Red Hat Earnings 2019-05-31

Red Hat Earnings 2019-05-31

RHT 10Q Quarterly Report

Balance Sheet	Income Statement	Cash Flow
Assets, Equity	Rev, G Profit, Net Income	Ops, Inv, Fin

Document

Table of Contents

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)



x	QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended May 31, 2019



¨	TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from to .

Commission File Number: 001-33162

RED HAT, INC.

(Exact name of registrant as specified in its charter)



Delaware	06-1364380
(State or other jurisdiction of incorporation or organization)	(I.R.S. Employer Identification No.)

100 East Davie Street, Raleigh, North Carolina 27601

(Address of principal executive offices, including zip code)

(919) 754-3700

(Registrant’s telephone number, including area code)



Securities registered pursuant to Section 12(b) of the Act:
Title of each class	Trading Symbol(s)	Name of each exchange on which registered
Common stock, $0.0001 par value	RHT	New York Stock Exchange

Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No ¨

Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files). Yes x No ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act.

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ¨

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ¨ No x

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date:

As of June 27, 2019, there were 178,093,007 shares of common stock outstanding.

Table of Contents

RED HAT, INC.



		Page
CAUTIONARY NOTE ON FORWARD-LOOKING STATEMENTS		3

	PART I FINANCIAL INFORMATION
ITEM 1:	FINANCIAL STATEMENTS
	Consolidated Balance Sheets at May 31, 2019 (unaudited) and February 28, 2019 (derived from audited financial statements)	4
	Consolidated Statements of Operations for the three months ended May 31, 2019 (unaudited) and 2018 (unaudited)	5
	Consolidated Statements of Comprehensive Income for the three months ended May 31, 2019 (unaudited) and 2018 (unaudited)	6
	Consolidated Statements of Cash Flows for the three months ended May 31, 2019 (unaudited) and 2018 (unaudited)	7
	Notes to Consolidated Financial Statements (unaudited)	8
	NOTE 1—Company and Merger Agreement
	NOTE 2—Summary of Significant Accounting Policies
	NOTE 3—Accounts Receivable
	NOTE 4—Leases
	NOTE 5—Identifiable Intangible Assets
	NOTE 6—Deferred Selling Costs
	NOTE 7—Derivative Instruments
	NOTE 8—Income Taxes
	NOTE 9—Convertible Notes
	NOTE 10—Commitments and Contingencies
	NOTE 11—Legal Proceedings
	NOTE 12—Stockholders’ Equity
	NOTE 13—Deferred Revenue and Performance Obligations
	NOTE 14—Earnings Per Share
	NOTE 15—Share-based Awards
	NOTE 16—Assets and Liabilities Measured at Fair Value on a Recurring Basis
	NOTE 17—Segment Reporting
	NOTE 18—Business Combinations

ITEM 2:	MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS	31
ITEM 3:	QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK	45
ITEM 4:	CONTROLS AND PROCEDURES	47

	PART II OTHER INFORMATION
ITEM 1:	LEGAL PROCEEDINGS	48
ITEM 1A:	RISK FACTORS	48
ITEM 2:	UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS	70
ITEM 6:	EXHIBITS	71

SIGNATURES		72

Table of Contents

CAUTIONARY NOTE ON FORWARD-LOOKING STATEMENTS

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

Table of Contents

PART I

ITEM 1.
FINANCIAL STATEMENTS

RED HAT, INC.

CONSOLIDATED BALANCE SHEETS

(in thousands—except share and per share amounts)



	May 31, 2019 (Unaudited)			February 28, 2019
ASSETS
Current assets:
Cash, cash equivalents and restricted cash	$	2,295,396		$	1,883,096
Investments in debt securities, short-term	177,625			293,361
Accounts receivable, net of allowances for doubtful accounts of $4,452 and $4,561, respectively	529,115			980,188
Prepaid expenses	250,571			282,507
Other current assets	36,743			24,504
Total current assets	3,289,450			3,463,656
Property and equipment, net of accumulated depreciation and amortization of $331,642 and $316,432, respectively	200,015			198,969
Operating right-of-use assets, net ⁽¹⁾	224,371			—
Goodwill	1,273,494			1,276,853
Identifiable intangibles, net	198,914			206,083
Investments in debt securities, long-term	188,172			248,512
Deferred tax assets, net	119,128			112,568
Other assets, net	80,395			81,648
Total assets	$	5,573,939		$	5,588,289
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Accounts payable and accrued expenses	$	458,456		$	491,259
Deferred revenue, short-term	2,016,488			2,161,206
Other current obligations	256			282
Convertible notes	188,553			69,827
Total current liabilities	2,663,753			2,722,574
Deferred revenue, long-term	781,043			821,218
Convertible notes	—			231,540
Operating lease liabilities ⁽¹⁾	188,133			—
Other long-term obligations	183,074			199,025
Commitments and contingencies (NOTES 10 and 11)
Stockholders’ equity:
Preferred stock, $0.0001 per share par value, 5,000,000 shares authorized, none outstanding	—			—
Common stock, $0.0001 per share par value, 300,000,000 shares authorized, 246,289,980 and 244,402,737 shares issued, and 178,083,153 and 176,800,502 shares outstanding, respectively	25			24
Additional paid-in capital	2,853,105			2,791,895
Retained earnings	2,195,189			2,054,069
Treasury stock, at cost, 68,206,827 and 67,602,235 shares, respectively	(3,242,725		)	(3,189,434		)
Accumulated other comprehensive loss	(47,658		)	(42,622		)
Total stockholders’ equity	1,757,936			1,613,932
Total liabilities and stockholders’ equity	$	5,573,939		$	5,588,289

_______


⁽¹⁾	Effective March 1, 2019, the Company adopted Accounting Standard Update 2016-02, Leases (Topic 842) (“ASC 842”). See NOTE 2—Summary of Significant Accounting Policies and NOTE 4—Leases for detailed information on adoption of ASC 842.

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

Table of Contents

RED HAT, INC.

CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands—except per share amounts)

(Unaudited)



	Three Months Ended
	May 31, 2019			May 31, 2018
Revenue:
Subscriptions	$	814,952		$	711,521
Training and services	119,159			102,009
Total revenue	934,111			813,530
Cost of revenue:
Subscriptions	61,899			52,173
Training and services	82,384			70,526
Total cost of revenue	144,283			122,699
Gross profit	789,828			690,831
Operating expense:
Sales and marketing	394,201			348,815
Research and development	182,961			166,506
General and administrative	80,548			63,354
Total operating expense	657,710			578,675
Income from operations	132,118			112,156
Interest income	9,254			7,834
Interest expense	1,959			6,319
Other expense, net	766			2,194
Income before provision for income taxes	138,647			111,477
Benefit for income taxes	(2,473		)	(1,713		)
Net income	$	141,120		$	113,190
Net income per share:
Basic	$	0.80		$	0.64
Diluted	$	0.76		$	0.59
Weighted average shares outstanding:
Basic	177,400			177,302
Diluted	186,635			190,739

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

Table of Contents

RED HAT, INC.

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

(in thousands)

(Unaudited)



	Three Months Ended
	May 31, 2019			May 31, 2018
Net income	$	141,120		$	113,190
Other comprehensive income (loss):
Change in foreign currency translation adjustment, net of tax benefit of $465 and $0, respectively	(6,256		)	(10,831		)
Available-for-sale securities:
Unrealized gain on available-for-sale securities during the period	2,023			38
Reclassification for gain realized on available-for-sale securities, reported in Other expense, net	(239		)	(128		)
Tax (expense) benefit	(564		)	16
Net change in available-for-sale securities (net of tax)	1,220			(74		)
Total other comprehensive loss	(5,036		)	(10,905		)
Comprehensive income	$	136,084		$	102,285

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

Table of Contents

RED HAT, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

(Unaudited)



	Three Months Ended
	May 31, 2019			May 31, 2018
Cash flows from operating activities:
Net income	$	141,120		$	113,190
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization	36,754			27,054
Amortization of debt discount and transaction costs	1,885			5,838
Repayments of convertible notes attributable to debt discount	(13,981		)	—
Share-based compensation expense	50,168			46,005
Net amortization of bond premium on debt securities available for sale	271			743
Other	(872		)	(2,298		)
Changes in operating assets and liabilities:
Accounts receivable	445,186			299,439
Other receivables	(12,278		)	(35,160		)
Prepaid expenses	28,844			25,382
Accounts payable and accrued expenses	(58,271		)	(28,642		)
Deferred revenue	(158,729		)	(104,592		)
Other	(143		)	(800		)
Net cash provided by operating activities	459,954			346,159
Cash flows from investing activities:
Purchase of investment in debt securities available for sale	—			(108,336		)
Proceeds from maturities of investment in debt securities available for sale	110,431			87,004
Proceeds from sales of investment in debt securities available for sale	64,899			525
Proceeds from sales of strategic equity investments	—			1,300
Purchase of developed software and other intangible assets	(4,134		)	(2,866		)
Payments for property and equipment	(23,513		)	(12,963		)
Other	(124		)	(986		)
Net cash provided by (used in) investing activities	147,559			(36,322		)
Cash flows from financing activities:
Proceeds from exercise of common stock options	369			875
Proceeds from employee stock purchase program	7,501			15,262
Payments related to net settlement of share-based compensation awards	(81,274		)	(77,094		)
Purchase of treasury stock	—			(150,019		)
Proceeds (payments) on other borrowings, net	26			(299		)
Repayments of convertible notes attributable to principal	(102,163		)	(25,953		)
Net cash used in financing activities	(175,541		)	(237,228		)
Effect of foreign currency exchange rates on cash, cash equivalents and restricted cash	(19,672		)	(28,261		)
Net increase in cash, cash equivalents and restricted cash	412,300			44,348
Cash, cash equivalents and restricted cash at beginning of the period	1,883,096			1,724,132
Cash, cash equivalents and restricted cash at end of the period	$	2,295,396		$	1,768,480
Restricted cash included in cash, cash equivalents and restricted cash	$	—		$	1,137

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

RED HAT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

NOTE 1—Company and Merger Agreement

Red Hat, Inc., incorporated in Delaware, together with its subsidiaries (“Red Hat” or the “Company”) is a leading global provider of open source software solutions, using a community-powered approach to develop and offer reliable and high-performing operating system, virtualization, management, middleware, cloud and storage technologies.

Open source software is an alternative to proprietary software and represents a different model for the development and licensing of commercial software code than that typically used for proprietary software. Because open source software code, generally, is freely shared, there are customarily no licensing fees for the use of open source software. Therefore, the Company does not recognize revenue from the licensing of the code itself. The Company provides value to its customers through the development, aggregation, integration, testing, certification, delivery, maintenance, enhancement and support of its Red Hat technologies, and by providing a level of performance, scalability, flexibility, reliability and security for the technologies the Company packages and distributes. Moreover, because communities of developers not employed by the Company assist with the creation of the Company’s open source offerings, opportunities for further innovation of the Company’s offerings are supplemented by these communities.

The Company derives its revenue and generates cash from customers primarily from two sources: (i) subscription revenue and (ii) training and services revenue. These arrangements typically involve subscriptions to Red Hat technologies. The arrangements with the Company’s customers that produce this revenue and cash are explained in further detail in NOTE 2—Summary of Significant Accounting Policies.

Merger Agreement

On October 28, 2018, the Company entered into an Agreement and Plan of Merger (the “Merger Agreement”) with International Business Machines Corporation, a New York corporation (“IBM”), and Socrates Acquisition Corp., a Delaware corporation and a wholly owned subsidiary of IBM (“Sub”), pursuant to which, among other things, Sub will merge with and into the Company, with the Company surviving as a wholly owned subsidiary of IBM (the “Merger”). The Board of Directors of the Company and the Board of Directors of IBM each approved the Merger and the Merger Agreement.

At the effective time of the Merger (the “Effective Time”), subject to the terms and conditions of the Merger Agreement, each share of common stock, par value $0.0001 per share, of the Company issued and outstanding immediately prior to the Effective Time (other than (i) cancelled shares, (ii) dissenting shares, and (iii) subsidiary converted shares) shall be converted into the right to receive $190.00 in cash without interest. On December 12, 2018, the Company filed its definitive proxy statement on Schedule 14A (the “Proxy Statement”) with the Securities and Exchange Commission (“SEC”) for a special meeting of its stockholders to be held on January 16, 2019 in connection with the Merger. The Merger Agreement was adopted and approved by the Company’s stockholders at the January 16, 2019 special meeting of stockholders. The Company continues to expect the transaction to close in the second half of 2019, subject to certain conditions, including receipt of regulatory approvals. Until the closing, the Company will continue to operate as an independent company. The Company has incurred Merger-related costs of $9.9 million, which are included in General and administrative expenses in the Company’s Consolidated Statement of Operations for the three months ended May 31, 2019.

Consummation of the Merger is subject to certain customary conditions, including, without limitation, (i) the receipt of approvals, or the expiration or termination of the applicable waiting periods, under certain antitrust laws (including the waiting period under the Hart-Scott-Rodino Antitrust Improvements Act of 1976, as amended (the “HSR Act”) and clearance under Council Regulation 139/2004 of the European Union); and (ii) the absence of any temporary restraining order, preliminary or permanent injunction or other judgment or law issued by certain courts of competent jurisdiction or other governmental entity, in each case prohibiting consummation of the Merger, and no action or proceeding by a governmental entity before any court or certain other governmental entities of competent jurisdiction seeking to enjoin, restrain or otherwise prohibit consummation of the Merger. As of the filing of this Form 10-Q, the U.S. Department of Justice has concluded its review of IBM’s proposed acquisition of the Company without remedies or conditions and the Company has received a notice of early termination of the waiting period under the HSR Act. As of the filing of this Form 10-Q, the European Commission has unconditionally approved the proposed acquisition of the Company by IBM under the European Union Merger Regulation. Each party’s obligation to consummate the Merger is subject to certain other customary conditions.

Table of Contents

The Merger Agreement contains certain customary termination rights for the Company and IBM. Subject to certain limitations, the Merger Agreement may be terminated by either IBM or the Company if (i) the Merger is not consummated on or before October 28, 2019, which is subject to extension for two consecutive three-month periods by either party if all conditions are satisfied other than receipt of regulatory approvals and absence of legal restraints and (ii) an order having the effect of making the Merger illegal or otherwise prohibiting consummation of the Merger becomes final and non-appealable.

NOTE 2—Summary of Significant Accounting Policies

Basis of presentation

The unaudited interim consolidated financial statements as of and for the three months ended May 31, 2019 have been prepared by the Company pursuant to the rules and regulations of the SEC for interim financial reporting. These consolidated statements are unaudited and, in the opinion of management, include all adjustments (consisting of normal recurring adjustments and accruals) necessary for a fair statement of the consolidated balance sheets, consolidated operating results, consolidated other comprehensive income and consolidated cash flows for the periods presented in accordance with accounting principles generally accepted in the U.S. (“U.S. GAAP”). Operating results for the three months ended May 31, 2019 are not necessarily indicative of the results that may be expected for the fiscal year ending February 29, 2020. Certain information and footnote disclosures normally included in annual financial statements prepared in accordance with U.S. GAAP have been omitted in accordance with the SEC’s rules and regulations for interim reporting. These unaudited financial statements should be read in conjunction with the Company’s Consolidated Financial Statements, including notes thereto, included in the Company’s Annual Report on Form 10-K for the fiscal year ended February 28, 2019. Other than the accounting pronouncement adopted during the three months ended May 31, 2019 related to accounting for leases as described below, there have been no changes to the Company’s significant accounting policies from those described in NOTE 2—Summary of Significant Accounting Policies to the Consolidated Financial Statements contained in the Company’s Annual Report on Form 10-K for the fiscal year ended February 28, 2019.

The Company adopted Accounting Standards Update 2016-02, Leases, now commonly referred to as Accounting Standards Codification Topic 842 (“ASC 842”), effective March 1, 2019, using the modified retrospective method, which does not require adjustments to comparative periods nor require modified disclosures in those comparative periods.

Certain amounts for the three months ended May 31, 2018 have been reclassified to conform to the current period presentation.

The Company’s fiscal year ends on the last day of February, and the Company identifies fiscal years by the calendar years in which they end. For example, the fiscal year ending February 29, 2020 is referred to as “fiscal 2020.”

Consolidation policy

The accompanying Consolidated Financial Statements include the accounts of the Company and all of its wholly owned subsidiaries. All significant inter-company accounts and transactions are eliminated in consolidation. There are no significant foreign exchange restrictions on the Company’s foreign subsidiaries.

Use of estimates

The preparation of financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the balance sheet dates and the reported amounts of revenue and expenses during the reporting periods. Actual results could differ from such estimates. Estimates are used for, but not limited to, revenue recognition, goodwill and other long-lived assets, share-based compensation, income taxes and loss contingencies.

Revenue recognition

The Company derives its revenues from subscription contracts and training and service contracts. Revenue is recognized when performance obligations, as stipulated in the contracts, are transferred to a customer for an amount that reflects the consideration the Company expects to receive in exchange for those subscription contracts and training and service contracts.

RED HAT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

The Company applies the following five steps to recognize revenue:

1) Identify the contract with a customer. The Company determines that it has a contract with a customer when the contract is approved, the party’s rights regarding the products and services to be transferred can be identified, the payment terms for the products and services are identified, the customer’s ability and intent to pay can be determined, and the contract has commercial substance. Judgment is used to assess the customer’s ability and intent to pay, which is based upon factors including the customer’s historical payment experience or credit and financial information pertaining to the customer.

2) Identify the performance obligations in the contract. The Company’s performance obligations are identified based on the products and services that will be transferred to the customer that are both capable of being distinct and are distinct in the context of the contract and consist of (i) subscription offerings, including non-proprietary open-source software code delivered to the customer, software support subscriptions delivered to the customer, software support subscriptions embedded in partner products and learning subscriptions and (ii) training and services, including professional services sold at a fixed fee, professional services sold on a time-and-material-basis, training courses or units, and consulting units. In limited cases, the option to purchase additional subscription offerings or training and services may be offered at a price representing a material right. In such cases, the option to purchase is considered a distinct performance obligation.

3) Determine the transaction price. The Company determines transaction price based on the consideration expected to be received in exchange for transferring certain performance obligations to the customer. In determining the transaction price, variable consideration, if any, would be considered if, in management’s judgment, it is probable that a significant future reversal of cumulative revenue under the contract will not occur.

The Company’s contracts do not contain significant financing components. Specifically, the Company does not typically extend customer payment terms beyond a standard 30- to 60-day term and as a result the Company has elected the one-year-or-less safe harbor expedient and does not impute any interest.

The Company has elected to exclude all taxes from the transaction price (e.g., sales, use, value-added, etc.). Revenue is recognized net of such taxes.

4) Allocate the transaction price to performance obligations in the contract. When a contract contains a single performance obligation, the entire transaction price is allocated to that one performance obligation. Contracts that contain multiple performance obligations require an allocation of the transaction price to each performance obligation based on a relative standalone selling price (“SSP”). The Company typically determines SSP based on the observable price when the Company sells the subscriptions or training and services separately, taking into consideration the geographical region of the customer, type of offering and sales channel. In instances where SSP is not directly observable, the Company determines SSP either from the renewal rate paid for the performance obligation to the extent it is the same rate as stipulated in the initial customer contract or by using the expected-cost-plus-margin approach.

5) Recognize revenue when or as the performance obligation is satisfied. Revenue is recognized at the time the related performance obligation is satisfied by transferring the promised subscription offerings and training and services to a customer. For each performance obligation, a determination is made as to whether the control is transferred over time or at a point in time. For performance obligations satisfied over time, a method to measure progress toward complete satisfaction is selected, based upon the most faithful depiction of performance. The selected method for each performance obligation type is applied consistently to similar contracts.

Subscription revenue

Subscription revenue is comprised of direct and indirect sales of subscriptions relating to Red Hat technologies. Accounts receivable and deferred revenue are recorded at the time a customer enters into a binding and non-cancellable subscription agreement for the purchase of a subscription, subscription services are made available to the customer and the customer is billed. The deferred revenue amount is recognized as revenue ratably over the subscription period. Red Hat technologies are generally offered with base subscription periods of either one year or three years; the majority of the Company’s subscriptions have terms of one year. Under these subscription agreements, renewal rates are generally specified for renewal terms of one year or three years. Subscriptions generally entitle the end user to the technology itself and post-contract customer support, generally consisting of varying levels of support services as well as access to security updates, fixes, functionality enhancements, upgrades to the technologies, each on an if and when available basis, and compatibility with an ecosystem of certified hardware and software, during the term of the subscription. The Company sells its offerings through two principal channels: (1) direct, which includes sales by the Company’s sales force as well as web store sales, and (2) indirect, which includes certified cloud and service providers (“CCSPs”), distributors, original equipment manufacturers (“OEMs”), systems integrators and value added resellers.

RED HAT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

The Company recognizes revenue from the sale of Red Hat technologies ratably over the period of the subscription beginning on the commencement date of the subscription agreement. The Company has determined that the delivery of software code underlying the subscription is a distinct performance obligation as it is both capable of being distinct and is distinct within the context of a customer contract. The Company uses a non-proprietary open source development and licensing model to provide its software technologies to customers and therefore the amount of transaction price allocated to the underlying software code is negligible. The Company derives a portion of its revenue from CCSPs that provide public clouds with, and allow users to consume, computing resources as a service. The Company earns revenue based on subscription units consumed by the CCSP or its end users. The Company uses its historical cloud-usage data to estimate the amount of revenue earned and recognized each month and adjusts to actual amounts earned upon receipt of usage reports from the CCSPs in the following month. The differences between actual amounts earned and estimates made have generally been insignificant.

Training and services revenue

Training and services revenue is comprised of revenue for consulting, engineering and customer training courses or units and education services. Consulting services consist of time-based units or fixed-fee arrangements. For time-based arrangements, revenue is recognized over time as these services are performed and for fixed-fee arrangements, revenue is recognized based on the proportion of services performed. Engineering services represent revenue earned under fixed-fee arrangements with the Company’s OEM partners and other customers to provide for significant modification and customization of Red Hat technologies. The Company recognizes revenue for these fixed-fee engineering services based on a proportional performance basis using actual costs incurred to date over the estimated total projected costs, which includes a representative profit margin. A representative profit margin is determined based on analysis of a population of similar contracts by region. Revenue for customer training and education services is recognized on the dates the services are performed.

See NOTE 17—Segment Reporting for further information, including revenue by geographic area and significant product and service offerings.

Contract Balances

Timing of revenue recognition may differ from the timing of invoicing to customers. The Company records a receivable when revenue is recognized prior to invoicing, or deferred revenue when revenue is recognized subsequent to invoicing. For multi-year arrangements, the Company will generally invoice customers upfront or annually at the beginning of each annual coverage period. See below for the accounting policy related to receivables and see NOTE 13—Deferred Revenue and Performance Obligations for further information on deferred revenue balances.

Accounts receivable and allowance for doubtful accounts

Trade accounts receivable are recorded at the invoiced amount and do not bear interest. The allowance for doubtful accounts is the Company’s estimate of the amount of probable credit losses in the Company’s existing accounts receivable. The Company determines the allowance based on historical write-off experience and other qualitative factors. The Company reviews its allowance for doubtful accounts monthly. Past due balances over 90 days and over a specified amount are reviewed individually for collectability. All other balances are reviewed on a pooled basis by type of receivable. Account balances are charged off against the allowance when the Company determines it is probable the receivable will not be recovered. The Company does not have off-balance sheet credit exposure related to its customers. Unbilled receivables related to subscription and training and services contracts are included in accounts receivable. See NOTE 3—Accounts Receivable for further information on accounts receivable balances.

RED HAT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

Deferred selling costs

Deferred commissions are the incremental costs that are directly associated with non-cancellable subscription contracts with customers and consist of sales commissions and certain related fringe benefits earned by the Company’s sales force. The commissions are deferred and amortized on a straight-line basis over a period that approximates the subscription period. In determining the period that approximates the subscription period, the Company utilizes a portfolio approach that allows for the analysis of customer contracts with similar characteristics. The Company has determined that the effects on the financial statements of the portfolio approach would not differ materially from an individual customer contract analysis approach. The commission payments are paid in full subsequent to the month in which the customer’s service commences. The deferred commission amounts are recoverable through the future revenue streams under the non-cancellable customer contracts. In addition, the Company has the ability and intent under the commission plans with its sales force to recover commissions previously paid to its sales force in the event that customers breach the terms of their subscription agreements and do not fully pay for their subscription agreements. See NOTE 6—Deferred Selling Costs for further information on deferred commissions and the related amortization of deferred commissions.

Leases

The Company determines if an arrangement is a lease at inception. As part of that determination, the Company considers whether there is an implicitly or explicitly identified asset in an arrangement and whether the Company, as the lessee, has the right to control that asset.

Operating leases are included in operating right-of-use (“ROU”) assets, accounts payable and accrued expenses, and operating lease liabilities in the Company’s Consolidated Balance Sheets. Finance leases are included in property and equipment, other current obligations, and other long-term obligations in the Company’s Consolidated Balance Sheets.

ROU assets represent the Company’s right to use an underlying asset for the lease term and lease liabilities represent the Company’s obligation to make lease payments arising from the lease. Variable lease payments, other than those based on a rate or index, are not included in the recognition of ROU assets and lease liabilities but instead are recognized in the Consolidated Statement of Operations in the period in which the obligation for those payments is incurred. Operating lease ROU assets and liabilities are recognized at commencement date based on the present value of lease payments over the lease term. As most of the Company’s leases do not provide an implicit borrowing rate, the Company’s incremental borrowing rate at commencement date is used to determine the present value of lease payments. The lease terms may include options to extend or to purchase when it is reasonably certain that the Company will exercise those options. For termination options, the Company will adjust the lease term unless it is reasonably certain that the option will not be taken. Lease expense for lease payments is recognized on a straight-line basis over the lease term.

The Company has lease arrangements with both lease and non-lease components, which are generally accounted for as a single lease component. Additionally, for certain equipment leases, the Company applies a portfolio approach to effectively account for the operating lease ROU assets and liabilities.

Recent accounting pronouncements

Accounting pronouncements adopted

In August 2018, the FASB issued Accounting Standards Update 2018-15, Intangibles—Goodwill and Other—Internal-Use Software: Customer’s Accounting for Implementation Costs Incurred in a Cloud Computing Arrangement That Is a Service Contract (a consensus of the FASB Emerging Issues Task Force) (“ASU 2018-15”). The FASB issued ASU 2018-15 to align the requirements for capitalizing implementation costs in a cloud computing arrangement service contract with the requirements for capitalizing implementation costs incurred for an internal-use software license. The Company early adopted this standard effective March 1, 2019. The adoption of this standard did not significantly impact the Company’s Consolidated Financial Statements.

RED HAT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

In February 2016, the FASB issued Accounting Standards Update 2016-02, Leases (Topic 842) (“ASU 2016-02”). The FASB issued ASU 2016-02 to increase transparency and comparability among organizations with respect to accounting for leases by requiring the recognition of ROU assets and lease liabilities on the balance sheet. For income statement purposes, the FASB retained a dual model, requiring leases to be classified as either operating or finance. Along with ASU 2016-02, the Company also adopted Accounting Standards Update 2018-10, Codification Improvements to Topic 842 Leases (“ASU 2018-10”), Accounting Standards Update 2018-11, Targeted Improvements to Topic 842 Leases (“ASU 2018-11”), Accounting Standards Update 2018-20, Leases (Topic 842) Narrow-Scope Improvements for Lessors (“ASU 2018-20”) and Accounting Standards Updated 2019-01, Leases (Topic 842): Codification Improvements (“ASU 2019-01”), now commonly referred to as Accounting Standards Codification Topic 842 (“ASC 842”). The Company adopted ASC 842 as of March 1, 2019.

The Company adopted ASC 842 using the transition method, which does not require adjustments to comparative periods nor require modified disclosures in those comparative periods. The Company elected the transition package of practical expedients permitted within the new standard, which among other things, allows the carryforward of the historical lease classification. Further, upon adoption of the new guidance, the Company elected the practical expedients to combine lease and non-lease components for all asset classes and to not recognize ROU assets and lease liabilities for short-term leases for all asset classes.

ASC 842 had a material impact on the Company’s Consolidated Balance Sheets, but did not have an impact on the Consolidated Statements of Operations. The most significant impact was the recognition of ROU assets and lease liabilities for operating leases. At adoption, the Company recognized operating ROU assets of $237.4 million and operating lease liabilities of $244.5 million. Finance leases are not significant to the Company’s financials. The transition adjustment recognized in retained earnings as of March 1, 2019, was not material.

See NOTE 4—Leases for further information on the Company’s lease arrangements.

NOTE 3—Accounts Receivable

Accounts receivable are presented net of an allowance for doubtful accounts. Activity in the Company’s allowance for doubtful accounts is presented in the following table (in thousands):



As of	Balance at beginning of period		Charged to (recovery of) expense		Adjustments ⁽¹⁾		Balance at end of period
February 28, 2019	$	2,167	3,247		(853	)	$	4,561
May 31, 2019	$	4,561	(195	)	86		$	4,452

_______________


⁽¹⁾	Represents foreign currency translation adjustments and amounts written-off as uncollectible accounts receivable.

Included in accounts receivable, net of allowance for doubtful accounts, are unbilled receivables of $43.3 million and $40.2 million as of May 31, 2019 and February 28, 2019, respectively.

As of May 31, 2019, no individual customer accounted for 10% or more of the Company’s total accounts receivable. As of February 28, 2019, the Company had one customer whose accounts receivable balance individually represented 10%of total accounts receivable.

RED HAT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

NOTE 4—Leases

The Company has operating and finance leases for office locations, research and development facilities, data centers and certain equipment.

Supplemental balance sheet information related to leases was as follows (in thousands, except for lease term and discount rate):



	Balance Sheet Classification	May 31, 2019		February 28, 2019
Assets:
Operating	Operating right-of-use assets, net	$	224,371	$	—
Finance	Property and equipment, net of accumulated depreciation and amortization	579		281
Total leased assets		$	224,950	$	281

Liabilities:
Current:
Operating	Accounts payable and accrued expenses	$	46,633	$	—
Finance	Other current obligations	256		282
Long-term:
Operating	Operating lease liabilities	188,133		—
Finance	Other long-term obligations	336		6
Total lease liabilities		$	235,358	$	288

Prior to the adoption of ASC 842 on March 1, 2019, ROU assets and lease liabilities for operating leases were not recognized in the Consolidated Balance Sheets. The Company elected the practical expedient to not provide a comparable presentation in the Consolidated Balance Sheets for periods prior to adoption.

Supplemental information related to leases was as follows:



	May 31, 2019
Weighted average remaining lease term:
Operating leases	7.33 years
Finance leases	3.45 years



	May 31, 2019
Weighted average discount rate:
Operating leases	3.7	%
Finance leases	3.3	%

RED HAT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

The components of lease expense were as follows (in thousands):



		Three Months Ended
	Statement of Operations Classification	May 31, 2019		May 31, 2018
Operating lease expense	Cost of revenue, Operating expense	$	14,666	see note (1)
Variable lease expense	Cost of revenue, Operating expense	1,176		see note (1)
Finance lease expense:
Amortization of leased assets	Cost of revenue, Operating expense	146		276
Interest on lease liabilities	Interest expense	6		7
Total lease expense⁽²⁾		$	15,994	$	283

____________________


⁽¹⁾	Rent expense under operating leases was $13.4 million for the three months ended May 31, 2018.


⁽²⁾	Sublease income is recognized as a reduction to operating expense in the Consolidated Statement of Operations and is not material.

Supplemental cash flow information related to leases was as follows (in thousands):



	Three Months Ended May 31, 2019
Cash paid for amounts included in the measurement of lease liabilities:
Operating cash outflows from operating leases	$	14,043
Operating cash outflows from finance leases	$	6
Financing cash outflows from finance leases	$	112
Right-of-use assets obtained in exchange for lease obligations:
Operating leases	$	762
Finance leases	$	133

Maturities of lease liabilities were as follows (in thousands):



Fiscal Year	Operating leases			Finance leases
2020 (excluding the three months ended May 31, 2019)	$	40,737		$	258
2021	47,858			101
2022	42,467			101
2023	33,438			101
2024	26,339			82
Thereafter	79,125			—
Total lease payments	269,964			643
Less imputed interest	(35,198		)	(51		)
Total	$	234,766		$	592

RED HAT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

The following table, which was included in the Company’s Annual Report on Form 10-K for the fiscal year ended February 28, 2019, depicts gross minimum lease payments under non-cancellable operating and capital leases (in thousands):



Fiscal Year	Operating Leases		Capital Leases
2020	$	60,722	$	282
2021	51,060		6
2022	41,173		—
2023	32,016		—
2024	27,479		—
Thereafter	79,530		—
Total minimum lease payments	$	291,980	$	288

The difference between the Company’s total lease commitments as reported at February 28, 2019 compared to the March 1, 2019 ROU asset balance in the Consolidated Balance Sheets is primarily due to the required use of a discount factor (imputed interest) under the new lease guidance and certain amounts that are not included in the ROU asset under the new lease guidance.

NOTE 5—Identifiable Intangible Assets

Identifiable intangible assets consist primarily of trademarks, copyrights and patents, purchased technologies, customer and reseller relationships and covenants not to compete, all of which are amortized over the estimated useful life, generally on a straight-line basis, with the exception of customer and reseller relationships, which are generally amortized over the greater of straight-line over the estimated useful life or the related asset’s pattern of economic benefit. Useful lives range from two years to 10 years. As of May 31, 2019 and February 28, 2019, trademarks with an indefinite estimated useful life totaled $11.2 million and $11.4 million, respectively.

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



	May 31, 2019							February 28, 2019
	Gross Amount		Accumulated Amortization			Net Amount		Gross Amount		Accumulated Amortization			Net Amount
Trademarks, copyrights and patents	$	180,240	$	(86,132	)	$	94,108	$	176,704	$	(82,967	)	$	93,737
Purchased technologies	218,561		(118,705		)	99,856		219,196		(113,617		)	105,579
Customer and reseller relationships	105,562		(102,047		)	3,515		105,737		(100,947		)	4,790
Covenants not to compete	15,661		(14,800		)	861		15,787		(14,728		)	1,059
Other intangible assets	8,833		(8,259		)	574		8,833		(7,915		)	918
Total identifiable intangible assets	$	528,857	$	(329,943	)	$	198,914	$	526,257	$	(320,174	)	$	206,083

Amortization expense associated with identifiable intangible assets recognized in the Company’s Consolidated Financial Statements is summarized as follows (in thousands):



	Three Months Ended
	May 31, 2019		May 31, 2018
Cost of revenue	$	6,660	$	6,485
Sales and marketing	1,194		1,362
Research and development	34		34
General and administrative	2,517		2,373
Total amortization expense	$	10,405	$	10,254

RED HAT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

NOTE 6—Deferred Selling Costs

Deferred selling costs include commissions paid to the Company’s sales associates that are the incremental costs incurred to obtain contracts with customers. The commissions are deferred and amortized over a period to approximate the period of the subscription term. For further discussion on deferred commissions, see NOTE 2—Summary of Significant Accounting Policies.

Current and non-current deferred commissions are included in Prepaid expenses and Other assets, respectively, in the Company’s Consolidated Balance Sheets and are as follows (in thousands):



	May 31, 2019		February 28, 2019
Deferred commissions, current	$	183,462	$	201,971
Deferred commissions, non-current	45,860		47,849
Total deferred commissions	$	229,322	$	249,820

Amortization of deferred commissions is included in Sales and marketing expense in the Company’s Consolidated Statements of Operations. Amortization expense related to deferred commissions totaled $64.3 million and $56.2 million for the three months ended May 31, 2019 and May 31, 2018, respectively. There was no impairment loss in relation to the costs capitalized for the periods presented.

NOTE 7—Derivative Instruments

The Company transacts business in various foreign countries and is, therefore, subject to risk of foreign currency exchange rate fluctuations. From time to time, the Company enters into forward contracts to economically hedge transactional exposure associated with commitments arising from trade accounts receivable, trade accounts payable and fixed purchase obligations denominated in a currency other than the functional currency of the respective operating entity. All derivative instruments are recognized in the Consolidated Balance Sheets at their respective fair values. The Company has elected not to prepare and maintain the documentation required to qualify for hedge accounting treatment and, therefore, changes in fair value are recognized in the Consolidated Statements of Operations. See NOTE 16—Assets and Liabilities Measured at Fair Value on a Recurring Basis for information regarding the fair value hierarchy of derivative instruments.

The effects of derivative instruments on the Company’s Consolidated Financial Statements are as follows (in thousands):



	May 31, 2019						Classification of Gain (Loss) Recognized in Income on Derivatives	Three Months Ended May 31, 2019
	Balance Sheet Classification	Fair Value			Notional Value			Three Months Ended May 31, 2019
Assets—foreign currency forward contracts not designated as hedges	Other current assets	$	233		$	18,185	Other expense, net	$	645
Liabilities—foreign currency forward contracts not designated as hedges	Accounts payable and accrued expenses	(173		)	42,821		Other expense, net	(651		)
Total		$	60		$	61,006		$	(6	)



	May 31, 2018						Classification of Gain (Loss) Recognized in Income on Derivatives	Three Months Ended May 31, 2018
	Balance Sheet Classification	Fair Value			Notional Value			Three Months Ended May 31, 2018
Assets—foreign currency forward contracts not designated as hedges	Other current assets	$	111		$	21,554	Other expense, net	$	289
Liabilities—foreign currency forward contracts not designated as hedges	Accounts payable and accrued expenses	(790		)	28,112		Other expense, net	(1,136		)
Total		$	(679	)	$	49,666		$	(847	)

RED HAT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

NOTE 8—Income Taxes

The effective tax rate for the three months ended May 31, 2019 of (1.8)% differed from the U.S. federal statutory rate of 21% primarily due to excess tax benefits from share-based compensation, research tax credits and other discrete net tax benefits primarily related to an intra-entity transfer of assets. Tax expense for the three months ended May 31, 2019 included net discrete tax benefits of $28.8 million.

For the three months ended May 31, 2018, the Company’s then-effective tax rate of (1.5)%differed from the U.S. federal statutory rate of 21% primarily due to excess tax benefits from share-based compensation and research tax credits. Tax expense for the three months ended May 31, 2018, included net discrete tax benefits of $26.8 million primarily related to net excess tax benefits from share-based compensation.

The Company files a consolidated U.S. federal income tax return, as well as separate and combined income tax returns in numerous state and international jurisdictions. The Company is currently subject to examination by various taxing jurisdictions. The Company regularly assesses the potential outcomes of both ongoing and future examinations for the current and prior years, and believes that its provision for income taxes is adequate. The Company believes that some of these audits and negotiations may conclude during the next 12 months.

As of May 31, 2019, it is reasonably possible that total unrecognized tax benefits, including interest, may be reduced by approximately $68.2 million within the next 12 months primarily as a result of audit settlements in various tax jurisdictions, most of which would affect the Company’s effective tax rate.

NOTE 9—Convertible Notes

Convertible note offering

On October 7, 2014, the Company completed its offering of $805.0 million aggregate principal amount of the convertible notes. The convertible notes were sold in a private placement under a purchase agreement, dated as of October 1, 2014, entered into by and among the Company and the initial purchasers, for resale to qualified institutional buyers pursuant to Rule 144A under the Securities Act of 1933, as amended. For additional information, see NOTE 12—Convertible Notes to the Consolidated Financial Statements contained in the Company’s Annual Report on Form 10-K for the fiscal year ended February 28, 2019.

Indenture

On October 7, 2014, the Company entered into an indenture (the “Indenture”) with respect to the convertible notes with U.S. Bank National Association, as trustee (the “Trustee”). Under the Indenture, the convertible notes are senior unsecured obligations of the Company and bear interest at a rate of 0.25% per year, payable semiannually in arrears on April 1 and October 1 of each year, beginning on April 1, 2015. The convertible notes will mature on October 1, 2019, unless previously purchased or converted.

The convertible notes are convertible into shares of the Company’s common stock at an initial conversion rate of 13.6219 shares per $1,000 principal amount of the convertible notes (which is equivalent to an initial conversion price of approximately $73.41 per share), subject to adjustment upon the occurrence of certain events. Upon conversion of the convertible notes, holders will receive cash or shares of the Company’s common stock or a combination thereof, at the Company’s election.

Effective April 1, 2019, holders may convert their convertible notes at any time until the close of business on the second scheduled trading day immediately preceding the maturity date of the convertible notes. Upon conversion of the convertible notes on or after April 1, 2019, holders will receive on October 1, 2019 cash equal to the principal amount of the notes converted and shares of the Company’s common stock for the excess conversion value; provided that if the Merger is completed prior to October 1, 2019, then converting holders will receive cash for each $1,000 principal amount of convertible notes being converted equal to the conversion rate then in effect multiplied by the same per share cash consideration a common stockholder would receive in the Merger, subject to certain adjustments.

RED HAT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

During the first quarter of the fiscal year ending February 29, 2020, the Company settled notices of conversion with respect to $116.2 million aggregate principal amount of the convertible notes and elected to settle such conversions by paying cash for the principal amount and issuing 943,513 shares of common stock for the excess conversion value. The Company recognized a loss on settled conversions of $0.2 million for the three months ended May 31, 2019. Total settled conversions as of May 31, 2019 amounted to $614.6 million aggregate principal amount of the convertible notes. The Company settled conversions of $3.0 million in principal amount of the convertible notes in the second quarter of the fiscal year ending February 29, 2020 by paying cash for the principal amount and issuing shares of common stock for the excess conversion value.

Based on the closing price of the Company’s common stock of $184.30 on the last trading day of the first quarter of the fiscal year ending February 29, 2020, the if-converted value of the convertible notes as of May 31, 2019 exceeded their principal amount by approximately $287.6 million.

The Company classified the net carrying amount of the convertible notes as a current liability as it is expected to be cash-settled on or prior to October 1, 2019. The equity component of the convertible notes continues to be classified as additional paid-in capital as of May 31, 2019 because the Company had the option to settle the principal amount in shares.

The conversion rate is subject to customary anti-dilution adjustments. If certain corporate events described in the Indenture occur prior to the maturity date, the conversion rate will be increased for a holder who elects to convert its convertible notes in connection with such corporate events in certain circumstances.

The convertible notes are not redeemable prior to maturity, and no sinking fund is provided for the notes. If the Company undergoes a “fundamental change,” as defined in the Indenture, subject to certain conditions, holders may require the Company to purchase for cash all or any portion of their convertible notes. The fundamental change purchase price will be 100% of the principal amount of the convertible notes to be purchased plus any accrued and unpaid interest up to but excluding the fundamental change purchase date. If the Merger with IBM is consummated, it will constitute a “fundamental change” under the Indenture.

The Indenture contains customary terms and covenants, including that upon certain events of default occurring and continuing, either the Trustee or the holders of at least 25% in principal amount of the outstanding convertible notes may declare 100% of the principal of, and accrued and unpaid interest, if any, on, all the convertible notes to be due and payable.

In accounting for the issuance of the convertible notes, the Company separated the convertible notes into liability and equity components. The Company allocated the total transaction costs incurred to the liability and equity components based on their relative fair values. Issuance costs attributable to the liability component are being amortized to interest expense over the term of the convertible notes. The excess of the face value of the convertible notes as a whole over the carrying amount of the liability component (the “debt discount”) is being amortized to interest expense over the term of the convertible notes. In addition, the debt discount is impacted by the derecognition of the original debt discount on early settlements of convertible notes. The convertible notes consisted of the following (in thousands):



	May 31, 2019			February 28, 2019
Liability component:
Principal	$	190,396		$	306,552
Less: debt issuance costs	(211		)	(595		)
Less: debt discount	(1,632		)	(4,590		)
Net carrying amount	$	188,553		$	301,367
Equity component ⁽¹⁾	$	22,916		$	36,897
__________
⁽¹⁾ Recognized in the Consolidated Balance Sheets in Additional paid-in capital.

RED HAT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

The following table includes total interest expense recognized related to the convertible notes (in thousands):



	Three Months Ended
	May 31, 2019		May 31, 2018
Coupon rate 0.25% per year, payable semiannually	$	69	$	471
Amortization of convertible note issuance costs — liability component	384		831
Accretion of debt discount	1,501		5,007
Total interest expense related to convertible notes	$	1,954	$	6,309

The fair value of the convertible notes, which was determined based on inputs that are observable in the market (Level 2), and the carrying value of convertible notes (the carrying value excludes the equity component of the convertible notes classified in equity) is as follows (in thousands):



	May 31, 2019
	Fair Value		Carrying Value
Convertible notes	$	188,798	$	188,553

Convertible note hedge and warrant transactions

On October 1, 2014, the Company entered into convertible note hedge transactions and warrant transactions with certain of the initial purchasers of the convertible notes or their respective affiliates. In connection with the conversions of the convertible notes that settled in the first quarter of the fiscal year ending February 29, 2020, the Company exercised a portion of the options that are part of the convertible note hedge transactions for 954,731 shares of the Company’s common stock.

The convertible note hedge transactions are expected to offset, to the extent the Company’s common stock per share price does not exceed the $101.65 strike price of the warrants, which is subject to adjustments upon the occurrence of certain events, the potential dilution with respect to shares of the Company’s common stock upon any conversion of the convertible notes and/or offset any cash payments the Company is required to make in excess of the principal amount of the converted notes, as the case may be. To partially offset the $148.0 million cost of the convertible note hedge transactions, the Company issued warrants and received proceeds of $79.8 million. The number of shares of the Company’s common stock underlying the warrants total 10,965,630, the number of shares originally underlying the convertible notes and the convertible note hedge transactions. The combination of the convertible note hedge transactions and the warrant transactions effectively increases the initial conversion price of the convertible notes from $73.41 per share to $101.65 per share. As a result, the warrant transactions will have a dilutive effect with respect to the Company’s common stock to the extent that the market price per share of the Company’s common stock, as measured under the terms of the warrant transactions, exceeds the $101.65 strike price of the warrants. For the three months ended May 31, 2019 and May 31, 2018, the warrants were included in the computation of diluted shares outstanding because the warrants’ exercise price was less than the average market price of the Company’s common stock during the related period. However, subject to certain conditions, the Company may elect to settle all of the warrants in cash.

NOTE 10—Commitments and Contingencies

Product indemnification

The Company is a party to a variety of agreements pursuant to which it may be obligated to indemnify the other party from losses arising in connection with the Company’s services or products, or from losses arising in connection with certain events defined within a particular contract, which may include litigation or claims relating to intellectual property infringement, certain losses arising from damage to property or injury to persons or other matters. In each of these circumstances, payment by the Company is conditioned on the other party making a claim pursuant to the procedures specified in the particular contract, which procedures typically allow the Company to challenge the other party’s claims. Further, the Company’s obligations under these agreements may in certain cases be limited in terms of time and/or amount, and in some instances, the Company may have recourse against third parties for certain payments made by the Company.

RED HAT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

It is not possible to predict the maximum potential amount of future payments under these or similar agreements due to the conditional nature of the Company’s obligations and the facts and circumstances involved in each particular agreement. The Company does not record a liability for claims related to indemnification unless the Company concludes that the likelihood of a material claim is probable and estimable. Payments pursuant to these indemnification claims during the three months ended May 31, 2019 and May 31, 2018 were, in the aggregate, immaterial.

NOTE 11—Legal Proceedings

The Company experiences routine litigation in the normal course of its business, including patent litigation. The Company presently believes that the outcome of this routine litigation will not have a material adverse effect on its financial position, results of operations or cash flows.

NOTE 12—Stockholders’ Equity

The following table summarizes the changes in the Company’s stockholders’ equity during the three months ended May 31, 2019 (in thousands):



	Common Stock			Additional Paid-In Capital			Retained Earnings		Treasury Stock			Accumulated Other Comprehensive Loss			Total Stockholders’ Equity
	Shares	Amount		Additional Paid-In Capital			Retained Earnings		Treasury Stock			Accumulated Other Comprehensive Loss			Total Stockholders’ Equity
Balance at February 28, 2019	244,403	$	24	$	2,791,895		$	2,054,069	$	(3,189,434	)	$	(42,622	)	$	1,613,932
Net income	—	—		—			141,120		—			—			141,120
Other comprehensive loss, net of tax	—	—		—			—		—			(5,036		)	(5,036		)
Vest and exercise of share-based awards	944	1		368			—		—			—			369
Common stock repurchase	—	—		—			—		—			—			—
Share-based compensation expense	—	—		50,168			—		—			—			50,168
Minimum tax withholdings paid by the Company on behalf of employees related to net settlement of employee share-based awards	—	—		(81,274		)	—		—			—			(81,274		)
Re-issuance of treasury stock under employee stock purchase plan		—		23,323			—		16,614			—			39,937
Convertible note conversions	943	—		(1,296		)	—		—			—			(1,296		)
Exercises of convertible note hedges	—	—		69,380			—		(69,364		)	—			16
Other adjustments				541

Price	187.45	EPS	2
Shares	187	P/E	76
MCap	34,985	P/FCF	31
Net Debt	-2,295	EBIT	561
TEV	32,689	TEV/EBIT	58
TTM 2019-05-31, in MM, except price, ratios

10-Q	2019-05-31	Filed 2019-06-28
10-K	2019-02-28	Filed 2019-04-24
10-Q	2018-11-30	Filed 2019-01-04
10-Q	2018-08-31	Filed 2018-10-09
10-Q	2018-05-31	Filed 2018-07-09
10-K	2018-02-28	Filed 2018-04-26
10-Q	2017-11-30	Filed 2018-01-08
10-Q	2017-08-31	Filed 2017-10-05
10-Q	2017-05-31	Filed 2017-07-06
10-K	2017-02-28	Filed 2017-04-26
10-Q	2016-11-30	Filed 2017-01-05
10-Q	2016-08-31	Filed 2016-10-06
10-Q	2016-05-31	Filed 2016-07-07
10-K	2016-02-29	Filed 2016-04-26
10-Q	2015-11-30	Filed 2016-01-08
10-Q	2015-08-31	Filed 2015-10-07
10-Q	2015-05-31	Filed 2015-07-09
10-K	2015-02-28	Filed 2015-04-28
10-Q	2014-11-30	Filed 2015-01-08
10-Q	2014-08-31	Filed 2014-09-29
10-Q	2014-05-31	Filed 2014-07-09
10-K	2014-02-28	Filed 2014-04-24
10-Q	2013-11-30	Filed 2014-01-09
10-K	2013-02-28	Filed 2013-04-25
10-Q	2012-11-30	Filed 2013-01-08
10-Q	2012-08-31	Filed 2012-10-05
10-Q	2012-05-31	Filed 2012-07-06
10-K	2012-02-29	Filed 2012-04-25
10-Q	2011-11-30	Filed 2012-01-09
10-Q	2011-08-31	Filed 2011-10-06
10-Q	2011-05-31	Filed 2011-07-07
10-K	2011-02-28	Filed 2011-04-29
10-Q	2010-11-30	Filed 2011-01-10
10-Q	2010-08-31	Filed 2010-10-08
10-Q	2010-05-31	Filed 2010-07-09
10-K	2010-02-28	Filed 2010-04-29
10-Q	2009-11-30	Filed 2010-01-11

8-K	2019-07-09
8-K	2019-06-20
8-K	2019-05-31
8-K	2019-05-15
8-K	2019-03-25
8-K	2019-01-16
8-K	2018-12-17
8-K	2018-12-10
8-K	2018-10-28
8-K	2018-10-28
8-K	2018-09-19
8-K	2018-09-17
8-K	2018-08-09
8-K	2018-06-21
8-K	2018-06-21
8-K	2018-05-07
8-K	2018-05-06
8-K	2018-05-02
8-K	2018-03-26
8-K	2018-01-30
8-K	2018-01-30

EX-10.4	exhibit104q1fy20.htm
EX-31.1	exhibit311q1fy20.htm
EX-31.2	exhibit312q1fy20.htm
EX-32.1	exhibit321q1fy20.htm

Large accelerated filer

Accelerated filer

Non-accelerated filer

Smaller reporting company

Emerging growth company