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 quarter ended November
30, 2000
OR
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934 For the transition period from
to .
Commission File Number: 0-26281
RED HAT, INC.
(Exact name of registrant as specified in its charter)
Delaware
(State of Incorporation)
06-1364387
(I.R.S. Employer Identification No.)
2600 Meridian Parkway, Durham, North Carolina 27713
(Address of principal executive offices, including Zip Code)
(919) 547-0012
(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 the number of shares outstanding of each of the issuer's classes of
common stock, as of the latest practicable date:
As of December 31, 2000, there were 161,593,691 shares of common stock
outstanding.
RED HAT, INC.
TABLE OF CONTENTS
Page
----
PART I - FINANCIAL INFORMATION:
ITEM 1: FINANCIAL STATEMENTS
Consolidated Balance Sheets at November 30, 2000 (unaudited) and
February 29, 2000 3
Consolidated Statements of Operations for the three and nine months
ended November 30, 2000 and 1999 (unaudited) 4
Consolidated Statements of Cash Flows for the nine months
ended November 30, 2000 and 1999 (unaudited) 5
Notes to Consolidated Financial Statements 6
ITEM 2: MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS 10
ITEM 3: QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK 32
PART II - OTHER INFORMATION:
ITEM 2: CHANGES IN SECURITIES AND USE OF PROCEEDS 33
ITEM 6: EXHIBITS AND REPORTS ON FORM 8-K 33
SIGNATURES
EXHIBIT INDEX
PART I - FINANCIAL INFORMATION
ITEM 1: FINANCIAL STATEMENTS
RED HAT, INC.
CONSOLIDATED BALANCE SHEETS
ASSETS
November 30, February 29,
2000 2000
(unaudited)
-------------- --------------
Current assets:
Cash and cash equivalents $ 78,818,621 $ 242,426,032
Investments in debt and equity securities 73,749,940 27,460,222
Accounts receivable, net 17,341,104 7,893,936
Inventory 819,193 488,977
Prepaid expenses and other current assets 2,157,690 1,874,973
-------------- --------------
Total current assets 172,886,548 280,144,140
Property and equipment, net 13,173,104 7,909,103
Goodwill and intangibles, net 131,272,742 58,267,419
Investments in debt and equity securities 160,643,881 72,354,212
Other assets, net 8,762,888 4,859,958
-------------- --------------
Total assets $ 486,739,163 $ 423,534,832
============== ==============
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable $ 5,219,455 $ 10,774,546
Royalties payable 38,105 115,117
Accrued expenses 15,597,658 7,571,058
Deferred revenue 12,522,665 11,030,337
Current portion of capital lease obligations 356,162 366,062
-------------- --------------
Total current liabilities 33,734,045 29,857,120
Capital lease obligations 163,764 230,516
Commitments and contingencies - -
Stockholders' equity:
Preferred stock, $.0001 par value, 5,000,000 shares authorized, none - -
outstanding
Common stock, $.0001 par value, 225,000,0000 shares authorized,
161,536,179 and 153,333,621 shares issued and outstanding
at November 30, 2000 and February 29, 2000, 16,154 15,334
respectively
Additional paid-in capital 595,096,091 477,781,234
Shareholder receivables - (66,899)
Deferred compensation (40,570,598) (35,159,127)
Accumulated deficit (100,585,198) (48,607,478)
Accumulated other comprehensive income (loss) (1,115,095) (515,868)
-------------- --------------
Total stockholders' equity 452,841,354 393,447,196
-------------- --------------
Total liabilities and stockholders' equity $ 486,739,163 $ 423,534,832
============== ==============
The accompanying notes are an integral part of these consolidated financial
statements.
3
RED HAT, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
Three Months Ended Nine Months Ended
----------------------------- ----------------------------
November 30, November 30, November 30, November 30,
2000 1999 2000 1999
(unaudited) (unaudited) (unaudited) (unaudited)
------------- ------------- -------------- ------------
Revenue:
Subscription $ 11,808,818 $ 6,251,520 $ 29,597,144 $ 16,459,719
Services 9,157,850 3,814,592 23,221,230 12,190,797
Web 1,441,021 483,168 4,111,402 668,884
------------- ------------- ------------- ------------
Total revenue 22,407,689 10,549,280 56,929,776 29,319,400
------------- ------------- ------------- ------------
Cost of revenue:
Subscription 3,661,118 3,519,050 10,901,936 8,986,792
Services 5,041,492 2,393,070 12,855,313 6,328,375
Web 57,307 300,795 176,994 626,757
------------- ------------- ------------- ------------
Total cost of revenue 8,759,917 6,212,915 23,934,243 15,941,924
------------- ------------- ------------- ------------
Gross profit 13,647,772 4,336,365 32,995,533 13,377,476
------------- ------------- ------------- ------------
Operating expense:
Sales and marketing (excludes $1,917,211 and $306,077 in 10,368,577 6,489,811 28,352,098 15,154,705
stock-based compensation during the three month periods
ending November 30, 2000 and 1999, respectively, and
$4,992,084 and $420,513 during the nine month periods
ending November 30, 2000 and 1999, respectively)
Research and development (excludes $1,012,420 and 4,992,221 2,663,056 11,935,223 7,466,349
$325,145 in stock-based compensation during the three
month periods ending November 30, 2000 and 1999, respectively,
and $1,520,950 and $892,244 during the nine month peiods
ending November 30, 2000 and 1999, respectively)
General and administrative (excludes $1,868,609 and
$79,241 in stock-based compensation 6,737,708 2,155,654 21,208,763 6,144,820
during the three month periods ending November 30, 2000
and 1999, respectively, and $5,497,703 and $353,770
during the nine month periods ending November 30, 2000
and 1999, respectively)
Amortization of goodwill and intangibles 13,445,026 2,643 27,705,061 5,239
Stock-based compensation 4,798,240 710,463 12,010,737 1,666,527
------------- ------------- ------------- ------------
Total operating expense 40,341,772 12,021,627 101,211,882 30,437,640
------------- ------------- ------------- ------------
Loss from operations (26,694,000) (7,685,262) (68,216,349) (17,060,164)
------------- ------------- ------------- ------------
Interest income (expense):
Interest income 5,381,485 1,538,499 16,469,389 2,508,166
Interest expense (10,130) (112,753) (41,046) (439,908)
------------- ------------- ------------- ------------
Interest income, net 5,371,355 1,425,746 16,428,343 2,068,258
------------- ------------- ------------- ------------
Loss before income taxes (21,322,645) (6,259,516) (51,788,006) (14,991,906)
Provision for income taxes 90,744 39,112 189,714 240,981
------------- ------------- ------------- ------------
Net loss (21,413,389) (6,298,628) (51,977,720) (15,232,887)
Accretion of mandatorily redeemable preferred stock - - - (82,473)
------------- ------------- ------------- ------------
Net loss available to common stockholders $ (21,413,389) $ (6,298,628) $ (51,977,720 $ (15,315,360)
============= ============= ============= ============
Net loss per common share:
Basic (0.13) (0.05) (0.33) (0.18)
Diluted (0.13) (0.05) (0.33) (0.18)
Weighted average shares outstanding:
Basic 160,825,059 139,082,115 157,705,691 85,691,876
Diluted 160,825,059 139,082,115 157,705,691 85,691,876
The accompanying notes are an integral part of these consolidated financial
statements.
4
RED HAT, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
Nine Months Ended
--------------------------------------
November 30, November 30,
2000 1999
(unaudited) (unaudited)
------------- -------------
Cash flows from operating activities:
Net loss $ (51,977,720) $ (15,232,887)
Adjustments to reconcile net loss to net cash used in operating activities:
Effect on net loss of inclusion of Cygnus September 1999
results of operations twice - 981,314
Depreciation and amortization 30,953,888 1,365,645
Stock-based compensation expense 10,556,031 1,641,507
Noncash management compensation expense - 13,523
Provision for doubtful accounts 1,341,194 362,060
Provision for inventory obsolescence 544,672 -
Loss on sale of property and equipment 73,655 -
Deferred revenue 1,302,912 3,486,537
Changes in operating assets and liabilities:
Accounts receivable (11,886,919) (3,460,209)
Inventory (874,888) (1,508,081)
Prepaid expenses (166,951) (718,162)
Intangibles and other assets (4,018,475) (1,668,710)
Accounts payable (5,783,631) 2,915,621
Royalties payable (77,012) 77,269
Accrued expenses 5,005,461 2,431,551
------------- -------------
Net cash used in operating activities (25,007,783) (9,313,022)
------------- -------------
Cash flows from investing activities:
Purchase of investment securities (264,764,884) (154,220,661)
Proceeds from sales and maturities of investment securities 130,363,082 71,750,316
Proceeds from sale of equipment 29,528 -
Cost of acquisitions, net of cash and cash equivalents acquired 228,469 -
Purchase of property and equipment (8,457,887) (4,737,292)
------------- -------------
Net cash (used in) provided by investing activities (142,601,692) (87,207,637)
------------- -------------
Cash flows from financing activities:
Decrease in stockholders' notes receivable 66,899 (95,223)
Repayments of notes payable (507,291) (1,338,302)
Repurchase of restricted stock - (1,119)
Proceeds from issuance of common stock, net - 88,466,929
Proceeds from issuance of mandatorily redeemable preferred stock, net - 3,180,628
Proceeds from issuance of preferred stock - 4,973,881
Payment of offering costs (52,095) -
Proceeds from issuance of common stock under Employee Stock Purchase Plan 590,109 -
Proceeds from exercise of common stock options and warrants 4,794,900 3,361,750
Payments on capital lease obligations (113,646) (155,986)
------------- -------------
Net cash provided by financing activities 4,778,876 98,392,558
------------- -------------
Effect of foreign currency exchange rates on cash and cash equivalents (776,812) 32,224
Net (decrease) increase in cash and cash equivalents (163,607,411) 1,904,123
Cash and cash equivalents at beginning of the period 242,426,032 19,485,586
------------- -------------
Cash and cash equivalents at end of period $ 78,818,621 $ 21,389,709
============= =============
The accompanying notes are an integral part of these consolidated financial
statements.
5
NOTE 1-Organization
Red Hat offers users one single, trusted point of contact and a common platform
for developing, deploying and managing open source across Internet
infrastructure and devices that connect to the Internet, ranging from small
embedded devices to high availability clusters and integrated web
server/ecommerce OSes. The Red Hat Network, Red Hat's unique management
technology, helps companies worldwide easily manage it all by delivering open
source products, service, support and information on-line in real-time. Red Hat
was incorporated in Connecticut in March 1993 as ACC Corp., Inc. In September
1995, we changed our name to Red Hat Software, Inc. In September 1998, we
reincorporated in Delaware. In June 1999, we changed our name to Red Hat, Inc.
NOTE 2-Summary of Significant Accounting Policies
Unaudited Interim Financial Information
The interim consolidated financial statements as of November 30, 2000 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 generally accepted accounting principles. The consolidated
balance sheet at February 29, 2000 has been derived from the audited
consolidated financial statements at that date. Operating results for the three
and nine month periods ended November 30, 2000 are not necessarily indicative of
the results that may be expected for the year ending February 28, 2001. Certain
information and footnote disclosures normally included in financial statements
prepared in accordance with generally accepted accounting principles have been
omitted in accordance with the rules and regulations of the SEC. These interim
consolidated financial statements should be read in conjunction with the
consolidated financial statements and notes thereto for the year ended February
29, 2000.
Principles of Consolidation
The accompanying consolidated financial statements include the accounts of the
Company and all of its wholly-owned subsidiaries. All significant intercompany
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 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 date of the financial
statements and the reported amounts of revenues and expenses during the
reporting period. Actual results could differ from those estimates.
Revenue Recognition
Revenue from the sale of software products for which no technical support is
provided is generally recognized upon shipment of the products, net of a reserve
for estimated returns. A reserve for sales returns is recognized for sales of
software products to distributors, who have a right of return, based on
6
the Company's historical experience of sell-through to the end user by the
distributor. The Company recognizes revenue from the sale of software products
to new distributors of its software products based upon sell-through to the end
user until the Company has sufficient historical experience with the distributor
to allow the accurate estimation of sales returns.
The Company provides certain support and subscription services with Official Red
Hat Linux for a period of time, not exceeding six months, from the date of
registration of the software products for no additional fee. In accordance with
the provisions of Statement of Position No. 97-2, "Software Revenue Recognition"
("SOP 97-2") as amended by SOP 98-4 and SOP 98-9, the Company is recognizing all
of the revenue from the sale of Official Red Hat Linux ratably over the period
that the support and subscription services are provided. Revenue from sale of
books published by the Company, which is included in subscription revenue, is
recognized at the date of shipment, net of estimated returns.
Service revenue consists of revenue for technical support and maintenance
services, other than installation support, and customer training and education,
revenue for software compiling, debugging and optimization contracts
("Development Contracts") and royalty revenue. Revenue for technical support and
maintenance services, other than installation support, is deferred and
recognized ratably over the term of the agreement, which is typically twelve
months. Revenue for development contracts is recognized on the percentage-of-
completion method provided that the fee for such engineering services is fixed
or determinable and the collection of the resulting receivable is probable.
Revenue from customer training and education and other services is recognized at
the date the services are performed.
Royalty revenue, which is included in services revenue, is comprised primarily
of royalties received from the sale of rights to the Company's brand and
trademark and royalties received from international distributors of the
Company's products. Royalty revenue is recognized when received.
Web revenue related to advertising is recognized ratably in the period in which
the advertisement is displayed, provided that the Company has no significant
remaining obligations, at the lesser of the ratio of connections to the
advertiser's website delivered over total guaranteed connections to the
advertiser's website or the straight line basis over the term of the contract.
If minimum guaranteed connections are not met, the Company defers recognition of
the corresponding revenue until the guaranteed connections are achieved.
Net Loss Per Common Share
The Company computes net loss per common share in accordance with Statement of
Financial Accounting Standards No. 128, "Earnings Per Share," ("SFAS 128") and
SEC Staff Accounting Bulletin No. 98 ("SAB 98"). Under the provisions of SFAS
128 and SAB 98, basic net loss per common share ("Basic EPS") is computed by
dividing net loss available to common stockholders by the weighted average
number of common shares outstanding. Diluted net loss available to common
stockholders per common share ("Diluted EPS") is computed by dividing net loss
by the weighted average number of common shares outstanding and dilutive
potential common share equivalents. Potential common shares consist of shares
issuable upon the exercise of stock options and warrants and shares issuable
upon conversion of outstanding mandatorily redeemable preferred stock. The
calculation of net loss per share available to common stockholders does not
include 12,100,709 and 14,826,153 potential shares of common stock equivalents
for the three month periods ended November 30, 2000 and 1999, respectively, and
12,917,626 and 56,894,425 potential shares of common stock equivalents for the
nine month periods ended November 30, 2000 and 1999, respectively, as their
impact would be antidilutive.
Segment Reporting
In June 1997, the Financial Accounting Standards Board ("FASB") issued Statement
of Financial Accounting Standards No. 131, "Disclosures About Segments of an
Enterprise and Related Information" ("SFAS 131"). This statement requires
companies to report information about operating segments in interim and annual
financial statements. It also requires segment disclosures about products and
services, geographic areas and major customers. The Company adopted SFAS 131
effective for its fiscal year
7
ended February 28, 1998. Required segment disclosures are presented below:
The Company has international offices in the United Kingdom, Ireland, Germany,
France, Italy, Singapore, Australia, and Japan. The following disclosure
aggregates individually immaterial international operations and separately
discloses the significant international operations at and for the three and nine
month periods ended November 30, 2000.
North Asia Pacific
----- Europe ------------ Total
America ------ and Japan -----
------- ----------
Three Months Ended November 30, 2000
------------------------------------
Revenue from
unaffiliated
customers....... $ 17,827,974 $ 2,618,076 $1,961,639 $ 22,407,689
Net Loss......... $(18,936,893) $(1,756,399) $ (720,097) $(21,413,389)
Total Assets..... $473,671,308 $ 9,452,104 $3,615,751 $486,739,163
Nine Months Ended November 30, 2000
------------------------------------
Revenue from
unaffiliated
customers...... $ 45,688,510 $ 6,893,823 $ 4,347,443 $ 56,929,776
Net Loss........ $(45,496,797) $(3,670,305) $(2,810,618) $ (51,977,720)
Total Assets..... $473,671,308 $ 9,452,104 $ 3,615,751 $ 486,739,163
Comprehensive Income
In June 1997, the FASB issued Statement of Financial Accounting Standards No.
130, "Reporting Comprehensive Income" ("SFAS 130"). SFAS 130 establishes
standards for reporting and display of comprehensive income and its components
in a full set of general-purpose financial statements. SFAS 130 is effective for
financial statements for fiscal years beginning after December 15, 1997. The
Company's items of other comprehensive income (loss) during the three months
ended November 30, 2000 totaled $1,115,095 and are comprised of an unrealized
loss on investments in marketable securities of $398,061 and a foreign currency
translation adjustment of $717,034. The Company had no items of other
comprehensive income during the three month period ended November 30, 1999.
Recent Accounting Pronouncements
In June 1998, the FASB issued Statement of Financial Accounting Standards No.
133, "Accounting for Derivative Instruments and Hedging Activities" ("SFAS
133"). SFAS 133 establishes accounting and reporting standards for derivative
instruments, including certain derivative instruments embedded in other
contracts (collectively referred to as derivatives), and for hedging activities.
SFAS 133, as amended by SFAS 137, is effective for all fiscal quarters of all
fiscal years beginning after June 15, 2000, with earlier application encouraged.
The Company does not currently nor does it intend in the future to use
derivative instruments and therefore does not expect that the adoption of SFAS
133 will have any impact on its financial position or results of operations.
In December 1999, the Securities and Exchange Commission issued Staff Accounting
Bulletin No. 101, "Revenue Recognition in Financial Statements" ("SAB 101")
which addresses certain criteria for revenue recognition. SAB 101, as amended by
SAB 101A and SAB 101B, outlines the criteria that must be met to recognize
revenue and provides guidance for disclosures related to revenue recognition
policies. The Company is required to adopt SAB 101 in the first quarter of
fiscal 2002. The adoption of SAB 101 is not expected to have a material impact
on the consolidated financial position or results of operation.
8
NOTE 3-Business Combinations
In May 2000, the Company completed the acquisition of all of the outstanding
common stock of Bluecurve, Inc. ("Bluecurve") in exchange for the issuance of
972,083 shares of the Company's common stock and the assumption of all of the
outstanding stock options valued, in the aggregate, at $33,223,303, plus the
assumption of $1,021,544 in net liabilities. The acquisition of Bluecurve has
been accounted for using the purchase method of accounting in accordance with
APB 16 and, accordingly, the excess of purchase price over the fair values of
the net assets acquired of $34,244,847 has been recorded as goodwill, which is
being amortized on a straight-line basis over three years.
In July 2000, the Company completed the acquisition of all of the outstanding
common stock of WireSpeed Communications Corporation, Inc. ("WireSpeed") in
exchange for the issuance of 1,461,119 shares of the Company's common stock, and
the assumption of all of the outstanding stock options valued, in the aggregate,
at $35,832,638, plus the assumption of $741,525 in net liabilities. The
acquisition of WireSpeed has been accounted for using the purchase method of
accounting in accordance with APB 16 and, accordingly, the excess of purchase
price over the fair values of the net assets acquired of $36,574,163 has been
recorded as goodwill, which is being amortized on a straight-line basis over
three years. In addition to the above, additional shares may be issued, with a
market value as defined in the agreement, if certain performance objectives are
met. The number and value of these shares will be determined and recorded as
goodwill as the performance objectives are met.
In September 2000, the Company completed the acquisition of all of the
outstanding common stock of C2Net Software, Inc. ("C2Net") in exchange for the
issuance of 954,357 shares of the Company's common stock, and the assumption of
all of the outstanding stock options. The fair value of the shares and stock
options issued for vested stock options of C2Net, together with the intrinsic
value of stock options issued for unvested stock options of C2Net amounted to
$42,798,154, plus the assumption of $1,810,325 in net liabilities. The
acquisition of C2Net has been accounted for using the purchase method of
accounting in accordance with APB 16 and, accordingly, the excess of purchase
price over the fair values of the net assets acquired of $28,703,477 has been
recorded as goodwill, which is being amortized on a straight-line basis over
three years, and $15,905,002 has been recorded as deferred compensation in
accordance with FASB Interpretation No. 44, "Accounting for Certain Transactions
Involving Stock Compensation--an interpretation of APB Opinion No. 25", which is
being amortized over the remaining vesting period of the related stock options,
which averages approximately three years. In addition to the above, additional
shares may be issued, with a market value as defined in the agreement, if
certain performance objectives are met. The number and value of these shares
will be determined and recorded as goodwill as the performance objectives are
met.
9
ITEM 2 - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
Management's Discussion and Analysis of Financial Condition and Results of
Operations contains forward-looking statements that involve known and unknown
risks and uncertainties, including statements regarding Red Hat's strategy,
financial performance, and revenue sources. These risks and uncertainties may
cause Red Hat's actual results to differ materially from any 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 (the "SEC"), copies of which may be accessed through the SEC's web
site at http://www.sec.gov.
------------------
Overview
Red Hat offers users one single, trusted point of contact and a common platform
for developing, deploying and managing open source across Internet
infrastructure and devices that connect to the Internet, ranging from small
embedded devices to high availability clusters and integrated web
server/ecommerce OSes. The Red Hat Network, Red Hat's unique management
technology, helps companies worldwide easily manage it all by delivering open
source products, service, support and information on-line in real-time. Red Hat
was incorporated in Connecticut in March 1993 as ACC Corp., Inc. In September
1995, we changed our name to Red Hat Software, Inc. In September 1998, we
reincorporated in Delaware. In June 1999, we changed our name to Red Hat, Inc.
We have financed our activities to date through proceeds from the sale of equity
securities and cash flow from operations.
In January 2000, we acquired Cygnus Solutions ("Cygnus") in a transaction
accounted for as a pooling of interests. As a result of this acquisition, our
historical financial statements have been restated to include the results of
operations and accounts of Cygnus for all periods presented. In January, May,
July and September 2000, we acquired Hells Kitchen Systems, Inc. ("HKS"),
Bluecurve, WireSpeed, and C2Net, respectively in transactions accounted for in
accordance with the purchase method of accounting. As a result, our results of
operations include the operations of HKS, Bluecurve, WireSpeed, and C2Net from
the respective dates of acquisition.
Sales of Official Red Hat Linux have historically represented our principal
source of revenue. We derive our subscription revenue primarily from the sale of
software products and technical support contracts:
. through distributors to enterprise and retail accounts;
. directly to individual users and enterprises through our redhat.com
web site, our call center, and our direct sales force; and
. from original equipment manufacturers which license our software and
support services directly.
Revenues from the sale of software products for which no technical support is
provided are generally recognized upon shipment of the products, net of a
reserve for estimated returns. A reserve for sales returns is recognized for
sales of 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 Company recognizes revenues from the sale of software products
to new distributors of its software products based upon sell-through to the end
user until the Company has sufficient historical experience with the distributor
to allow the accurate estimation of sales returns.
The Company provides certain support and subscription services with Official Red
Hat Linux for a period of time, not exceeding six months, from the date of
registration of the software products for no additional fee. In accordance with
the provisions of Statement of Position No. 97-2, "Software Revenue Recognition"
("SOP 97-2") as amended by SOP 98-4 and SOP 98-9, the Company is recognizing all
of the revenue from the sale of Official Red Hat Linux ratably over the period
that the support and subscription services are provided. Revenue from sale of
books published by the Company, which is included in subscription
10
revenue, is recognized at the date of shipment, net of estimated returns.
Service revenues consist of revenue for technical support and maintenance
services, other than installation support, and customer training and education,
revenue for software compiling, debugging and optimization contracts
("Development Contracts") and royalty revenue. Revenue for technical support and
maintenance services, other than installation support, is deferred and
recognized ratably over the term of the agreement, which is typically twelve
months. Revenues for development contracts are recognized on the percentage-of-
completion method provided that the fee for such engineering services is fixed
or determinable and the collection of the resulting receivable is probable.
Revenue from customer training and education and other services is recognized at
the date the services are performed.
Royalty revenue, which is included in services revenue, is comprised primarily
of royalties received from the sale of rights to the Company's brand and
trademark and royalties received from international distributors of the
Company's products. Royalty revenue is recognized when received.
Web revenue related to advertising is recognized ratably in the period in which
the advertisement is displayed, provided that the Company has no significant
remaining obligations, at the lesser of the ratio of connections to the
advertiser's website delivered over total guaranteed connections to the
advertiser's website or the straight line basis over the term of the contract.
If minimum guaranteed connections are not met, the Company defers recognition of
the corresponding revenue until the guaranteed connections are achieved.
Web revenue is currently derived principally from short-term advertising
contracts in which we typically guarantee a minimum number of impressions to be
delivered to users over a specified period of time for a fixed fee. Advertising
rates are typically measured on a cost per thousand impressions basis.
Advertising revenue is recognized ratably in the period in which the
advertisement is displayed, provided that we have no significant remaining
obligations, at the lesser of the ratio of impressions delivered over total
guaranteed impressions or the straight line basis over the term of the contract.
If we do not meet minimum guaranteed impressions requirements, we defer
recognition of the corresponding revenue until the minimum number of guaranteed
impressions is achieved.
Prior to March 1999, we provided only minimal service offerings to our
customers. In March 1999, we developed and expanded our service offerings to
include comprehensive technical support and maintenance, developer support,
custom development, consulting, training and education and hardware
certification services. Revenue from technical support and maintenance
arrangements is deferred and recognized ratably over the term of the related
agreement, which is typically one year. Revenue from custom development,
consulting, training and education services, developer support and hardware
certification services, is recognized as the services are provided.
We provide custom development services for integrated device manufacturers and
also provide engineering services and developer support services for
microprocessor and product manufacturing companies. We recognize revenue on
these service arrangements on the percentage of completion method over the term
of the related development agreement. These custom development arrangements
generally have a term of three to six months. Support and maintenance
arrangements typically have terms of three months to two years. Revenue from
ongoing technical support and maintenance services was recognized ratably over
the term of the related technical support and maintenance agreement.
We have historically experienced fluctuations in our results of operations
related to the release of new versions of Official Red Hat Linux. We believe our
customers' anticipation of the release of these new versions has historically
resulted in, and will continue to result in, a decline in sales for several
months prior to the release and an increase in sales immediately following the
release.
11
Results of Operations
The following table sets forth the results of operations for Red Hat expressed
as a percentage of total revenue.
Three Months Ended Nine Months Ended
November 30, November 30,
2000 1999 2000 1999
------- ------- ------- -------
(Unaudited) (Unaudited)
Revenue:
Subscription 52.7% 59.3% 52.0% 56.1%
Services 40.9% 36.1% 40.8% 41.6%
Web 6.4% 4.6% 7.2% 2.3%
------ ----- ----- -----
Total revenue 100.0% 100.0% 100.0% 100.0%
------ ----- ----- -----
Cost of revenue:
Subscription 16.3% 33.3% 19.1% 30.7%
Services 22.5% 22.7% 22.6% 21.6%
Web 0.3% 2.9% 0.3% 2.1%
------ ----- ----- -----
Total cost of revenue 39.1% 58.9% 42.0% 54.4%
------ ----- ----- -----
Gross profit 60.9% 41.1% 58.0% 45.6%
------ ----- ----- -----
Operating expense:
Sales and marketing 46.3% 61.5% 49.8% 51.7%
Research and development 22.3% 25.2% 21.0% 25.5%
General and administrative 30.1% 20.4% 37.3% 21.0%
Amortization of goodwill and intangibles 60.0% 0.0% 48.7% 0.0%
Stock-based compensation 21.4% 6.8% 21.1% 5.6%
------ ----- ----- -----
Total operating expense 180.1% 113.9% 177.9% 103.8%
------ ----- ----- -----
Loss from operations -119.2% -72.8% -119.9% -58.2%
------ ----- ----- -----
Interest income (expense), net 24.0% 13.5% 28.9% 7.1%
------ ----- ----- -----
Loss before income taxes -95.2% -59.3% -91.0% -51.1%
Provision for income taxes 0.4% 0.4% 0.3% 0.8%
------ ----- ----- -----
Net loss -95.6% -59.7% -91.3% -51.9%
Accretion of mandatorily redeemable preferred stock 0.0% 0.0% 0.0% -0.3%
------ ----- ----- -----
Net loss available to common stockholders -95.6% -59.7% -91.3% -52.2%
====== ===== ===== =====
Three Months Ended November 30, 2000 and November 30, 1999
Total revenue
Total revenue increased 112.4% to $22.4 million in the three months ended
November 30, 2000 from $10.5 million in the three months ended November 30,
1999. Revenue from international operations totaled $4.6 million during the
three months ended November 30, 2000. We established international operations
for sale of our software products in August 1999. Prior to August 1999, our
international revenue was limited to revenue generated from custom development
services performed for international customers.
Subscription revenue
Subscription revenue is comprised primarily of revenue from sales of Official
Red Hat Linux and related software products, sales of software development
tools, and technical support and maintenance. Subscription revenue increased
88.9% to $11.8 million in the three months ended November 30, 2000 from $6.3
million in the three months ended November 30, 1999. This increase was
primarily due to the release of two new versions of Official Red Hat Linux
during fiscal 2000, rapid growth of our international operations, and an
increase in technical support and maintenance revenue as a result of our
increased focus on providing these services in fiscal year 2001 as compared to
fiscal year 2000. As a percentage of total revenue, subscription revenue
decreased to 52.7% in the three months ended November 30, 2000 from 59.3% in the
three months ended November 30, 1999. The decrease in subscription revenue as a
percentage of total revenue is primarily a result of the timing of our product
releases and the growth in our services revenue.
Services revenue
Services revenue is primarily comprised of custom development fees, learning
services fees, and short-term consulting contracts. Services revenue increased
140.1% to $9.2 million in the three months ended November 30, 2000 from $3.8
million in the three months ended November 30, 1999. The increase in services
revenue resulted primarily from an increase in custom development revenue due to
an increase in the number, size and scope of custom development contracts and an
increase in training and education revenue due to the expansion of our course
offerings. As a percentage of total revenue, services revenue increased to
40.9% in the three months ended November 30, 2000 from 36.1% in the three months
ended November 30, 1999. The increase in services revenue as a percentage of
total revenue is primarily a result of the high rate of growth of our learning
services business as Open Source Solutions, specifically Red Hat Linux, continue
to be adopted by the enterprise.
Web revenue
Web revenue is comprised primarily of fees generated from contracts with
advertisers to display advertisements on our web site. Web revenue increased to
$1.4 million in the three months ended November 30, 2000 from $0.5 million in
the three months ended November 30, 1999. As a percentage of total revenue, web
revenue increased to 6.4% in the three months ended November 30, 2000 from 4.6%
in the three months ended November 30, 1999. These increases were due to the
commencement of our web initiatives during the fiscal year ended February 29,
2000.
12
Cost of revenue
Cost of subscription revenue
Cost of subscription revenue consists of expenses we incur to manufacture,
package and distribute our products and related documentation. These costs
include expenses for physical media, literature and packaging, fulfillment and
shipping, and labor related costs to provide technical support and maintenance.
Cost of subscription revenue increased 4.0% to $3.7 million in the three months
ended November 30, 2000 from $3.5 million in the three months ended November 30,
1999. This increase was directly related to the increase in sales volumes as a
result of the release of Version 7 of Official Red Hat Linux in September 2000
and costs incurred to provide technical support and maintenance services. As a
percentage of subscription revenue, cost of subscription revenue decreased to
31.0% in the three months ended November 30, 2000 from 56.3% in the three months
ended November 30, 1999. This decrease was due to an increase in sales volumes
in the three months ended November 30, 2000.
Cost of services revenue
Cost of services revenue is primarily comprised of salaries and related costs
incurred for custom development, training and education, and hardware
certification services. We incur no direct costs related to royalties received
from the licensing of our trademarks to third parties. Cost of services revenue
increased 110.7% to $5.0 million in the three months ended November 30, 2000
from $2.4 million in the three months ended November 30, 1999. This increase
was primarily due to the addition of personnel to provide custom development,
training and education, and hardware certification services, and the development
of our services organization. As a percentage of services revenue, cost of
services revenue decreased to 55.1% in the three months ended November 30, 2000
from 62.7% in the three months ended November 30, 1999. This decrease was
primarily due to the increase in learning services revenues.
We expect cost of services to increase as we further expand our service
offerings. Cost of services as a percentage of services revenue is expected to
vary significantly from period to period depending upon:
. the mix of services we provide;
. the number and scope of custom development contracts;
. whether such services are provided by us or third-party partners and
contractors;
. the overall utilization rate of our services staff; and
. the use of our redhat.com web site to deliver these services
Cost of web revenue
Cost of web revenue includes the cost of developing advertising on our web site.
Cost of web revenue decreased 80.9% to $57,000 in the three months ended
November 30, 2000 from $0.3 million in the three months ended November 30, 1999.
As a percentage of web revenue, cost of web revenue decreased to 4.0% in the
three months ended November 30, 2000 from 62.3% in three months ended November
30, 1999. These decreases were due to the development of our web advertising
group and initial expenses related to our offering of web advertising for the
first time during the fiscal year ended February 29, 2000.
Gross Profit
Gross profit increased 214.7% to $13.6 million in the three months ended
November 30, 2000 from $4.3
13
million in the three months ended November 30, 1999. As a percentage of total
revenue, gross profit increased to 60.9% in the three months ended November 30,
2000 from 41.1% in the three months ended November 30, 1999. These increases
were primarily the result of the increases in sales of software products, due to
the release of Version 7 of Official Red Hat Linux in September 2000, and the
high rate of growth of our learning services business. These revenue increases
were partially offset by increased costs of services resulting from the addition
of personnel to provide custom development, training and education, and hardware
certification services, and the development of our services organization.
Operating expense
Sales and marketing
Sales and marketing expense consists primarily of salaries and other related
costs for sales and marketing personnel, sales commissions, travel, public
relations and marketing materials and tradeshows. Sales and marketing expense
increased 59.8% to $10.4 million in the three months ended November 30, 2000
from $6.5 million in the three months ended November 30, 1999. The increase in
sales and marketing expense was due primarily to higher advertising and
promotional costs incurred to promote the release of Version 7 of Official Red
Hat Linux, our web advertising and service offerings and, to a lesser extent,
our new software development tools. As a percentage of total revenue, sales and
marketing expense decreased to 46.3% in the three months ended November 30, 2000
from 61.5% in the three months ended November 30, 1999. We expect sales and
marketing expense to continue to increase in dollar amount as we promote the
expansion of our services offerings and web site and expand our international
subscription operations.
Research and development
Research and development expense consists primarily of personnel and related
costs for development of our software products and web site. Research and
development expense increased 87.5% to $5.0 million in the three months ended
November 30, 2000 from $2.7 million in the three months ended November 30, 1999.
As a percentage of total revenue, research and development expense decreased to
22.3% in the three months ended November 30, 2000 from 25.2% in the three months
ended November 30, 1999. The increase in research and development expense
resulted from increased spending due to expansion in the number of open source
product offerings. We expect research and development expense to continue to
increase in dollar amount as we continue to add content to our web site and
create additional features for Official Red Hat Linux.
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 and merger and
acquisition costs. General and administrative expense increased 212.6% to $6.7
million in the three months ended November 30, 2000 from $2.2 million in the
three months ended November 30, 1999. This increase resulted from:
. an increase in merger and acquisition costs of $2.3 million in the
three months ended November 30, 2000 from $0.1 million in the three
months ended November 30, 1999. This increase was primarily due to the
number of acquisitions completed thus far in fiscal 2001. Merger and
acquisition expense consists of costs incurred in connection with
investigating potential acquisitions, costs of integrating acquired
companies, costs of elimination of redundancies created from
acquisition, and the cost of acquisitions accounted for using the
pooling of interests method of accounting.
. an increase in payroll costs due to an increase in the number of
general and administrative personnel to support the growth of our
business;
14
. an increase in legal, accounting, and insurance costs as a result of
our status as a public company; and
. our geographic expansion.
As a percentage of total revenue, general and administrative expense increased
to 30.1% in the three months ended November 30, 2000 from 20.4% in the three
months ended November 30, 1999. We expect general and administrative expense,
excluding merger and acquisition costs, to continue to increase in dollar amount
and decrease as a percentage of revenue as we add administrative personnel to
support our business expansion.
Amortization of goodwill and intangibles
Amortization of goodwill and intangibles expense consists of the amortization of
goodwill and other intangible assets. Goodwill, which represents the excess of
acquisition cost over the net assets acquired in business combinations, is
amortized over its estimated useful life which is three years. Costs incurred
for acquiring trademarks, copyrights and patents are capitalized and amortized
using the straight line method over their estimated useful lives, which range
from 5 to 15 years. Amortization of goodwill and intangibles expense increased
to $13.4 million in the three months ended November 30, 2000 from $3,000 in the
three months ended November 30, 1999. As a percentage of total revenue,
amortization of goodwill and intangibles expense increased to 60.0% in the three
months ended November 30, 2000 from 0.0% in the three months ended November 30,
1999. These increases were primarily due to the acquisitions of HKS in January
2000, Bluecurve in May 2000, WireSpeed in July 2000, and C2Net in September
2000.
Stock-based compensation
Stock-based compensation expense consists of the amortization of deferred
compensation related to stock options granted to employees, primarily members of
our management team that were recruited immediately prior to our initial public
offering in August 1999 and those stock options acquired in acquisitions with an
exercise price below the fair market value of our common stock at the date of
grant. Deferred compensation is amortized over the vesting period of the
related stock options, which is generally four years or over the remaining
vesting period of options issued in acquisitions for unvested acquiree options.
Stock-based compensation also includes the amortization of deferred compensation
related to the value of certain shares of common stock to be issued to certain
HKS shareholders contingent on their continued employment with the Company for a
period of three years after the date of acquisition, as well as, the employer
portions of tax liabilities paid upon exercise of non-qualified stock options
and warrants. Stock-based compensation expense increased to $4.8 million in the
three months ended November 30, 2000 from $0.7 million in the three months ended
November 30, 1999. As a percentage of total revenue, stock based compensation
expense increased to 21.4% in the three months ended November 30, 2000 from 6.8%
in the three months ended November 30, 1999.
Other income (expense), net
Other income (expense), net consists of interest income earned on cash deposited
in money market accounts and other short-term investments, net of interest
expense incurred on capital leases. Other income (expense), net increased to
income of $5.4 million in the three months ended November 30, 2000 from income
of $1.4 in the three months ended November 30, 1999. As a percentage of total
revenue, other income (expense), net increased to 24.0% in the three months
ended November 30, 2000 from 13.5% in the three months ended November 30, 1999.
These increases resulted from higher average cash and investment balances in the
three months ended November 30, 2000 as compared to the three months ended
November 30, 1999 due primarily to the receipt of proceeds from the sale of
common stock in our initial and secondary public offerings in August 1999 and
February 2000, respectively.
Provision for income taxes
Provision for income taxes increased to $0.1 million for the three months ended
November 30, 2000 from
15
$40,000 in the three months ended November 30, 1999. The increase in provision
for income taxes for the three months ended November 30, 2000 was primarily due
to a increase in foreign taxes paid.
Nine Months Ended November 30, 2000 and November 30, 1999
Total revenue
Total revenue increased 94.2% to $56.9 million in the nine months ended November
30, 2000 from $29.3 million in the nine months ended November 30, 1999. Revenue
from international operations totaled $11.2 million during the nine months ended
November 30, 2000. We established international operations for sale of our
software products in August 1999. Prior to August 1999, our international
revenue was limited to revenue generated from custom development services
performed for international customers.
Subscription revenue
Subscription revenue increased 79.8% to $29.6 million in the nine months ended
November 30, 2000 from $16.5 million in the nine months ended November 30, 1999.
This increase was primarily due to the release of two new versions of Official
Red Hat Linux during fiscal 2000, rapid growth of our international operations
and an increase in technical support and maintenance revenue as a result of our
increased focus on providing these services in fiscal year 2001 as compared to
fiscal year 2000. As a percentage of total revenue, subscription revenue
decreased to 52.0% in the nine months ended November 30, 2000 from 56.1% in the
nine months ended November 30, 1999. This decrease in subscription revenue as a
percentage of total revenue is primarily a result of the timing of our product
releases and the growth in our services revenue.
Services revenue
Services revenue increased 90.5% to $23.2 million in the nine months ended
November 30, 2000 from $12.2 million in the nine months ended November 30, 1999.
The increase in services revenue resulted primarily from an increase in custom
development revenue due to an increase in the number, size and scope of custom
development contracts and an increase in training and education revenue due to
the expansion of our course offerings. As a percentage of total revenue,
services revenue decreased to 40.8% in the nine months ended November 30, 2000
from 41.6% in the nine months ended November 30, 1999. The decrease in services
revenue as a percentage of total revenue is primarily a result of the expansion
of our web initiatives and the growth in our subscription revenue.
Web revenue
Web revenue increased to $4.1 million in the nine months ended November 30, 2000
from $0.7 million in the nine months ended November 30, 1999. As a percentage
of total revenue, web revenue increased to 7.2% in the nine months ended
November 30, 2000 from 2.3% in the nine months ended November 30, 1999. These
increases were due to the commencement of our web initiatives during the fiscal
year ended February 29, 2000.
Cost of revenue
Cost of subscription revenue
Cost of subscription revenue increased 21.3% to $10.9 million in the nine months
ended November 30, 2000 from $9.0 million in the nine months ended November 30,
1999. This increase was directly related to the increase in costs to provide
telephone support and subscription services upon the release of Version 6.2 of
Official Red Hat Linux and the increase in sales volumes as a result of the
release of
16
Version 7 of Official Red Hat Linux in September 2000 and costs incurred to
provide technical support and maintenance services. As a percentage of
subscription revenue, cost of subscription revenue decreased to 36.8% in the
nine months ended November 30, 2000 from 54.6% in the nine months ended November
30, 1999. This decrease was due to an increase in sales volumes, which resulted
in a decrease in cost per unit, and use of the internet as a delivery mechanism
for the technical support and maintenance of our products in the nine months
ended November 30, 2000.
Cost of services revenue
Cost of services revenue increased 103.1% to $12.9 million in the nine months
ended November 30, 2000 from $6.3 million in the nine months ended November 30,
1999. This increase was primarily due to the addition of personnel to provide
custom development, training and education, and hardware certification services,
and the development of our services organization. As a percentage of services
revenue, cost of services revenue increased to 55.4% in the nine months ended
November 30, 2000 from 51.9% in the nine months ended November 30, 1999. This
increase was primarily due to the increased use of third-party partners and
contractors to deliver our training and education courses.
We expect cost of services to increase as we further expand our service
offerings. Cost of services as a percentage of services revenue is expected to
vary significantly from period to period depending upon:
. the mix of services we provide;
. the number and scope of custom development contracts;
. whether such services are provided by us or third-party partners and
contractors;
. the overall utilization rate of our services staff; and
. the use of our redhat.com web site to deliver these services
Cost of web revenue
Cost of web revenue decreased 71.8% to $0.2 million in the nine months ended
November 30, 2000 from $0.6 million in the nine months ended November 30, 1999.
As a percentage of web revenue, cost of web revenue decreased to 4.3% in the
nine months ended November 30, 2000 from 93.7% in nine months ended November 30,
1999. These decreases were due to the development of our web advertising group
and initial expenses related to our offering of web advertising for the first
time during the nine months ended November 30, 1999.
Gross Profit
Gross profit increased 146.6% to $33.0 million in the nine months ended November
30, 2000 from $13.4 million in the nine months ended November 30, 1999. As a
percentage of total revenue, gross profit increased to 58.0% in the nine months
ended November 30, 2000 from 45.6% in the nine months ended November 30, 1999.
These increases were primarily the result of the increases in sales of software
products, due to the release of Version 6.2 of Official Red Hat Linux in March
2000, the release of Version 7 of Official Red Hat Linux in September 2000, and
web advertisements which were at a higher proportion relative to the associated
cost of revenue. These revenue increases were partially offset by increased
costs of services resulting from the addition of personnel to provide custom
development, training and education, and hardware certification services, and
the development of our services organization.
Operating expense
Sales and marketing
17
Sales and marketing expense increased 87.1% to $28.4 million in the nine months
ended November 30, 2000 from $15.2 million in the nine months ended November 30,
1999. This increase was due primarily to higher advertising and promotional
costs incurred to promote the release of Version 7 and 6.2 of Official Red Hat
Linux, our web advertising and service offerings and, to a lesser extent, our
new software development tools. This increase was also due to higher costs
resulting from joint marketing arrangements with distributors. As a percentage
of total revenue, sales and marketing expense decreased to 49.8% in the nine
months ended November 30, 2000 from 51.7% in the nine months ended November 30,
1999. We expect sales and marketing expense to continue to increase in dollar
amount and decrease as a percentage of total revenue as we promote the expansion
of our services offerings and web site and expand our international subscription
operations.
Research and development
Research and development expense increased 59.9% to $11.9 million in the nine
months ended November 30, 2000 from $7.5 million in the nine months ended
November 30, 1999. As a percentage of total revenue, research and development
expense decreased to 21.0% in the nine months ended November 30, 2000 from 25.5%
in the nine months ended November 30, 1999. The increase in research and
development expense resulted from increased spending related to the development
of our web initiatives and costs incurred to complete the development of Version
7 and 6.2 of Official Red Hat Linux, partially offset by a decrease in spending
related to the development of software development tools as these products were
completed during the year ended February 29, 2000.
General and administrative
General and administrative expense increased 245.1% to $21.2 million in the nine
months ended November 30, 2000 from $6.1 million in the nine months ended
November 30, 1999. This increase resulted from:
. an increase in merger and acquisition costs of $6.9 million in the
nine months ended November 30, 2000 from $0.1 million in the nine
months ended November 30, 1999. This increase was primarily due to the
number of acquisitions completed thus far in fiscal 2001.
. an increase in payroll costs due to an increase in the number of
general and administrative personnel to support the growth of our
business;
. an increase in legal and accounting costs due to our initial public
offering and our geographic expansion; and
. an increase in insurance costs as a result of our becoming a public
company.
As a percentage of total revenue, general and administrative expense increased
to 37.3% in the nine months ended November 30, 2000 from 21.0% in the nine
months ended November 30, 1999. We expect general and administrative expense,
excluding merger and acquisition costs, to continue to decrease as a percentage
of revenue.
Amortization of goodwill and intangibles
Amortization of goodwill and intangibles expense increased to $27.7 million in
the nine months ended November 30, 2000 from $5,000 in the nine months ended
November 30, 1999. As a percentage of total revenue, amortization of goodwill
and intangibles expense increased to 48.7% in the nine months ended November 30,
2000 from 0.0% in the nine months ended November 30, 1999. These increases were
primarily due to the acquisitions of HKS in January 2000, Bluecurve in May 2000,
WireSpeed in July 2000, and C2Net in September 2000.
Stock-based compensation
18
Stock-based compensation expense increased to $12.0 million in the nine months
ended November 30, 2000 from $1.7 million in the nine months ended November 30,
1999. As a percentage of total revenue, stock based compensation expense
increased to 21.1% in the nine months ended November 30, 2000 from 5.6% in the
nine months ended November 30, 1999.
Other income (expense), net
Other income (expense), net increased to income of $16.4 million in the nine
months ended November 30, 2000 from income of $2.1 in the nine months ended
November 30, 1999. As a percentage of total revenue, other income (expense),
net increased to 28.9% in the nine months ended November 30, 2000 from 7.1% in
the nine months ended November 30, 1999. These increases resulted from higher
average cash and investment balances in the nine months ended November 30, 2000
as compared to the nine months ended November 30, 1999 due primarily to the
receipt of proceeds from the sale of common stock in our initial and secondary
public offerings in August 1999 and February 2000, respectively.
Provision for income taxes
Provision for income taxes decreased to $0.2 million for the nine months ended
November 30, 2000 from $0.3 million in the nine months ended November 30, 1999.
Accretion of mandatorily redeemable preferred stock
Accretion of mandatorily redeemable preferred stock decreased to zero in the
nine months ended November 30, 2000 from $82,000 in the nine months ended
November 30, 1999. Accretion of mandatorily redeemable preferred stock ceased
with the completion of our initial public offering in August 1999 when all
outstanding mandatorily redeemable preferred stock converted to common stock.
Historical 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, and cash flows from operations. At November 30, 2000, cash and
liquid investments totaled $313.2 million, and are included on our balance sheet
as cash and cash equivalents and investments in debt and equity securities.
At November 30, 2000, cash and cash equivalents totaled $78.8 million, a
decrease of $163.6 million as compared to February 29, 2000. The decrease in
cash and cash equivalents resulted from the purchase of net investments in debt
and equity securities of $134.4 million, cash used by operations of $25.0
million, $8.5 million for the purchase of office and computer equipment, and
repayment of notes payable of $0.5 million. This was partially offset by the
receipt of $4.8 million in proceeds from exercise of stock options and warrants
and $0.6 million in proceeds from issuance of common stock under the Employee
Stock Purchase Plan during the nine months ended November 30, 2000.
Cash used by operations of $25.0 million in the nine months ended November 30,
2000, represented the net loss of $52.0 million, an increase in accounts
receivable of $11.9 million, an increase in intangibles and other assets of $4.0
million, and a decrease in accounts payable of $5.8 million, partially offset by
an increase in accrued expenses of $5.0 million, an increase in deferred revenue
of $1.3 million, and net non cash charges of $43.5 million. The increase in
accounts receivable, accrued expenses and deferred revenue resulted primarily
from the release of Version 7 of Official Red Hat Linux to our distributors in
September 2000.
Cash used in investing activities for the nine months ended November 30, 2000
was comprised of the purchase of investments in debt securities, net of
maturities, of $134.4 million, and purchases of property and equipment totaling
$8.5 million.
19
Cash from financing activities of $4.8 million for the nine months ended
November 30, 2000 was primarily comprised of $4.8 million in proceeds from the
exercise of stock options and warrants, $0.6 million in proceeds from issuance
of common stock under the Employee Stock Purchase Plan, and repayment of notes
payable of $0.5 million.
We have experienced a substantial increase in our operating expenses since our
inception in connection with the growth of our operations and staffing and the
expansion of our services operation and web initiatives. Our capital
requirements during the year ending February 28, 2001 depend on numerous factors
including the amount of resources we devote to:
. fund our domestic and international expansion;
. enhance our redhat.com web site;
. expanding our product offerings;
. improve and extend our service offerings;
. pursue strategic acquisitions and alliances;
. make possible investments in businesses, products and technologies;
and
. expand our sales and marketing programs and conduct more aggressive
brand promotions.
We believe that the net proceeds from our public offerings of common stock in
August 1999 and February 2000, together with cash flow from operations, will be
sufficient to meet our anticipated cash needs for working capital and capital
expenditures for the foreseeable future.
Recent Accounting Pronouncements
In June 1998, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standards No. 133, "Accounting for Derivative Instruments
and Hedging Activities". This statement establishes accounting and reporting
standards for derivative instruments, including certain derivative instruments
embedded in other contracts, and for hedging activities. Statement of Financial
Accounting Standards No. 133 as amended by Statement of Financial Accounting
Standards No. 137, is effective for all fiscal quarters of all fiscal years
beginning after June 15, 2000, with earlier application encouraged. We do not
currently, nor do we intend in the future, to use derivative instruments and
therefore do not expect that the adoption of Statement of Financial Accounting
Standards No. 133 will have any impact on our financial position or results of
operations.
In December 1999, the SEC issued Staff Accounting Bulletin No. 101, "Revenue
Recognition in Financial Statements" ("SAB 101") which addresses certain
criteria for revenue recognition. SAB 101, as amended by SAB 101A and SAB 101B,
outlines the criteria that must be met to recognize revenue and provides
guidance for disclosures related to revenue recognition policies. The adoption
of SAB 101 is not expected to have a material impact on the consolidated
financial position or results of operation.
Year 2000 Compliance
Year 2000 Readiness Disclosure
By the end of 1999, we had evaluated our Year 2000 readiness in preparation for
issues that could result from computer programs being written using two digits
to define
20
the applicable year rather than four to define the applicable year and century.
We believe that we were prepared for the transition to the Year 2000 and did not
experience any significant Year 2000 problems with respect to our products,
third party products that we bundle with Official Red Hat Linux or our internal
management information systems or other systems, applications or infrastructure.
Since January 1, 2000, our internal management information systems and non-
information systems have functioned properly. In addition, we have not
experienced any material Year 2000 issues related to our interaction with third
parties. We have not experienced any material disruption in our ability to
provide our products and services to our customers, collect payments or report
accurate data to management or any other business interruptions due to Year 2000
issues. While we will continue to monitor our products and systems and those of
third parties with whom we have material business relationships to ensure that
no unexpected Year 2000 issues develop, we have no reason to expect any of these
issues.
Factors Affecting Future Results
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 MATERIALLY
TO DIFFER 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 SEC, COPIES OF WHICH MAY BE ASSESSED THROUGH THE SEC'S WEB SITE
AT HTTP://WWW.SEC.GOV.
Risks Related to our Linux-based Open Source Business Model
Our open source software business model is unproven
We have not demonstrated the success of our open source business model, which
gives our customers the right to freely copy and distribute our software. No
other company has built a successful open source business. Few open source
software products have gained widespread commercial acceptance partly due to the
lack of viable open source industry participants to offer adequate service and
support on a long term basis. In addition, open source vendors are not able to
provide industry standard warranties and indemnities for their products, since
these products have been developed largely by independent parties over whom open
source vendors exercise no control or supervision. If open source software
should fail to gain widespread commercial acceptance, we would not be able to
sustain our revenue growth and our business could fail.
We depend on the support of Linus Torvalds and other prominent Linux developers
to release major product upgrades and maintain market share
We may not be able to release major product upgrades of Official Red Hat Linux
on a timely basis because the heart of Official Red Hat Linux, the Linux kernel,
is maintained by third parties. Linus Torvalds, the original developer of the
Linux kernel, and a small group of independent engineers are primarily
responsible for the development and evolution of the Linux kernel. If this
group of developers fails to further develop the Linux kernel or if Mr. Torvalds
or other prominent Linux developers, such as
21
Alan Cox, David Miller or Stephen Tweedie, were to join one of our competitors
or no longer work on the Linux kernel, we will have to either rely on another
party to further develop the kernel or develop it ourselves. We cannot predict
whether enhancements to the kernel would be available from reliable alternative
sources. We could be forced to rely to a greater extent on our own development
efforts, which would increase our development expenses and may delay our product
release and upgrade schedules. In addition, any failure on the part of the
kernel developers to further develop and enhance the kernel could stifle the
development of additional Linux-based applications.
We may not be able to effectively assemble and test our software because it
consists largely of code developed by independent third parties over whom we
exercise no control, which could result in unreliable products and damage to our
reputation
Official Red Hat Linux, in compressed form, consists of approximately 546
megabytes of code. Of that total, approximately 500 megabytes have been
developed by independent third parties, including approximately 10 megabytes of
code contained in the Linux kernel. Included within the 546 megabytes of code
are approximately 700 distinct software components developed by thousands of
individual programmers which we must assemble and test before we can release a
new version of Official Red Hat Linux. If these components are not reliable,
Official Red Hat Linux could fail, resulting in serious damage to our reputation
and potential litigation. Although we attempt to assemble only the best
available components, we cannot be sure that we will be able to identify the
highest quality and most reliable components or successfully assemble and test
them. In addition, if these components were no longer available, we would have
to develop them ourselves, which would significantly increase our development
expenses.
The scarcity of software applications for Linux-based operating systems could
prevent commercial adoption of our products
Our products will not gain widespread commercial adoption until there are more
third-party software applications designed to operate on Linux-based operating
systems. These applications include word processors, databases, accounting
packages, spreadsheets, e-mail programs, Internet browsers, presentation and
graphics software and personal productivity applications. We intend to encourage
the development of additional applications that operate on Linux-based operating
systems by attracting third-party developers to the Linux platform, by providing
open source tools to create these applications and by maintaining our existing
developer relationships through marketing and technical support for third-party
developers. If we are not successful in achieving these goals, however, our
products will not gain widespread commercial acceptance and we will not be able
to maintain our product sales growth.
We may not be able to generate revenue from sales of Official Red Hat Linux if
users can more quickly download it from the Internet
Anyone can download a free copy of Red Hat Linux from the Internet. However,
because this download can take up to 36 hours using a standard telephone
connection, many of our users choose to buy the shrink-wrapped version of
Official Red Hat Linux. If hardware and data transmission technology advances
in the future to the point where increased bandwidth allows users to more
quickly download our products from the Internet, users may no longer choose to
purchase Official Red Hat Linux. This could lead to a significant loss of
product revenue.
We may not succeed in shifting our business focus from traditional shrink-
wrapped software sales to offering subscription-based product and services
offerings
We are focusing our sales and marketing efforts on providing subscription-based
products and services as opposed to relying on sales of shrink-wrapped software.
This change has required us to expend significant financial and managerial
resources and may ultimately prove unsuccessful. The failure to successfully
implement this transition of our sales model could materially adversely affect
our operating results.
22
Our customers may find it difficult to install and implement Red Hat Linux,
which could lead to customer dissatisfaction and damage our reputation
Installation and implementation of Red Hat Linux often involves a significant
commitment of resources, financial and otherwise, by our customers. This
process can be lengthy due to the size and complexity of our products and the
need to purchase and install new applications. The failure by us to attract and
retain services personnel to support our customers, the failure of companies
with which we have strategic alliances to commit sufficient resources towards
the installation and implementation of our products, or a delay in
implementation for any other reason could result in dissatisfied customers. This
could damage our reputation and the Red Hat brand and result in decreased
revenue.
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. Historically, different groups of open source software programmers
have competed with each other to develop new technology. Typically one of those
groups develops the technology that becomes more widely used than that developed
by others. If we adopt new technology and incorporate it into our products, and
competing technology becomes more widely used, the market appeal of our products
may be reduced, which could harm our reputation, diminish the Red Hat brand and
result in decreased revenue.
Risks Related to our Financial Results and Condition
Our limited operating history in the new and developing market for Linux-based
operating systems makes it difficult to evaluate our business
Red Hat was formed in March 1993. We began offering Red Hat Linux in October
1994. Our limited operating history makes it difficult to evaluate the risks and
uncertainties that we face. Our failure to address these risks and uncertainties
could cause our business results to suffer and result in the loss of all or part
of your investment.
We have limited combined operating history with the companies we have acquired
since our initial public offering and may have difficulty integrating these
businesses
The successful integration of the operations, products, services and personnel
of Red Hat and the five companies we have acquired since our initial public
offering -- Cygnus Solutions, Hell's Kitchen Systems, Inc., Bluecurve, Inc.,
WireSpeed Communications Corporation and C2Net Software, Inc. -- is important to
the future financial performance of the combined enterprise. The anticipated
benefits of these acquisitions may not be achieved unless, among other things,
the operations, products, services and personnel of the acquired companies are
successfully combined with those of Red Hat in a timely and efficient manner.
Integration of these companies' operations, products, services and personnel may
be hampered because, among other things:
. the products and services offered by each of the acquired companies and Red
Hat are highly complex and have been developed independently;
. integration of the product lines of Red Hat and each of the acquired
companies will require the coordination of separate development and
engineering teams from each company; and
. the employees and management of the acquired companies and Red Hat are
located in disparate geographical regions.
23
In addition, the costs associated with integrating these companies' operations,
products, services and personnel may be substantial and could include, among
other things:
. employee redeployment or relocation; and
. the combination of research and development teams and processes.
Any of these difficulties and costs encountered in the transition process, could
divert the attention of management, and could have an adverse impact on the
revenues and operating results of the combined enterprise.
We expect to incur substantial losses for the foreseeable future
We have incurred operating losses in five of our previous six fiscal years,
including our most recent fiscal year ended February 29, 2000. We expect to
incur significant losses for the foreseeable future, as we substantially
increase our sales and marketing, research and development and administrative
expenses. In addition, we are investing considerable resources in our web
initiative and to expand our professional services offerings. As a result, we
cannot be certain when or if we will achieve sustained profitability. Failure to
become and remain profitable may adversely affect the market price of our common
stock and our ability to raise capital and continue operations.
You should not rely on our quarterly results of operations as an indication of
our future results because they fluctuate significantly and are difficult to
forecast
Due to our limited combined operating history and the unpredictability of our
business, our revenue and operating results may fluctuate significantly from
quarter to quarter and are difficult to forecast. 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 if our revenue falls short of our expectations.
Accordingly, a revenue shortfall in a particular quarter would have a
disproportionate adverse effect on our operating results for that quarter. You
should not rely on quarter-to-quarter comparisons of our results of operations
as an indication of our future performance. Our future operating results may
fall below expectations of securities analysts or investors, which would likely
cause the market price of our common stock to decline significantly.
We may not be able to effectively attract additional enterprise customers and
preserve relationships with current enterprise customers, which could adversely
affect revenue
Historically, we focused our sales and marketing efforts on product sales to
individuals. We have recently, however, begun to focus our efforts on expanding
our enterprise customer base. To this end, we have invested extensively to
attract enterprise customers. In addition, we have gained a significant number
of enterprise customers through our acquisition of Cygnus Solutions. These
enterprise customers expect diverse and extensive service programs, and if we
are unable to continue to successfully expand and enhance our service offerings,
we may not be able to meet these customers' needs or attract new customers, and,
consequently, our revenue would suffer.
Our failure to update and modernize our internal systems, procedures and
controls may prevent the implementation of our business strategies in a rapidly
evolving market and may retard our future growth
Our operational and financial systems, procedures and controls, which were
adequate for a small private company, are becoming outdated as we grow. Since
March 1, 1999 we have increased the number of employees more than tenfold. To
accommodate this growth, we have evaluated our financial and operational
systems, procedures and controls. Although we have revised or are in the process
of revising and updating most of them, if we continue our rapid growth, we may
not be able to improve our transaction processing and reporting systems and
procedures, or expand and train our expanding workforce quickly
24
enough to maintain a competitive position in our markets. In addition, failure
to quickly replace obsolete systems, procedures and controls could impede our
management's decision-making abilities. This, in turn, may impair our ability to
pursue business opportunities and may hamper future growth.
We may not be able to generate enough additional revenue from our international
expansion to offset the costs associated with establishing and maintaining
foreign operations
A key component of our growth strategy is to expand our presence in foreign
markets. We have recently established subsidiaries or offices in Canada,
Ireland, the United Kingdom, Germany, Italy, Japan, France, Singapore and
Australia, and are considering further expansion worldwide. We may also enter
other markets as opportunities arise. It will be costly to establish
international facilities and operations, promote our brand internationally, and
develop localized web sites and other systems. Revenue from international
activities may not offset the expense of establishing and maintaining these
foreign operations. In addition, because we have little experience in marketing
and distributing products or services for these markets, we may not benefit from
any first-to-market advantages.
Our management team may not be able to successfully implement our business
strategies because it has only recently begun to work together
Our business is highly dependent on the ability of our management to work
together effectively to meet the demands of our growth. Several members of our
senior management have been employed by us for a relatively short period of
time. These individuals have not previously worked together as a management
team. In addition, the members of our management team who have been with us
since 1997 or earlier have had only limited experience managing a rapidly
growing company on either a public or private basis. The failure of our
management team to work together effectively could prevent efficient decision-
making by our executive team, affecting product development and sales and
marketing efforts, which would negatively impact our operating results.
We depend on our key personnel
Our future success depends on the continued services of a number of key
directors and officers, including our Chairman, Robert Young, our Chief
Executive Officer and President, Matthew Szulik, our Chief Operating Officer,
Tim Buckley, and our Chief Financial Officer, Kevin Thompson. The loss of the
technical knowledge and industry expertise of any of these people could
seriously impede our success. Moreover, the loss of one or a group of our key
employees, particularly to a competitor, and any resulting loss of customers
could reduce our market share and diminish the Red Hat brand.
We may lack the financial and operational resources needed to increase our
market share and compete effectively with Microsoft, other established operating
systems developers, software development tools developers and other service and
support providers
In the market for operating systems, we face significant competition from larger
companies with greater financial resources and name recognition than we have.
These competitors, which offer hardware-independent multi-user operating systems
for Intel platforms and/or UNIX-based operating systems, include Microsoft,
Novell, IBM, Sun Microsystems, The Santa Cruz Operation, AT&T, Compaq, Hewlett-
Packard, Olivetti and Unisys. Some of these competitors currently, or may in the
future, produce and market open source operating systems.
With our acquisition of Cygnus, we now face competition in the market for
software development tools and operating systems for special purpose computing.
Our competitors in this market, some of which have greater market share than we
do, include Wind River Systems, Integrated Systems Incorporated, Green Hills
Software, and the Metrowerks subsidiary of Motorola. Some of these companies
currently produce or use open source software as part of their product
offerings. We may not be able to compete effectively in this market if customers
choose proprietary solutions. If the demand for open source solutions in this
market expands, however, we could lose market share as existing competitors
reposition or new companies emerge to address the opportunity.
25
As we increase our services offerings, we may face competition from larger and
more capable companies that currently service and support other operating
systems, particularly UNIX-based operating systems, due to the fact that Linux-
and UNIX-based operating systems share many common features. These companies
may be able to leverage their existing service organizations and provide higher
levels of support on a more cost-effective basis than we can. We may not be
able to compete successfully with these current or potential competitors.
We may not be able to match the promotional activities and pricing policies
offered by other suppliers of Linux-based and other open source operating
systems, which could result in a loss of market share
In the new and rapidly-evolving market for Linux-based operating systems, we
face intense competition from a number of other suppliers of Linux-based
operating systems. We also face competition to a lesser extent from developers
of non-Linux-based open source operating systems such as BSD-based operating
systems. BSD-based operating systems such as FreeBSD, NetBSD and OpenBSD are
open source operating systems produced by communities of developers working
together via the Internet, and which are published and distributed by Walnut
Creek CD-ROM, among others. We expect competition in broader open source
operating systems and the Linux-based operating systems market to intensify. In
addition, companies like Sun Microsystems and Corel, which are more established
and have larger customer bases than we do, have indicated a growing interest in
the market for Linux-based operating systems. These companies may be able to
undertake more extensive promotional activities, adopt more aggressive pricing
policies, and offer more attractive terms to their customers than we can.
Furthermore, because Linux-based operating systems can be downloaded from the
Internet for free or purchased at a nominal cost and modified and re-sold with
few restrictions, traditional barriers to entry are minimal. Accordingly, it is
possible that new competitors or alliances among existing competitors may emerge
and rapidly acquire significant market share.
If we fail 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 on our ability to continue to establish and maintain
strategic distribution and other collaborative relationships with industry-
leading hardware manufacturers, distributors, software vendors 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,
the companies with which we have strategic alliances are free to pursue
alternative technologies and to 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.
We may not be able to meet the operational and financial challenges that we will
encounter as our international operations expand
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;
. fluctuations in exchange rates may negatively affect our operating results;
. we may not be able to repatriate the earnings of our foreign operations;
26
. we have to comply with a wide variety of foreign laws with which we are not
familiar;
. we may not be able to adequately protect our trademarks overseas due to the
uncertainty of laws and enforcement in certain countries relating to the
protection of intellectual property rights;
. reductions in business activity during the summer months in Europe and
certain other parts of the world could negatively impact the operating
results of our foreign operations;
. export controls could prevent us from shipping our products into and from
some markets;
. multiple and possibly overlapping tax structures could significantly reduce
the financial performance of our foreign operations;
. 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 in some international markets could result
in the forfeiture of some foreign assets and the loss of sums spent
developing and marketing those assets.
Expanding our services business will be costly and may not result in any benefit
to us
We have expanded our strategic focus to place additional emphasis on consulting,
custom engineering and development, education and support services, from which
we have historically derived an insignificant amount of revenue. We cannot be
certain that our customers will engage our professional services organization to
assist with support, consulting, custom development, training and implementation
of our products. We also cannot be certain that we can attract or retain a
sufficient number of the highly qualified services personnel that the expansion
of our services business will need. In addition, this expansion has required,
and will continue to require, significant additional expenses and development,
financial and operational resources. The need for these additional resources
will place further strain on our management, financial and operational resources
and may make it more difficult for us to achieve and maintain profitability.
Attempts to expand by means of business combinations and strategic alliances may
not be successful and may harm our operational efficiency, financial performance
and relationships with employees and third parties
We may continue to expand our operations or market presence by entering into
additional business combinations, investments, joint ventures or other strategic
alliances with hardware manufacturers, software vendors, Internet companies,
open source software developers or other companies both in the United States and
internationally. Our ability to expand in this way may be limited due to the
many financial and operational risks accompanying these transactions. For
example:
. we may have difficulty assimilating the operations, technology and personnel
of the combined companies;
. our business may be disrupted by the allocation of resources to consummate
these transactions;
. we may have problems retaining key technical and managerial personnel from
acquired companies;
. we may experience one-time in-process research and development charges and
ongoing expenses associated with amortization of goodwill and other
purchased intangible assets;
. our stockholders will suffer dilution if we issue equity to fund these
transactions;
. acquired businesses may initially be unprofitable resulting in our
assumption of operating losses and increased expenses;
27
. our reputation may be harmed if the open source development community does
not approve of these transactions;
. our relationships with existing employees, customers and business partners
may be weakened or terminated as a result of these transactions; and
. our investment activities, particularly with respect to emerging-growth
technology companies, are inherently risky and we may not realize any
benefit from such activities.
Risks Related to our Internet Strategy
We may fail to promote and enhance our web site effectively, which may prevent
us from attracting new visitors, advertisers or electronic commerce partners to
our web site
Enhancing the redhat.com web site is critical to our ability to increase our
revenue. In order to attract and retain Internet users, advertisers and
electronic commerce partners, we intend to substantially increase our
expenditures for enhancing and further developing our web site. Our success in
promoting and enhancing the redhat.com web site will also depend on our ability
to provide high quality content, features and functionality. If we fail to
promote our web site successfully or if visitors to our web site or advertisers
do not perceive our services to be useful, current or of high quality, our
ability to generate revenue from our web site will be significantly impaired.
Visitors to our web site could experience delays and decreased performance
during periods of heavy traffic, which could result in dissatisfaction with our
web site and damage to our reputation
Our web site must accommodate a high volume of traffic and deliver frequently
updated information. Our web site has in the past experienced slower response
times or decreased traffic for a variety of reasons. These occurrences have not
had a material impact on our business. These types of occurrences in the
future, however, could materially adversely affect our reputation and brand name
and could cause users to perceive our web site as not functioning properly.
Under these circumstances, our users might choose another web site or other
methods to obtain Linux-based operating systems or Linux-related information.
Because there is no industry standard for the measurement of the effectiveness
of Internet advertising, advertisers may not increase or even maintain their
current levels of Internet advertising, which would prevent us from generating a
significant amount of revenue from our web site
As we execute our Internet strategy, we expect to derive an increasing
percentage of our revenue from sponsorships and advertising on our web site. We
may not generate these revenues if advertisers do not maintain or increase their
current levels of Internet advertising. As there is no industry standard for the
measurement of the effectiveness of Internet advertising, advertisers that
currently advertise on the Internet may reduce or eliminate this form of
advertising and advertisers that have traditionally relied upon other
advertising media may be reluctant to begin to advertise on the Internet.
Moreover, widespread adoption of currently available software programs that
limit or prevent advertisements from being delivered to an Internet user's
computer would negatively affect the commercial viability of Internet
advertising and would further deter advertisers from increasing or maintaining
current levels of Internet advertising. Our ability to successfully execute our
Internet strategy will be adversely affected if the market for Internet
advertising fails to develop or develops more slowly than expected.
We may not be able to respond quickly to new pricing models for advertising,
which could prevent us from attracting quality sponsors to our web site
Different pricing models are used to sell advertising on the Internet. It is
difficult to predict which, if any, will emerge as the industry standard. If we
cannot quickly and successfully respond to changes in pricing models for
Internet advertising, or identify and adopt any industry standards that may
emerge, we will not be able to attract a sufficient number of quality sponsors
and our Internet advertising strategy will fail.
28
We may be unable to adequately measure the demographics of visitors to our web
site, which is critical to our ability to attract advertising revenue
We expect that it will be important to our advertisers that we accurately
measure the demographics of the visitors to our web site. While we have not
committed significant resources to the measurement of demographics to date, we
are currently implementing systems designed to record demographic data on our
web site's visitors. This implementation may be costly, and if not done
effectively, may not permit us to accurately measure the demographic
characteristics of our web site's visitors. Until these new systems are
functional, we will continue to rely on third parties to provide some of these
measurement services. If these parties were unable to provide these services, we
would need to obtain them from other providers, which might not be readily
available. Companies may choose not to advertise on our web site or may pay less
for advertising if they do not perceive our measurements or measurements made by
third parties to be reliable.
Our Internet strategy will fail if the infrastructure of the Internet is not
continually developed and maintained
The success of our Internet strategy will depend in large part on the continued
development and maintenance of the infrastructure of the Internet. Because
global commerce and the online exchange of information is new and evolving, we
cannot predict with any certainty that the Internet will be a viable commercial
marketplace in the long term. The Internet has experienced, and we expect it to
continue to experience, significant growth in the number of users and amount of
traffic. If the Internet continues to experience an increased number of users,
frequency of use or increased bandwidth requirements of users, it may not be
able to support the demands placed upon it by this growth, and its performance
and reliability may suffer. Furthermore, the Internet has experienced a variety
of outages and other delays as a result of damage to portions of its
infrastructure, and could face similar outages and delays in the future. Any
outage or delay could affect the level of Internet usage, as well as the volume
of traffic on our web site. In addition, the Internet could lose its viability
due to increased governmental regulation and delays in the development or
adoption of new standards and protocols to handle increased levels of activity.
If the necessary infrastructure, standards or protocols or complementary
products, services or facilities are not developed, or if the Internet does not
become a viable commercial marketplace, our Internet strategy will not succeed.
We are vulnerable to unexpected network interruptions caused by system failures,
which may result in reduced visitor traffic on our web site, decreased revenue
and harm to our reputation
Substantially all of our communications hardware and other hardware related to
our web site is located at our facilities, although we have back-up and co-
location hardware for our web site located at third-party facilities. Fire,
floods, hurricanes, tornadoes, earthquakes, power loss, telecommunications
failures, break-ins and similar events could damage these systems. In addition,
although we have implemented network security measures, our servers are
vulnerable to computer viruses, electronic break-ins, human error and other
similar disruptive problems which could adversely affect our systems and web
site. Although we try to prevent unauthorized access to our systems, we cannot
eliminate this risk entirely. We could lose revenue and suffer damage to our
reputation if our systems were affected by any of these occurrences. Our
insurance policies may not adequately compensate us for any losses that may
occur due to failures or interruptions in our systems. We do not presently have
any secondary "off-site" systems or a formal disaster recovery plan.
Risks Related to Legal Uncertainty
We could be prevented from selling or developing our products if the GNU General
Public License and similar licenses under which our products are developed and
licensed are not enforceable
The Linux kernel and the Red Hat Linux operating system have been developed and
licensed under the GNU General Public License and similar licenses. These
licenses state that any program licensed under
29
them may be liberally copied, modified and distributed. We know of no
circumstance under which these licenses have been challenged or interpreted in
court. Accordingly, it is possible that a court would hold these licenses to be
unenforceable in the event that someone were to file a claim asserting
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 our products.
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 us and our customers, errors have been and may continue to be
found in our products after commencement of commercial shipments. This risk is
exacerbated by the fact that most 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 yet 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 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. 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.
We are vulnerable to claims that our products infringe third-party intellectual
property rights particularly because our products are comprised of many distinct
software components developed by thousands of independent parties
We may be exposed to future litigation based on claims that our products
infringe the intellectual property rights of others. This risk is exacerbated by
the fact that most of the code in our products is developed by independent
parties over whom we exercise no supervision or control. Claims of infringement
could require us to reengineer our products or seek to obtain licenses from
third parties in order to continue offering our products. In addition, an
adverse legal decision affecting our intellectual property, or the use of
significant resources to defend against this type of claim, could place a
significant strain on our financial resources and harm our reputation.
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 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. We have registered some
of our trademarks in the United States, Europe and Australia and have other
trademark applications pending in the United States, Europe, Australia, Canada,
Europe and Japan. 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.
We may be sued as a result of information published or posted on or accessible
from our redhat.com web site
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We may be subjected to claims for defamation, negligence, copyright or trademark
infringement or other claims relating to the information we publish on our web
site. These types of claims have been brought, sometimes successfully, against
online services in the past, and can be costly to defend. We may also be
subjected to claims based on content that is accessible from our web site
through links to other web sites or through content and materials that may be
posted by visitors to our web site. We believe that the scope and amount of our
commercial and general liability insurance is appropriate, given our current
financial position. However, this insurance may not adequately protect us
against these types of claims. We have not been a party to any lawsuit of this
type to date.
Risks Related to the Market for Our Common Stock
Our stock price has been extremely volatile and you may not be able to resell
your shares at or above the offering price
The trading price of our common stock has been and is likely to continue to be
highly volatile and could be subject to wide fluctuations in response to factors
such as:
. actual or anticipated variations in quarterly operating results;
. new products or services offered by Red Hat or our competitors;
. changes in financial estimates by securities analysts;
. conditions or trends in the Internet, Linux and software industries;
. changes in the economic performance and/or market valuations of other
Internet, Linux and software industries;
. announcements by us or our competitors of significant acquisitions,
strategic partnerships, joint ventures or capital commitments;
. additions or departures of key personnel;
. sales of common stock; and
. other events or factors, many of which are beyond our control.
In addition, the stock market in general, and the Nasdaq National Market and the
market for Internet-related and technology companies in particular, has
experienced extreme price and volume fluctuations that have often been unrelated
or disproportionate to the operating performance of such companies. In addition,
broad market and industry factors may materially adversely affect the market
price of our common stock, regardless of our actual operating performance. In
the past, following periods of volatility in the market price of a company's
securities, securities class-action litigation has often been instituted against
such companies. Such litigation, if instituted, could result in substantial
costs and a diversion of management's attention and resources, which would
materially adversely affect our business, financial condition and operating
results.
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ITEM 3. Quantitative and Qualitative Disclosures about Market Risk
Interest Rate Risk
The primary objective of Red Hat's investment activities is to preserve
principal while at the same time maximizing yields without significantly
increasing risk. To achieve this objective, the Company maintains its portfolio
of cash equivalents, short-term and long-term investments in a variety of
securities, including both government and corporate obligations and money market
funds. Most of our cash equivalents, short-term and long-term investments are
at fixed interest rates, therefore the fair value of these investments is
affected by changes in market interest rates. However, because our investment
portfolio is primarily comprised of investments in U.S. Government obligations
and high-grade commercial paper, an immediate 10% change in market interest
rates would not have a material effect on the fair market value of our
portfolio. Therefore, we would not expect our operating results or cash flows to
be affected to any significant degree by the effect of a sudden change in market
interest rates on our investment portfolio.
Red Hat did not hold derivative financial instruments as of November 30, 2000,
and has never held such investments in the past.
Foreign Currency Risk
Approximately 20% of the Company's revenues for the nine months ended November
30, 2000 were generated by sales outside the United States. The Company is
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.
Additionally, the assets and liabilities of the Company's non-U.S. operations
are translated into U.S. dollars at exchange rates in effect as of the
applicable balance sheet dates, and revenue and expense accounts of these
operations are translated at average exchange rates during the month the
transactions occur. Unrealized translation gains and losses will be included as
an adjustment to stockholders' equity.
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PART II - OTHER INFORMATION
ITEM 2: CHANGES IN SECURITIES AND USE OF PROCEEDS
Sales of Unregistered Securities
In September 2000, the Company issued 954,357 shares of its common stock
in exchange for the acquisition of all of the outstanding capital stock of
C2Net. The offering and sale of Red Hat common stock was made in reliance
upon the exemption from registration provided by Section 3(a) (10) of the
Securities Act of 1933, as amended. A fairness hearing for the transaction
was held by the Office of the North Carolina Secretary of State pursuant
to Section 78A-30 of the General Statutes of North Carolina.
Use of Proceeds
On August 11, 1999 the Securities and Exchange Commission declared
effective the Company's Registration Statement on Form S-1 (File number
333-80051), relating to the initial public offering of the Company's
Common Stock, $.0001 par value. The offering commenced on August 11, 1999
and all shares covered by the Registration Statement were sold. The
proceeds to the Company, net of underwriting discounts and costs, was
approximately $88.5 million. The following are the uses of such proceeds
from the effective date of the registration statement (August 11, 1999)
through November 30, 2000:
Cash and cash equivalents: $37,128,936
Working capital: $51,337,993
None of the net proceeds from the IPO were used to pay, directly or
indirectly, directors, officers, persons owning ten percent or more of the
Company's equity securities, or affiliates of the Company.
ITEM 6: EXHIBITS AND REPORTS ON FORM 8-K
a. List of Exhibits:
Exhibit Description of Exhibit
----------------------
No.
---
11.1 Statement Regarding Computation of Per Share Earnings
* Previously filed.
33
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.
Date: January 12, 2001 RED HAT, INC.
By: /s/ MATTHEW J. SZULIK
------------------------------
Matthew J. Szulik
President and Chief Executive Officer
(Officer on behalf of the Registrant)
By: /s/ KEVIN B. THOMPSON
------------------------------
Kevin B. Thompson
Chief Financial Officer
(Principal Financial Officer)
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EXHIBIT INDEX
Exhibit Description of Exhibit
----------------------
No.
---
11.1 Statement Regarding Computation of Per Share Earnings
* Previously filed.
35