow with some more detail. I think the reason why we are seeing the kind of strong performance that we are seeing is because, as I said, I think we are executing well.

The sales team has come together nicely over the last 12 to 15 months. I think the economy is getting a little bit better. People have deferred IT purchases and they need it now, so they''re beginning to buy. Frankly, open source -- the old open source model and the economics of the subscription model had been very persuasive with customers.

James M. Whitehurst

In fact, we have continued to work over the last couple of years building out much broader and deeper and more strategic relationships with all kind of partners, be the channel partners, systems integrators -- deeper OEM relationships and all of those are really starting to pay off now.

Next question, please.

Operator

Your next question comes from Richard Williams with Cross Research.

Richard Williams – Cross Research

Hi guys. Can you hear me okay?

James M. Whitehurst

Sure, Richard.

Richard Williams – Cross Research

I wonder if you could just run by region in terms of the business conditions you saw?

Charles E. Peters Jr.

I think just to generalize, as I said, overall we have seen strength pretty much globally. I don''t -- other than the one mega deal in the U.S., the eight-figure deal, the regions performed, I’d say well pretty much across-the-board. There is no other distinction that would be necessary to draw.

Richard Williams – Cross Research

And what FX rate are you assuming in your guidance?

Charles E. Peters Jr.

You said what foreign exchange rate?

Richard Williams – Cross Research

Yes.

Charles E. Peters Jr.

Okay. What I said is rate as approximately yesterday. And as I recall, the euro rate yesterday was about $1.23, yen rate yesterday was about $1.91 -- excuse me, 91, sorry.

Richard Williams – Cross Research

Okay. Thanks guys. See you tomorrow.

Charles E. Peters Jr.

I was going to say, just as a reminder to everybody, those two rates are important to us, but we do business in roughly 20 or more currencies. So other rates also have impact on our results.

Operator

And your next question comes from Brad Whitt with Gleacher & Company.

Brad Whitt – Gleacher & Company

Hey guys. Thanks for taking my question. Along the virtualization front, I wondered if you could give us more color around adoption for RHEL, whether that is meeting your expectations or exceeding your expectations and then what will we expect to hear around the BDR management tools this week, anything new there?

James M. Whitehurst

Well, I would say, it is certainly meeting our expectations. In general, we tripled the number of customers during the quarter and almost tripled the number of proof of concepts we have going on, so a lot of interest out there. It is broad-based interest. So we have a lot of things going on, so very, very, very pleased there. In terms of VDI, again I will encourage you to come tomorrow if you want to hear more in terms of what we might announce this week.

Operator

And your next question comes from Bhavan Suri with William Blair.

Bhavan Suri – William Blair

Hey guys. Thanks for taking my question. Just a follow-up on the virtualization. What sort of conversion rate are you seeing from that POC to actual implementations for RHEV?

James M. Whitehurst

That is a good question. I don''t have a good number, because we are just getting going, so a lot of them are underway. The number is, we are hearing about 70% and rising, so actually it is quite, quite good. Recognize we are not going into brand-new customers. These are generally existing customers who are running our other products in mission-critical environments. So these are generally people who know us, trust us and have been waiting for the product. So, so far, so good.

Bhavan Suri – William Blair

Then -- so given this is probably some form of replacement, are you taking share here from the existing VMware base or folks that are testing Microsoft or folks that were using Xen?

Charles E. Peters Jr.

First of all, it doesn''t necessarily need to be a replacement. Keep in mind that the penetration of virtualization is still quite low, even VMware would tell you that. In some cases it may well be a replacement, but I think in many cases it is a greenfield startup opportunity.

James M. Whitehurst

I think generally that -- many of those customers do have VMware in their environment, but I think most of the customers I have talked to about this would like to have more than one hypervisor, simply kind of the lock-in they have seen in other categories. I think maybe that movie; they have seen it. And so I would say the vast majority of our customers very much are looking to have two.

Bhavan Suri – William Blair

Okay. I guess one of the things I''m trying to understand here is for Microsoft or Windows you virtualize and you get the sort of capacity bump and you can reduce the hardware. But with Linux the capacity utilization has been typically higher. So what is the driver behind the use of virtualization? Is it just backup and recovery type of stuff? And if that is the case, what is the ROI around that?

James M. Whitehurst

First off, our virtualization -- Windows is certified as a guest on our virtualization. So we are seeing a lot of people using our virtualization technology to virtualize Windows guest. So you can''t just look at it as Linux. There is also in terms of disaster recovery, in terms of just in general higher reliability and availability, a whole series of reasons why people are looking to do it. Especially, if people are looking for things like internal cloud deployments, given the scalability and the performance and also the economics at the hypervisor level, there is just a lot of interest.

Charles E. Peters Jr.

Next question.

Operator

All right. Your next question comes from Matt Hedberg with RBC Capital.

Matthew Hedberg – RBC Capital

Hey guys, nice quarter. Charlie, could you give us a sense for what headcount was at the end of the quarter and then going forward throughout the remainder of the year what are the plans there, I guess, not only on the core OS, but also on the JBoss side?

Charles E. Peters Jr.

At the end of the quarter, we had just approximately 3,300 employees and as we have done really for the last several years, we''ve been adding somewhere between 80 and 100 people a quarter. I would say over the last year or so more of those employees have been outside the United States than in the United States. So at this point in time actually more than 50% of the employees are based outside of the U.S.

Matthew Hedberg – RBC Capital

And then, if I could, one quick follow-up on the verticals. You guys obviously talked about good strength across all verticals. I assume the federal government was also a source of -- or in-line at least with expectations?

Charles E. Peters Jr.

I would say the federal government and governments generally are typically in our top verticals. I would say -- I will share more tomorrow at analyst day. I actually have some data I am going to share about the top verticals. Government will be in that list.

Matthew Hedberg – RBC Capital

Great. Thanks.

Charles E. Peters Jr.

Okay.

Operator

Your next question comes from Sarah Friar with Goldman Sachs.

Stephanie Withers – Goldman Sachs

Hey guys. It is actually Stephanie Withers on for Sarah. Most of my questions have been answered so far, but I wonder if -- you clearly did a great job on the cost side this quarter. I wonder if you could quantify for us a little bit the impact of the incentive comp coming back and then did that impact the G&A line as well or can we expect that same kind of level of discipline on the G&A line that we saw this quarter?

James M. Whitehurst

Can you just clarify what you meant by the incentive comp coming back? What do you mean by that?

Stephanie Withers – Goldman Sachs

I thought you mentioned in your prepared remarks that there were some incentive compensation coming back or through-ups [ph].

Charles E. Peters Jr.

No, I don''t think I said that. There was a question earlier on -- one of the earlier questions was, were there any changes in sales compensation this year compared to last year. And sorry -- one thing I did say, maybe there was some confusion -- that it is our intention to do a merit increase for employees as of July 1, 18 months since the last merit increase.

Stephanie Withers – Goldman Sachs

Right.

Charles E. Peters Jr.

I don''t have a quantification of that for this call. But it is -- it does increase costs, increase our performance warrants it or the performance of our people warrants it.

Stephanie Withers – Goldman Sachs

Okay. Great. Thank you.

Operator

And your next question comes from Brad Reback with Oppenheimer.

Brad Reback – Oppenheimer & Company

Hey guys. How are you?

Charles E. Peters Jr.

Hey Brad, how are you?

Brad Reback – Oppenheimer & Company

Good, Charlie, just following up on that vertical question a little bit, I know on the last call -- and you guys have talked about it in the past, trying to grow outside of your four main verticals. Did you have any success there? How is the pipeline looking? Whatever color you can give there would be very helpful?

Charles E. Peters Jr.

I think I sort of may have tangentially hit on it in that the largest deal we had this quarter -- the largest deal in our history was not something in any of our large -- our core largest verticals. So call it a new start in something, maybe something new. We are always looking to get outside of the top verticals. In fact, we have a whole program around mainstream adoption that Jim has talked about -- in fact, others have talked about before, which we continue to push as one of our strategic initiatives.

Brad Reback – Oppenheimer & Company

Great. Thanks very much.

Operator

I would now like to turn the conference back to Mr. McCallum for any closing remarks.

Tom McCallum

That concludes our first-quarter earnings call and thank you again for joining us. We look forward to speaking with many of you tomorrow. If you can''t join us please dial into the webcast. Thank you.

Charles E. Peters Jr.

Thank you very much.

Operator

Ladies and gentlemen, this does conclude today''s Red Hat Q1 2011 earnings conference call. You may now all disconnect.