Document
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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
OR 
¨
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from                to                .
Commission File Number: 001-33162 
 
RED HAT, INC.
(Exact name of registrant as specified in its charter) 
 
Delaware
06-1364380
(State or other jurisdiction of
incorporation or organization)
(I.R.S. Employer
Identification No.)
100 East Davie Street, Raleigh, North Carolina 27601
(Address of principal executive offices, including zip code)
(919) 754-3700
(Registrant’s telephone number, including area code) 
 
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.
 
Large accelerated filer
x
 
Accelerated filer
¨
 
 
Non-accelerated filer
¨
 
Smaller reporting company
¨
 
 
 
 
 
Emerging growth company
¨
 
If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ¨
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes  ¨    No  x
Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date:
As of June 27, 2019, there were 178,093,007 shares of common stock outstanding.


Table of Contents

RED HAT, INC.
 
 
 
Page
 
 
 
 
 
ITEM 1:
 
 
Consolidated Balance Sheets at May 31, 2019 (unaudited) and February 28, 2019 (derived from audited financial statements)
 
Consolidated Statements of Operations for the three months ended May 31, 2019 (unaudited) and 2018 (unaudited)
 
Consolidated Statements of Comprehensive Income for the three months ended May 31, 2019 (unaudited) and 2018 (unaudited)
 
Consolidated Statements of Cash Flows for the three months ended May 31, 2019 (unaudited) and 2018 (unaudited)
 
 
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:
ITEM 3:
ITEM 4:
 
 
 
 
 
ITEM 1:
ITEM 1A:
ITEM 2:
ITEM 6:
 
 
 


2

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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.


3

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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.

4


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.

5


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.

6


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.

7



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.

8

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 2Summary 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.

9


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.

10


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.

11


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.


12


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 3Accounts 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.

13


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


NOTE 4Leases
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
%



14


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




15


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 5Identifiable 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




16


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


NOTE 6Deferred 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 7Derivative 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
 
 
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
 
 
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
)



17


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


NOTE 8Income 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 9Convertible 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.

18


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.


19


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 10Commitments 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.

20


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 11Legal 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 12Stockholders’ 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
 
 
 
 
 
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

 

 
(541
)
 

 

Balance at May 31, 2019
246,290

 
$
25

 
$
2,853,105

 
$
2,195,189

 
$
(3,242,725
)
 
$
(47,658
)
 
$
1,757,936


21


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


The following table summarizes the changes in the Company’s stockholders’ equity during the three months ended May 31, 2018 (in thousands):
 
Common Stock
 
Additional
Paid-In
Capital
 
Retained
Earnings
 
Treasury
Stock
 
Accumulated
Other
Comprehensive
Loss
 
Total
Stockholders’
Equity
 
Shares
 
Amount
 
 
 
 
 
Balance at February 28, 2018
238,689

 
$
24

 
$
2,416,080

 
$
1,619,688

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

Net income

 

 

 
113,190

 

 

 
113,190

Other comprehensive loss, net of tax

 

 

 

 

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

 

 
875

 

 

 

 
875

Common stock repurchase

 

 
(17,175
)
 

 
(132,844
)
 

 
(150,019
)
Share-based compensation expense

 

 
46,005

 

 

 

 
46,005

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

 

 
(77,094
)
 

 

 

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

 
18,471

 

 
13,740

 

 
32,211

Convertible note conversions
185

 

 
(835
)
 

 

 

 
(835
)
Exercises of convertible note hedges
 
 

 
13,598

 

 
(13,598
)
 

 

Cumulative-effect adjustment from adoption of ASU 2016-01
 
 

 

 
392

 

 

 
392

Balance at May 31, 2018
239,779

 
$
24

 
$
2,399,925

 
$
1,733,270

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



    
Share repurchase programs
On June 21, 2018, the Company announced that its board of directors authorized the repurchase of up to $1.0 billion of Red Hat’s common stock from time to time on the open market or in privately negotiated transactions. The new program commenced on July 1, 2018, and will expire on the earlier of (i) June 30, 2020 or (ii) a determination by the board of directors, Chief Executive Officer or Chief Financial Officer to discontinue the program. The new program replaced the previous $1.0 billion repurchase program, which expired on June 30, 2018.
During the three months ended May 31, 2019, the Company did not repurchase any shares of its common stock under this repurchase plan program.
From its commencement on July 1, 2018 through May 31, 2019, the Company repurchased 1,838,241 shares of its common stock at an aggregate cost of $262.8 million under this repurchase program.
As of May 31, 2019, the amount available under this program for the repurchase of the Company’s common stock was $737.2 million, which remains unchanged from February 28, 2019. Pursuant to the Merger Agreement, the Company does not anticipate additional repurchases of the Company’s common stock prior to the consummation of the Merger with IBM.


22


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


Accumulated other comprehensive loss
Accumulated other comprehensive loss was comprised of the following (in thousands):
 
 
May 31, 2019
 
February 28, 2019
Accumulated loss from foreign currency translation adjustment, net of tax
 
$
(47,756
)
 
$
(41,500
)
Accumulated unrealized gain (loss), net of tax, on available-for-sale securities
 
98

 
(1,122
)
Accumulated other comprehensive loss
 
$
(47,658
)
 
$
(42,622
)

NOTE 13Deferred Revenue and Performance Obligations
Activity in the Company’s deferred revenue accounts is presented in the following table (in thousands):
 
 
February 28, 2019
 
Revenue recognized from opening balance
 
Deferred revenue, net (1)
 
May 31, 2019
Deferred revenue, short-term
 
$
2,161,206

 
$
(705,210
)
 
$
560,492

 
$
2,016,488

Deferred revenue, long-term
 
821,218

 

 
(40,175
)
 
781,043

Total deferred revenue
 
$
2,982,424

 
$
(705,210
)
 
$
520,317

 
$
2,797,531

____________________ 
(1) 
Includes revenue recognized from current period customer contracts and the impact from foreign currency exchange rate fluctuations.
As of May 31, 2019, the value of customer contracts allocated to performance obligations not yet satisfied, including $2.80 billion of total deferred revenue, was approximately $3.75 billion, of which approximately 60% is expected to be recognized as revenue within the next 12 months and the remainder thereafter.
In addition to the approximately $3.75 billion of customer contract value allocated to performance obligations not yet satisfied, as of May 31, 2019, the Company has offered customers options to purchase additional services at an agreed-upon price per hour that total approximately $163.9 million.
The summation of the customer contract value allocated to performance obligations not yet satisfied and the options to purchase additional services equals approximately $3.91 billion, which the Company considers as its total backlog.
NOTE 14Earnings Per Share
The Company computes basic net income per common share by dividing net income available to common stockholders by the weighted average number of common shares outstanding. Diluted net income per common share is computed by dividing net income available to common stockholders by the weighted average number of common shares and dilutive potential common share equivalents then outstanding. Potential common share equivalents consist of shares issuable upon the exercise of stock options, vesting of share-based awards, settlement of convertible notes, or exercise of warrants.
The following table reconciles the numerators and denominators of the earnings per share (“EPS”) calculation (in thousands, except per share amounts):
 
Three Months Ended
 
May 31, 2019
 
May 31, 2018
Net income available to common stockholders
$
141,120

 
$
113,190

Weighted average common shares outstanding
177,400

 
177,302

Incremental shares attributable to assumed vesting or exercise of outstanding equity award shares
2,803

 
3,833

Dilutive effect of convertible notes
1,554

 
5,686

Dilutive effect of warrants
4,878

 
3,918

Diluted shares
186,635

 
190,739

Diluted net income per share
$
0.76

 
$
0.59


 


23


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


With respect to the Company’s convertible notes, the Company will settle the principal amount of the convertible notes in cash upon conversion. As a result, upon conversion of the convertible notes, only the amounts payable in excess of the principal amounts of the convertible notes are considered in diluted EPS under the treasury stock method. See NOTE 9—Convertible Notes for detailed information on the convertible notes.
Warrants to purchase 10,965,630 shares of the Company’s common stock at $101.65 per share were outstanding during the three months ended May 31, 2019 and May 31, 2018. For the three months ended May 31, 2019 and May 31, 2018, the warrants were included in the computation of diluted EPS because the warrants’ exercise price was less than the average market price of the Company’s common stock during the related period.
The following share awards are not included in the computation of diluted EPS because the aggregate value of proceeds considered received upon either exercise or vesting was greater than the average market price of the Company’s common stock during the related periods and the effect of including such share awards in the computation would be anti-dilutive (in thousands): 
 
Three Months Ended
 
May 31, 2019
 
May 31, 2018
Number of shares considered anti-dilutive for calculating diluted EPS
43

 


NOTE 15Share-based Awards
The Company measures share-based compensation cost at the grant date, based on the estimated fair value of the award and recognizes the cost over the employee requisite service period, typically on a straight-line basis. The Company estimates the fair value of stock options using the Black-Scholes-Merton valuation model. The fair value of nonvested share awards, nonvested share units and performance share units are measured at their underlying closing share price on the day of grant.
The following summarizes share-based compensation expense recognized in the Company’s Consolidated Financial Statements (in thousands):
 
 
Three Months Ended
 
 
May 31, 2019
 
May 31, 2018
Cost of revenue
 
$
4,945

 
$
5,128

Sales and marketing
 
21,904

 
19,520

Research and development
 
16,002

 
14,782

General and administrative
 
7,317

 
6,575

Total share-based compensation expense (1)
 
$
50,168

 
$
46,005

__________ 
(1)
Total share-based compensation expense included $1.7 million and $4.0 million, respectively, of expense related to the Company’s employee stock purchase plan (“ESPP”) for the three months ended May 31, 2019 and May 31, 2018.
Share-based compensation expense qualifying for capitalization was insignificant for each of the three months ended May 31, 2019 and May 31, 2018. Accordingly, no share-based compensation expense was capitalized during these periods.

24


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


The following table summarizes the Company’s share-based awards granted, by type:
 
Three Months Ended
 
May 31, 2019
 
May 31, 2018
 
Shares and
Share Units
Underlying Awards
 
Weighted
Average Per Share Award Fair Value
 
Shares and
Share Units
Underlying Awards
 
Weighted
Average Per Share Award Fair Value
Service-based shares and share units
885,436

(1)(2) 
$
183.37

 
669,450

(1) 
$
160.53

Performance share units—target


$

 
173,014

 
$
163.56

Performance share awards


$

 
64,219

(2) 
$
163.56

Total share-based awards
885,436

 
$
183.37

 
906,683

 
$
161.32


_________ 
(1) 
Service-based shares and share units granted during the three months ended May 31, 2019 include 639,439 share units that vest over a three-year period with one-third vesting on the first anniversary of the grant date and one-twelfth vesting quarterly over the remaining two years and 56,487 share units that vest over a three-year period with one-third vesting annually over the three-year period. Service-based share units granted during the three months ended May 31, 2018 vest over a four-year period with one-quarter vesting annually over the four- year period.
(2) 
Service-based shares and share units granted during the three months ended May 31, 2019 include 189,510 restricted stock awards that vest over a three-year period with one-third vesting annually over the three-year period. Restricted stock awards granted during the three months ended May 31, 2018 were subject to the achievement of a specified dollar amount of revenue for fiscal 2019 (the “RSA Performance Goal”). Since the Company achieved the RSA Performance Goal, 25% of the restricted stock vests on or about July 16, 2019, and the remainder vests ratably on a quarterly basis over the course of the subsequent three-year period, provided that the grantee’s business relationship with the Company has not ceased.
NOTE 16Assets and Liabilities Measured at Fair Value on a Recurring Basis
Fair value is defined as the exchange price that would be received for the purchase of an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for such asset or liability in an orderly transaction between market participants on the measurement date. Valuation techniques used to measure fair value should maximize the use of observable inputs and minimize the use of unobservable inputs. To measure fair value, the Company uses the following fair value hierarchy based on three levels of inputs, of which the first two are considered observable and the last unobservable:
Level 1—Quoted prices in active markets for identical assets or liabilities.
Level 2—Inputs other than Level 1 that are observable, either directly or indirectly, such as quoted prices for similar assets or liabilities; quoted prices in markets that are not active; or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the assets or liabilities.
Level 3—Unobservable inputs that are supported by little or no market activity and are significant to the fair value of the assets or liabilities.
The Company’s investments are comprised primarily of debt securities that are classified as available for sale and recorded at their fair values. Liquid investments with effective maturities of three months or less at the date of purchase are classified as cash equivalents. Investments with remaining effective maturities of twelve months or less from the balance sheet date are classified as short-term investments. Investments with remaining effective maturities of more than twelve months from the balance sheet date are classified as long-term investments. The Company’s Level 1 financial instruments are valued using quoted prices in active markets for identical instruments. The Company’s Level 2 financial instruments, including derivative instruments, are valued using quoted prices for identical instruments in less active markets or using other observable market inputs for comparable instruments.

25


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


Unrealized gains and temporary losses on investments classified as available for sale are included within accumulated other comprehensive income, net of any related tax effect. Realized gains and losses are recorded using the specific identification method and upon realization, such amounts are reclassified from accumulated other comprehensive income to Other expense, net. Realized gains and losses and other than temporary impairments, if any, are reflected in the Company’s Consolidated Statements of Operations as Other expense, net. The Company does not recognize changes in the fair value of its investments in income unless a decline in value is considered other than temporary. The vast majority of the Company’s investments are priced by pricing vendors. These pricing vendors use the most recent observable market information in pricing these securities or, if specific prices are not available for these securities, use other observable inputs. In the event observable inputs are not available, the Company assesses other factors to determine the security’s fair value, including broker quotes or model valuations. Independent price verifications of all holdings are performed by pricing vendors that are then reviewed by the Company. In the event a price fails a pre-established tolerance check, it is researched so that the Company can assess the cause of the variance to determine what the Company believes is the appropriate fair value.
The Company minimizes its credit risk associated with investments by investing primarily in investment-grade, liquid securities. The Company’s policy is designed to limit exposures to any one issuer depending on credit quality. Periodic evaluations of the relative credit standing of those issuers are considered in the Company’s investment strategy.
The following table summarizes the composition and fair value hierarchy of the Company’s financial assets and liabilities at May 31, 2019 (in thousands):
 
May 31, 2019
 
Level 1
 
Level 2
 
Level 3
Assets:
 
 
 
 
 
 
 
Money markets (1)
$
901,570

 
$
901,570

 
$

 
$

Available-for-sale securities (1):
 
 
 
 
 
 
 
Commercial paper
255,780

 

 
255,780

 

U.S. agency securities
203,135

 

 
203,135

 

Corporate securities
162,662

 

 
162,662

 

Foreign currency derivatives (2)
233

 

 
233

 

Liabilities:
 
 
 
 
 
 
 
Foreign currency derivatives (3)
(173
)
 

 
(173
)
 

Total
$
1,523,207

 
$
901,570

 
$
621,637

 
$

__________ 
(1) 
Included in Cash, cash equivalents and restricted cash, Investments in debt securities, short-term or Investments in debt securities, long-term in the Company’s Consolidated Balance Sheet at May 31, 2019, in addition to $1.14 billion of cash.
(2) 
Included in Other current assets in the Company’s Consolidated Balance Sheet at May 31, 2019.
(3) 
Included in Accounts payable and accrued expenses in the Company’s Consolidated Balance Sheet at May 31, 2019.

26


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


The following table summarizes the composition and fair value hierarchy of the Company’s financial assets and liabilities at February 28, 2019 (in thousands):
 
February 28, 2019
 
Level 1
 
Level 2
 
Level 3
Assets:
 
 
 
 
 
 
 
Money markets (1)
$