Red Hat Q4 Earnings Call Transcript

123jump.com Staff
31 Mar, 2009
New York City

The open source software developer fourth quarter revenue grew 18% to $166.2 million riding on record software license sales while earnings dropped 27% to $16 million. Earnings per share were 8 cents against 10 cents in the year ago quarter.

Red Hat, Inc. ((RHT))
Q4 2009 Earnings Call Transcript
March 25, 2009, 5:00 p.m. ET

Executives

Tom McCallum – Vice President, Investor Relations
James Whitehurst – President & Chief Executive Officer
Charles Peters – Executive Vice President & Chief Financial Officer

Analysts

Steven Ashley – Robert W. Baird
Apai [ph] for Heather Bellini – UBS
Katherine Egbert – Jefferies & Co
Kash Rangan – Merrill Lynch
Brent Thill – Citigroup
Adam Holt – Morgan Stanley
Mark Murphy – Piper Jaffray
Sarah Friar – Goldman Sachs
John DiFucci – JP Morgan
Nabil Elsheshai – Pacific Crest Securities
Brent Williams – Benchmark Company
Tim Klasell – Thomas Weisel Partners
Richard Williams – Cross Research
Michael Turits – Raymond James

Presentation

Operator

Good afternoon. My name is Shanel (ph) and I will be your conference operator today. At this time I would like to welcome everyone to the Red Hat quarter four 2009 earnings conference call. All lines have been placed on mute to prevent any background noise. After the speakers'' remarks there will be a question-and-answer session. (Operator instructions) If you’d like to ask a question during this time simply press * then the number 1 on your telephone keypad. If you have already done so please press the pound sign now, then press “*1” again to ensure your question is registered. If you’d like to withdraw your question press the pound key. I would now like to turn the call over to Mr. Tom McCallum, Vice President of Investor Relations for Red Hat, Inc.

Tom McCallum – Vice President of Investor Relations

Thank you operator, hello and welcome to Red Hat''s fiscal fourth quarter and fiscal year end 2009 earnings call. 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 maybe downloaded from redhat.com on the Investor Relations page.

Also on this page you will be able to find an historic reconciliation schedule of GAAP to non-GAAP financial metrics. Various remarks 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, March 25, 2009 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 change. Therefore you should not rely on these forward-looking statements as representing our estimates or views as any date subsequent to today.

With that, I''d like to turn the call over to Jim.

James Whitehurst – Chief Executive Officer

Thank you, Tom and let me add my welcome to all of you joining us on today''s call. Fiscal year 2009 marks my first full-year at Red Hat and I am pleased to report that we delivered solid results for both the quarter and full year in spite of the challenging global economy. We saw strong demand for our solutions across all products and geographies. This drove a solid combination of revenue growth, profitability and cash flow. For FY ''09 we grew revenues by 25%, operating income by 24% while generating over 236 million in operating cash flow.

Three factors continue to make Red Hat the open source leader among customers and partners and this is enabling us to outperform many of our peers and competitors. First and foremost is value. Our value proposition continues to resonate with customers who are looking to cut costs and achieve a rapid ROI. Our price performance proposition is highly attractive during good times and we believe it is even more compelling during difficult economic times. While our existing key customers continue to renew and increase the scope of their commitments to Red Hat, we are also seeing increased interest in buying from approximately 40,000 new customers drawn to our high value low cost product this year alone.

Second, our open source development model, we are the only publicly traded pure play open source software company and are recognized as the leader in collaborative software development. We are true to the open source model because we believe it produces better software for our customers. This has firmly established our brand in the IT community and we have earned a high level of confidence with hardware companies and ISPs as evidenced by our ecosystem, which is the largest in the open source industry.

By adhering to the principles of open source development, we have attracted key contributors and partners to participate and have won loyalty from customers and finally, customer led innovation. In this environment, we are seeing customers who recognize the potential to increase their performance through the use of open source solution. These are the customers who strategically partner with Red Hat and purchase open source technology to weave it into their own value-based business offering. In turn this often helps these innovative customers to differentiate themselves from their competition as they leverage the flexibility, scale and security of Red Hat products. For example, Covad Communications, a leading provider of integrated voice and data communications not only cut costs using our middleware solutions but improve their time-to-market for new products.

Now let me provide you with some highlights from our fourth quarter. We continue to see strong renewals and growth from our top customers. For the quarter, we renewed all of our top 25 deals scheduled to renew this quarter, and they renewed at approximately 132% of the prior year''s value. This growth percentage is being driven by further adoption of virtualization using well advanced platform, as nearly half of the top renewal customers upgraded to or increased the number of RHEL advanced platform servers in their Data Centers. For the year we have added 1,000 as we renewed all of the top 100 deals up for renewal an achievement that we believe is only accomplished with the delivery of significant value to our customers.

Our middleware business also delivered solid results in the fourth quarter, continuing to grow in large accounts. In fact, 30% of our largest 30 deals included a middleware component. We also saw momentum continue to build around our SOA solution, which now has over 75 customers. In conjunction with the Red Hat virtual tradeshow during the quarter, the middleware team announced the availability JBoss Enterprise Portal Platform 4.3, an integrated and standard spaced open source platform for hosting and portal based applications and rich web presences. The team also announced an open source project JBoss MASS to focus on the creation of migration tools and a migration resource center to accelerate the adoption of JBoss Enterprise Middleware. This quarter, we also announced plans for advancing virtualization, as one of only two companies in the world with core virtualization technology integrated with a leading enterprise standard operating system. Our virtualization strategy centers on breaking down barriers for customers to deploy virtualized systems, like cost, performance, scalability and security.

We''ve designed a family of products to drive broad virtualization deployment inside the datacenter, including Red Hat Virtualization Manager for servers, which is a virtual server management system. Red Hat Virtualization Manager for Desktops, which is a VDI management system including a remote rendering technology called SPICE. Red Hat Enterprise Virtualization Hypervisor, which is a standalone small footprint hypervisor that is based on the KVM technology we acquired this year and is targeted at the OEM market. And finally Red Hat Enterprise Linux, which has the integrated hypervisor technology based on KVM and will be available starting with RHEL 5.4.

Virtualization is not new to Red Hat and we recently announced customer case studies where customers have already been reaching and exceeding their goals of reducing costs and lowering carbon footprint with Red Hat''s virtualization solution. Let me give you two examples. First a European real estate listing company reduced energy usage by 25%, hardware costs by 60% and carved out additional operating costs with Red Hat management solution. They realized full ROI in just three months and reported zero downtime with Red Hat virtualization solution. We also announced the Bank of New Zealand reduced power consumption by almost 40% and realized significant ROI with a simpler more efficient deployment. And finally during the quarter, we redeemed the remainder of our convertible debt. We are now essentially debt free with over $846 million in cash and investments and approximately 10% fewer diluted shares than when we started FY ''09. Q4 capped off a solid year for Red Hat and now let me summarize our key accomplishments for FY ''09 that are based on the top priorities I discussed at the beginning of the year.

First to focus our business on our fast growing datacenter infrastructure solutions, which we believe represents a $50 billion market space. This focus has allowed us to further innovate our core RHEL and JBoss products, while launching several new products such as the SOA suite, MRG and Linux on the Mainframe. All of these provide solid incremental growth opportunities in the datacenter and are showing early traction with our customers. In addition we made key acquisitions of Amentra and Qumranet that support our middleware and datacenter strategies. The integration process of both companies has gone very well. We’ve already seen benefits of Amentra on increased sales of the JBoss business and the capabilities added from Qumranet have improved our position in virtualization.

Second, we continue to invest in our own infrastructure to allow us to become more efficient as we seek to scale to the $1 billion revenue level. Some of the improvement in margin we achieved over the last couple of quarters can be attributed to the efficiencies gained in our processes and systems. And third we continue to build out our partner ecosystem including channel partners, major ISPs and tier one systems integrators. We achieved success driving 23% growth in channel bookings in FY ''09 but realized there is an additional opportunity. In FY ''09 we more than doubled the number of partners to approximately 4,500 and our advanced business partner category grew from less than 100 to 350 global partners. We also provided over 2,800 partner training days and increased the number of technicians, engineers and architects that are Red Hat certified in the channel to 2,400.

Now looking at fiscal 2010, our key strategic initiatives are designed to strengthen our long-term growth profile and gain market share in the face of a turbulent macro economic environment. First, we will drive for broader mainstream adoption like expanding our marketing and commercial capabilities around our award winning solutions to address this enormous market opportunity. Second, we will drive for free-to-paid conversions with programs to encourage users without Red Hat subscriptions into our subscription-based value offerings the number of companies trying and experimenting with open source software towards the number buying subscriptions from us.

In other words, there''s a huge market opportunity. No new hardware sales are needed. We are tuning our marketing and sales messages to inform and attract these companies. We have also designed programs to educate our customers on the value and terms of Red Hat subscriptions and ensure compliance with these terms. In Q4 we closed two large deals, one of which was a multi-year, multi-million dollar deal that represented our largest conversion from free-to-paid as well as a six figure conversion deal with another customer. Our third initiative is to further enhance our routes to market distribution model. As I mentioned earlier, we''ve had good success over the last two years with our channels business. In FY ''10 we will continue to build out the channels including a focus on systems integrators and ISVs and relative processes and systems improvement to better scale this part of our business. The fourth and final initiative is to execute on our technology roadmap to enable us to maintain our technology leadership position and drive future sales. For example, bringing the new virtualization offerings to market, as I mentioned earlier, we believe begins to change the game in the virtualization market.

In summary, we are pleased with our fiscal 2009 results in which we clearly gained market share and we remained positive on our outlook for fiscal 2010. There is no doubt that we must operate in the challenging macroeconomic environment that lies ahead, but still based on what we see today, with no debt, a strong cash position, and a contemporary business model based on a recurring subscription model we feel that we are in a good spot to continue investing to strengthen our market position and our long-term growth. The guidance that Charlie will give includes double digit revenue growth, as well as operating margin expansion.

Finally, I want to thank our 2,900 employees for their tireless efforts that delivered these results, and I am confident that they will remain keenly focused on our customers and stakeholders which will further elevate our market leadership position during FY 2010. With that, let me turn the call over to Charlie who will review our financial results and provide additional details on our outlook for fiscal year 2010.

Charles Peters – Chief Financial Officer

Thank you, Jim. We are pleased with our strong finish of fiscal year 2009. Through a combination of consistent sales effort, good operational execution and focused cost management, we performed well across all products and geographies. Last week you got near full about foreign exchange rate volatility from other software companies, so I won''t take a lot of time covering the same ground. Suffice it to say, that with about 47% of our revenue outside the U.S. the dramatic weakening of foreign currencies versus the U.S. dollar since September of 2008 masks the underlying Q3 and Q4 growth rates in local currencies. Nevertheless, our performance this year enabled us to deliver strong financial results, despite the difficult economic environment. These results are highlighted by 25% annual revenue growth, strong growth in operating cash flow, stronger growth in free cash flow, and much stronger growth in both, on view on a per share basis.

Double-digit growth in full year non-GAAP EPS with fourth quarter EPS coming in $0.02 higher than the top of our guidance range. Our results demonstrate once again how our subscription-based recurring revenue model provides superior visibility and predictability for our investors. Turning to the details of our fourth quarter performance, let''s start with bookings and billings, which both set new quarterly records at more than $200 million each. It was also the first time ever that quarterly billings exceeded $200 million. The breadth, depth and geographic diversity of our business was impressive. The strength was broad with thousands of new customers, and deep with many large deals. Here is some color of our top 30 deals. Three were greater than $5 million. 18 were greater than $1 million and over 70% included RHEL advanced platform, that''s RHEL AP and over 30% of the deals had a JBoss component. We also achieved another milestone in Q4 closing over 100 deals greater than $250,000, clearly gaining market share and demonstrating that we are the Linux platform of choice in the enterprise.

I''m asked frequently how our business grows faster than the server growth rate published by certain industry analysts. Here is why. We saw role on mainframes, PCs, workstations, and devices as well as servers. On the server side, our penetration on Blade is disproportionately high and faster growing than servers generally. In addition, many of our customers put our software on their existing hardware, which clearly eliminates the need for a new hardware sale, any new hardware sale at all. And finally, we continue to make progress in our efforts to attract users of Linux that are not Red Hat subscribers, or so-called free-to-pay initiative including conversion from less committed Linux distributions. Again, no new hardware is required. As Jim mentioned earlier, we had two large free-to-paid deals this quarter, one of which made it into our top 30. And of course, we are also experiencing good growth in middleware and management products that is unrelated to hardware sales.

Back to bookings, our Q4 bookings mix was 56% from the Channel and 44% came from direct sales versus a 55:45 split in Q3. The trend of increasing Channel bookings to the highest percent in nearly two years reflects the progress we have made on our key initiatives to build out this route to market as Jim discussed earlier. Geographically, 57% of bookings came from the Americas, 28% from EMEA, and 15% from APAC. There was broad global demand but weak currency rates, particularly in Asia skew the APAC percent down a little. By now it should be clear that our business is solid. However, as I have done in the past, I will add a few additional year end statistics on bookings that would help further demonstrate the point, including some statistics which I have not disclosed before. To be clear, similar to prior years we will not be updating these statistics on a quarterly basis.

First, we had another year of record bookings which after our normal Q4 to Q1 decline grew sequentially every quarter thereafter. Our off balance sheet backlog that is the portion of customer contracts to be billed in the future, grew sequentially and at a higher rate every quarter this year. The balance now exceeds $190 million, up over 50%, from the balance we reported at last yearend.

This sizable backlog along with our deferred revenue balance provides us with better visibility into near-term future performance than many of our peers. Q4 billings were $206 million, an 11% increase over the prior year. On a rolling four quarter average, billings were $188 million, an 18% increase over the prior year fourth quarter average. Billings are calculated by adding revenue to the change in deferred revenue shown on the cash flow statement, which excludes the impact of foreign exchange rates on deferred revenue.

Now, let''s talk about our financial performance starting with revenue. Fourth quarter revenue was $166.2 million, inline with guidance, and 18% higher than last year. Quarterly subscription revenue was $139 million, up 14% from last year. Subscription revenue, which is a recurring revenue stream constituted 84% of total revenue in Q4. Quarterly training and services revenue was $27 million, up 37% as a result of Amentra and growth in our consulting engagements. The sequential decline from Q3 related to the holiday season, which was slightly larger than expected, was likely exacerbated by the effects of the macro economy on training spending. However, we were able to adjust our own expenses down as well, which resulted in improved training margins for the quarter. We continue to be pleased with the quality and the value of our customer training and we were recently recognized as the sole leader in the IDC market space, worldwide IT education, and training 2009 vendor analysis, beating out all other large software vendors. Nearly 38,000 Red Hat certified engineers have been certified by us since we launched the program in 1999.

Continuing on down the income statement, on a non-GAAP basis, excluding stock compensation and amortization expense, overall gross margin was 86% for Q4 essentially unchanged from Q4, last year. Subscription gross margin improved 60 basis points over the year to approximately 94% while training and services gross margin improved approximately 280 basis points from Q4 last year, driven mainly by better utilization and higher gross margins from the Amentra business. Q4 non-GAAP operating expense came in at $103 million, less than a $1 million increase from last quarter. This expense management is the result of actions we started in August to put a more intense focus on discretionary items and to look for innovative ways to reduce expenses while still maintaining investments in our business. It is also partially a result of the process and system improvements, we made earlier in the year and which are continuing.

Weak foreign currencies also reduced expenses compared to Q3 by approximately $600,000, principally in R&D. One example of an innovative expense saving was a highly successful full day virtual trade show we held for our middleware business. At a significantly lower cost than a traditional trade show, we were able to attract more than 2,500 individuals to learn more about our offerings. Q4 non-GAAP operating income was $40 million, increasing 27% compared to last year. This represents an operating margin of 23.9%. It is 180 basis points better than last year and 70 basis points better than last quarter. Moving on, other income net, which is attributable primarily to investment income, was $5 million, inline with our guidance but substantially lower than last year and last quarter both of which included one-time gains and higher interest income.

Our non-GAAP tax rate, which reflects actual cash taxes that we expect to pay, is still approximately 5%. Our non-GAAP diluted earnings per share were $0.22, which was $0.02 better than the high-end of our guidance range for the quarter. To briefly address highlights for the income statement for the full year, revenue grew to $653 million, a 25% increase. Subscription revenue grew to $541 million, an increase of 20%. Non-GAAP operating income grew to $148 million, an increase of 24%. Other income, which is primarily interest income fell $15 million to $39 million as we used cash for acquisitions and to buy back Red Hat stock and retire all of our convertible bonds. And of course the substantial decline of interest rates also was a major factor. The $15 million reduction in other income is comprised of a drop of $20 million in net interest income, which is partially offset by other gains. As I talk about cash flow later, keep in mind that interest income is included in operating cash flow and other gains are not. Non-GAAP EPS for the full year was $0.86, an increase of 12%.

Now let''s turn to the balance sheet and the cash flow statement. We ended the year with $846 million in cash and investments after redeeming all $570 million of our convertible bonds and repurchasing 2.9 million shares of our common stock over the course of the fiscal year. We are now debt free, and we have eliminated approximately 22 million diluted shares or over 10%. DSO was 57 days versus 60 days last year, and we are very pleased with the consistency of this metric. 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. Total deferred revenue at quarter end was $543 million, an increase of $70 million or 15% over the prior yearend. The increase was $43 million in current deferred revenue and $27 million in long-term deferred revenue. Excluding the foreign currency rate change the year-over-year change in deferred revenue was actually $98 million which you can find on the statement of cash flows.

Moving to the statement of cash flows, cash flow from operations was $60 million for the quarter and $236 million for the full year. For the full year this is a 16% absolute growth or 22% on a per share basis due to the substantial reduction in diluted shares. Because CapEx was only 24 million this year, the increase in free cash flow per share was even more impressive at 38%. Again, keep in mind we achieved this growth in the face of a $20 million reduction in net interest income for the year. Now, before turning to guidance, let me remind investors about how we are calculating non-GAAP results beginning in fiscal 2010. For fiscal 2010 income statement, I will provide the same non-GAAP adjustments to pre-tax income as in the past. Pre-tax, we adjust for only two items, which are stock compensation expense and amortization of intangibles.

As I mentioned last year, starting in fiscal year 2010 that is the fiscal year, which began on March 1, 2009, we will be reporting non-GAAP results using the same tax rate, which we used for GAAP reporting and we have good news here. Due to better than expected tax planning, we are now forecasting an effective annual GAAP tax rate of 35% for the coming year, rather than the 39%, which I had previously guided and which is built into most models.

We will report non-GAAP net income and EPS using a 35% tax rate in Q1, and will adjust historic comparisons accordingly, so that all periods reflect the GAAP tax rate. The historic reconciliation is available on our Investor Relations website. As I stated in the past year, this change will have virtually no impact on GAAP operating cash flow. More good news, for information only, we now expect our cash tax rate to be about 5% throughout fiscal year that we are now in, as a result of approximately $80 million of remaining NOLs and other tax credits carry forwards.

Let me now turn to guidance, I realize that many others have stopped providing guidance or limited what they provide. We feel that we are in the best position to give an indication of our outlook. But we realized that the global economic situation and the volatility of exchange rates among other things make forecasting this year especially challenging. With that in mind, I offer the following as guidance based upon foreign exchange rates approximately where they were yesterday, and based on our present view of the macroeconomic environment. We expect double digit revenue growth in both constant currencies and U.S. dollars. Although, the apparent U.S. dollar growth rate is likely to be somewhat muted through the end of the August quarter because of difficult foreign exchange comparisons last year we are forecasting total revenue in the range of $720 million to $735 million for the fiscal year of 2010, representing an annual growth rate of between 10% and 13% in U.S. dollars.

We believe that we can expand our full year non-GAAP operating margin by approximately 100 basis points, while also investing in future growth opportunities. You should expect substantially lower other income again due to lower investment balances and much lower interest rates. For purposes of guidance, I am estimating a further reduction of approximately $20 million in net interest income, which will result in net other income of approximately $3 million per quarter. For those of you building models, keep in mind that this reduction affects both income and operating cash flow. I have seen models that seem to have overlooked this. Assuming a 35% tax rate, and approximately 195 million diluted shares, one would estimate diluted non-GAAP EPS in the range of $0.58 per share to $0.62 per share for the full year fiscal 2010. On a GAAP basis, we estimate quarterly stock compensation expense of approximately $13 million and amortization expense of $5 million.

From a cash flow perspective, we anticipate operating cash flow for the full year of between $240 million to $250 million, which incorporates the assumptions about growth in operating income offset by the assumed $20 million reduction in net interest income as previously discussed. Since the diluted share count is expected to decline significantly again from 211 million in fiscal year 2009 to approximately 195 million in fiscal year 2010, or 8%, you may wish to consider cash flow on a per share basis in addition to more traditional measures. I would expect that we will produce $30 million to $40 million of additional cash this year, not included in our operating cash flow, which is related to tax savings from usage of NOLs which originated from stock compensation deductions. This will be recorded in our cash from financial activities line item as it has been for the past several years.

CapEx is expected to be relatively consistent with last year at $25 million to $30 million, meaning that free cash flow per share will also stay strong due to the expected lower share count. Finally, looking at Q1, we offer the following guidance. Revenue is estimated to be between $171 million and $173 million. Non-GAAP operating margin is estimated to be approximately 23%. Other income net is estimated at around $3 million and non-GAAP EPS is estimated to be approximately $0.13 a share to $0.14 a share. In summary, we are pleased that our recurring revenue model has helped us to continue driving solid financial results. We firmly believe that we have the opportunity to grow our business as open source gains further adoption among enterprise customers, and Red Hat continues to gain market share.

We will continue to prudently manage our expenses and investments during fiscal 2010. Even in this difficult macro economic environment, we are targeting double digit revenue growth, improving our operating margins and increasing cash flow per share.

Operator, I''d now like to turn it back to you for the first question.

Question-and-Answer Session

Tom McCallum

For today''s question-and-answer period we will be asking everyone to limit themselves to one question and one follow up question, please. We have a lot in the queue. Thank you. Operator, you can go ahead and poll the audience for questions.

Operator

Your first question is from the line of Steve Ashley with Robert W. Baird.

Steven Ashley – Robert W. Baird

Hi, thanks. I''d actually like to talk about the virtualization business. You talked about the strong renewals, 132% being driven by the virtualization. Is there anything more you could tell us about what kind of adoption rates you are seeing for virtualization and what is driving that in the customer''s eyes? Thanks.

Charles Peters

To be clear, it''s driven by AP and a lot of AP is driven by the benefits around virtualization. Unfortunately, all we have is really anecdotal from discussing with our channel partners and with our sales force on why people are picking AP. So again we know what the rate of AP adoption is and so we can guess on why. We are just seeing continuing interest in virtualization as a way to save on number of servers and power et cetera, et cetera. So clearly, strong interest there and since our recent announcement clearly increasing interest.

Steven Ashley – Robert W. Baird

And just a quick follow up on the free-to-fee business. We are trying to understand the opportunity there. Is this a situation where someone is using RHEL and they are supposed to be paying for it and they are not paying for it? Or is this something where they are using Fedora and you are simply pointing out the value proposition of migrating them over to the paid RHEL? Thanks.

James Whitehurst

We had two different situations this quarter, Steve, both relate to the operating system. And one was a customer that was trying to just to do their own and realized it was too expensive to support their own and much better value and less money to buy a subscription. And another situation was one in which there was a customer situation where they reported more than they actually originally had paid for.

Charles Peters

Okay. One other note quickly, Steve. And I was down in Latin America last week, and you know, frankly probably the majority of our deals of a material size are all free-to-fee. These are all customers who are currently running some community additions and as they get larger and start moving it into more mission critical applications they want support. So it really depends on where in the world and many different circumstances.

Steven Ashley – Robert W. Baird

Thanks.

Tom McCallum

Next question, please.

Operator

Your next question is from Heather Bellini with UBS.

Apai – UBS

Hi, this is Apai [ph] for Heather. You talked about I think about half of the renewal customers upgraded to the AP version. Now, what percent of your total install base has moved to this product and at what level of penetration do you think you can get towards that?

James Whitehurst

The answer is background, historically about 70% of the RHEL customers are on the ES version, sort of the mid-range version and over time, the customers have been moving to RHEL 5 and either the standard level or advanced platform. The statistic of the 50% of renewals including an AP component, I think is indicative of the type of movement we are seeing in terms of where we are overall, probably more a higher percentage of new customers go there to begin with.

Apai – UBS

Got you, so now you have less than 70% on ES and more on AP?

James Whitehurst

That is true.

Apai – UBS

Okay. Thanks.

Operator

Your next question is from the line of Katherine Egbert with Jefferies.

Katherine Egbert – Jefferies & Co

Hi. Good afternoon. I want to talk about your non-GAAP operating margin. I mean it was up pretty nicely here in February. You have got it down a little bit for the May quarter. Can you tell us what you think steady state is in and if steady state is going to continue its improvement or not? Thanks.

Charles Peters

If you mean, Katherine, what are the success goals beyond the one year, the goal for this coming year is approximately 100 basis points improvement and I think that there is an opportunity for continuous improvement beyond that. So it''s not, we''re not thinking about flat operating margins. In terms of specifically Q1 we continue to invest in sales including sales training and so there are some cost in Q1 that relate to that but take it down a bit in Q1.

Katherine Egbert – Jefferies & Co

Okay, thanks, Charlie that''s perfect and then just as a follow up. Can you talk about the opportunity in VDI? Jim you mentioned in your prepared comments some wins around that? And then may be just make a comment on what you think about the network market? Thanks.

James Whitehurst

Sure. On VDI, quite frankly, we expected that market to develop very slowly and so we guided revenue around from that we''re really thinking more on the server side. It is still a nascent market, so I don''t have a good number, but I would say we are very pleasantly surprised at the amount of interest that''s coming to us in VDI. So I think that market is certainly developing faster than we thought. Again it''s very, very small base, so hard to come up with the number but we are very, very pleased with that. In terms of the network market, we are not a real player in the consumer space. We are an enterprise company providing enterprise support and so we really aren''t a player in that space. There are netbooks that are based on our Fedora distribution which is great, but in terms of part of our core business model we currently don''t play there.

Katherine Egbert – Jefferies & Co

Okay, thanks. Good job.

Tom McCallum

Next question please.

Operator

Your next question is from the line of Kash Rangan with Merrill Lynch.

Kash Rangan – Merrill Lynch

Hi thank you very much. I apologize for the overhead noise here and also sorry if this question has been asked. Jim and Charlie, I was wondering, if you could comment about how you, what''s your take on the IBM proposed acquisition of Sun. How that might impact your relationship with IBM? Does it strengthen it or really not change it at all given the open scenarios initiative that Sun has got going out for some time? And also secondly, I''m assuming that did you probably look at the server unit growth rates that IDC has been putting out. I know that they have certain other levers that can help your model, but I''m wondering what the underpinning assumption is behind your billings and cash flow projections as you model out server unit growth. What kind of server unit growth rate decline are you modeling behind your cash flow and bookings assumptions, I was just curios. Thank you very much.

Charles Peters

With regards to the rumors on IBM and Sun, at this point the rumors and…so right now we are keeping our head down both serving our customers, obviously we have relationships with both IBM and Sun. But right now we are worried about serving our customers. And we will see what happens there as we get more time free.

Kash Rangan – Merrill Lynch

No, no I understand. But assuming that it were to go through, how would you or what''s your thought process in mind, which is sort of game plan if it goes through, how would you approach the industry?

James Whitehurst

Yes. It''s a hypothetical question. We will have to deal with it whenever comes to fruition. Let me answer your second question about the growth rate, which is, we use many inputs in billing our model, one of which is estimates by various sources about server growth. But as I said, our growth has many components, far beyond servers and other types of devices that are computers that Linux is on, middleware management, not to mention the free-to-pay. So, it''s just one factor of many. I would say since neither one of us said it in the prepared remarks that our pipeline looks good, quite strong. Our deferred revenue is strong, our backlog is strong. So, therefore our visibility looks pretty good at this time. I don''t know, we also do a bottom up build from our sales force with Korus [ph] and so that''s a nice check on any top down numbers. So, again, our reasons are pretty tight because we''re pretty confident in our view of demand.

Tom McCallum

Thanks. Next question please.

Operator

Your next question is from the line of Brent Thill with Citigroup.

Brent Thill – Citigroup

Thanks. Charlie if you can just go back to the deferred revenue and billings, you''ve seen a pretty sharp decline year-over-year in the growth rate. Can you just give us sense? Obviously, you grew 25% last year, now you are guiding 10% to 13%. But when you look at the billings and your pipeline, do you expect this to stabilize now and grow from this level? Or how do you reconcile what''s happening with the growth rate on both deferred…?

Charles Peters

I think that the easiest way to answer that question is to look at the guidance I provided on operating cash flow. The only way that one could provide the guidance on operating cash flow and particularly in the face of another 20 million decline in interest income, would be some assumptions about growth in deferred revenue and billings and probably backlog again for the year.

Brent Thill – Citigroup

Okay. And Jim, I guess a number of tech companies have indicated in the last couple of months that they are seeing some form of stabilization in the environment versus what we saw last fall when markets were in a free fall? Can you just comment at a very high level, what customers are saying to you at this point versus what you saw last fall?

James Whitehurst

We luckily never quite saw that same dip. We''ve seen a lot of interest from customers in open source as their budget have gotten tight. We see that interest continuing and a lot of discussions started then are just now coming to fruition. So, I haven''t seen real reduction in tight budgets. Maybe there is not the same quite level of desperation in people''s voices but budgets are tight this year. Budgets are set and we think that''s good for us at open source.

Brent Thill – Citigroup

Great, thanks a lot.

Tom McCallum

Operator, next question please.

Operator

Your next question is from the line of Adam Holt with Morgan Stanley.

Adam Holt – Morgan Stanley

Good afternoon. You mentioned you had a lot of success renewing the largest customers that came up for renewal in the quarter. I was hoping you could comment on what renewal rates were like outside of the top 25 for the rest of the companies that came up for renewal both in terms of the percentages and of the dollar value as well. And then just, if you look at the quarter, what was the sort of the rough mix between renewals and new billings in the fourth quarter?

Charles Peters

The first thing is on the renewal rate it continues to get better based upon all of the work we''ve been doing really over the last couple of years, which we''ve discussed before. Most of which has to do with gathering information about the end customer in various ways if we sell it through the channel. Business that we sell direct where we have the information, we have a very high renewal rate, so nothing really new to report other than continuous incremental improvement. Relative to the mix of renewals versus new business, as Jim said, we had 40,000 new customers during the year. It''s a very large number. Some of those customers would clearly make it into the top 30 list that we talk about each quarter. But the vast majority, are going to be customers that are starting off small. They may be could be as small as one subscription to as much as five or 10 that eventually grow over time.

Adam Holt – Morgan Stanley

And if I could just ask one quick follow up on the, on some of the large sales your getting from converting people from free-to-pay particularly around the customer audit program. Now that you are into that a couple of months, I know it''s still early, but do you have any sense for how big you think the opportunity is within your install base of people that are either abusing and not fully paying or can be converted to a bigger contract?

James Whitehurst

Frankly, I think the bigger opportunity is people who are trying to support their own open source, hiring engineers and trying to put and do their own support and finally coming to the realization that it is very expensive. It’s probably not as…doesn''t have the same value as buying a subscription from us. I do think in some cases that mostly inadvertent I think some customers may have deployed more than they should have but I don''t think that''s the biggest opportunity.

Adam Holt – Morgan Stanley

Terrific thank you.

Operator

Your next question is from the line of Mark Murphy with Piper Jaffray.

Mark Murphy – Piper Jaffray

Thank you, just a follow up question on the free-to-pay conversion rates. Any sense for what that conversion rate is, and is 10% a descent guess? And then any sense on how that would trend in this fiscal year and what types of actions can you take to accelerate that pace?

Charles Peters

On the free-to-pay at this point if you mean if the conversion rate is at 10% of the total billings, the answer would be certainly no.

Mark Murphy – Piper Jaffray

No, Charlie. I actually mean, sorry I wasn''t clear on that. If you look at the number of unpaid RHEL servers in the marketplace, what percentage of those do you think are converting to paid annually?

Charles Peters

Oh I see. Yes, it''s, at this point it would be a very small percentage only because we''ve just begun really in the last probably four months or five months. There''s a fair amount of work that we are doing including some marketing and sales work here that I think will help it accelerate but it is still amazing effort for us but we think a very large potential.

Mark Murphy – Piper Jaffray

And then Charlie as a follow up, what is the expected FX impact to revenue in FY ''10 in percentage terms or in other words kind of the spread between constant currency and U.S. dollar growth?

Charles Peters

For our fiscal year ''10, if you assume the rates for yesterday as I mentioned, the rates yesterday interestingly enough were reasonably close to the rates in Q4 and reasonably close to the rates in Q3 of this past year, where there was a big difference is in Q1 and Q2 of last year. The euro rate was around 1.54 to 1.56 and the rate over the last couple of days here on the euro was 1.35 to 1.36. So, that would be a pretty sizable difference on the euro for the first two quarters. Hence in my remarks I said through the August quarter, the currency comparisons would be difficult.

Mark Murphy – Piper Jaffray

Okay. So Charlie, if you net that out for the year, what is that, a couple or a few points?

Charles Peters

I don''t have that for the phone call. Maybe we can follow up on that.

Mark Murphy – Piper Jaffray

Okay. Thank you.

Tom McCallum

Next question, please.

Operator

Your next question is from the line of Sarah Friar with Goldman Sachs.

Sarah Friar – Goldman Sachs

Thanks for taking my question. Charlie, just a quick question on duration of deals, I know you don''t normally call it out unless there was a change. But are you seeing shifting in customers maybe wanting to either buy a bigger amount for a longer period to lock in a price or alternatively to try and save some up front cash by trying to go for shorter.

Charles Peters

Although, there was really no substantial change in duration, we''re still at around 23 to 24 months as the average duration. I can tell you or the unasked question is about the pricing, pricing continues to be consistent. Our discounting philosophy approach and level is consistent and has been consistent for the last several years. But the duration has actually gotten a little bit longer, a couple of months longer over the last 18 months from somewhere from where it was around 22 months now its about 23 months, 24 months.

Sarah Friar – Goldman Sachs

Got it, very helpful and then a quick follow up for you Jim, if you don''t mind on VDI, what do you think that, as you look at 2009, in terms of deployment, what gets people from pilots into larger scale deployments? And maybe the other way to ask it is, what''s the gating factor? Is it costs? We don''t have budget yet or is it that the technology is still from mainland?

James Whitehurst

It is much more of the technology proving itself out. We feel very good about our solution, but it''s got to get through the trials and get people there. Especially, with our SPICE protocol, we are far ahead in our ability to bring a kind of real-life experience with video that others can''t. But still, it''s just a matter of some time to go through the POCs and before we move into the roll out.

Sarah Friar – Goldman Sachs

Got it, okay. That''s helpful. Thank you.

Tom McCallum

Next question, please.

Operator

Your next question is from the line of John DiFucci with JP Morgan.

John DiFucci – JP Morgan

Thank you. Charlie, it sounds like business momentum was good this quarter, especially, given the macro backdrop but, what accounted for the big sequential increase in prepaid expenses and other long-term liabilities? And it doesn''t look like it is a seasonal effect. And again, business looks like it was pretty good but it doesn''t, especially, what''s happening out there. But on a seasonal basis it doesn''t look like it was that much better where you''d sort of expect that.

Charles Peters

One other thing that always kicks in and it is one of the factors at the end of the year is prepaid commissions. The only item that we defer, the only expense that we defer and amortize that''s related to the subscription model is sales commissions. Our fourth quarter sales commissions are generally quite a bit higher than they are in the rest of the year and those would go into a prepaid expense. They also probably would be in the accrual item at the end of the year, and then they are amortized over the period of the subscription. The other items in the long-term obligations are probably long-term deferred tax items.

John DiFucci – JP Morgan

But even on the commissions, I mean, you had a…it looks like about a $21 million sequential up-tick in prepaids and other and that''s just a lot more than I mean last year it was flattish, the year before up a little bit, 5 million, the year before actually down, no not down, up 1 million or so. Is there anything else in there that''s anything happening there, to help us understand that a little better?

Charles Peters

I think it''s mostly going to be taxes. It''s the way that deferred taxes, assets and liabilities are accounted for is going be the biggest thing.

John DiFucci – JP Morgan

Okay.

Tom McCallum

Operator, next question please?

Operator

Your next question is from the line of Nabil Elsheshai with Pacific Crest.

Nabil Elsheshai – Pacific Crest Securities

First on the JBoss, you talked about the tax rates for the large deals. But I was wondering if you can talk a little bit about standalone sales for JBoss and what kind of traction you are getting there?

James Whitehurst

As we have talked about, JBoss continues to grow much faster than the core business. And we continue to see success really around the world in all regions. Both with the application server, as well with some of the new products like the SOA suite. So, we''re continuing to see momentum.

Nabil Elsheshai – Pacific Crest Securities

Okay and then, you mentioned pricing being stabilized. But I believe Novell mentioned the possibility of getting more aggressive on the pricing in SUSE. Have you seen that? How much do you guys compete or overlap with them, where that could cause short-term pricing pressure?

James Whitehurst

So just a comment on that, we compete against free all the time, and so it doesn''t get anymore aggressive or cheaper than free. In the case of the Microsoft/Novell arrangement, where Microsoft has prepaid, they basically have free certificate. So, I''m not clear how to get more aggressive than that. And I think the rest of our results kind of speak for themselves.

Nabil Elsheshai – Pacific Crest Securities

Great.

Tom McCallum

Next question please, operator.

Operator

Your next question is from the line of Brent Williams with Benchmark Company.

Brent Williams – Benchmark Company

Excuse me, I wanted to look at you mentioned the JBoss migration package that open source is being developed in conjunction with community. What specific platforms do you think are the lead choices and where are the pieces already built? How much of that depends on contributions from the community? In other words, is this sort of signaling that you are really moving more aggressively to migrate potentially customers from non-open source application servers, you know what I mean?

James Whitehurst

Obviously if, well, a lot of JBoss business is people migrating over to save money on license fees. And this is really about building a community not just around feature functionality, but around actual migration. So it''s a way to get customers involved to help solve their own problems. It''s not specifically designed to go after any particular other application server. It''s really collecting tools and best practices and technologies, regardless of where someone is moving from. Again, it is really not meant to be targeted at other application servers as much as it''s really meant to help our customers implement our products.

Brent Williams – Benchmark Company

Okay. And then the follow up is you mentioned that one of your free-to-pay deals the large one was somebody who had their own Linux distribution, and then moved to a commercial one. Would that be perhaps a very quiet civilian agency in Maryland or Virginia that''s affiliated with the Defense Department? And if it''s a government agency does that really have any broader implications for Linux adoption in the government?

James Whitehurst

We don''t have any, obviously specific identification of any of these customers. But I can tell you that open source and RHEL, specifically, is well adopted in the government, not only U.S. government but state and local government and foreign governments and it''s very popular. So, the government markets are very good one for us.

Brent Williams – Benchmark Company

Right, I am just looking at given the expense and the difficulty. Obviously, there is somebody who has some pretty good technical jobs to maintain their own distribution. I am just trying to figure out if there is among that relatively small number of customers, doing that is that a trend that we should look for more of?

James Whitehurst

I think, it''s probably, its either small customers…small number of customers are doing, or customers that are foolhardy trying to do it.

Brent Williams – Benchmark Company

Okay.

Tom McCallum

Next question please.

Operator

Your next question is from the line of Tim Klasell with Thomas Weisel Partners.

Tim Klasell – Thomas Weisel Partners

Yes. Good afternoon guys and congrats on the quarter. I am wondering if you could give us just a little bit better color on the Qumranet acquisition. How that did during the quarter as far as revenues are concerned?

James Whitehurst

I''ll pick that up, Tim. First of all, the integration has gone very well, and that you''ve heard a series of virtualization announcements from us over the last month or so, which is indicative of lot of the progress made by the guys from Qumranet and others. But we do not break out anything specific about the results of Qumranet.

Tim Klasell – Thomas Weisel Partners

Okay. And just have a follow on to the final question. Has there been a change in your JBoss pipeline per se? If you are talking about making migration obviously off of other proprietary application servers. In the past, was it primarily a green field opportunity, new applications being deployed and now are we beginning to see more migration, is that a signal there?

James Whitehurst

I think the pipeline remains strong, but I don''t know that there is any – necessarily any major change. We are seeing situations where some customers are asking about migrations off of proprietary platforms, but and maybe a little bit more than before. But that''s about all.

Tim Klasell – Thomas Weisel Partners

Okay.

James Whitehurst

There are some customers who with the dislocation around partners and others around the BEA-Oracle merger, that have wanted to look at alternatives.

Tim Klasell – Thomas Weisel Partners

Okay, great and then percentage of bookings greater than a year?

James Whitehurst

Yes, I will have to follow up with you on that, because we have to get on to the next couple of questions in a few minutes.

Tom McCallum

Next question operator.

Operator

Your next question is from the line of Richard Williams with Cross Research.

Richard Williams – Cross Research

Hi. Thanks for taking the question. Could you give us a little more color on the geographies, please?

James Whitehurst

I think what I said in my remarks is really all geographies were strong. In terms of the percentage for APAC which was 15% of the bookings. It looks a little bit lower but its primarily because of the currency situation in APAC, so really globally, we had pretty good performance.

Richard Williams – Cross Research

Okay. And as a follow up, have you seen any significant change in the length of the sales cycle? Thank you.

James Whitehurst

Not really. I think that one of the things of a tight budget is people really are scrubbing and some times it maybe an extra layer of management but it really has not changed the length of our sales cycle in any meaningful way.

Charles Peters

I have one comment as we do more middleware obviously that sales cycle is longer and so on average maybe its going up but it is a mix between middleware versus platforms. I don''t think there is a change in either one.

Tom McCallum

Operator, we have time for one more question and after that, Jim is going to provide us with some quick summary comments.

Operator

Yes. So your final question is from the line of Michael Turits with Raymond James.

Michael Turits – Raymond James

Hey guys, thanks. Charlie when you talked about the offsetting factors, the decline in server shipments listed about four of them in your talk. Can you think in order and then tell us, which are really the major ones that are contributing, because some of them are there but maybe not as big?

Charles Peters

I''d say one of the big ones is the – maybe the last comment I made which is the fact we have a disproportionately high share of VoIP servers which is growing faster than servers generally. In addition, it is kind of hard to quantify is that we do sell RHEL on other types of workstations, PCs that don''t get picked up in the server count in these various external surveys. And so that is probably the second devices and then mainframes are probably I''m not sure if it is in that order but are lesser and lesser important.

Michael Turits – Raymond James

And then, what about the repurposing as well as free-to-pay, are those next inline and are they material or are they just small factor?

James Whitehurst

I think the repurposing actually is probably relatively meaningful and I don''t know that we always know for certain, how to quantify that. The free-to-pay as I said before, it is a nascent activity for us about five months old. We''ve got some real focus on it and we think that there is some real traction to gain there but it still early.

Charles Peters

And frankly, we don''t have perfect data on this. We will have a customer come in and buy, $300,000 worth of RHEL. How much of that replacement versus new servers? We may not necessarily know. So, we are kind of in the weeds doing bottom up forecasting and then kind of backing back into it. So, it is a little bit of all of those. It is hard to kind of stress it down to the specifics.

Michael Turits – Raymond James

And although you mentioned attach rates on AP, what about an aggregate, what in aggregate is happening with ASPs for server? Are we seeing that flat increase? Where is that going?

Charles Peters

As I said before the pricing philosophy really hasn''t changed nor has our discounting philosophy. We do some times discount for large deals and some times for term or other things. But overall, no major change. AP is just specifically AP when someone upgrades from the old ES version to AP it is almost because of the higher value of the product they''re going to pay a higher price for it so that does help the ASP.

Michael Turits – Raymond James

Alright, thanks.

James Whitehurst

And Charlie, just to wrap up with a few comments, for a few thoughts to leave you with, first of, again to emphasize on guidance for FY ''10 we’re guiding to double digit revenue growth with a 100 basis points improvement in operating margins. Second, market share our record billings, bookings, off balance sheet growth, customer growth as well as top deals this quarter, which included a milestone of over 100 deals greater than $250,000, show we are gaining market share in this environment. Third, balance sheet, we are now essentially debt free with a healthy cash balance and 10% fewer shares than we started the year. For 2010 we are guiding up to 20% increase in unlevered operating cash flow per share. And lastly, our business model, this provides us with visibility and predictability as approximately two-thirds of our subscription revenue guidance will come from deferred revenues and off balance sheet backlog.

Alright, with that, we appreciate you all joining us on the call today. Thank you.

Tom McCallum

Thank you, operator.

Operator

Ladies and gentlemen, this does conclude today''s conference call. You may now disconnect.