Red Hat 10Q 2006 Q2 Quarterly report

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 August 31, 2005

¨	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: 000-26281

RED HAT, INC.

(Exact name of registrant as specified in its charter)

Delaware

(State or other jurisdiction of incorporation or organization)

06-1364380

(I.R.S. Employer Identification No.)

1801 Varsity Drive, Raleigh, North Carolina 27606

(Address of principal executive offices, including zip code)

(919) 754-3700

(Registrant’s telephone number, including area code)

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

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

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 August 31, 2005, there were 176,949,288 shares of common stock outstanding.

RED HAT, INC.

TABLE OF CONTENTS


		Page
PART I	FINANCIAL INFORMATION:

ITEM 1:	FINANCIAL STATEMENTS	3

	Consolidated Balance Sheets at August 31, 2005 (unaudited) and February 28, 2005	3

	Consolidated Statements of Operations for the three months and six months ended August 31, 2005 (unaudited) and 2004 (unaudited)	4

	Consolidated Statements of Cash Flows for the three months and six months ended August 31, 2005 (unaudited) and 2004 (unaudited)	5

	Notes to Consolidated Financial Statements (unaudited)	6

ITEM 2:	MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS	20

ITEM 3:	QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK	41

ITEM 4:	CONTROLS AND PROCEDURES	42

PART II	OTHER INFORMATION:	44

ITEM 1:	LEGAL PROCEEDINGS	44

ITEM 2:	UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS	46

ITEM 4:	SUBMISSION OF MATTERS TO VOTE OF SECURITY HOLDERS	46

ITEM 6:	EXHIBITS	47

SIGNATURES		48

PART I FINANCIAL INFORMATION

ITEM 1: FINANCIAL STATEMENTS

RED HAT, INC.

CONSOLIDATED BALANCE SHEETS

(In thousands—except share amounts)


	August 31, 2005			February 28, 2005
	(unaudited)
ASSETS
Current assets:
Cash and cash equivalents	$	148,056		$	140,169
Investments in debt securities		369,364			181,028
Accounts receivable, net		57,797			48,402
Earnings in excess of billings		1,788			3,557
Prepaid expenses and other current assets		13,154			12,097

Total current assets		590,159			385,253
Property and equipment, net		34,037			32,726
Goodwill		75,996			73,591
Identifiable intangibles, net		14,825			16,740
Investments in debt securities		448,198			607,566
Other assets, net		16,561			18,160

Total assets	$	1,179,776		$	1,134,036


LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Accounts payable	$	4,892		$	8,426
Accrued expenses		28,544			21,065
Deferred revenue		144,973			109,426
Other current obligations		239			282

Total current liabilities		178,648			139,199
Deferred lease credits		5,080			5,179
Long term deferred revenue		39,061			27,890
Other long term obligations		223			97
Convertible debentures		570,000			600,000
Stockholders’ equity:
Minority interest		537			557
Preferred stock, $.0001 par value, 5,000,000 shares authorized, none outstanding		—			—
Common stock, $.0001 par value, 300,000,000 shares authorized, 188,012,654 and 186,569,771 shares issued, and 176,949,288 and 176,740,771 shares outstanding at August 31, 2005 and February 28, 2005, respectively		19			19
Additional paid-in capital		724,867			714,604
Deferred compensation		(3,109	)		(4,792	)
Accumulated deficit		(202,632	)		(231,798	)
Treasury stock at cost, 11,063,366 and 9,829,000 shares at August 31, 2005 and February 28, 2005 , respectively		(124,097	)		(107,409	)
Accumulated other comprehensive loss		(8,821	)		(9,510	)

Total stockholders’ equity		386,764			361,671

Total liabilities and stockholders’ equity	$	1,179,776		$	1,134,036

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

RED HAT, INC.

CONSOLIDATED STATEMENTS OF OPERATIONS

(In thousands—except share and per share amounts)


	Three Months Ended						Six Months Ended
	August 31, 2005			August 31, 2004			August 31, 2005			August 31, 2004
	(unaudited)			(unaudited)			(unaudited)			(unaudited)
Subscription and services revenue:
Subscription:
Enterprise technologies	$	53,758		$	33,941		$	102,501		$	63,909
Retail		—			561			—			936
Embedded		569			423			1,067			648

Total subscription revenue		54,327			34,925			103,568			65,493

Services:
Enterprise technologies		10,684			10,492			22,067			20,978
Embedded development services		707			907			863			1,617

Total services revenue		11,391			11,399			22,930			22,595

Total subscription and services revenue		65,718			46,324			126,498			88,088

Cost of subscription and services revenue:
Subscription:
Enterprise technologies and retail		4,955			2,807			10,734			4,720
Embedded		48			62			102			131

Total cost of subscription revenue		5,003			2,869			10,836			4,851

Services:
Enterprise technologies		6,015			5,241			12,164			10,727
Embedded development services		574			736			1,220			1,613

Total cost of services revenue		6,589			5,977			13,384			12,340

Total cost of subscription and services revenue		11,592			8,846			24,220			17,191

Gross profit enterprise technologies and retail		53,472			36,946			101,670			70,376
Gross profit embedded		654			532			608			521

Total gross profit		54,126			37,478			102,278			70,897

Operating expense:
Sales and marketing		20,478			15,034			40,793			28,415
Research and development		10,450			8,435			20,298			15,710
General and administrative		11,271			7,265			21,614			14,884

Total operating expense		42,199			30,734			82,705			59,009

Income from operations		11,927			6,744			19,573			11,888
Other income and expense, net		8,220			5,995			15,956			13,331
Interest expense		(1,556	)		(1,555	)		(3,122	)		(3,118	)

Income before provision for income taxes		18,591			11,184			32,407			22,101
Provision (benefit) for income taxes		1,859			(641	)		3,241			(641	)

Net income	$	16,732		$	11,825		$	29,166		$	22,742

Net income per share:
Basic	$	0.09		$	0.06		$	0.16		$	0.12
Diluted	$	0.09		$	0.06		$	0.15		$	0.12
Weighted average shares outstanding:
Basic		177,208			183,422			176,995			182,952
Diluted		208,583			218,836			207,894			218,874

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

RED HAT, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands)


	Three Months Ended						Six Months Ended
	August 31, 2005			August 31, 2004			August 31, 2005			August 31, 2004
	(unaudited)			(unaudited)			(unaudited)			(unaudited)
Cash flows from operating activities:
Net income	$	16,732		$	11,825		$	29,166		$	22,742
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization		3,751			2,409			7,298			4,715
Deferred income taxes		(606	)		(1,236	)		(799	)		(1,236	)
Stock-based compensation expense		1,310			1,110			2,495			2,398
Gain from repurchase of convertible debentures		(1,544	)		—			(3,140	)		—
Provision for doubtful accounts		57			266			141			1,014
Amortization of debt issue costs		770			776			1,552			1,541
Loss on disposal of property and equipment		891			—			996			—
Other		102			102			22			(30	)
Changes in operating assets and liabilities:
Accounts receivable and earnings in excess of billings		(9,837	)		849			(9,241	)		2,998
Prepaid expenses and other current assets		615			321			(790	)		(142	)
Identifiable intangibles and other assets		(29	)		(564	)		325			(1,215	)
Accounts payable		735			922			(3,367	)		185
Accrued expenses		5,091			2,901			7,555			2,333
Deferred revenue		27,760			11,186			50,246			26,721
Deferred lease credits		(42	)		(44	)		(99	)		(84	)

Net cash provided by operating activities		45,756			30,823			82,360			61,940

Cash flows from investing activities:
Purchase of investment securities		(130,577	)		(57,232	)		(139,177	)		(642,512	)
Proceeds from sales and maturities of investment securities		19,731			61,154			111,017			285,342
Acquisitions of businesses, net of cash acquired		(2,500	)		—			(2,500	)		—
Purchase of other investments		—			—			(767	)		—
Purchase of property and equipment		(4,716	)		(2,570	)		(7,988	)		(7,938	)

Net cash provided by (used in) investing activities		(118,062	)		1,352			(39,415	)		(365,108	)

Cash flows from financing activities:
Repurchase of convertible debentures		(18,091	)		—			(26,301	)		—
Structured stock repurchases		—			—			1,031			—
Net proceeds from issuance of common stock under Employee Stock Purchase Plan		770			—			1,497			872
Proceeds from exercise of common stock options		5,418			1,701			7,124			12,111
Purchase of treasury stock		(11,560	)		—			(16,688	)		—
Other financing		415			(359	)		83			(607	)

Net cash provided by (used in) financing activities		(23,048	)		1,342			(33,254	)		12,376

Effect of foreign currency exchange rates on cash and cash equivalents		(958	)		(522	)		(1,804	)		(1,826	)
Net increase (decrease) in cash and cash equivalents		(96,312	)		32,995			7,887			(292,618	)
Cash and cash equivalents at beginning of the period		244,368			135,691			140,169			461,304

Cash and cash equivalents at end of period	$	148,056		$	168,686		$	148,056		$	168,686

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

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

NOTE 1—Organization

Red Hat, Inc., incorporated in Delaware, together with its subsidiaries (“Red Hat” or the “Company”) is the recognized global technology and brand leader in providing an enterprise operating platform based on open source technology for the large enterprise. The Company applies its technology leadership to create its enterprise operating platform, Red Hat Enterprise Linux (“RHEL”) and infrastructure technology solutions, based on open source technology. The Company’s enterprise solutions meet the functionality requirements and performance demands of the large enterprise and the third-party computer hardware and software applications that are critical to the large enterprise. The Company provides the chief information officers of the largest companies in the world with the choice of a RHEL operating platform for all application areas including the technical/developer workstation, edge of the network applications, the information technology infrastructure (applications such as database, ERP and large file systems), the corporate desktop and the data center. Red Hat Network (“RHN”) provides an integrated management service that allows RHEL technologies to be updated, configured and the performance of these and other technologies to be monitored in an automated fashion. These and other technology solutions reflect the Company’s continuing commitment to provide an enterprise-wide infrastructure platform based on open source technology.

NOTE 2—Summary of Significant Accounting Policies

Unaudited Interim Financial Information

The unaudited interim consolidated financial statements as of and for the three months ended August 31, 2005 have been prepared by the Company pursuant to the rules and regulations of the Securities and Exchange Commission (the “SEC”) for interim financial reporting. These consolidated statements are unaudited and, in the opinion of management, include all adjustments (consisting of normal recurring adjustments and accruals) necessary to present fairly the consolidated balance sheets, consolidated operating results, and consolidated cash flows for the periods presented in accordance with accounting principles generally accepted in the United States of America. Operating results for the three month and six month periods ended August 31, 2005 are not necessarily indicative of the results that may be expected for the fiscal year ending February 28, 2006. Certain information and footnote disclosures normally included in annual financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been omitted in accordance with the SEC’s rules and regulations for interim reporting.

Principles of Consolidation

The accompanying consolidated financial statements include the accounts of the Company and all of its wholly-owned subsidiaries. Entities that are not wholly-owned, but for which a controlling financial interest is maintained by the Company are consolidated. The non-controlling interest of these entities is presented as a separate component of stockholders’ equity. All significant inter-company accounts and transactions are eliminated in consolidation.

Use of Estimates

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America 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 date and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from such estimates.

Reclassifications

Certain prior period amounts were reclassified to conform with current period presentation.

In connection with preparation of the consolidated financial statements at February 28, 2005, the Company concluded that it was appropriate to classify its investments in auction rate securities as short-term available-for-sale investments. In prior quarters, such investments were classified as cash and cash equivalents. The Company has made corresponding revisions to the accompanying consolidated statements of cash flows to reflect the gross purchases and sales of these securities as investing activities. As a result, cash used in investing activities decreased by $25.1 million in the quarter and increased $ 2.8 million in the six month period, each ended August 31, 2004. This revision in classification does not affect previously reported cash flows from operations or from financing activities.

Impairment of Long-Lived Assets

The Company evaluates the recoverability of its property and equipment and other assets in accordance with Statement of Financial Accounting Standards No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets” (“SFAS 144”). SFAS 144 requires that one accounting model be used for long-lived assets to be disposed of by sale, whether previously held and used or newly acquired, and broadens the presentation of discontinued operations to include more disposal transactions. An impairment loss is recognized when the net book value of such assets exceeds the estimated future undiscounted cash flows attributable to the assets or the business to which the assets relate. Impairment losses are measured as the amount by which the carrying value exceeds the fair value of the assets. The Company had no impairments of its long lived assets in the three month or six month periods ended August 31, 2005.

Deferred Commissions

Deferred commissions are the incremental costs that are directly associated with non-cancelable subscription contracts with customers and consist of sales commissions paid to the Company’s sales force. The commissions are deferred and amortized over twelve months. 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-cancelable 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 pay fully for their subscription agreements. Amortization of deferred commissions is included in sales and marketing expense in the accompanying consolidated statements of operations. Deferred commissions are included in prepaid expenses and other current assets on the accompanying consolidated balance sheets.

Debt Issue Costs

The costs related to the issuance of the convertible debentures, which closed on January 12, 2004, were capitalized and are being amortized to interest expense through January, 2009, the first scheduled date on which holders have the option to require the Company to repurchase the convertible debentures. Issuance costs related to the Company’s convertible debentures totaled $15.7 million and primarily consisted of investment banking fees, legal and other professional fees. Amortization expense, which is included in interest expense, was approximately $0.8 and $1.6 million for the three months and six months ended August 31, 2005 and 2004, respectively.

Revenue Recognition

The Company recognizes revenue in accordance with Statement of Position No. 97-2, “Software Revenue Recognition” (“SOP 97-2”), as amended by SOP 98-4 and SOP 98-9, and Staff Accounting Bulletin No. 101

(“SAB 101”), as amended by Staff Accounting Bulletin No. 104. The Company establishes persuasive evidence of an arrangement for each type of revenue transaction based on either a signed contract with the end customer, a click-through contract on the Company’s website whereby the customer agrees to the Company’s standard subscription terms, signed distribution contracts with Original Equipment Manufacturers (“OEMs”) and other resellers, or, in the case of individual training seats, through receipt of payment which indicates acceptance of the Company’s training agreement terms.

Subscription Revenue

Subscription revenue is comprised of enterprise and embedded revenues. Accounts receivable and deferred revenue are recorded at the time a customer is billed after entering into a binding agreement for the purchase of a subscription and subscription services are made available to the customer. The deferred revenue amount is amortized to income as discussed below.

Enterprise subscription revenue is comprised primarily of revenue from sales of RHEL technology solutions; however, through April 2004, the Company also generated enterprise subscription revenue from sales of Red Hat Linux and related software development tools. Red Hat enterprise technologies are generally offered with either one or three year base subscription periods; the majority of our subscriptions have one-year terms. These technologies are sold under a subscription agreement which generally specifies one or three year renewal rates. The base subscription entitles the end user to the technology itself and post-contract customer support (“PCS”) consisting of security errata, updates to the technology and upgrades to new versions of RHEL, on a when and if available basis, during the term of the subscription. The Company sells RHEL through four channels: distribution, direct sales, OEMs and the web. The Company recognizes revenue from the sale of RHEL offerings ratably over the period of the subscription beginning on the commencement date of the subscription agreement. The Company does not sell the RHEL technology or the components of the PCS that are included in the subscription on a stand alone basis.

Subscription arrangements with large enterprise customers often have contracts with multiple elements (e.g., software technology, maintenance, training, consulting and other services). The Company allocates revenue to each element of the arrangement based on vendor-specific objective evidence of its fair value when it can demonstrate sufficient evidence of the fair value of at least those elements that are undelivered. The fair value of each element in multiple element arrangements is created by either (i) providing the customer with the ability during the term of the arrangement to renew that element at the same rate paid for the element included in the initial term of the agreement or (ii) selling the element on a stand-alone basis. The services offered by the Company as part of these multiple element arrangements also meet all of the requirements set forth in SOP 97-2 to allow for these services to be accounted for separately.

In addition, the Company’s enterprise subscription revenue is partially derived from sales of its RHN offerings. RHN is a Company-hosted, internet-based set of services used to promote the security, availability and management of the Company’s Red Hat technology solutions offered by the Company as well as providing functionality for managing other technologies. RHN may be subscribed to at the time of, and in addition to, one of the Company’s RHEL offerings or on a stand alone basis. Revenues are recognized ratably over the term of the subscription beginning not before the commencement date of the subscription.

The Company previously sold Red Hat Linux consumer products through retail distributors. Sale of retail products was discontinued at the end of fiscal 2005. The revenue associated with products whose subscription period was 30 days or less was recognized immediately upon shipment to the distributor because the cost to the Company associated with such subscriptions was de minimis. For retail products whose subscription period for support services was greater than 30 days, the Company recognized the revenue ratably over the period that the subscription services were provided, beginning on the estimated date of purchase by the end user. A reserve for sales returns was recognized for sales of retail software products to distributors, who have a right of return, based on the Company’s historical experience of sell-through to the end user by the distributor. The predominant

portion of the Company’s retail distribution agreements provide that distributors only have 90 days from date of original shipment to return unsold product. The Company recognized revenues from sales of retail products with subscription periods less than 30 days upon shipment to the distributor because the Company was able to estimate returns with a reasonable degree of accuracy, the fee was fixed or determinable and collection of the resulting receivable was probable.

Embedded subscription consists of revenue for technical support and maintenance services provided pursuant to software compiling, debugging and optimization agreements. Revenue is recognized ratably over the term of the agreement, which is typically 12 months.

Services Revenue

Services revenue is comprised of enterprise technology services and embedded development. Enterprise technology services are comprised of revenue for enterprise consulting and engineering services, and customer training and education. Enterprise technology services are provided under agreements in which customers either pay the Company on a fixed fee or hourly basis to assist in the deployment of enterprise technologies. Enterprise technology engineering services represent revenues earned under fixed fee or hourly arrangements, principally with the Company’s OEM partners to add functionality to its RHEL line of technologies. Revenues under hourly arrangements are recognized as work is performed. Revenues under fixed fee arrangements are recognized on a proportional performance basis. Revenue from customer training and education is recognized as the services are performed.

Embedded development services are contracts for software compiling, debugging, and optimization. Revenue is recognized on the proportional performance method, provided that the Company has the ability to make reliable estimates of future performance requirements, the fee for such services is fixed or determinable and collection of the resulting receivable is probable.

Stock-Based Compensation

The Company accounts for stock-based compensation based on the provisions of Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB 25”), which states that no compensation expense is recorded for stock options or other stock-based awards to employees that are granted with an exercise price equal to or above the market value per share of the Company’s common stock on the grant date. When the exercise price is less than market value, deferred compensation is recorded for the difference and is amortized to compensation expense over the vesting period of the stock option.

The following table provides certain stock-based compensation information (in thousands):


	Three Months Ended				Six Months Ended
	August 31, 2005		August 31, 2004		August 31, 2005		August 31, 2004
	(unaudited)		(unaudited)		(unaudited)		(unaudited)
Stock-based compensation in:
Sales and marketing expense	$	19	$	—	$	31	$	108
Research and development expense		53		48		105		240
General and administrative expense		1,238		1,084		2,359		2,238

Total stock-based compensation	$	1,310	$	1,132	$	2,495	$	2,586

SFAS No. 123, “Accounting for Stock-Based Compensation”(“SFAS 123”), as amended by SFAS No. 148, “Accounting for Stock-Based Compensation-Transition and Disclosure an Amendment of FASB Statement No. 123” (“SFAS 148”), requires the Company to disclose pro forma information regarding stock option grants issued to its employees. SFAS 123 specifies certain valuation techniques that produce estimated compensation

charges that are included in the pro forma results below. These amounts have not been reflected in the Company’s Consolidated Statement of Operations because APB 25 specifies that no compensation charge arises when the exercise price of employees’ stock options equals the market value of the underlying stock at the grant date, as in the case of options granted to the Company’s employees during the fiscal periods reflected below. The fair value of options was estimated using the following assumptions for the three months ended August 31, 2005 and 2004:


	Three Months Ended August 31, 2005		Three Months Ended August 31, 2004
Expected dividend yield	0	%	0	%
Risk-free interest rate	3.83	%	3.38	%
Expected volatility	60.77	%	88.85	%
Expected life (in years)	3		5

A reduction in the expected life of options granted during the three months ended August 31, 2005 results primarily from a change in the contractual life of options granted. Options granted during the three months ended August 31, 2005 carry a contractual life of 5 years verses 10 years for options granted during the three months ended August 31, 2004.

The following table illustrates the effect on net income and earnings per share if the Company had applied the fair value recognition provisions of SFAS 123 to stock based employee compensation (in thousands, except per share amounts):


	Three Months Ended August 31, 2005 (unaudited)			Three Months Ended August 31, 2004 (unaudited)
Net income, as reported	$	16,732		$	11,825
Add: Recognized stock-based compensation expense for options, net of related tax effects		1,179			1,132
Deduct: total stock-based employee compensation expense determined under the fair value based method for all awards, net of related tax effects		(10,038	)		(11,421	)

Pro forma net income	$	7,873		$	1,536

Earnings per share data:
Basic as reported	$	0.09		$	0.06
Basic pro forma	$	0.04		$	0.01
Diluted as reported	$	0.09		$	0.06
Diluted pro forma	$	0.04		$	0.01

	Six Months Ended August 31, 2005 (unaudited)			Six Months Ended August 31, 2004 (unaudited)
Net income, as reported	$	29,166		$	22,742
Add: Recognized stock-based compensation expense for options, net of related tax effects		2,245			2,586
Deduct: total stock-based employee compensation expense determined under the fair value based method for all awards, net of related tax effects		(19,906	)		(25,676	)

Pro forma net income (loss)	$	11,505		$	(348	)

Earnings (loss) per share data:
Basic as reported	$	0.16		$	0.12
Basic pro forma	$	0.07		$	0.00
Diluted as reported	$	0.15		$	0.12
Diluted pro forma	$	0.07		$	0.00

The weighted average estimated fair value of employee stock options granted was $ 6.44 and $13.22 per share during the three months ended August 31, 2005 and 2004, respectively.

Deferred Taxes

The Company accounts for income taxes using the liability method that requires the recognition of deferred tax assets or liabilities for the temporary differences between financial reporting and tax bases of the Company’s assets and liabilities and for tax carryforwards at enacted statutory tax rates in effect for the years in which the differences are expected to reverse. The Company has recorded a valuation allowance against the majority of its deferred tax assets due to uncertainty of realization of these deferred tax assets. During the three months and six months ended August 31, 2005, the Company recorded a tax expense of $1.9 million and $3.2 million, respectively.

The Company continues to assess the realizability of other net deferred tax assets, which primarily consist of net operating losses and stock option expense deductions in the United States. In assessing the realizability of net deferred tax assets, management considers whether it is more likely than not that some portion or all of the deferred tax assets will be realized. In making this assessment, management considers historical trend of taxable losses, projected future taxable income and the reversal of deferred tax liabilities. As of August 31, 2005, the net deferred tax asset balance was $166 million of which $162 million is offset by a valuation allowance. The deferred tax asset balance includes approximately $152 million attributable to domestic net operating losses carried forward. To the extent the deferred tax assets are realized, these amounts would be credited to the provision for income taxes, additional paid in capital and goodwill. Based on the Company’s positive trend of earnings, the Company believes the uncertainty regarding the deferred tax assets may in the future diminish to the point where deferred tax assets may be realized. If the Company would be able to realize deferred tax assets in the future in excess of the net recorded amount, an adjustment to the deferred tax asset could increase income and stockholder’s equity, and reduce goodwill, in the quarter when such a determination is made.

Earnings per share

The Company computes net income per common share in accordance with Statement of Financial Accounting Standards No. 128, “Earnings Per Share,” (“SFAS 128”), SEC Staff Accounting Bulletin No. 98 (“SAB 98”) and Emerging Issues Task Force No. 04-8, “The Effect of Contingently Convertible Instruments on Diluted EPS” (“EITF 04-8”). Under the provisions of SFAS 128 and SAB 98, basic net income per common share (“Basic EPS”) is computed by dividing net income available to common stockholders by the weighted average number of common shares outstanding. Diluted net income per common share (“Diluted EPS”) is computed by dividing net income adjusted for interest expense and amortization of debt issuance costs associated with the convertible debentures, 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 and convertible securities such as our convertible debentures. Diluted net income per share assumes the conversion of the convertible debentures using the “if converted” method.

The following table reconciles the numerators and denominators of the earnings per share calculation for the three months and six months ended August 31, 2005 and 2004 (in thousands, except per share amounts):


	Three Months Ended (unaudited)				Six Months Ended (unaudited)
	August 31, 2005		August 31, 2004 (1)		August 31, 2005		August 31, 2004 (1)
Diluted net income per share computation:
Net income	$	16,732	$	11,825	$	29,166	$	22,742
Interest expense on convertible debentures, net of related tax effects		654		750		1,326		1,500
Amortization of debt issuance costs, net of related tax effects		693		776		1,397		1,541

Net income—diluted	$	18,079	$	13,351	$	31,889	$	25,783

Weighted Average common shares outstanding		177,208		183,422		176,995		182,952
Incremental shares attributable to assumed exercise of outstanding options		8,839		11,969		8,013		12,477
Incremental shares attributable to assumed exercise of convertible debentures		22,536		23,445		22,886		23,445

		208,583		218,836		207,894		218,874
Diluted net income per share	$	0.09	$	0.06	$	0.15	$	0.12

(1)	In accordance with EITF 04-8, prior year three months and six months diluted earnings per share have been presented to include the incremental shares attributable to assumed exercise of convertible debentures. No change in reported diluted earnings per share resulted from such inclusion.

Segment Reporting

The Company identifies its operating segments primarily based on differences in the nature of its products and services and on geographic location. The Company’s operating segments are enterprise and embedded. These segments reflect the Company’s primary focus, sales of enterprise technology subscriptions to large enterprises, and the fact that management has decided to maintain a presence in the embedded systems market. Retail subscription revenue is included in the enterprise segment because results of retail subscription sales are not reviewed on a disaggregated basis from the Company’s other enterprise subscriptions. Performance of these segments is evaluated based on their respective gross profit margins as disclosed in the Company’s Consolidated Statements of Operations.

The Company’s enterprise segment principally relates to the sale of Red Hat software subscriptions or support services subscriptions for enterprise customers using Red Hat software. Red Hat enterprise products are infrastructure technologies and the Company’s enterprise services are provided in support of the enterprise software that it distributes. The Company’s embedded segment is based on providing service and support primarily related to embedded devices. This business continues to target a unique subset of customers that are separate and distinct from the Company’s enterprise customers, employs dedicated resources and is managed separately. Results of this segment are regularly reviewed separately from the Company’s enterprise products for the purpose of allocating resources and assessing performance.

The Company evaluates its assets on a consolidated basis only. Accordingly, no information has been provided and no allocations have been made related to segment assets.

The Company has international sales offices in a number of jurisdictions, including the United Kingdom, France, Italy, Ireland, Germany, Sweden, Spain, Netherlands, China, Singapore, Hong Kong, Korea, Australia, India and Japan. The Company manages its international business on a Europe-wide and Asia Pacific-wide basis.

The following disclosure aggregates individually immaterial international operations and separately discloses the significant international operations at and for the three months and six months ended August 31, 2005 and 2004 (in thousands):


	North America		Europe			Asia Pacific		Total

	Three Months Ended August 31, 2005 (unaudited)
Revenue from unaffiliated customers	$	44,349	$	11,471		$	9,898	$	65,718
Net income	$	15,380	$	1,278		$	74	$	16,732
Total assets at August 31, 2005	$	1,115,673	$	38,081		$	26,022	$	1,179,776

	Three Months Ended August 31, 2004 (unaudited)
Revenue from unaffiliated customers	$	31,624	$	7,688		$	7,012	$	46,324
Net income (loss)	$	11,678	$	(1,061	)	$	1,208	$	11,825
Total assets at August 31, 2004	$	1,105,831	$	30,694		$	30,309	$	1,166,834


	North America		Europe			Asia Pacific			Total

	Six Months Ended August 31, 2005 (unaudited)
Revenue from unaffiliated customers	$	85,652	$	22,181		$	18,665		$	126,498
Net income (loss)	$	28,576	$	1,111		$	(521	)	$	29,166
Total assets at August 31, 2005	$	1,115,673	$	38,081		$	26,022		$	1,179,776

	Six Months Ended August 31, 2004 (unaudited)
Revenue from unaffiliated customers	$	60,069	$	14,849		$	13,170		$	88,088
Net income (loss)	$	22,750	$	(1,692	)	$	1,684		$	22,742
Total assets at August 31, 2004	$	1,105,831	$	30,694		$	30,309		$	1,166,834

Recent Accounting Pronouncements

In March 2004, the Financial Accounting Standards Board (“FASB”) approved the consensus reached on the Emerging Issues Task Force Issue No. 03-01, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments” (“EITF 03-01”). EITF 03-01 provides guidance on determining when an investment is considered impaired, whether that impairment is other-than-temporary and the measurement of an impairment loss. EITF 03-01 also provides new disclosure requirements for other-than-temporary impairments on debt and equity investments. In September 2005, the FASB decided that the guidance provided in EITF 03-01 would be applied prospectively and that the effective date would be reporting periods beginning after December 15, 2005. The adoption of EITF 03-01 is not expected to have a material impact on our financial position or results of operations.

In December 2004, the FASB issued Statement of Financial Accounting Standards No. 123R, “Share-Based Payment” (“SFAS 123R”). The statement replaces SFAS 123 and supersedes APB 25. SFAS 123R focuses primarily on accounting for transactions in which an entity obtains employee services in share-based payment transactions. The adoption of the statement will result in the expensing of the fair value of stock options granted to employees in the basic financial statements. Previously, the Company elected to only disclose the impact of expensing the fair value of stock options in the notes to the financial statements. See “Accounting for Stock-Based Compensation” in NOTE 2. The statement becomes effective for the Company on March 1, 2006.

SFAS 123R applies to new equity awards and to equity awards modified, repurchased or canceled after the effective date. Additionally, compensation cost for the portion of awards for which the requisite service has not been rendered that are outstanding as of the effective date shall be recognized as the requisite service is rendered on or after the effective date. The compensation cost for that portion of awards shall be based on the grant-date fair value of those awards as calculated from the pro forma disclosures under SFAS 123. Changes to the grant-date fair value of equity awards granted before the effective date of SFAS 123R are precluded. The compensation cost for those earlier awards shall be attributed to periods beginning on or after the effective date of SFAS 123R using the attribution method that was used under SFAS 123, except that the method of recognizing forfeitures only as they occur shall not be continued. Any unearned or deferred compensation (contra-equity accounts) related to those earlier awards shall be eliminated against the appropriate equity accounts. Additionally, common stock purchased pursuant to stock options granted under our employee stock purchase plan will be expensed based upon the fair market value of the stock option.

SFAS 123R also allows for a modified version of retrospective application to periods before the effective date. Modified retrospective application may be applied either (a) to all prior years for which SFAS 123 was effective or (b) only to prior interim periods in the year of initial adoption. An entity that chooses to apply the modified retrospective method to all prior years for which SFAS 123 was effective shall adjust financial statements for prior periods to give effect to the fair-value-based method of accounting for awards granted, modified or settled in cash in fiscal years beginning after December 15, 1994, on a basis consistent with the pro forma disclosures required for those periods by SFAS 123. Accordingly, compensation cost and the related tax effects will be recognized in those financial statements as though they had been accounted for under SFAS 123. Changes to amounts as originally measured on a pro forma basis are precluded.

The adoption of SFAS 123R will have a material impact on our results of operations. The future results will be impacted by the number and value of additional stock option grants as well as the value of existing unvested stock options. For more information on the impact of expensing stock options on the three months ended August 31, 2005 and 2004, see “Accounting for Stock-Based Compensation” in NOTE 2.

In December 2004, the FASB issued Statement of Financial Accounting Standards No. 153, “Exchange of Non-monetary Assets” (“SFAS 153”), which is an amendment to APB Opinion No. 29. The guidance in APB Opinion No. 29, “Accounting for Non-monetary Transactions,” is based on the principle that exchanges of non-monetary assets should be measured based on the fair value of the assets exchanged. The guidance in that opinion, however, included certain exceptions to that principle. SFAS 153 amends APB Opinion No. 29 to eliminate the exception for non-monetary exchanges of similar productive assets and replaces it with a general exception for exchanges of non-monetary assets that do not have commercial substance. A non-monetary exchange has commercial substance if the future cash flows of the entity are expected to change significantly as a result of the exchange. The adoption of SFAS 153 is not expected to have a material impact on our financial position or results of operations.

In October 2004, the American Jobs Creation Act of 2004 (the “AJCA”) was passed. The AJCA provides a deduction for income from qualified domestic production activities which will be phased in from 2005 though 2010. In return, the AJCA also provides for a two-year phase-out of the existing extra-territorial income exclusion for foreign sales that was viewed to be inconsistent with international trade protocols by the European Union.

In December 2004, the FASB issued FASB Staff Position No. 109-1, “Application of FASB Statement No. 109, Accounting for Income Taxes, to the Tax Deduction on Qualified Production Activities by the American Jobs Creation Act of 2004” (“FSP 109-1”). FSP 109-1 treats the deduction as a “special deduction” as described in SFAS No. 109. As such, the special deduction has no effect on deferred tax assets and liabilities existing at the enactment date. Rather, the impact of this deduction will be reported in the same period in which the deduction is claimed in our tax return. The Company is currently evaluating the impact the AJCA will have on our results of operations and financial position.

The AJCA also creates a temporary incentive for U.S. corporations to repatriate accumulated income earned abroad by providing an 85% dividends received deduction for certain dividends from controlled foreign corporations. The deduction is subject to a number of limitations. The Company is evaluating the AJCA and is not yet in a position to decide whether, or to what extent, it might repatriate foreign earnings that have not yet been remitted to the U.S.; however, upon finalization of our assessment, it is reasonably possible that the Company will repatriate some amount. The amount of income tax incurred should the Company repatriate some level of earnings cannot be reasonably estimated at this time. The Company expects to finalize its assessment by the end of fiscal 2006.

In May 2005, the FASB issued Statement of Financial Accounting Standards No. 154, “Accounting Changes and Error Corrections” (“SFAS 154”). SFAS 154 replaces APB Opinion No. 20, “Accounting Changes” and SFAS No. 3, “Reporting Accounting Changes in Interim Financial Statements” and changes the requirements for the accounting for, and reporting of, a change in accounting principle. SFAS 154 applies to all voluntary changes in accounting principle. It also applies to changes required by an accounting pronouncement in the unusual instance that the pronouncement does not include specific transition provisions. When a pronouncement includes specific transition provisions, those provisions should be followed. SFAS 154 is effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005.

NOTE 3—Comprehensive Income

The Company’s comprehensive income is comprised of net income, foreign currency translation adjustments, and unrealized gains and losses on marketable securities classified as available-for-sale. Comprehensive income for the three month and six month periods ended August 31, 2005 and 2004 was as follows (in thousands):


	Three Months Ended						Six Months Ended
	August 31, 2005 (unaudited)			August 31, 2004 (unaudited)			August 31, 2005 (unaudited)			August 31, 2004 (unaudited)
Comprehensive income:
Net income	$	16,732		$	11,825		$	29,166		$	22,742
Foreign currency translation adjustments		(132	)		(62	)		(141	)		(360	)
Change in unrealized losses on marketable securities		(447	)		4,197			831			(8,188	)

Total comprehensive income, net of taxes	$	16,153		$	15,960		$	29,856		$	14,194

As of August 31, 2005 and February 28, 2005, the Company holds investments in debt securities with an unrealized loss of $9.9 million and $10.7 million, respectively.

NOTE 4—Legal Proceedings

Red Hat Professional Consulting, Inc., formerly PTI, a wholly owned subsidiary of the Company acquired in February 2001, together with its former directors and some of its former principal shareholders, is a defendant in a suit brought by a former employee in DeKalb County Superior Court in Georgia (Case No. 00-CV-5509-8). The plaintiff asserts, among other things, breach of various employment agreements and seeks monetary damages. Red Hat Professional Consulting, Inc. has filed an answer, affirmative defenses and counterclaims denying all liability and has filed a motion to dismiss which remains pending. All discovery in the matter is complete. The Company has been indemnified in this matter by the former PTI shareholders and further believes that the likelihood of a material loss is remote.

District of New York issued an order that transferred all of the so-called IPO allocation actions, including the complaints involving the Company, to one judge for coordinated pre-trial proceedings (Case No. 21 MC 92). The court has consolidated the actions into a single action. The plaintiffs contend that the defendants violated federal securities laws by issuing registration statements and prospectuses that contained materially false and misleading information and failed to disclose material information. Plaintiffs also challenge certain IPO allocation practices by underwriters and the lack of disclosure thereof in initial public offering documents. On April 19, 2002, plaintiffs filed amended complaints in each of the 310 consolidated actions, including the Red Hat action. The relief sought consists of unspecified damages. No discovery has occurred to date. The individual director and officer defendants have been dismissed from the case without prejudice. The Company believes these complaints are without merit and will defend itself vigorously in this matter. There can be no assurance, however, that this matter will be resolved in the Company’s favor. The Company, among other issuers, the plaintiffs, and the insurers have agreed, in concept, to a proposed settlement whereby the Company would be released from this litigation without further payment from the Company. That proposed settlement has been submitted to the court for its consideration, and the court has accepted the proposed settlement subject to certain amendments. A fairness hearing on the proposed settlement has been scheduled for April 24, 2006.

Commencing on August 4, 2003, the Company filed suit against The SCO Group, Inc. (“SCO”) in the U.S. District Court for the District of Delaware seeking a declaratory judgment that the Company is not infringing any of SCO’s intellectual property rights (Civil Action No. 03-722-SLR). In addition, the Company has asserted claims against SCO under Delaware and federal law, including deceptive trade practices, unfair competition, tortious interference with prospective business opportunities, trade libel and violations of the Lanham Act. The Company contends that SCO has made false and misleading public statements in alleging that software code, in which SCO claims to own copyrights and trade secrets, was misappropriated and incorporated into the Company’s product and that SCO has threatened legal action. On September 15, 2003, SCO filed a motion to dismiss contending, among other things, that no actual controversy exists such that the declaratory judgment that the Company seeks would be warranted. On April 6, 2004, the Court denied SCO’s Motion to Dismiss but stayed further action in the case pending the resolution of litigation pending in the U.S. District Court for the District of Utah between SCO and IBM. On April 20, 2004, Red Hat filed a motion for reconsideration contending that a stay based on the Utah case would be inappropriate; SCO has filed an opposition to that motion. On March 31, 2005, the Court denied the Company’s motion to reconsider but extended to the Company the right to renew the motion should matters materially change in the SCO v. IBM litigation.

In the summer of 2004, 14 class action lawsuits were filed against the Company and several of its present and former officers on behalf of investors who purchased the Company’s securities during various periods from June 19, 2001 through July 13, 2004. All 14 suits were filed in the U.S. District Court for the Eastern District of North Carolina. In each of the actions, plaintiffs seek to represent a class of purchasers of the Company’s common stock during some or all of the period from June 19, 2001 through July 13, 2004. All of the claims arise in connection with the Company announcement on July 13, 2004 that it would restate certain of its financial statements (the “Restatement”). One or more of the plaintiffs assert that certain present and former officers (the “Individual Defendants”) and the Company variously violated Sections 10(b) and 20(a) of the Securities Exchange Act of 1934 and Rule 10b-5 thereunder by issuing the financial statements that the Company subsequently restated. One or more of the plaintiffs seek unspecified damages, interest, costs, attorneys’ and experts’ fees, an accounting of certain profits obtained by the Individual Defendants from trading in the Company’s common stock, disgorgement by the Company’s chief executive office and former chief financial officer of certain compensation and profits from trading in the Company’s common stock pursuant to Section 304 of the Sarbanes-Oxley Act of 2002, and other relief. As of September 8, 2004, all of these class action lawsuits were consolidated into a single action referenced as Civil Action No. 5:04-CV-473BR and titled In re Red Hat, Inc. Securities Litigation. Lead counsel and lead plaintiff in the case have now been designated, and on May 6, 2005, the plaintiffs filed an amended consolidated class action complaint. On July 29, 2005, the Company, on behalf of itself and the Individual Defendants, filed a motion to dismiss the action for failure to state a claim upon which relief may be granted. Also on that date PricewaterhouseCoopers LLP, also a defendant, filed a separate motion to dismiss. The Company intends to vigorously defend this class action lawsuit. There can

be no assurance, however, that the Company will be successful, and an adverse resolution of the lawsuit could have a material adverse effect on the Company’s financial position and results of operations in the period in which the lawsuit is resolved. The Company is not presently able to reasonably estimate potential losses, if any, related to the lawsuit.

In addition to the class action claims, a purported shareholder derivative action was filed, in connection with the Restatement, on August 20, 2004, in the Wake County Superior Court in North Carolina (Civil Action No. 04-CVS-11746), against certain present and former officers and directors of the Company and also naming the Company as a nominal defendant. This suit was subsequently assigned to the North Carolina Business Court. The suit claims that certain of the Company’s present and former officers and directors breached their fiduciary duties to the Company’s stockholders and to the Company. The complaint is derivative in nature and does not seek relief from the Company. On July 21, 2005, plaintiff filed an amended complaint and defendants subsequently filed a motion to dismiss based on the amended complaint that is now pending before the court. A hearing on the motion to dismiss has been scheduled for December 20, 2005. The Company believes there are legal and factual defenses to the claims, which the Company intends to vigorously pursue. There is, however, no assurance that the Company will prevail in defending this action.

Commencing on October 7, 2004, a petition was entered in the United States Bankruptcy Court in the Eastern District of North Carolina (Case No. 04-03642-5) by the bankruptcy administrator of ArsDigita GmbH, a German company, seeking to recover certain assets acquired by RH Interchange, Inc., a wholly-owned subsidiary of the Company, in an asset acquisition in February 2002. Petitioner claims that the German company received insufficient consideration for the transfer of the purchased assets and seeks to avoid the transaction. Petitioner seeks recovery of those transferred assets still in the possession of either the Company or RH Interchange and compensation for those assets no longer in their possession. On November 29, 2004, the Company and its subsidiary filed a motion to dismiss the petition; that petition was subsequently denied and thereafter discovery commenced. The Company believes there are substantial legal and factual defenses to the petition, which the Company intends to vigorously pursue. There is no assurance the Company will prevail in defending this action. The Company is not presently able to reasonably estimate potential losses, if any, related to the petition.

The Company also experiences other routine litigation in the normal course of our business. The Company believes that the outcome of this routine litigation will not have a material adverse effect on its consolidated financial position and results of operations.

NOTE 5—Income Taxes

During the three and six month periods ended August 31, 2005, the Company recorded $1.9 million and $3.2 million, respectively, of income tax expense based on an effective tax rate of 10%. The Company’s effective tax rate differs from the U.S. Federal statutory rate primarily due to U.S. net operating loss carryforwards. The provision for income tax expense for the quarter ended August 31, 2005, consists of domestic federal alternative minimum tax expense as well as foreign income tax expense.

The Company accounts for income taxes using the liability method that requires the recognition of deferred tax assets or liabilities for the temporary difference between financial reporting and tax bases of the Company’s assets and liabilities and for tax carryforwards at enacted statutory tax rates in effect for the years in which the differences are expected to reverse. The Company has recorded a valuation allowance against a majority of its deferred tax assets due to uncertainty of realization of these deferred tax assets.

the net deferred tax asset balance was $166 million of which $162 million is offset by a valuation allowance. The deferred tax asset balance includes approximately $152 million attributable to domestic net operating losses carried forward. To the extent the deferred tax assets are realized, these amounts would be credited to the provision for income taxes, additional paid in capital and goodwill. Based on the Company’s positive trend of earnings, we believe the uncertainty regarding the deferred tax assets may in the future diminish to the point where deferred tax assets may be realized. If the Company would be able to realize deferred tax assets in the future in excess of the net recorded amount, an adjustment to the deferred tax asset could increase income and stockholder’s equity, and reduce goodwill, in the quarter when such a determination is made.

NOTE 6—Share Repurchase Program and Debt Buyback

The Company’s Board of Directors has previously authorized a common stock repurchase program of up to $250.0 million of the Company’s common stock from time to time on the open market or in privately negotiated transactions. At August 31, 2005, approximately $133.3 million remained available under the program to repurchase shares of the Company’s common stock. The program is scheduled to expire March 31, 2006, unless the program is discontinued earlier by a determination of the Board of Directors, the chief executive office or the chief financial officer.

During the three months ended August 31, 2005, the Company acquired 769,366 shares of the Company’s common stock under the stock repurchase program at a total cost of approximately $11.6 million. During the six months ended August 31, 2005, the Company acquired 1,234,366 shares of the Company’s common stock under the stock repurchase program at a total cost of approximately $16.7 million. These amounts were recorded as treasury stock on the Company’s Consolidated Balance Sheets and included 669,366 common shares acquired through structured stock repurchase transactions.

From time to time, the Company has entered into, and may in the future enter into, structured stock repurchase transactions with financial institutions as part of the stock repurchase program. These transactions may require upfront payments to the counter-party financial institution and may result in either the receipt of stock or cash depending on the market price of the stock at the maturity of the agreement. During the three months ended August 31, 2005, the Company entered into a $10.0 million structured stock repurchase transaction which matured and settled during the period and resulted in the repurchase of 669,366 shares of the Company’s common stock. During the six months ended August 31, 2005, the Company entered into $30.0 million of structured stock repurchase transactions which matured and settled during the period. These transactions resulted in the Company receiving $20.0 million of its investment returned with a premium of $1.0 million and repurchasing 669,366 shares of the Company’s common stock. The $1.0 million premium was recorded as additional paid-in capital and all shares received pursuant to structured stock repurchase transactions are recorded as treasury stock on the Company’s Consolidated Balance Sheets.

The Company’s Board of Directors has also previously authorized a program to purchase up to $50.0 million of the Company’s 0.5% convertible senior debentures due 2024 from time to time on the open market or in privately negotiated transactions. At August 31, 2005, approximately $23.7 million remained available to repurchase the Company’s debentures pursuant to the program. The program is scheduled to expire March 31, 2006, unless the program is discontinued earlier by a determination of the Board of Directors, the chief executive office or the chief financial officer.

During the three months ended August 31, 2005, the Company repurchased $20.0 million in face value of its debentures at a cost of $18.1 million. The repurchased debentures were canceled pursuant to terms of the indenture and the $1.9 million difference between the face value and the cost was recorded as other income in the Company’s Consolidated Income Statement, net of $0.4 million write-off of deferred debt issuance costs related to the canceled debentures. During the six months ended August 31, 2005, the Company repurchased $30.0 million in face value of its debentures at a cost of $26.3 million. The repurchased debentures were canceled pursuant to terms of the indenture and the $3.7 million difference between the face value and the cost was

recorded as other income in the Company’s Consolidated Income Statement, net of $0.6 million write-off of deferred debt issuance costs related to the canceled debentures.

NOTE 7—Goodwill

In accordance with SFAS 142, the Company completed the annual impairment test as of February 28, 2005 and no goodwill impairment was deemed necessary. The following is a summary of goodwill by reportable segment for the quarters ended August 31, 2005 and February 28, 2005 (in thousands):


	Enterprise			Embedded		Consolidated
Balance at February 28, 2005	$	54,075		$	19,516	$	73,591
Add: Acquisition earn-out		2,500			—		2,500
Deduct: Impact of foreign currency fluctuations and other		(95	)		—		(95	)

Balance at August 31, 2005	$	56,480		$	19,516	$	75,996

In April 2005 the conditions requiring the Company to pay $2.5 million under the earn-out provisions of an acquisition consummated in December 2004 were achieved, resulting in an increase in goodwill for the six months ended August 31, 2005.

NOTE 8—Identifiable Intangible Assets

Identifiable intangible assets consist primarily of purchased technologies, customer and reseller relationships, trademarks, copyrights and patents, which are amortized over the estimated useful life on a straight line basis. Useful lives range from three to five years for purchased technologies and customer and reseller relationships and three to ten years for trademarks, copyrights and patents. There were no additions to identifiable intangible assets during the three month and six month periods ended August 31, 2005. Amortization of identifiable intangible assets, which was previously reported as a separate item on the Consolidated Statement of Operations, has been reclassified to conform with current period presentation as follows:


	Three Months Ended				Six Months Ended
	August 31, 2005 (unaudited)		August 31, 2004 (unaudited)		August 31, 2005 (unaudited)		August 31, 2004 (unaudited)
Amortization of identifiable intangible assets included in:
Cost of subscription revenue—enterprise technologies and retail	$	660	$	—	$	1,320	$	—
Sales and marketing expense	$	297	$	178	$	595	$	337

Total amortization of identifiable intangible assets	$	957	$	178	$	1,915	$	337

ITEM 2—MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Forward-looking statements in this Quarterly Report on Form 10-Q are made pursuant to the safe harbor provisions of Section 21E of the Securities Exchange Act of 1934. Investors are cautioned that statements in this Quarterly Report on Form 10-Q that are not strictly historical statements, including, without limitation, statements regarding current or future financial performance, management’s plans and objectives for future operations, product plans and performance, management’s assessment of market factors, and statements regarding the strategy and plans of Red Hat and its strategic partners, constitute forward-looking statements. These forward-looking statements 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 in the future to differ materially from the forward-looking statements. These risks and uncertainties include, without limitation, the risks detailed below and in Red Hat’s other filings with the Securities and Exchange Commission, copies of which may be accessed through the SEC’s web site at http://www.sec.gov.

OVERVIEW

We are a global leader in providing open source software solutions to the enterprise. We are also the market leader in providing enterprise-ready open source operating system platforms.

Open source software is an alternative to proprietary software and represents a different paradigm for the development of commercial software code than that used for the development of proprietary software. Because open source software code is freely shared, there are no licensing fees for the distribution of the open source software. Therefore, we do not recognize revenue from the licensing of the code itself. We provide value to our customers through the integration, testing and maintenance of our solutions and technologies, by providing a common framework for third-party technology hardware and software providers to certify their product’s operation with open source solutions and technologies, and by providing a level of scalability, stability and accountability for the solutions we package and distribute. Moreover, because communities of developers not employed by us assist with the creation of our open source offerings, opportunities for innovation of our offerings are supplemented by these communities.

We sell our enterprise solutions and technologies, such as our operating system platform, Red Hat Enterprise Linux (“RHEL”), through subscriptions, and we recognize revenue over the period of the subscription agreements with our customers. In addition, we provide certain managed services for each of our technologies through Red Hat Network (“RHN”) as a component of our subscriptions. We market our offerings primarily to large enterprises, government organizations, small and medium size businesses and educational institutions.

We have focused on introducing and gaining acceptance for our enterprise technologies. Since introducing our initial enterprise open source operating system platform, RHEL, it has gained widespread independent software vendor (“ISV”) and independent hardware vendor (“IHV”) support. We have continued to build our enterprise line of offerings by expanding our enterprise operating system platform offerings and introducing new systems management services, clustering capability, file management systems, directory and certificate technologies and enhanced security functionality. We intend to bring the value of open source technology to other key areas of the enterprise infrastructure as the development community efforts support and customer needs dictate.

For the three months ended August 31, 2005, total revenue increased 41.9% to $65.7 million from $46.3 million in the three months ended August 31, 2004. This increase resulted from an increasing level of adoption of RHEL as a primary computing platform by the larger enterprise customers, as well as growing penetration of the small and mid-sized business market and increased adoption of other Red Hat enterprise solutions and

technologies. Our ability to continue to increase adoption rates of Red Hat enterprise offerings and maintain competitive pricing are critical to our success.

We derive our revenues and generate cash from customers from two sources: (i) subscription revenue, and (ii) services revenue, each of which includes enterprise services and embedded services as described under “Critical Accounting Policies” below. We no longer sell retail products. The arrangements with our customers that create enterprise subscription revenues are explained in further detail under “Critical Accounting Policies” below and in NOTE 2 to the Consolidated Financial Statements. These agreements typically involve the sale of subscriptions to RHEL and in certain cases will include the sales of subscriptions to other Red Hat offerings or Red Hat services. Our revenues are also affected by corporate, government and consumer spending levels. In evaluating the performance of our business, we consider a number of factors. These factors include total revenues, operating income, operating margin and cash flows. In addition, we also consider the following factors in our evaluation process:

Subscriptions. Our enterprise technologies are sold under subscription agreements. These agreements typically have a one or three year subscription period. The base subscription entitles the end user to maintenance, including configuration support and updates and upgrades to the technology, when and if available, during the term of the subscription through RHN. Our customers have the ability to purchase higher levels of subscriptions that increase the level of support the customer is entitled to receive. Subscription revenue increased in the first and second quarter of fiscal 2006 and each quarter during fiscal 2005 and 2004 and is being driven primarily by the market acceptance of using the Linux operating system in the enterprise and our expansion of sales channels during these periods.

Sales by geography. We operate our business in three geographic regions: The Americas (U.S., Latin America and Canada); EMEA (Europe, Middle East and Africa); and Asia Pacific (principally Singapore, Japan, India, Australia, Korea and China). In the second quarter of fiscal 2006, $21.4 million or 32.5% of our revenue was generated outside North America compared to $14.7 million or 31.7% in second quarter of fiscal 2005. While our revenue in both EMEA and Asia Pacific relative to total revenues for the second quarter of fiscal 2006 did not change significantly when compared to the corresponding quarter in fiscal 2005, the percentage of our revenues generated from our international operations is expected to gradually increase as our international sales force and channels become more mature and as we enter new locations or expand our presence in existing locations. We have offices in more than 25 locations throughout the world.

Deferred revenue balances. Our deferred revenue balance at August 31, 2005 was $184.0 million. Because of our subscription model and revenue recognition policies, deferred revenues improve predictability of future revenues. Deferred revenues at August 31, 2005, have increased by more than 16.5% as compared to the balance at May 31, 2005 of $157.9 million.

Cash, cash equivalents and investments in debt securities. Cash, cash equivalents and short term and long term investments in debt securities balances at August 31, 2005 totaled $965.6 million. During the first six months of fiscal 2006, we generated $82.4 million in cash flow from operations primarily related to the increase in sales of subscriptions during the period. Our significant cash balance gives us the ability to take advantage of opportunities such as: acquisition opportunities, increasing investment in international areas and purchasing our own common stock and debt securities.

In fiscal 2006, we will focus on, among other things, (i) continuing to build on the global market momentum behind the adoption of open source solutions by enterprise customers; (ii) continuing our market penetration through channel partners and international expansion; (iii) driving renewal rates of subscriptions sold in prior periods and (iv) increasing the contribution to our subscription sales by hardware vendors.

CRITICAL ACCOUNTING POLICIES

Our critical accounting policies include the following:

•

Revenue recognition;

•

Impairment of long-lived assets; and

•

Deferred taxes.

Revenue Recognition

We recognize revenue in accordance with Statement of Position No. 97-2, “Software Revenue Recognition” (“SOP 97-2”) as amended by SOP 98-4 and SOP 98-9, and Staff Accounting Bulletin No. 101 (“SAB 101”), as amended by Staff Accounting Bulletin No. 104. Revenue recognition in accordance with these pronouncements can be complex due to the nature and variability of our sales transactions.

Subscription Revenue

Subscription revenue is comprised of enterprise and embedded revenues. Retail products are no longer sold. Accounts receivable and deferred revenue are recorded at the time a customer enters into a binding 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 amortized to income. Enterprise subscription revenue is comprised primarily of revenue from sales of RHEL technology solutions, however, through April 2004, we also generated enterprise subscription revenue from sales of Red Hat Linux and related software development tools. Red Hat enterprise technologies are generally offered with either one or three year base subscription periods; the majority of our subscriptions have one-year terms. Under these subscription agreements, renewal rates are generally specified for one or three year renewal terms. The base subscription entitles the end user to the technology itself and post contract customer support (“PCS”) consisting of security errata, updates to the technology, upgrades to new versions of RHEL, on a when and if available basis, during the term of the subscription. We sell RHEL through four channels: distribution, direct sales, original equipment manufacturers (“OEMs”) and the web. We recognize revenue from the sale of RHEL offerings ratably over the period of the subscription beginning on the commencement date of the subscription agreement. We do not sell the RHEL technology or the components of the PCS that are included in the subscription on a stand alone basis.

Subscription arrangements with large enterprise customers often have contracts with multiple elements (e.g., software technology, maintenance, training, consulting and other services). We allocate revenue to each element of the arrangement based on vendor-specific objective evidence of its fair value when we can demonstrate sufficient evidence of the fair value of at least those elements that are undelivered. The fair value of each element in multiple element arrangements is created by either (i) providing the customer with the ability during the term of the arrangement to renew that element at the same rate paid for the element included in the initial term of the agreement or (ii) selling the services on a stand-alone basis.

In addition, our enterprise subscription revenue is partially derived from sales of our RHN offerings. RHN is a Company-hosted, internet-based set of services used to help promote the security, availability and management of our Red Hat technology solutions as well as provide functionality for managing other technologies. RHN may be subscribed to at the time of, and in addition to, one of our RHEL offerings or on a stand alone basis. Revenues are recognized ratably over the term of the subscription beginning on the commencement date of the subscription.

Through our retail distributors, we formerly sold Red Hat Linux consumer products. In accordance with SOP 97-2, the revenue associated with products whose subscription period was 30 days or less was recognized immediately because the cost to us associated with such subscriptions was de minimis. For retail products whose

subscription period for support services was greater than 30 days, we recognized the revenue ratably over the period that the subscription services were provided beginning on the estimated date of purchase by the end user. A reserve for sales returns was recognized for sales of retail software products to distributors, who had a right of return, based on our historical experience of sell-through to the end user by the distributor. The predominant portion of our retail distribution agreements provided that distributors only have 90 days from date of original shipment to return unsold product. We recognized revenues from sales of retail products with subscription periods less than 30 days upon shipment to the distributor because we were able to estimate returns with a reasonable degree of accuracy, the fee was fixed and determinable and collection of the resulting receivable was probable. Our retail customers did not receive the right to future upgrades or new versions of the technology. Embedded subscription consists of revenue for technical support and maintenance services provided pursuant to software compiling, debugging, and optimization agreements. Revenue is recognized ratably over the term of the agreement, which is typically 12 months.

Services Revenue

Services revenue is comprised of enterprise technology services and embedded development. Enterprise technology services are comprised of revenue for enterprise consulting and engineering services and customer training and education. Enterprise technology consulting services are provided under agreements in which customers pay us on a fixed fee or hourly basis to assist in the deployment of enterprise technologies. Enterprise technology engineering services represent revenues earned under fixed fee or hourly arrangements, principally with our OEM partners, to add functionality to our RHEL line of technologies. Revenues under hourly arrangements are recognized as work is performed. Revenues under fixed fee arrangements are recognized either on a proportional performance basis or upon passage of time dependent upon the terms of each individual engagement. Revenue from customer training and education is recognized as the services are performed.

Embedded development services are contracts for software compiling, debugging, and optimization. Revenue is recognized on the proportional performance method, provided that the Company has the ability to make reliable estimates of future performance requirements, the fee for such services is fixed and determinable and collection of the resulting receivable is probable.

Impairment of Long-Lived Assets

We evaluate the recoverability of our property and equipment and other assets in accordance with Statement of Financial Accounting Standards No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” (“SFAS 144”). SFAS 144 requires that one accounting model be used for long-lived assets to be disposed of by sale, whether previously held and used or newly acquired, and broadens the presentation of discontinued operations to include more disposal transactions. An impairment loss is recognized when the net book value of such assets exceeds the estimated future undiscounted cash flows attributable to the assets or the business to which the assets relate. We perform this assessment on an annual basis, typically during the fourth quarter of the fiscal year. Impairment losses are measured as the amount by which the carrying value exceeds the fair value of the assets.

Deferred Taxes

We account for income taxes using the liability method that requires the recognition of deferred tax assets or liabilities for the temporary difference between financial reporting and tax bases of the Company’s assets and liabilities and for tax carryforwards at enacted statutory tax rates in effect for the years in which the differences are expected to reverse. The Company has recorded a valuation allowance against a majority of its deferred tax assets due to uncertainty of realization of these deferred tax assets. During the three months and six months ended August 31, 2005, the Company recorded a tax expense of $1.9 million and $3.2 million.

We continue to assess the realizability of other net deferred tax assets, which primarily consist of net operating losses and stock option expense deductions in the United States. In assessing the realizability of net deferred tax assets, management considers whether it is more likely than not that some portion or all of the deferred tax assets will be realized. In making this assessment, management considers the historical trend of taxable losses, projected future taxable income and the reversal of deferred tax liabilities. As of August 31, 2005, the net deferred tax asset balance was $166 million of which $162 million is offset by a valuation allowance. The deferred tax asset balance includes approximately $152 million attributable to domestic net operating losses carried forward. To the extent the deferred tax assets are realized, these amounts would be credited to the provision for income taxes, additional paid in capital and goodwill. Based on the Company’s positive trend of earnings, we believe the uncertainty regarding the deferred tax assets may diminish to the point where deferred tax assets may be realized. If the Company would be able to realize deferred tax assets in the future in excess of the net recorded amount, an adjustment to the deferred tax asset could increase income and stockholder’s equity, and reduce goodwill, in the quarter when such a determination is made.

RESULTS OF OPERATIONS

The following table is a summary of our results of operations for the three month and six month periods ended August 31, 2005 and 2004, respectively:


	Three Months Ended						Six Months Ended
	August 31, 2005			August 31, 2004			August 31, 2005			August 31, 2004
	(unaudited)			(unaudited)			(unaudited)			(unaudited)
Subscription and services revenue:
Subscription:
Enterprise technologies	$	53,758		$	33,941		$	102,501		$	63,909
Retail		—			561			—			936
Embedded		569			423			1,067			648

Total subscription revenue		54,327			34,925			103,568			65,493

Services:
Enterprise technologies		10,684			10,492			22,067			20,978
Embedded development services		707			907			863			1,617

Total services revenue		11,391			11,399			22,930			22,595

Total subscription and services revenue		65,718			46,324			126,498			88,088

Cost of subscription and services revenue:
Subscription:
Enterprise technologies and retail		4,955			2,807			10,734			4,720
Embedded		48			62			102			131

Total cost of subscription revenue		5,003			2,869			10,836			4,851

Services:
Enterprise technologies		6,015			5,241			12,164			10,727
Embedded development services		574			736			1,220			1,613

Total cost of services revenue		6,589			5,977			13,384			12,340

Total cost of subscription and services revenue		11,592			8,846			24,220			17,191

Gross profit enterprise technologies and retail		53,472			36,946			101,670			70,376
Gross profit embedded		654			532			608			521

Total gross profit		54,126			37,478			102,278			70,897

Operating expense:
Sales and marketing		20,478			15,034			40,793			28,415
Research and development		10,450			8,435			20,298			15,710
General and administrative		11,271			7,265			21,614			14,884

Total operating expense		42,199			30,734			82,705			59,009

Income from operations		11,927			6,744			19,573			11,888
Other income and expense, net		8,220			5,995			15,956			13,331
Interest expense		(1,556	)		(1,555	)		(3,122	)		(3,118	)

Income before provision for income taxes		18,591			11,184			32,407			22,101
Provision (benefit) for income taxes		1,859			(641	)		3,241			(641	)

Net income	$	16,732		$	11,825		$	29,166		$	22,742

Net income per share:
Basic	$	0.09		$	0.06		$	0.16		$	0.12
Diluted	$	0.09		$	0.06		$	0.15		$	0.12
Weighted average shares outstanding:
Basic		177,208			183,422			176,995			182,952
Diluted		208,583			218,836			207,894			218,874

Three Months Ended August 31, 2005 and August 31, 2004

Total revenue

Total revenue increased 41.9% to $65.7 million in the three months ended August 31, 2005 from $46.3 million in the three months ended August 31, 2004. This increase was primarily driven by significant growth in enterprise technologies subscriptions.

Subscription revenue

Subscription revenue is comprised of revenue from enterprise technologies (RHEL, RHN, Red Hat Directory Server and other products), retail and embedded customers. Subscription revenue increased 55.6% to $54.3 million for the three months ended August 31, 2005 from $34.9 million for the three months ended August 31, 2004.

Enterprise technologies subscriptions and retail

Enterprise technologies subscriptions revenue primarily relates to both direct and indirect sales of Red Hat enterprise technologies. Enterprise technologies subscriptions revenue increased 58.4% to $53.8 million for the quarter ended August 31, 2005 from $33.9 million for the quarter ended August 31, 2004. The increase in subscription revenue sales is being driven by broad market acceptance and the increasing use of the Linux operating system in mission critical areas of computing by the large enterprise, as well as increasing revenue through OEM and distributor relationships that we have developed and continue to develop. Our sales force has also increased to better address the growing market opportunity globally and with new product offerings.

There were no retail revenues in the quarter ended August 31, 2005 compared to $0.6 million for the quarter ended August 31, 2004. This decrease is due to our discontinuance of this product and our focus on the sale of subscriptions of our enterprise technologies to enterprise customers rather than on the consumer market.

Embedded subscription

Embedded subscription revenue increased 34.5% to $0.6 million for the three months ended August 31, 2005 from $0.4 million for the three months ended August 31, 2004. The increase in embedded subscription revenue is primarily due to the timing of contracts, not due to any overall change in market demand.

Services revenue

Enterprise technologies services

Enterprise technologies services include fees received from enterprise customers for deployment of Red Hat enterprise technologies, customer training and education fees and fees received for adding certain functionality to RHEL for our major hardware partners. Enterprise technologies services revenue increased 1.8% to $10.7 million in the three months ended August 31, 2005 from $10.5 million in the three months ended August 31, 2004. The increase in enterprise technologies services revenue is primarily due to an increase in consulting fees received from enterprise customers for deployment of Red Hat enterprise technologies of approximately $0.3 million as compared to the same prior year period. The adoption of Linux as a primary computing platform increases the need for consulting services.

Embedded development services

Embedded development services revenue declined by 22.1% to $0.7 million for the three months ended August 31, 2005 compared to $0.9 million for the three months ended August 31, 2004. The reduction primarily relates to our reduced focus and personnel on this business to a small core team which maintains a presence in this market place.

Cost of revenue

Cost of subscription revenue

Cost of enterprise subscription revenue primarily consists of expenses we incur to manufacture, package, distribute, support and provide maintenance for our solutions. These costs include expenses for physical media, literature and packaging, fulfillment and shipping, labor-related costs to provide technical support and maintenance and bandwidth costs for RHN. Cost of enterprise subscription revenue increased 74.4% to $5.0 million in the three months ended August 31, 2005 from $2.9 million in the three months ended August 31, 2004. The overall increase results from $1.0 million of additional staff costs, $0.7 million of additional amortization expense related to identifiable intangible assets acquired in the fourth quarter of fiscal 2005, $0.2 million of additional packaging and product material costs, and $0.2 million of depreciation costs.

Cost of services revenue

Cost of services revenue is primarily comprised of salaries and related costs, incurred for our personnel to deliver training and education, open source consulting, engineering and hardware certification services. Cost of services revenue increased 10.2% to $6.6 million in the three months ended August 31, 2005 from $6.0 million in the three months ended August 31, 2004. The increase is primarily related to an increase in costs associated with our training and education services of $0.5 million, a $0.2 million increase in consulting costs and a $0.1 million decrease in our engineering services costs.

Gross profit

While total cost of revenue increased 31.0% to $11.6 million from $8.8 million during the three months ended August 31, 2004, total revenues increased 41.9% to $65.7 million during the three months ended August 31, 2005 from $46.3 million during the three months ended August 31, 2004. As a result, gross profit increased 44.4% to $54.1 million (82.4% of total revenue) for the three months ended August 31, 2005 from $37.5 million (80.9% of total revenue) for the three months ended August 31, 2004. This increase was primarily due to the increase in revenue related to our Red Hat enterprise technology subscription offerings, which have higher gross margins than services. Gross margins on total subscription revenues were $49.3 million and $32.1 million during the three months ended August 31, 2005 and 2004, respectively. Gross margins on total service revenues were $4.8 million and $5.4 million during the three months ended August 31, 2005 and 2004, respectively.

Operating expenses

Sales and marketing

Sales and marketing expense consists primarily of salaries and other related costs for personnel, sales commissions, travel, public relations and marketing materials and tradeshows. Sales and marketing expense increased 36.2% to $20.5 million (31.2% of total revenue) in the three months ended August 31, 2005 from $15.0 million (32.5% of total revenue) in the three months ended August 31, 2004. This increase was primarily due to increased staffing and the related $3.7 million increase in compensation costs and a $1.4 million increase in advertising and promotion costs.

Research and development

as a result of a business acquisition in the fourth quarter of fiscal 2005 and to support the continued development and integration of our Red Hat enterprise technologies. Professional fees and expendable equipment costs increased $0.2 million.

General and administrative

General and administrative expense consists primarily of personnel and related costs for general corporate functions, including finance, accounting, legal, human resources, facilities and information systems expenses. General and administrative expense increased 55.1% to $11.3 million (17.2% of total revenue) in the three months ended August 31, 2005 from $7.3 million (15.7% of total revenue) in the three months ended August 31, 2004. This increase relates primarily to increased administrative compensation costs of $1.7 million, losses of approximately $0.9 million recognized on the disposal of fixed assets, an increase in office expenses of $0.2 million, an increase in legal and other professional fees of $0.4 million and an increase in depreciation expense of $0.8 million.

Other income and expense, net

Other income and expense, net consists of interest income earned on cash deposited in money market accounts and invested in short and long-term fixed income instruments, gain on the extinguishment of certain long-term debt, net gains realized on the sale of investments and net foreign currency revaluation gains and losses. Other income and expense, net, increased to $7.3 million in the three months ended August 31, 2005 from $6.0 million in the three months ended August 31, 2004. The increase is primarily related to a $1.5 million net gain recognized on the extinguishment of long term debt and a $0.9 million increase in interest income during the three months ended August 31, 2005 compared to the three months ended August 31, 2004. The increase in interest income is attributable primarily to higher rates of return. Partially offsetting the increase in other income and expense, net was a decrease of $0.6 million in realized gains on the sale of investments during the three months ended August 31, 2005 compared to the three months ended August 31, 2004.

Interest expense

Interest expense primarily consists of interest and the related amortization of deferred debt issuance costs associated with the convertible debentures. During the three months ended August 31, 2005, interest expense was $1.6 million which was approximately the same amount of interest expense incurred during the three months ended August 31, 2004.

Taxes

During the three months ended August 31, 2005, the Company recorded $1.9 million of income tax expense based on an effective tax rate of 10%. The Company’s effective tax rate differs from the U.S. Federal statutory rate primarily due to U.S. net operating loss carryforwards. The provision for income tax expense for the three months ended August 31, 2005, consists of domestic federal alternative minimum tax expense as well as foreign income tax expense. During the three months ended August 31, 2004, the Company recognized an income tax benefit of $0.6 million resulting primarily from the reversal of the valuation allowance pertaining to certain foreign deferred tax assets.

Six Months Ended August 31, 2005 and August 31, 2004

Total revenue

Total revenue increased 43.6% to $126.5 million in the six months ended August 31, 2005 from $88.1 million in the six months ended August 31, 2004. This increase was primarily driven by significant growth in enterprise technologies subscriptions. Retail revenues declined due to our discontinuance of this product.

Subscription revenue

Subscription revenue is comprised of revenue from enterprise technologies (RHEL, RHN, Red Hat Network, Red Hat Directory Server and other products), retail and embedded. Subscription revenue increased 58.1% to $103.6 million for the six months ended August 31, 2005 from $65.5 million for the six months ended August 31, 2004 primarily due to the increase in the volume of subscriptions sold.

Enterprise technologies subscriptions and retail

Enterprise technologies subscriptions revenue primarily relates to both direct and indirect sales of Red Hat enterprise technologies. Enterprise technologies subscriptions revenue increased 60.4% to $102.5 million for the six months ended August 31, 2005 from $63.9 million for the six months ended August 31, 2004. The increase in subscription revenue sales is being driven by broad market acceptance and the increasing use of the Linux operating system in mission critical areas of computing by the large enterprise, as well as increasing revenue through OEM and distributor relationships that we have developed and continue to develop. Our sales force has also increased to better address the growing market opportunity globally and with new product offerings.

There were no retail revenues in the six months ended August 31, 2005 compared to $0.9 million for the six months ended August 31, 2004. This decrease is due to our discontinuance of this product and our focus on the sale of subscriptions of our enterprise technologies to enterprise customers rather than on the consumer market.

Embedded subscriptions

Embedded subscription revenue increased 64.7% to $1.1 million for the six months ended August 31, 2005 from $0.6 million for the six months ended August 31, 2004. The increase in embedded subscription revenue is primarily due to the timing of contracts, not due to any overall change in market demand.

Services revenue

Enterprise technologies services

Enterprise technologies services include fees received from enterprise customers for deployment of Red Hat enterprise technologies, customer training and education fees and fees received for adding certain functionality to RHEL for our major hardware partners. Enterprise technologies services revenue increased 5.2% to $22.1 million in the six months ended August 31, 2005 from $21.0 million in the six months ended August 31, 2004. The increase in enterprise technologies services revenue is primarily due to an increase in consulting fees received from enterprise customers for deployment of Red Hat enterprise technologies of approximately $0.7 million and an increase in the revenues earned from customer training and education of $0.4 million as compared to the prior year period. The adoption of Linux as a primary computing platform increases the need for consulting services and training.

Embedded development services

Embedded development services revenue declined by 46.6% to $0.9 million for the six months ended August 31, 2005 compared to $1.6 million for the six months ended August 31, 2004. The reduction primarily relates to our reduced focus and personnel on this business to a small core team which maintains a minimal presence in this market place.

Cost of revenue

Cost of subscription revenue

literature and packaging, fulfillment and shipping, labor-related costs to provide technical support and maintenance and bandwidth costs for RHN. Cost of enterprise subscription revenue increased 123.4% to $10.8 million in the six months ended August 31, 2005 from $4.9 million in the six months ended August 31, 2004. The overall increase results from $2.3 million of additional staff costs, $1.3 million of additional amortization expense related to identifiable intangible assets acquired in the fourth quarter of fiscal 2005, $1.1 million of additional packaging and product material costs, $0.7 million of depreciation costs and $0.1 million of costs associated with facilities and systems to handle high subscription volumes, and the transfer of certain employees from engineering functions to customer support activities.

Cost of services revenue

Cost of services revenue is primarily comprised of salaries and related costs incurred for our personnel to deliver training and education, open source consulting, engineering and hardware certification services. Cost of services revenue increased 8.5% to $13.4 million in the six months ended August 31, 2005 from $12.3 million in the six months ended August 31, 2004. The increase is primarily related to an increase in costs associated with our training and education services of $1.2 million, a $0.3 million increase in consulting costs and a $0.4 million decrease in our engineering services costs.

Gross profit

While total cost of revenue increased 40.9% to $24.2 million during the six months ended August 31, 2005 from $17.2 million during the six months ended August 31, 2004, total revenues increased 43.6% to $126.5 million during the six months ended August 31, 2005 from $88.1 million during the six months ended August 31, 2004. As a result, gross profit increased 44.3% to $102.3 million (80.9% of total revenue) for the six months ended August 31, 2005 from $70.9 million (80.5% of total revenue) for the six months ended August 31, 2004. This increase was primarily due to the increase in revenue related to our Red Hat enterprise technology subscription offerings, which have higher gross margins than services. Gross margins on total subscription revenues were $92.7 million and $60.6 million during the six months ended August 31, 2005 and 2004, respectively. Gross margins on total services revenues were $9.5 million and $10.3 million during the six months ended August 31, 2005 and 2004, respectively.

Operating expenses

Sales and marketing

Sales and marketing expense consists primarily of salaries and other related costs for personnel, sales commissions, travel, public relations and marketing materials and tradeshows. Sales and marketing expense increased 43.6% to $40.8 million (32.2% of total revenue) in the six months ended August 31, 2005 from $28.4 million (32.3% of total revenue) in the six months ended August 31, 2004. This increase was primarily due to increased staffing and the related $8.6 million increase in compensation costs and a $2.2 million increase in advertising and promotion costs.

Research and development

Research and development expense consists primarily of personnel and related costs for development of software technologies and systems management offerings. Research and development expense increased 29.2% to $20.3 million (16.0% of total revenue) in the six months ended August 31, 2005 from $15.7 million (17.8% of total revenue) in the six months ended August 31, 2004. The increase in research and development expense resulted from a $4.1 million increase in engineering compensation expense. We increased our staffing as a result of an acquisition in the fourth quarter of fiscal 2005 and to support the continued development and integration of our Red Hat enterprise technologies. Other increases in professional fees and expendable equipment costs totaled approximately $0.6 million for the six months ended August 31, 2005.

General and administrative

General and administrative expense consists primarily of personnel and related costs for general corporate functions, including finance, accounting, legal, human resources, facilities and information systems expenses. General and administrative expense increased 45.2% to $21.6 million (17.1% of total revenue) in the six months ended August 31, 2005 from $14.9 million (16.9% of total revenue) in the six months ended August 31, 2004. This increase relates primarily to increased administrative compensation costs of $2.9 million, a $1.7 million increase in accounting, legal and other professional fees and losses of approximately $1.0 million recognized on the disposal of fixed assets. Other increases include $0.6 million in communication costs, $0.4 million in depreciation expense and $0.4 million in expendable equipment costs.

Other income and expense, net

Other income and expense, net consists of interest income earned on cash deposited in money market accounts and invested in short and long-term fixed income instruments, gain on the extinguishment of certain long-term debt, net gains realized on the sale of investments and net foreign currency revaluation gains and losses. Other income and expense, net, increased to $16.0 million in the six months ended August 31, 2005 from $13.3 million in the six months ended August 31, 2004. The increase is primarily related to a $3.1 million net gain recognized on the extinguishment of long-term debt and a $1.6 million increase in interest income during the six months ended August 31, 2005 compared to the six months ended August 31, 2004. The increase in interest income is attributable primarily to higher rates of return. Partially offsetting the increase in other income and expense, net was a decrease of $2.1 million in realized gains on the sale of investments during the six months ended August 31, 2005 compared to the six months ended August 31, 2004.

Interest expense

Interest expense primarily consists of interest and the related amortization of deferred debt issuance costs associated with the convertible debentures. During the six months ended August 31, 2005, interest expense was $3.1 million which was approximately the same amount of interest expense incurred during the six months ended August 31, 2004.

Taxes

During the six month period ended August 31, 2005, the Company recorded $3.2 million of income tax expense based on an effective tax rate of 10%. The Company’s effective tax rate differs from the U.S. Federal statutory rate primarily due to U.S. net operating loss carryforwards. The provision for income tax expense for the six months ended August 31, 2005, consists of domestic federal alternative minimum tax expense as well as foreign income tax expense. During the six months ended August 31, 2004, the Company recognized an income tax benefit of $0.6 million resulting primarily from the reversal of the valuation allowance pertaining to certain foreign deferred tax assets.

Liquidity and Capital Resources

We have historically derived a significant portion of our liquidity and operating capital from the sale of equity securities, including private sales of preferred stock and the sale of common stock in our initial and secondary public offerings, the issuance of convertible debentures and borrowings under working capital lines of credit. At August 31, 2005, we had total cash and investments of $965.6 million, which is comprised of $148.1 million in cash and cash equivalents, $369.4 million of short-term, fixed-income investments and $448.1 million of long-term, fixed-income investments. This compares to total cash and investments of $928.8 million at February 28, 2005. At August 31, 2005, we have an unrealized loss of $9.9 million on our investments in debt securities. We currently have sufficient liquidity with $148.1 million in cash and cash equivalents on hand that we presently do not intend to liquidate our short and long-term investments prior to their scheduled maturity date.

However, in the event that we did liquidate these investments prior to their scheduled maturities and there were no changes in market interest rates, we could be required to recognize a realized loss on those investments when we liquidate.

At August 31, 2005, cash and cash equivalents totaled $148.1 million, a decrease of $96.3 million as compared to May 31, 2005. The decrease in cash and cash equivalents resulted primarily from $118.1 million cash used in investing, primarily related to purchases of debt securities and $23.0 million cash used in financing activities, due primarily to repurchases of our 0.5% senior convertible debentures due 2024 and the Company’s common stock. These uses of cash were partially offset by $45.8 million of cash provided by operations.

Cash provided by operations of $45.8 million in the three months ended August 31, 2005, includes net income of $16.7 million, adjusted to exclude the impact of non-cash revenues and expenses, which totaled $4.7 million net source of cash. Changes in operating assets and liabilities were a net source of cash of $24.4 million primarily resulting from an increase in deferred revenue of $27.8 million and an increase in accrued expenses of $5.1 million, partially offset by an increase of $9.8 million in accounts receivable and earnings in excess of billings. The increase in deferred revenue is due to growth in billings and the nature by which we generally obtain payments from customers for subscriptions to our technologies in advance of the subscription period.

Cash used in investing activities of $118.1 million for the three months ended August 31, 2005 was primarily comprised of net purchases of fixed income investment securities of $110.8 million, purchases of property and equipment totaling $4.7 million and a required payment of $2.5 million under an earn-out provision related to an acquisition consummated in December 2004.

Cash used in financing activities of $23.0 million for the three months ended August 31, 2005 was primarily comprised of $18.1 million in purchases of convertible debentures and $11.6 million in purchases of the Company’s common stock pursuant to the previously announced expanded share repurchase program to acquire up to an aggregate of $250 million of our common stock and $50 million of our 0.5% senior convertible debentures due 2024, partially offset by proceeds from issuance of common stock due to employees exercise of stock options and purchases under the Employee Stock Purchase Plan totaling $6.2 million in the aggregate and other borrowings related to fixed asset purchases totaling $0.4 million.

In January 2004, we issued $600 million in convertible senior debentures, of which $570 million remains outstanding. The debentures mature on January 15, 2024 and bear interest at a rate of 0.5% per annum, payable semiannually on January 15 and July 15 of each year. The debentures are senior unsecured obligations and rank equally in right of payment with all of our other existing and future unsecured and unsubordinated debt. The debentures are convertible into shares of our common stock under certain circumstances prior to maturity at a conversion rate of 39.0753 shares per $1,000 principal amount of debentures (which represents a conversion price of approximately $25.59 per share), subject to adjustment under certain conditions. We may redeem the debentures, in whole or in part, in cash at any time on or after January 15, 2009. Holders of the debentures may require us to redeem the debentures, in whole or in part, in cash on January 15 of 2009, 2014 and 2019. As of August 31, 2005, no debentures were redeemed. Accrued interest to the redemption date will be paid by us in any such redemption. Interest payments of $1.5 million were made during the quarter ended August 31, 2005 and accrued interest at August 31, 2005 was $0.4 million. During the quarter ended August 31, 2005, the Company repurchased $20 million in face value of its 0.5% convertible senior debentures due 2024 at a cost of $18.1 million. The repurchased debentures were canceled pursuant to terms of the indenture and the $1.9 million difference in face value and the cost was recorded as other income in the Company’s Consolidated Income Statement, net of a $0.4 million write-off of deferred debt issuance costs related to the canceled debentures.

We have and will continue to utilize cash and investments to fund, among other potential uses, purchases of our common stock, purchases of our convertible debentures, purchases of fixed assets and mergers and acquisitions.

Given our strong operating cash flow and the $965.6 million of cash and investments held at August 31, 2005, we do not presently anticipate the need to raise cash to fund our operations either through the sale of additional equity or through the issuance of debt for the foreseeable future. However, we may take advantage of favorable capital market situations that may arise from time to time to raise additional capital.

We believe that cash flow from operations will continue to improve; however, there can be no assurances that we will improve our cash flow from operations from the current rate or that such cash flows will be adequate to fund other investments or acquisitions that we may choose to make. We may choose to accelerate the expansion of our business from our current plans, which may require us to raise additional funds through the sale of equity or debt securities or through other financing means. There can be no assurances that any such financing would occur in amounts or on terms favorable to us, if at all.

We have no off-balance sheet financing arrangements and do not utilize any “structured debt”, “special purpose” or similar unconsolidated entities for liquidity or financing purposes.

RISK FACTORS

RISKS RELATED TO OUR BUSINESS

If open source software programmers, most of whom we do not employ, do not continue to develop and enhance open source technologies, we may be unable to develop new products or adequately enhance our existing products.

We rely to a significant degree on several largely informal communities of independent open source software programmers to develop and enhance our products. For example, Linus Torvalds, a prominent open source software developer, and a relatively small group of software engineers, many of whom are not employed by us, are primarily responsible for the development and evolution of the Linux kernel, which is the heart of the RHEL operating system. If these groups of programmers fail to adequately further develop and enhance open source technologies, we would have to rely on other parties to develop and enhance our products or we would need to develop and enhance our products with our own resources. We cannot predict whether further developments and enhancements to these technologies would be available from reliable alternative sources. In either event, our development expenses could be increased and our product release and upgrade schedules could be delayed. Moreover, if third party software programmers fail to adequately further develop and enhance open source technologies, the development and adoption of these technologies could be stifled and our products could become less competitive.

If we fail to continue to establish and maintain strategic distribution and other collaborative relationships with industry-leading companies, we may not be able to attract and retain a larger customer base.

Our success depends in part on our ability to continue to establish and maintain strategic distribution and other collaborative relationships with industry-leading hardware manufacturers (such as Hewlett-Packard, Dell, IBM, Fujitsu and others), distributors, software vendors (such as Oracle) and enterprise solutions providers. These relationships allow us to offer our products and services to a much larger customer base than we would otherwise be able to through our direct sales and marketing efforts. We may not be able to maintain these relationships or replace them on attractive terms. In addition, our existing strategic relationships do not, and any future strategic relationships may not, afford us any exclusive marketing or distribution rights. As a result, many of the companies with which we have strategic alliances pursue alternative technologies and develop alternative products and services in addition to or in lieu of our products and services, either on their own or in collaboration with others, including our competitors. Moreover, we cannot guarantee that the companies with which we have strategic relationships will market our products effectively or continue to devote the resources necessary to provide us with effective sales, marketing, and technical support.

If third-party enterprise software application providers do not continue to make their applications compatible with our Linux-based operating system offerings, our software will cease to be competitive.

Our products will not be competitive unless enterprise software applications are compatible with our Linux-based operating system offerings. We intend to encourage the development of additional applications that operate on both current and new versions of our Linux-based operating systems by, among other means, attracting third-party developers to the Linux platform, providing open source tools to create these applications and maintaining our existing developer relationships through marketing and technical support. If we are not successful in achieving these goals, however, our products will not be competitive and our sales growth will be adversely affected.

We may be unable to predict the future course of open source technology development, which could reduce the market appeal of our products and damage our reputation.

We do not exercise control over many aspects of the development of open source technology. Different groups of open source software programmers compete with one another to develop new technology. Typically,

the technology developed by one group will become more widely used than that developed by others. If we acquire or adopt new technology and incorporate it into our products but competing technology becomes more widely used or accepted, the market appeal of our products may be reduced and that could harm our reputation, diminish the Red Hat brand and result in decreased revenue.

Because of characteristics of open source software, there are few technology barriers to entry in the open source market by new competitors and it may be relatively easy for new competitors with greater resources than we have to enter our markets and compete with us.

One of the characteristics of open source software is that anyone can modify the existing software or develop new software that competes with existing open source software. Such competition can develop without the degree of overhead and lead time required by traditional proprietary software companies. It is possible for a new competitor with greater resources than ours to develop its own open source solutions, potentially reducing the demand for our solutions.

We have entered into and may continue to enter into or seek to enter into business combinations and acquisitions, which may be difficult to complete, integrate, disrupt our business, dilute stockholder value or divert management attention.

As part of our business strategy, we have in the past and, in the future, may enter into business combinations and acquisitions. We have limited experience in making acquisitions, and acquisitions present significant challenges and risks, including:

•

The difficulty of integrating the operations and personnel of the acquired companies;

•

The maintenance of acceptable standards, controls, procedures and policies;

•

The potential disruption of our ongoing business and distraction of management;

•

The impairment of relationships with employees and customers as a result of any integration of new management and other personnel;

•

The inability to maintain a relationship with customers of the acquired business;

•

The difficulty of incorporating acquired technology and rights into our products and services;

•

The potential failure to achieve the expected benefits of the combination or acquisition;

•

Expenses related to the acquisition;

•

Potential unknown liabilities associated with the acquired businesses; and

•

Unanticipated expenses related to acquired technology and its integration into existing technology.

There can be no assurance that we will manage these challenges and risks successfully. Moreover, if we are not successful in completing acquisitions that we have or may pursue, our business strategy may be adversely affected, and we may incur substantial expenses and divert significant management time and resources. In addition, in pursuing such acquisitions, we could use substantial portions of our available cash as all or a portion of the purchase price. We could also issue additional securities as consideration for these acquisitions, which could cause our stockholders to suffer significant dilution, or incur substantial debt. Any acquisition may not generate additional revenue or profit for us.

If we fail to effectively manage our growth, our operations and financial results could be adversely affected.

We have expanded our operations rapidly in recent years. For example, our total revenues increased from approximately $124.7 million for the year ended February 29, 2004 to approximately $196.5 million for the year

ended February 28, 2005. Moreover, the total number of our employees has increased over that year. In addition, we continue to explore ways to extend our product and service offerings, and geographic reach. Our growth has placed and may continue to place a strain on our management systems, information systems, resources and internal controls. Our ability to successfully offer products and services and implement our business plan requires adequate information systems and resources and oversight from our senior management. As we grow, we must also continue to hire, train, supervise and manage new employees. We may not be able to hire, or adequately train, supervise and manage sufficient personnel or develop management and operating systems to adequately manage our expansion effectively. If we are unable to adequately manage our growth and improve our controls, systems and procedures, our operations and financial results could be adversely affected.

We rely, to a significant degree, on an indirect sales channel for distribution of our products and services, and disruption of any part of this channel could adversely affect the sales of our products.

We use a variety of different distribution methods to sell our products and services, including indirect channel partners, such as third party OEMs, resellers and distributors. A number of these partners in turn distribute via their own networks of channel partners (e.g., distributors and resellers), with whom we have no direct relationship. We rely, to a significant degree, on our channel partners. Our indirect distribution channel could be affected by disruptions in the relationships of and with our channel partners and their networks, including their customers or suppliers. We cannot guarantee that our channel partners will market our products effectively. Disruptions in our distribution channel or poor marketing support by channel partners could lead to decreased sales or slower than expected growth.

Security and privacy breaches may expose us to liability and cause us to lose clients

Our security measures may not prevent security breaches that could harm our business. Currently, a significant number of our users provide us with credit card and other confidential information and authorize us to bill their credit card accounts directly for our products and services. We rely on encryption and authentication technology licensed from third parties to effect secure transmission of this confidential information. Advances in computer capabilities, new discoveries in the field of cryptography or other developments may result in a compromise or breach of the technology used by us to protect customer data. Any compromise of our security could harm our reputation or financial condition and, therefore, our business. In addition, a party who is able to circumvent our security measures could, among other effects, misappropriate proprietary information, cause interruptions in our operations or expose customers to computer viruses.

We are vulnerable to system failures, which could harm our business.

We rely on our technology infrastructure to sell our products and services and to fulfill orders. Our systems are vulnerable to damage or interruption from natural disasters, power loss, telecommunication failures, terrorist attacks, computer viruses, computer denial-of-service attacks, and similar events. The majority of our systems are not redundant, and our disaster recovery planning is not sufficient for all eventualities. Our systems are also subject to break-ins, sabotage and intentional acts of vandalism. Despite any precautions we may take, such problems could result in interruptions in our services, which could harm our reputation and financial condition. We do not carry business interruption insurance sufficient to compensate us for losses that may result from interruptions in our service as a result of system failures.

Any interruption in the availability of our websites would create a large volume of user questions and complaints that would need to be addressed by our customer support personnel rather than by self-help. Additionally, any unscheduled interruption in our services would likely result in a loss of revenues and could cause some users to switch to our competitors.

RISKS RELATED TO LEGAL UNCERTAINTY

We could be prevented from selling or developing our software if the GNU General Public License and similar licenses under which our products are developed and licensed are not enforceable.

A number of our offerings, including RHEL, have been developed and licensed under the GNU General Public License and similar open source licenses. These licenses state that any program licensed under them may be liberally copied, modified and distributed. The GNU General Public License is a subject of litigation in the case of The SCO Group, Inc. v. International Business Machines Corp., pending in the United States District Court for the District of Utah. It is possible that a court would hold these licenses to be unenforceable in that litigation or that someone could assert a claim for proprietary rights in a program developed and distributed under them. Any ruling by a court that these licenses are not enforceable, or that Linux-based operating systems, or significant portions of them, may not be liberally copied, modified or distributed, would have the effect of preventing us from selling or developing all or a portion of our products.

Our subscription-based contract model may encounter customer resistance.

The subscription agreement used for many of our products, including RHEL, requires customers to agree to a subscription for our services for each machine on which they deploy our subscription based products. At the same time, the subscription agreement places no restriction on the customer’s right to redistribute the products. While we believe this practice complies with the requirements of the GNU General Public License, and while we have reviewed this practice with the Free Software Foundation, the organization that maintains and provides interpretations of the GNU General Public License, we may still encounter customer resistance to this distribution model. To the extent we are unsuccessful in promoting or defending this distribution model, our business and operating results could be materially and adversely affected.

If our products are found to infringe third-party intellectual property rights, we could be required to redesign our products, replace components of our products or enter into license agreements with third parties.

We have committed to our customers with valid, registered enterprise subscriptions that if any portion of our enterprise products are found to infringe any third party intellectual property rights we will, at our expense and option: (i) obtain the right for the customer to continue to use the product consistent with their subscription agreement with us; (ii) modify the product so that it is non-infringing; or (iii) replace the infringing component with a non-infringing component. Although we cannot predict whether we will need to satisfy this commitment, satisfying the commitment could be costly and time consuming and could materially and adversely affect our financial results. In addition, our insurance policies may not adequately cover our exposure to this type of claim.

We are vulnerable to claims that our products infringe third-party intellectual property rights because our products are comprised of software components, many of which are developed by numerous independent parties, and an adverse legal decision affecting our intellectual property could materially harm our business.

We are vulnerable to claims that our products infringe third-party intellectual property rights including trade secrets because our products are comprised of software components, many of which are developed by numerous independent parties. Claims for infringement of intellectual property rights may be filed and may seek damages and injunctive relief. The risk of infringement claims is exacerbated by the fact that much of the code in our products is developed by numerous independent parties over whom we exercise no supervision or control. It is further exacerbated by our lack of access to unpublished software patent applications. Claims of infringement could require us to seek to obtain licenses from third parties in order to continue offering our products, reengineer our products, or discontinue the sale of our products in the event that obtaining licenses and reengineering could not be accomplished on a timely and cost effective basis, which could adversely affect our business and operating results and may do so materially.

SCO Group, Inc., or SCO, has publicly alleged that certain Linux kernels contain unauthorized UNIX code or derivative works. On November 4, 2003, we filed a complaint against SCO in the United States District Court for the District of Delaware seeking, among other things, a declaratory judgment that we are not infringing any of SCO’s intellectual property rights. SCO, to date, has not asserted a claim of infringement against us. Uncertainty concerning SCO’s allegations, regardless of their merit, could adversely affect sales of our products. If SCO were to prevail in this or other actions related to their claims regarding Linux, our business could be materially and adversely affected. Defending patent infringement, copyright infringement and/or trade secret claims, even claims without significant merit, can be expensive. An adverse legal decision regarding the intellectual property in and to our technology and other offerings could harm our business and may do so materially.

Our products may contain defects that may be costly to correct, delay market acceptance of our products and expose us to litigation.

Despite testing by ourselves and our customers, errors have been and will likely continue to be found in our products after commencement of commercial shipments. This risk is exacerbated by the fact that much of the code in our products is developed by independent parties over whom we exercise no supervision or control. If errors are discovered, we may have to make significant expenditures of capital to eliminate them and may not be able to successfully correct them in a timely manner or at all. Errors and failures in our products could result in a loss of, or delay in, market acceptance of our products and could damage our reputation and our ability to convince commercial users of the benefits of Linux-based operating systems and other open source software products.

In addition, failures in our products could cause system or other failures for our customers who may assert warranty and other claims for substantial damages against us. Although our license agreements with our customers typically contain provisions designed to limit our exposure to potential product liability claims, it is possible that these provisions may not be effective or enforceable under the laws of some jurisdictions. In addition, our insurance policies may not adequately limit our exposure to this type of claim. These claims, even if unsuccessful, could be costly and time consuming to defend.

Our efforts to protect our trademarks may not be adequate to prevent third parties from misappropriating our intellectual property rights.

Our most valuable intellectual property is our collection of trademarks. The protective steps we have taken in the past have been, and may in the future continue to be, inadequate to protect, and deter misappropriation of, our trademark rights. Although we do not believe that we have suffered any material harm from misappropriation to date, we may be unable to detect the unauthorized use of, or take appropriate steps to enforce, our trademark rights in a timely manner. We have registered some of our trademarks in the Americas, Europe, Asia and Australia and have other trademark applications pending in each of those regions. Effective trademark protection may not be available in every country in which we offer or intend to offer our products and services. Failure to adequately protect our trademark rights could damage or even destroy the Red Hat brand and impair our ability to compete effectively. Furthermore, defending or enforcing our trademark rights could result in the expenditure of significant financial and managerial resources.

In connection with our restatement of historical financial statements, class action lawsuits have been filed against us and additional lawsuits may be filed.

Following our announcement in July 2004 of our intention to restate certain historical financial statements, 14 class action lawsuits and three derivative lawsuits were commenced against us and certain of our current and former directors and officers, by or on behalf of persons claiming to be our stockholders and persons claiming to have purchased or otherwise acquired our securities at specified dates beginning as early as June 19, 2001 and continuing through July 13, 2004. The 14 class action lawsuits have since been consolidated into a single lawsuit. In addition, a derivative suit is pending that relates to the restatement of certain historical financial statements.

Additional lawsuits may be filed against us. Regardless of the outcome of any of these actions, it is likely that we will incur substantial defense costs and that such actions will cause a diversion of our management’s time and attention. If we do not prevail in these cases we could be required to pay substantial damages or settlement costs, which could have a material adverse affect on our financial condition or results of operations. We are unable at this time to assess the validity of the claims or estimate the possible range of damages that might be incurred as a result of the lawsuits. We have not yet established any financial reserves relating to any of these lawsuits.

We may suffer material adverse consequences if we are deemed to be an investment company and may incur significant costs to avoid investment company status.

We may be deemed to be an investment company under the Investment Company Act of 1940 (the “1940 Act”), if we own investment securities with a value exceeding 40% of our total assets, unless a particular exclusion or safe harbor provision applies. A large portion of our assets has been invested in investment grade interest-bearing securities, many of which constitute “investment securities” under the 1940 Act. As of February 28, 2005, our “investment securities” exceeded 40% of our total assets. We believe that we are excluded from the definition of investment company and the registration requirements of the 1940 Act, but absent further interpretation by the courts or the SEC of the relevant exclusions, this result cannot be assured. Investment companies are subject to registration under the 1940 Act and compliance with a variety of restrictions and requirements imposed under the 1940 Act. If we were to be deemed an investment company, we would become subject to these restrictions and requirements of the 1940 Act and the consequences of having been an investment company without registering thereunder, could have a material adverse impact on our business.

In addition, we may incur significant costs to avoid investment company status if an exclusion from the 1940 Act were to be considered unavailable to us at a time when the value of our investments that constitute “investment securities” exceeds 40% of our total assets. If we were required to change the allocation of our assets to reduce our ownership of securities that constitute “investment securities,” and acquire non-investment security assets, this could result in transaction costs and a reduction in the rate of return on our liquid assets.

RISKS RELATED TO OUR FINANCIAL RESULTS AND CONDITION

You should not rely on our quarterly results of operations as an indication of our future results.

Due to the unpredictability of the technology spending environment, our revenue and operating results have fluctuated and may continue to fluctuate from quarter to quarter. We base our current and projected future expense levels, in part, on our estimates of future revenue. Our expenses are, to a large extent, fixed in the short term. We may not be able to adjust our spending quickly enough to protect our projected operating results for a quarter if our revenue in that quarter falls short of our expectations. If, among other considerations, our future operating results fall below expectations of securities analysts or investors or we are unable to increase or maintain profitability, the market price of our common stock may decline.

We may not be able to continue to attract capable management personnel.

Our ability to retain key management personnel or hire capable new management personnel as we grow may be challenged to the extent the technology sector performs well and/or if companies with more generous compensation packages or greater perceived growth opportunities compete for the same personnel. In addition, historically we have used stock options as a key component of our compensation packages. Changes in the accounting for equity compensation, including stock options, could adversely affect our earnings or force us to use more cash compensation to attract and retain capable personnel. Volatility in the stock market may reduce the value of our equity awards to the recipient. Such events may affect our ability to successfully attract and retain key management personnel.

We depend on our key personnel that we employ.

Our future success depends on the continued services of a number of key officers and employees. The loss of the technical knowledge and industry expertise of any of these individuals could seriously impede our success. Moreover, the loss of these individuals, particularly to a competitor, and any resulting loss of customers could reduce our market share and diminish the Red Hat brand and adversely affect our business or stock price.

We may lack the financial and operational resources needed to increase our market share and compete effectively.

In the market for operating systems and applications, we face significant competition from larger companies with greater financial resources and name recognition than we have. Competitors, which offer hardware-independent multi-user operating systems for Intel platforms and/or Linux and UNIX-based operating systems, include Microsoft, Novell, IBM, Sun Microsystems, Hewlett-Packard and Unisys. We may lack the financial and operational resources needed to compete successfully with our current competitors as well as potential new competitors. Competitive pressures could affect prices or demand for our products and services, resulting in reduced profit margins and loss of market opportunity. We may have to lower the prices of our products and services to stay competitive, which could affect our margins and financial condition. In addition, if our pricing and other factors are not sufficiently competitive, we may lose market share. Industry consolidation may, also effect competition by creating larger and potentially stronger competitors in the markets in which we compete, which may have an adverse effect on our business.

In the market for services offerings, we face significant competition from larger companies, including those that currently provide service and training related to the Linux operating system as well as other operating systems, particularly UNIX-based operating systems, due to the fact that Linux-and UNIX-based operating systems share many common features. These larger companies, including IBM, Novell and Hewlett-Packard, may be able to leverage their existing service organizations and provide higher levels of consulting and training on a more cost-effective basis than we can. We may not be able to compete successfully with our current or potential competitors.

We may not be able to meet the operational and financial challenges that we will encounter as our international operations, which represented 32.9% of our total revenue for the year ended February 28, 2005, continue to expand.

Our international operations accounted for 32.9% of total revenue for the year ended February 28, 2005. As we expand our international operations, we will face a number of additional challenges associated with the conduct of business overseas. For example:

•

We may have difficulty managing and administering a globally-dispersed business and we may need to reorganize our sales and technical support services forces, staff key management positions and successfully localize software products for a significant number of international markets;

•

Fluctuations in exchange rates may negatively affect our operating results;

•

We have to comply with a wide variety of foreign laws;

•

We may not be able to adequately protect our intellectual property rights overseas due among other reasons to the uncertainty of laws and enforcement in certain countries relating to the protection of intellectual property rights;

•

Export controls and times of crisis could prevent us from shipping our products into and out of certain markets;

•

Changes in import/export duties and quotas could affect the competitive pricing of our products and services and reduce our market share in some countries; and

•

Economic or political instability or terrorist acts in some international markets could result in the forfeiture of some foreign assets and the loss of sums spent developing and marketing those assets.

Any failure by us to effectively manage the challenges associated with the international expansion of our operations could adversely affect our business, operating results and financial condition.

We may be exposed to potential risks if we do not have an effective system of disclosure controls or internal controls or fail on an on-going basis to properly address and implement Section 404 of Sarbanes-Oxley.

We must comply, on an on-going basis, with the requirements of Section 404 of the Sarbanes-Oxley Act of 2002 (“SOX”), including those provisions that establish the requirements for both management and auditors of public companies with respect to reporting on internal control over financial reporting. These requirements first became applicable to the Company on February 28, 2005. The requirements associated with Section 404 are relatively new and untested, and we cannot be certain that measures we have taken, and will take, will be sufficient or timely completed to meet the Section 404 requirements on an on-going basis, or that we will be able to implement and maintain adequate disclosure controls and controls over our financial processes and reporting in the future, particularly in light of our rapid growth and international expansion, which is expected to result in on-going changes to our control systems and areas of potential risk.

If we fail to maintain an effective system of disclosure controls or internal control over financial reporting, including satisfaction of the requirements of Section 404 of SOX, we may not be able to accurately or timely report on our financial results or adequately identify and reduce fraud. As a result, the financial position of our business could be harmed; current and potential future shareholders could lose confidence in the Company and/or our reported financial results, which may cause a negative effect on our trading price; and we could be exposed to litigation or regulatory proceedings, which may be costly or divert management attention.

ITEM 3: QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

We are exposed to the impact of interest rate changes, foreign currency fluctuations and changes in the market value of our investments.

Interest Rate Risk

Our exposure to market rate risk for changes in interest rates relates primarily to our investment portfolio. The primary objective of our investment activities is to preserve principal and liquidity while at the same time maximizing yields without significantly increasing risk. To achieve this objective, we maintain our portfolio of cash equivalents, short-term and long-term investments in a variety of fixed-income securities, including both government and corporate obligations and money market funds. Investments in both fixed rate and floating rate interest earning instruments carry a degree of interest rate risk. Fixed rate securities may have their fair market value adversely impacted due to a rise in prevailing interest rates, while floating rate securities may produce less income than expected if interest rates fall. Due in part to these factors, our future investment income may fall short of expectations due to changes in interest rates or we may suffer losses in principal if forced to sell securities which have declined in market value due to changes in interest rates.

Our convertible debentures are at fixed rates and therefore interest expense is not impacted by a change in rates. The fair market value of the debentures is subject to interest rate risk and market risk due to the convertible feature of the debentures. Generally the fair market value of fixed interest rate debt increases as interest rates fall and decreases as interest rates rise. Generally, the fair market value of debt with conversion features permitting conversion into stock of the issuer, like the debentures, also increases as the market price of the underlying stock increases and decreases as the market price falls, assuming constant market interest rates. The interest and market value changes affect the fair market value of the debentures but do not impact our financial position, cash flows

or results of operations. The fair value of the debentures was approximately $498.0 million and $514.0 million based on quoted market prices as of August 31, 2005 and February 28, 2005, respectively.

Investment Risk

The fair market value of the investment portfolio is subject to interest rate risk. Based on a sensitivity analysis performed on this investment portfolio, a hypothetical one percentage point increase in prevailing interest rates would result in an approximate $9.6 million and $13.1 million decrease in the fair value of our available-for-sale investment securities as of August 31, 2005 and February 28, 2005, respectively.

Derivative Instruments

We did not hold derivative financial instruments as of August 31, 2005.

Foreign Currency Risk

Approximately 32.5% and 32.3% of our revenues for the three month and six month periods ended August 31, 2005, respectively were produced by sales outside the United States. We are exposed to significant risks of foreign currency fluctuation primarily from receivables denominated in foreign currency and are subject to transaction gains and losses, which are recorded as a component in determining net income. The income statements of our non-U.S. operations are translated into U.S. dollars at the average exchange rates for each applicable period. To the extent the U.S. dollar weakens against foreign currencies, the translation of these foreign currency denominated transactions results in increased revenues, operating expenses and net income for our non-U.S. segments. Similarly, our revenues, operating expenses and net income will decrease for our non-U.S. operations if the U.S. dollar strengthens against foreign currencies. Using the average foreign currency exchange rates from fiscal 2005, our revenues from non-U.S. operations for the three month period ended August 31, 2005 would have been higher than we reported using the exchange rates for fiscal 2006, by approximately $0.3 million. For the six month period ended August 31, 2005 our revenues from non-U.S. operations would have been lower by approximately $0.3 million had we used the average foreign currency exchange rates from fiscal 2005 rather than exchange rates applicable for fiscal 2006. Additionally, the assets and liabilities of our non-U.S. operations are translated into U.S. dollars at exchange rates in effect as of the applicable balance sheet dates, while related revenue and expense accounts of these operations are translated at average exchange rates during the month in which related transactions occur. Translation gains and losses are included as an adjustment to stockholders’ equity and included in other comprehensive income.

ITEM 4. CONTROLS AND PROCEDURES

Role of Controls and Procedures

Our management, including our chief executive officer and chief financial officer, does not expect that our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act) or our internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) will prevent all errors and all fraud. A control system, no matter how well designed and operated, can provide only reasonable, not absolute, assurance that the control system’s objectives will be met. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of the controls must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within a company have been detected. These inherent limitations include the realities that judgments in decision-making can be faulty and that breakdowns can occur because of simple error and mistake. Controls can also be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of the controls. The design of any system of controls is based in part on certain assumptions about the likelihood of future events. Because of the inherent limitations in a cost-effective control system, misstatements due to error or

fraud may occur and not be detected. Also projections of any evaluation of effectiveness of controls and procedures to future periods are subject to the risk that the controls and procedures may become inadequate because of changes in conditions, or that the degree of compliance with the controls and procedures may have deteriorated.

Evaluation of Disclosure Controls and Procedures

Our management, with the participation of our chief executive officer and chief financial officer, evaluated the effectiveness of our disclosure controls and procedures as of the end of the period covered by this report. Based on this evaluation, our chief executive officer and chief financial officer concluded that, as of the end of the period covered by this report, our disclosure controls and procedures were effective in that they provide reasonable assurance that information required to be disclosed by us in the reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms.

Changes in Internal Control Over Financial Reporting

No changes in our internal control over financial reporting occurred during the fiscal quarter covered by this report that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

PART II: OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

Commencing on or about March 29, 2001, the Company and certain of its officers and directors were named as defendants in a series of purported class action suits arising out of the Company’s initial public offering and secondary offering. On August 8, 2001, Chief Judge Michael Mukasey of the U.S. District Court for the Southern District of New York issued an order that transferred all of the so-called IPO allocation actions, including the complaints involving the Company, to one judge for coordinated pre-trial proceedings (Case No. 21 MC 92). The court has consolidated the actions into a single action. The plaintiffs contend that the defendants violated federal securities laws by issuing registration statements and prospectuses that contained materially false and misleading information and failed to disclose material information. Plaintiffs also challenge certain IPO allocation practices by underwriters and the lack of disclosure thereof in initial public offering documents. On April 19, 2002, plaintiffs filed amended complaints in each of the 310 consolidated actions, including the Red Hat action. The relief sought consists of unspecified damages. No discovery has occurred to date. The individual director and officer defendants have been dismissed from the case without prejudice. The Company believes these complaints are without merit and will defend itself vigorously in this matter. There can be no assurance, however, that this matter will be resolved in the Company’s favor. The Company, among other issuers, the plaintiffs, and the insurers have agreed, in concept, to a proposed settlement whereby the Company would be released from this litigation without further payment from the Company. That proposed settlement has been submitted to the court for its consideration, and the court has accepted the proposed settlement subject to certain amendments. A fairness hearing on the proposed settlement has been scheduled for April 24, 2006.

in connection with the Company announcement on July 13, 2004 that it would restate certain of its financial statements (the “Restatement”). One or more of the plaintiffs assert that certain present and former officers (the “Individual Defendants”) and the Company variously violated Sections 10(b) and 20(a) of the Securities Exchange Act of 1934 and Rule 10b-5 thereunder by issuing the financial statements that the Company subsequently restated. One or more of the plaintiffs seek unspecified damages, interest, costs, attorneys’ and experts’ fees, an accounting of certain profits obtained by the Individual Defendants from trading in the Company’s common stock, disgorgement by the Company’s chief executive officer and former Chief Financial Officer of certain compensation and profits from trading in the Company’s common stock pursuant to Section 304 of the Sarbanes-Oxley Act of 2002, and other relief. As of September 8, 2004, all of these class action lawsuits were consolidated into a single action referenced as Civil Action No. 5:04-CV-473BR and titled In re Red Hat, Inc. Securities Litigation. Lead counsel and lead plaintiff in the case have now been designated, and on May 6, 2005, the plaintiffs filed an amended consolidated class action complaint. On July 29, 2005, the Company, on behalf of itself and the Individual Defendants, filed a motion to dismiss the action for failure to state a claim upon which relief may be granted. Also on that date PricewaterhouseCoopers LLP, also a defendant, filed a separate motion to dismiss. The Company intends to vigorously defend this class action lawsuit. There can be no assurance, however, that the Company will be successful, and an adverse resolution of the lawsuit could have a material adverse effect on the Company’s financial position and results of operations in the period in which the lawsuit is resolved. The Company is not presently able to reasonably estimate potential losses, if any, related to the lawsuit.

ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

The following table provides information about purchases by the Company during the fiscal quarter ended August 31, 2005 of equity securities that are registered by the Company pursuant to Section 12 of the Securities Exchange Act of 1934, as amended.


Period	Total Number of Shares Purchased	Average Price Paid per Share		Total Number of Shares Purchased as Part of Publicly Announced Program (1)	Approximate Dollar Value of Shares that May Yet be Purchased Under the Program (1)
June 1-30, 2005	—		—	—	$	144.9 million
July 1-31, 2005	100,000	$	15.58	100,000	$	143.3 million
August 1-31, 2005 (2)	669,366	$	14.94	669,366	$	133.3 million
Total (as of August 31, 2005)	769,366	$	15.02	769,366	$	133.3 million

(1)

On March 31, 2005, the Company announced that its Board of Directors had authorized the expansion of its previously announced common stock repurchase program. Under the expanded program, the Company is authorized to repurchase up to an aggregate of $250 million, or an additional $150 million from the Company’s previously authorized September 2004 Stock Repurchase Program, of the Company’s common stock. The program will expire on the earlier of (i) March 31, 2006, or (ii) a determination by the Board of Directors, the chief executive office or the chief financial officer to discontinue the program.

(2)	Shares were settled and transferred by August 31, 2005. The number of shares and the share acquisition price were fixed on July 28, 2005 as part of a structured share repurchase transaction. See Note 6 to the Consolidated Financial Statements, “Share Repurchase Program and Debt Buyback.”

ITEM 4: SUBMISSIONS OF MATTERS TO A VOTE OF SECURITY HOLDERS

On August 26, 2005, the Company held its 2005 annual meeting of stockholders (the “Annual Meeting”). At the Annual Meeting, the following Class III directors were elected: William S. Kaiser, Edward R. Kozel and Robert F. Young. The Class I directors whose terms of office continued after the Annual Meeting were Dr. W. Steve Albrecht and Dr. Marye Anne Fox. The Class II directors whose terms of office continued after the annual meeting were: General H. Hugh Shelton, U.S. Army Retired, Eugene J. McDonald and Matthew J. Szulik.

Set forth below is the number of votes cast for or withheld with respect to each nominee for director and the number of votes cast for or against or abstaining for the other matter submitted to a vote of the stockholders at the Annual Meeting.

(1)

Election of Directors:


	Number of Votes
NOMINEES	SHARES FOR	SHARES WITHHELD
William S. Kaiser	149,036,205	459,588
Edward R. Kozel	149,017,495	478,298
Robert F. Young	148,971,639	524,154

(2)

Ratification of PricewaterhouseCooper LLP as independent registered public accounting firm for the fiscal year ending February 28, 2006:


RATIFICATION OF INDEPENDENT REGISTERED ACCOUNTING FIRM		Number of Votes
VOTES FOR:		148,960,055
VOTES AGAINST:		384,627
ABSTENTIONS:		151,112

ITEM 6: EXHIBITS

(a) List of Exhibits


31.1		Certification of Matthew J. Szulik, Chief Executive Officer, President and Chairman of the Board of Directors, pursuant to Rule 13a-14(a) under the Securities Exchange Act of 1934

31.2		Certification of Charles E. Peters, Jr., Executive Vice President and Chief Financial Officer, pursuant to Rule 13a-14(a) under the Securities Exchange Act of 1934

32.1		Certifications of Matthew J. Szulik, Chief Executive Officer, President and Chairman of the Board of Directors, and Charles E. Peters, Jr., Executive Vice President and Chief Financial Officer, pursuant to 18 U.S.C. Section 1350

SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.


	RED HAT, INC.

Date: October 11, 2005	By:	/S/ MATTHEW J. SZULIK
		Matthew J. Szulik President and Chief Executive Officer (Officer on behalf of the Registrant)


	RED HAT, INC.

Date: October 11, 2005	By:	/S/ CHARLES E. PETERS, JR.
		Charles E. Peters, Jr. Executive Vice President and Chief Financial Officer (Principal Financial Officer)

Positive
Negative
Uncertain
Constraining
Legalese
Litigous
Readability	H.S. freshman Avg

Red Hat Inactive 10-Q2006 Q2 Quarterly report

Content analysis