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 May 31, 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 June 30, 2000, there were 156,995,909 shares of common stock outstanding.
RED HAT, INC.
TABLE OF CONTENTS
Page
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PART I - FINANCIAL INFORMATION:
ITEM 1: FINANCIAL STATEMENTS
Consolidated Balance Sheets at May 31, 2000 (unaudited) and February 29, 2000 3
Consolidated Statements of Operations for the three months ended May 31, 2000
and 1999 (unaudited) 4
Consolidated Statements of Cash Flows for the three months ended May 31, 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 13
ITEM 3: QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK 35
PART II - OTHER INFORMATION:
ITEM 2: CHANGES IN SECURITIES AND USE OF PROCEEDS 36
ITEM 6: EXHIBITS AND REPORTS ON FORM 8-K 36
SIGNATURES
EXHIBIT INDEX
2
PART 1-FINANCIAL INFORMATION
ITEM 1: FINANCIAL STATEMENTS
RED HAT, INC.
CONSOLIDATED BALANCE SHEETS
ASSETS
May 31, February 29,
2000 2000
(unaudited)
------------- -------------
Current assets:
Cash and cash equivalents $ 106,050,164 $ 242,426,032
Short-term investments 48,314,139 27,460,222
Accounts receivable, net 10,250,190 7,893,936
Inventory 1,343,816 488,977
Prepaid expenses and other current assets 2,175,166 1,874,973
------------- -------------
Total current assets 168,133,475 280,144,140
Property and equipment, net 8,894,542 7,909,103
Goodwill and intangibles, net 87,870,770 58,267,419
Long-term investments 176,260,633 72,354,212
Other assets, net 7,713,678 4,859,958
------------- -------------
Total assets $ 448,873,098 $ 423,534,832
============= =============
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable $ 5,909,724 $ 10,774,546
Royalties payable 40,822 115,117
Accrued expenses 13,078,768 7,571,058
Deferred revenue 12,030,907 11,030,337
Current portion of capital lease obligations 366,315 366,062
------------- -------------
Total current liabilities 31,426,536 29,857,120
Capital lease obligations 190,483 230,516
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,
156,388,959 and 153,333,621 shares issued and outstanding
at May 31, 2000 and February 29, 2000, respectively 15,639 15,334
Additional paid-in capital 514,104,772 477,781,234
Shareholder receivables -- (66,899)
Deferred compensation (32,066,408) (35,159,127)
Accumulated deficit (63,458,936) (48,607,478)
Accumulated other comprehensive income (loss) (1,338,988) (515,868)
------------- -------------
Total stockholders' equity 417,256,079 393,447,196
------------- -------------
Total liabilities and stockholders' equity $ 448,873,098 $ 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
-------------------------------
May 31, May 31,
2000 1999
(unaudited) (unaudited)
-------------- --------------
Revenue:
Subscription $ 8,537,501 $ 4,321,540
Services 6,260,334 3,832,458
Web 1,230,863 80,050
------------- -------------
Total revenue 16,028,698 8,234,048
------------- -------------
Cost of revenue:
Subscription 3,688,543 2,235,901
Services 3,629,234 1,615,890
Web 61,250 123,000
------------- -------------
Total cost of revenue 7,379,027 3,974,791
------------- -------------
Gross profit 8,649,671 4,259,257
------------- -------------
Operating expense:
Sales and marketing (excludes $1,507,550 in stock-based 9,493,407 3,740,859
compensation for the three months ended May 31, 2000)
Research and development (excludes $285,454 and $248,739 3,271,184 2,381,782
in stock-based compensation for the three months ended May 31, 2000
and May 31, 1999, respectively)
General and administrative (excludes $1,924,749 and $122,886 3,771,148 2,019,577
in stock-based compensation for the three months ended May 31, 2000
and May 31, 1999, respectively)
Amortization of goodwill and intangibles 5,231,387 1,298
Stock-based compensation 3,717,753 371,625
Mergers, acquisitions and other 3,359,026 -
------------- -------------
Total operating expense 28,843,905 8,515,141
------------- -------------
Loss from operations (20,194,234) (4,255,884)
------------- -------------
Interest income (expense):
Interest income 5,415,381 447,140
Interest expense (8,191) (219,213)
------------- -------------
Interest income, net 5,407,190 227,927
------------- -------------
Loss before income taxes (14,787,044) (4,027,957)
Provision for income taxes 64,414 61,576
------------- -------------
Net loss (14,851,458) (4,089,533)
Accretion of mandatorily redeemable preferred stock - (43,080)
------------- -------------
Net loss available to common stockholders $ (14,851,458) $ (4,132,613)
============= =============
Net loss per common share:
Basic (0.10) (0.08)
Diluted (0.10) (0.08)
Weighted average shares outstanding:
Basic 154,664,865 49,925,913
Diluted 154,664,865 49,925,913
The accompanying notes are an integral part of these consolidated financial
statements.
4
RED HAT, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
Three Months Ended
--------------------------------
May 31, May 31,
2000 1999
(unaudited) (unaudited)
--------------- ---------------
Cash flows from operating activities:
Net loss $ (14,851,458) $ (4,089,533)
Adjustments to reconcile net loss to net cash used in operating activities:
Depreciation and amortization 6,120,447 214,001
Stock-based compensation expense 3,155,219 307,540
Provision for doubtful accounts 522,464 120,126
Provision for inventory obsolescence 165,520 --
Loss on sale of property and equipment 40,968 2,749
Deferred revenue 2,217,104 3,060,873
Changes in operating assets and liabilities:
Accounts receivable (4,710,675) (2,489,669)
Inventory (1,020,359) (728,560)
Prepaid expenses (275,627) (425,071)
Intangibles and other assets (2,900,406) (301,161)
Accounts payable (4,984,767) 1,267,809
Royalties payable (74,295) (52,074)
Accrued expenses 4,409,911 188,884
------------- -------------
Net cash used in operating activities (12,185,954) (2,924,086)
------------- -------------
Cash flows from investing activities:
Purchase of investment securities (226,794,764) --
Proceeds from sales and maturities of investment securities 101,113,082 1,014,474
Cash acquired through acquisition 488,761 --
Purchase of property and equipment (1,943,835) (632,084)
------------- -------------
Net cash (used in) provided by investing activities (127,136,756) 382,390
------------- -------------
Cash flows from financing activities:
Decrease in stockholders' notes receivable 66,899 5,969
Repayments of notes payable -- (1,126,863)
Proceeds from issuance of mandatorily redeemable preferred stock, net -- 3,188,035
Proceeds from issuance of preferred stock -- 5,148,448
Proceeds from issuance of common stock under Employee Stock Purchase Plan 96,674 --
Proceeds from exercise of common stock options and warrants 2,724,825 1,840,852
Payments on capital lease obligations (39,780) (40,823)
------------- -------------
Net cash provided by financing activities 2,848,618 9,015,618
------------- -------------
Effect of foreign currency exchange rates on cash and cash equivalents 98,224 --
Net increase in cash and cash equivalents (136,375,868) 6,473,922
Cash and cash equivalents at beginning of the year 242,426,032 19,485,586
------------- -------------
Cash and cash equivalents at end of year $ 106,050,164 $ 25,959,508
============= =============
The accompanying notes are an integral part of these consolidated financial
statements.
5
NOTE 1-Organization
Red Hat, Inc. and its subsidiaries ("Red Hat" or the "Company") are a leading
developer and global provider of open source software products and services, and
have built a comprehensive web site dedicated to the open source software
community. Red Hat, Inc. was incorporated in Connecticut in March 1993 as ACC
Corp., Inc. In September 1995 ACC Corp., Inc. changed its name to Red Hat
Software, Inc. In September 1998, Red Hat Software, Inc. reincorporated in
Delaware. In June 1999, Red Hat Software, Inc. changed its name to Red Hat, Inc.
On January 7, 2000, Red Hat acquired Cygnus Solutions, Inc. in a transaction
accounted for using the pooling of interests method of accounting (See NOTE 3).
All prior period financial statements of Red Hat have been restated to reflect
this combination.
NOTE 2-Summary of Significant Accounting Policies
Unaudited Interim Financial Information
The interim consolidated financial statements as of May 31, 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
month period ended May 31, 2000 are not necessarily indicative of the results
that may be expected for the year ended 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.
Cash and Cash Equivalents
The Company considers investments purchased with a maturity period of three
months or less at the date of purchase to be cash equivalents.
6
Accounts Receivable
The Company's accounts receivable include $5,046,598 and $2,433,095 in unbilled
receivables at May 31, 2000 and February 29, 2000, respectively. Unbilled
receivables arise as revenues for custom development services are recognized
under the percentage-of-completion method. These amounts are billable at
specified dates, which do not necessarily coincide with timing of revenue
recognition.
Investments
The Company's investments at May 31, 2000 and February 29, 2000 are in debt
securities which are classified as available for sale and carried at market
value in accordance with Statement of Financial Accounting Standards No. 115
"Accounting for Certain Investments in Debt and Equity Securities" ("SFAS 115").
The Company's investments are considered available for sale as these securities
could potentially be sold in response to needs for liquidity, changes in the
availability of and the yield on alternative instruments or changes in funding
sources or terms. The Company has an unrealized loss of $1,496,991 and $575,647
related to these investments at May 31, 2000 and February 29, 2000, which is
recorded as other comprehensive income (loss), a separate component of
stockholders' equity.
Inventory
The costs incurred for duplicating the computer software, documentation, and
training materials sold by the Company from the product masters and for
packaging the product for distribution are capitalized as inventory using the
weighted average method and charged to cost of sales when revenue from the sale
of units is recognized. Management periodically evaluates the realizability of
inventory based on planned release dates of product updates and records a
reserve for obsolescence when necessary. The reserve for inventory obsolescence
was $95,000 and $335,000 at May 31, 2000 and February 29, 2000, respectively.
Capitalized Software Costs
Capitalization of software development costs begins upon the establishment of
technological feasibility and ceases when the product is available for general
release. The establishment of technological feasibility and the ongoing
assessment of recoverability of capitalized software development costs requires
considerable judgment by management concerning certain external factors
including, but not limited to, technological feasibility, anticipated future
gross revenue, estimated economic life and changes in software and hardware
technologies. As a result of the Company's practice of releasing source code
that it has developed on a weekly basis for unrestricted download on the
Internet, there is generally no passage of time between achievement of
technological feasibility and the availability of the Company's product for
general release. Therefore, the Company has no capitalized software development
costs at May 31, 2000 and February 29, 2000.
Property and Equipment
Property and equipment is primarily comprised of furniture and computer
equipment which are recorded at cost and depreciated using the straight-line
method over their estimated useful lives which range from 3 to 10 years.
Expenditures for maintenance and repairs are charged to operations as incurred;
major expenditures for renewals and betterments are capitalized and depreciated.
Property and equipment acquired under capital leases are being depreciated over
their estimated useful lives or the respective lease term, if shorter.
Goodwill and Intangibles
Goodwill and intangible assets, which represent the excess of acquisition cost
over the tangible net assets acquired in business combinations, is amortized
over its estimated useful life which is three years. Costs incurred for
acquiring certain intangible assets such as trademarks, copyrights and patents
are
7
capitalized and amortized using the straight-line method over their estimated
useful lives, which range from 5 to 15 years.
Other Assets
Other assets includes security deposits which are expected to be refunded to the
Company upon termination of certain leases, investments in other companies
accounted for using the cost method of accounting and the long-term portion of
the Company's prepaid directors' and officers' insurance premiums, which is
amortized to general and administrative expense over the term of the insurance
policy.
Impairment of Long-Lived Assets
The Company evaluates the recoverability of its property and equipment, and
other assets in accordance with Statement of Financial Accounting Standards No.
121, "Accounting for the Impairment of Long-Lived Assets to be Disposed of"
("SFAS 121"). SFAS 121 requires recognition of impairment of long-lived assets
in the event the net book value of such assets exceeds the estimated future
undiscounted cash flows attributable to such assets or the business to which
such intangible assets relate. No impairments were required to be recognized
during the three month periods ended May 31, 2000 and 1999.
Revenue Recognition
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.
Upon the release of Version 6.0 of Official Red Hat Linux in May 1999, the
Company began providing certain telephone and e-mail technical support services
with Official Red Hat Linux and Red Hat Secure Web Server for a period of 90
days from the date of registration of the software products for no additional
fee. In June 1999, the Company also began to provide to purchasers of Official
Red Hat Linux and Red Hat Secure Web Server subscription services for a period
of six months from the date of registration of the software products. In October
1999, the Company released Version 6.1 of Red Hat Linux and began to include the
Secure Web Server product in the "professional" version of Version 6.1 of
Official Red Hat Linux. In accordance with the provisions of Statement of
Opinion 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 Versions 6.0 and 6.1 Official Red Hat Linux over the period that the
technical support and subscription services are provided as the Company does not
sell these technical support and subscription services separately and therefore
does not have vendor specific objective evidence of the fair value of these
services. These revenues are recognized ratably over the period that the
technical support and subscription services are provided in proportion to the
costs incurred to provide such technical support and subscription services as
compared to estimated total costs to be incurred. 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 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
8
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.
Royalty Costs
Royalties that the Company is required to pay on applications licensed from
third parties that are a component of the software products sold by the Company
are expensed as cost of sales on a per unit basis as software products are sold.
Royalties paid in advance of the sale of the Company's software products are
included in prepaid expenses and recorded as expense when the related software
products are sold.
Stock-Based Compensation
The Company accounts for stock-based compensation based on the provisions of
Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to
Employees" ("APB 25"), which states that no compensation expense is recorded for
stock options or other stock-based awards to employees that are granted with an
exercise price equal to or above the estimated fair value per share of the
Company's common stock on the grant date. In the event that stock options are
granted with an exercise price below the estimated fair market value of the
Company's common stock at the grant date, the difference between the fair market
value of the Company's common stock and the exercise price of the stock option
is recorded as deferred compensation. Deferred compensation is amortized to
compensation expense over the vesting period of the stock option. 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. The Company recognized
$3,155,219 and $349,040 in non-cash compensation expense related to amortization
of deferred compensation during the three month periods ended May 31, 2000 and
1999, respectively. In addition, the Company also classifies the employer
portion of tax liabilities paid upon exercise of non-qualified stock options and
warrants as stock-based compensation. The Company has adopted the disclosure
requirements of Statement of Financial Accounting Standards No. 123, "Accounting
for Stock-Based Compensation" ("SFAS 123"), which requires compensation expense
to be disclosed based on the fair value of the options granted at the date of
the grant.
Sales and Marketing Expenses
Sales and marketing expenses consist primarily of costs, including salaries and
sales commissions, of all personnel involved in the sales process and related
expenses. Sales and marketing expenses also include costs of advertising and
trade shows. All costs of advertising, including cooperative marketing
arrangements, the software products, books and related services offered by the
Company are expensed as incurred.
Development Costs
Development costs include expenses incurred by the Company to develop, enhance,
manage, monitor and operate the Company's web sites and costs of managing and
integrating data on the Company's web sites. In March 1998, the Accounting
Standards Executive Committee of the American Institute of
9
Certified Public Accountants ("AICPA") issued Statement of Position No. 98-1
"Accounting for the Costs of Computer Software Developed or Obtained for
Internal Use," ("SOP 98-1") which provides guidance regarding when software
developed or obtained for internal use should be capitalized. SOP 98-1 is
effective for fiscal years beginning after December 15, 1998. The Company
adopted SOP 98-1 effective March 1, 1999. With the adoption of this standard,
the Company began accounting for the software development component of product
development costs associated with internal use software in accordance with SOP
98-1, which requires that certain costs incurred during the application
development stage be capitalized, while costs incurred during the preliminary
project stage and post implementation/operation stage should be expensed as
incurred. Capitalized product development costs are amortized over the estimated
life of the related application. The adoption of SOP 98-1 did not have a
material impact on the Company's consolidated financial statements.
Income Taxes
The Company accounts for income taxes using the liability method which requires
the recognition of deferred tax assets or liabilities for the temporary
differences between financial reporting and tax bases of the Company's assets
and liabilities and for tax carryforwards at enacted statutory tax rates in
effect for the years in which the differences are expected to reverse. The
effect on deferred taxes of a change in tax rates is recognized in income in the
period that includes the enactment date. In addition, valuation allowances are
established when necessary to reduce deferred tax assets to the amounts expected
to be realized.
Foreign Currency Translation
The majority of the Company's international sales are currently denominated in
U.S. dollars. The U.S. dollar has been determined to be the functional currency
for the Company's European operations and local currencies have been determined
to be the functional currencies for the Company's Asian operations. Foreign
exchange gains and losses, which result from the process of remeasuring foreign
currency financial statements into U.S. dollars are included in the statements
of operations. Foreign exchange gains and losses which result from the
translation of foreign currency financial statements into U.S. dollars where the
local currency is the functional currency is included as a separate component of
stockholders' equity.
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 and dilutive potential common
share equivalents then outstanding. 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 14,564,355 and 81,161,759 potential shares of common stock equivalents
for the three month periods ended May 31, 2000 and 1999, 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 ended February 28, 1998. Required segment
disclosures are presented below:
10
The Company has international offices in the United Kingdom, Ireland, Germany,
Switzerland, Australia, and Japan. The following disclosure aggregates
individually immaterial international operations and separately discloses the
significant international operations at and for the three month period ended May
31, 2000.
Three Months Ended May 31, 2000
-------------------------------
Asia Pacific
North America Europe and Japan Total
------------- ------ ------------ -----
Revenues from
unaffiliated
customers........... $ 12,951,647 $ 2,072,556 $ 1,004,495 $ 16,028,698
Net Loss .............. $ (12,807,901) $ (1,001,157) $ (1,042,400) $ (14,851,458)
Total Assets........... $ 435,474,709 $ 10,766,071 $ 2,632,318 $ 448,873,098
Internal Use Software
In March 1998, the Accounting Standards Executive Committee of the American
Institute of Certified Public Accountants issued Statement of Position No. 98-1
"Accounting for the Costs of Computer Software Developed or Obtained for
Internal Use" "SOP 98-1" which provides guidance regarding when software
developed or obtained for internal use should be capitalized. The Company
adopted SOP 98-1 effective March 1, 1999. The adoption of SOP 98-1 did not have
a material impact on the Company's financial position or results of operations.
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 May 31, 2000 totaled $1,338,988 and are comprised of an unrealized loss on
investments in marketable securities of $1,496,991 and a foreign currency
translation adjustment of $158,003. The Company had no items of other
comprehensive income during the three month period ended May 31, 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
11
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.
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.
NOTE 4-Fair Value of Financial Instruments
The carrying value of cash and cash equivalents, accounts receivable, and
accounts payable at May 31, 2000 and February 29, 2000 approximated their fair
value due to the short-term nature of these items. The fair value of the
Company's short-term and long-term investments at May 31, 2000 and February 29,
2000, differed from their historical cost by $1,496,991 and $575,647,
respectively. The Company had no realized gains or losses on investments during
the three month periods ended May 31, 2000 and 1999.
NOTE 5-Subsequent Event
On June 14, 2000, the Company executed a definitive agreement to acquire all of
the outstanding capital stock and assume all of the outstanding stock options of
Wirespeed, Inc., ("Wirespeed") for up to 1,531,232 shares of the Company's
common stock. Wirespeed is a leading developer of network and telecommunications
components for embedded systems software. The acquisition will be accounted for
using the purchase method of accounting. Accordingly, a portion of the purchase
price will be allocated to net tangible and intangible assets acquired based on
their estimated fair market values. The balance of the purchase price will be
recorded as goodwill.
12
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, copies of which may be accessed through the SEC's web site at
http://www.sec.gov.
- ------------------
Overview
We are a leading global developer and provider of open source software and
solutions, and have built a comprehensive web site dedicated to the open source
software community. We were 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 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 2000, we acquired HKS in a
transaction accounted for in accordance with the purchase method of accounting.
As a result, our results of operations include the results of operations of HKS
from the date of the 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.
We recognize revenue from software product sales to distributors and original
equipment manufacturers for which no technical support is provided at the time
our products are shipped, net of a reserve for estimated sales returns. This
reserve is recognized based on our historical experience with these
distributors' rates of sell-through to the end user. Revenue from the sale of
software products to individual users and enterprises for which no technical
support is provided is recognized on the date we ship the software products.
Upon the release of Version 6.0 of Red Hat Linux in May 1999, we began selling
Official Red Hat Linux and Red Hat Secure Web Server with 30 days of free
telephone technical support, 90 days of free e-mail technical support and 180
days of subscription services. In accordance with the provisions of Statement of
Opinion No. 97-2 "Software Revenue Recognition", we are recognizing all of the
revenue from the sale of Versions 6.0 and 6.1 of Official Red Hat Linux ratably
over the period that the technical support and subscription services are
provided in proportion to the costs incurred to provide such technical support
and subscription services as compared to estimated total costs to be incurred.
Cygnus recognized revenue on the sale of its software products at the date such
products were shipped to the distributor or customer net of a reserve for
estimated sales returns. This reserve was recognized based on each individual
distributor's right of return under the distribution agreement and Cygnus'
historical experience of sales returns of its software products. Cygnus used the
same method of revenue
13
recognition for product sales for which no technical support is provided as we
do, and we have continued to use this method for these sales.
We have recently added new features to our redhat.com web site and intend to
develop additional features which we believe will result in an increase in both
the number of visitors who access our web site and in revenue generated through
our web site, including through
. the sale of our own software and solutions;
. the sale of third-party products;
. the sale of products co-branded or bundled with third-party products;
and
. the sale of advertising.
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. We did not generate revenue from the sale of
advertising on our web site until the first quarter of the fiscal year ended
February 29, 2000.
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.
Cygnus provides custom development services for integrated device manufacturers
and also provides engineering services and developer support services for
microprocessor and product manufacturing companies. Cygnus recognizes revenue on
its 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
continued to use this method of revenue recognition for these services.
We have historically experienced fluctuations in our results of operations
related to the release of new versions of 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. Prior to our release of Version 6.0 of Official Red Hat Linux in May
1999 and of Version 6.1 of Official Red Hat Linux in October 1999, software
product sales decreased, but after each release we experienced an immediate
significant increase in both the volume and dollar amount of software product
sales. In addition, we believe that revenue from the sale of Official Red Hat
Linux and related products will decline as a percentage of total revenue in the
future as we continue to expand our services offerings and execute our web
initiatives.
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
May 31,
2000 1999
---------- ----------
(Unaudited)
Revenue:
Subscription 53.3% 52.5%
Services 39.1% 46.5%
Web 7.6% 1.0%
-------- --------
Total revenue 100.0% 100.0%
-------- --------
Cost of revenue:
Subscription 23.0% 27.2%
Services 22.6% 19.6%
Web 0.4% 1.5%
-------- --------
Total cost of revenue 46.0% 48.3%
-------- --------
Gross profit 54.0% 51.7%
-------- --------
Operating expense:
Sales and marketing 59.2% 45.4%
Research and development 20.4% 28.9%
General and administrative 23.5% 24.5%
Amortization of goodwill and intangibles 32.7% 0.1%
Stock-based compensation 23.2% 4.5%
Mergers, acquisitions and other 21.0% 0.0%
-------- --------
Total operating expense 180.0% 103.4%
-------- --------
Loss from operations -126.0% -51.7%
-------- --------
Interest income, net 33.7% 2.8%
-------- --------
Loss before income taxes -92.3% -48.9%
Provision for income taxes 0.4% 0.8%
-------- --------
Net loss -92.7% -49.7%
Accretion of mandatorily redeemable preferred stock 0.0% -0.5%
-------- --------
Net loss available to common stockholders -92.7% -50.2%
======== ========
15
Three Months Ended May 31, 2000 and May 31, 1999
Total revenue
Total revenue increased 94.7% to $16.0 million in the three months ended May 31,
2000 from $8.2 million in the three months ended May 31, 1999. Revenue from
international operations totaled $3.1 million during the three months ended May
31, 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 publications about
Linux-based operating systems, sales of software development tools, and
technical support and maintenance. Subscription revenue increased 97.6% to $8.5
million in the three months ended May 31, 2000 from $4.3 million in the three
months ended May 31, 1999. As a percentage of total revenue, subscription
revenue increased to 53.3% in the three months ended May 31, 2000 from 52.5% in
the three months ended May 31, 1999. These increases were primarily due to the
release of Version 6.2 of Official Red Hat Linux in March 2000.
Services revenue
Services revenue is primarily comprised of custom development fees, training and
education fees, and short-term consulting contracts. Services revenue increased
63.4% to $6.3 million in the three months ended May 31, 2000 from $3.8 million
in the three months ended May 31, 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 in the three months ended May 31, 2000. As a percentage of total
revenue, services revenue decreased to 39.1% in the three months ended May 31,
2000 from 46.5% in the three months ended May 31, 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 is comprised primarily of fees generated from contracts with
advertisers to display advertisements on our web site. Web revenue increased to
$1.2 million in the three months ended May 31, 2000 from $80,000 in the three
months ended May 31, 1999. As a percentage of total revenue, web revenue
increased to 7.6% in the three months ended May 31, 2000 from 1.0% in the three
months ended May 31, 1999. These increases were due to the commencement of our
web initiatives during the fiscal year ending February 29, 2000. We expect web
revenue to increase as a percentage of revenue in the future as advertising
revenue and royalties from the sale of third-party products and products
co-branded or bundled with third-party products continues to grow.
16
Cost of revenue
Cost of subscription revenue
Cost of subscription revenue primarily 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. Also included are royalties we pay for licensing third-party
applications included in our software products. Cost of subscription revenue
increased 65.0% to $3.7 million in the three months ended May 31, 2000 from $2.2
million in the three months ended May 31, 1999. This increase was directly
related to the increase in costs to provide telephone support and subscription
services upon the release of Version 6.0 of Official Red Hat Linux and the
increase in sales volumes as a result of the release of Version 6.2 of Official
Red Hat Linux in March 2000. As a percentage of subscription revenue, cost of
subscription revenue decreased to 43.2% in the three months ended May 31, 2000
from 51.7% in the three months ended May 31, 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 three months ended May 31, 2000. We expect
the costs of subscription revenue to continue to decrease as a percentage of
revenue in the future as sales volumes increase.
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 124.6% to $3.6 million in the three months ended May 31, 2000 from
$1.6 million in the three months ended May 31, 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 58.0% in the three months ended May 31, 2000 from 42.2% in
the three months ended May 31, 1999. This increase was primarily due to cost of
services revenue increasing at a higher rate than services revenue.
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 to $61,000 in the three months ended May 31, 2000
from $0.1 million in the three months ended May 31, 1999. As a percentage of
web revenue, cost of web revenue decreased to 5.0% in the three months ended
May 31, 2000 from 153.7% in three months ended May 31, 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 three
months ended May 31, 1999.
17
Gross Profit
Gross profit increased 103.1% to $8.6 million in the three months ended May 31,
2000 from $4.3 million in the three months ended May 31, 1999. As a percentage
of total revenue, gross profit increased to 54.0% in the three months ended May
31, 2000 from 51.7% in the three months ended May 31, 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, 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
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 153.8% to $9.5 million in the three months ended May 31, 2000 from
$3.7 million in the three months ended May 31, 1999. As a percentage of total
revenue, sales and marketing expense increased to 59.2% in the three months
ended May 31, 2000 from 45.4% in the three months ended May 31, 1999. These
increases were due primarily to higher advertising and promotional costs
incurred to promote the release of Version 6.2 of Official Red Hat Linux, our
web advertising and service offerings and, to a lesser extent, our new software
development tools. These increases were also due to higher costs resulting from
joint marketing arrangements with distributors. 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 37.3% to $3.3 million in the three months ended
May 31, 2000 from $2.4 million in the three months ended May 31, 1999. As a
percentage of total revenue, research and development expense decreased to 20.4%
in the three months ended May 31, 2000 from 28.9% in the three months ended May
31, 2000. 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 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. 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 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. General and
administrative expense increased 86.7% to $3.8 million in the three months ended
May 31, 2000 from $2.0 million in the three months ended May 31, 1999. This
increase resulted from:
. an increase in payroll costs due to an increase in the number of
general and administrative personnel to support the growth of our
business;
18
. 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 decreased
to 23.5% in the three months ended May 31, 2000 from 24.5% in the three months
ended May 31, 1999. We expect general and administrative expense 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 $5.2 million in the three months ended May 31, 2000 from $1,000 in the three
months ended May 31, 1999. As a percentage of total revenue, amortization of
goodwill and intangibles expense increased to 32.7% in the three months ended
May 31, 2000 from 0.1% in the three months ended May 31, 1999. These increases
were primarily due to the acquisition of HKS in January 2000.
Stock-based compensation
Stock-based compensation expense consists of the amortization of deferred
compensation related to stock options granted to employees, primarily new
members of our management team that were recruited immediately prior to our
initial public offering in August 1999, 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. 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 $3.7 million in the three months ended May 31, 2000 from $0.4
million in the three months ended May 31, 1999. As a percentage of total
revenue, stock based compensation expense increased to 23.2% in the three months
ended May 31, 2000 from 4.5% in the three months ended May 31, 1999. Stock-based
compensation is expected to be approximately $12.7 million, $12.0 million, and
$10.4 million in fiscal years 2001, 2002, and 2003, respectively.
Mergers, acquisitions, and other
Mergers, acquisitions and other expense consists of costs incurred in connection
with investigating potential acquisitions, the cost of acquisitions accounted
for using the pooling of interests method of accounting, and other one-time
nonrecurring expenses. Mergers, acquisitions and other expense increased to $3.4
million in the three months ended May 31, 2000 from zero in the three months
ended May 31, 1999. As a percentage of total revenue, mergers, acquisitions and
other expense increased to 21.0% in the three months ended May 31, 2000. These
increases were primarily due to the cancellation of an advertising contract not
expected to provide a future benefit to the Company.
Interest income (expense), net
Interest 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. Interest income (expense), net
increased to income of $5.4 million in the three months ended May 31, 2000 from
19
income of $0.2 million in the three months ended May 31, 1999. As a percentage
of total revenue, interest income (expense), net increased to 33.7% in the three
months ended May 31, 2000 from 2.8% in the three months ended May 31, 1999.
These increases resulted from higher average cash and investment balances in the
three months ended May 31, 2000 as compared to the three months ended May 31,
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 $64,000 for the three months ended May
31, 2000 from $62,000 in the three months ended May 31, 1999. The increase in
provision for income taxes for the three months ended May 31, 2000 was primarily
due to an increase in certain foreign income tax expenses.
Accretion of mandatorily redeemable preferred stock
Accretion of mandatorily redeemable preferred stock decreased to zero in the
three months ended May 31, 2000 from $43,000 in the three months ended May 31,
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 from cash flows from operations.
At May 31, 2000, cash and cash equivalents totaled $106.1 million, a decrease of
$136.4 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 $125.7 million, cash used by operations of $12.2 million, and $1.9
million used for the purchase of office and computer equipment. This was
partially offset by proceeds of $2.7 million from the exercise of stock options
and warrants and cash acquired through acquisition of $0.5 million during the
three months ended May 31, 2000.
Cash used by operations of $12.2 million in the three months ended May 31, 2000,
represented the net loss of $14.9 million, an increase in accounts receivable of
$4.7 million, an increase in inventory of $1.0 million, an increase in
intangibles and other assets of $2.8 million, and a decrease in accounts payable
of $5.0 million, partially offset by an increase in accrued expenses of $4.4
million, an increase in deferred revenue of $2.2 million, and net non cash
charges of $9.9 million. The increase in accounts receivable, accrued expenses
and deferred revenue resulted primarily from the release of Version 6.2 of
Official Red Hat Linux to our distributors in March 2000.
Cash used in investing activities for the three months ended May 31, 2000 was
comprised of the purchase of investments in debt securities, net of maturities,
of $125.7 million, purchases of property and equipment totaling $1.9 million,
and cash acquired through acquisition of $0.5 million.
Cash from financing activities of $2.8 million for the three months ended May
31, 2000 was primarily comprised of $2.7 million in proceeds from the exercise
of stock options and warrants.
At February 29, 2000, cash and cash equivalents totaled $242.4 million, an
increase of $222.9 million as compared to February 28, 1999. The increase in
cash and cash equivalents resulted from the receipt of $337.1 million in net
proceeds from the issuance of common stock in August 1999 and February 2000,
$8.2 million in proceeds from issuance of preferred stock in March, April, and
June 1999, $2.7 million in proceeds from receipt of repayment of stockholders'
notes receivable, and $3.9 million in proceeds from exercise of stock options
and warrants. This was partially offset by the purchase of net investments in
20
debt and equity securities of $101.9 million, cash used by operations of $17.1
million, repayments of notes payable of $2.4 million, and $6.7 million for the
purchase of office and computer equipment.
Cash used by operations of $17.1 million in the year ended February 29, 2000,
represented the net loss of $39.8 million, an increase in accounts receivable of
$2.5 million, an increase in intangibles and other assets of $1.8 million and an
increase in prepaid expenses of $1.0 million, partially offset by an increase in
accounts payable and accrued expenses of $12.0 million, an increase in deferred
revenue of $4.9 million, and net non cash charges of $11.7 million. The increase
in accounts receivable, accounts payable, accrued expenses and deferred revenue
resulted from the release of Versions 6.0 of Official Red Hat Linux to our
distributors in late April 1999 and Version 6.1 of Official Red Hat Linux in
early October 1999. These releases resulted in increased sales which resulted in
higher amounts of accounts receivable from distributors and deferred revenues at
February 29, 2000.
Cash used in investing activities was comprised of the purchase of investments
in debt securities, net of maturities, of $101.9 million and purchases of
property and equipment totaling $6.7 million.
Cash from financing activities of $349.1 million for the year ended February 29,
2000 was comprised of $8.2 million in net proceeds from the sale of our
preferred stock, $3.9 million in proceeds from the exercise of stock options and
warrants, $2.7 million in proceeds from receipt of repayment of stockholders'
notes receivable, and $337.1 million in net proceeds from the sale of our common
stock in August 1999 and February 2000. This was partially offset by repayments
of notes payable of $2.4 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;
. 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 at least the next 12 to 18 months. We may need to raise
additional funds, however, in order to fund more rapid expansion. We may seek to
sell additional equity or debt securities or to obtain a credit facility. The
sale of additional equity or debt securities, if convertible, could result in
additional dilution to our stockholders. The incurrence of indebtedness would
result in increased fixed obligations and could result in operating covenants
that would restrict our operations. We cannot guarantee that financing will be
available in amounts or on terms acceptable to us, if at all.
Recent Developments
In May 2000, the Company completed the acquisition of all of the outstanding
capital stock of Bluecurve, Inc. ("Bluecurve") in exchange for the issuance of
972,083 shares of the Company's common
21
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.
On June 14, 2000, the Company executed a definitive agreement to acquire all of
the outstanding common stock and assume all of the outstanding stock options of
Wirespeed, Inc., ("Wirespeed") for up to 1,531,232 shares of the Company's
common stock. Wirespeed is a leading developer of network and telecommunications
components for embedded systems software. The acquisition will be accounted for
using the purchase method of accounting. Accordingly, a portion of the purchase
price will be allocated to net tangible and intangible assets acquired based on
their estimated fair market values. The balance of the purchase price will be
recorded as goodwill.
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 1998, the Accounting Standards Executive Committee of the American
Institute of Certified Public Accountants issued Statement of Position No. 98-9,
"Modification of Statement of Position No. 97-2, Software Revenue Recognition,
with Respect to Certain Transactions". Statement of Position No. 98-9 amends
Statement of Position No. 97-2 to require recognition of revenue using the
"residual method" in circumstances outlined in Statement of Position No. 98-9.
Under the residual method, revenue is recognized as follows:
. the total fair value of undelivered elements, as indicated by vendor
specific objective evidence is deferred and subsequently recognized in
accordance with the relevant sections of Statement of Position No. 97-
2; and
. the difference between the total arrangement fee and the amount
deferred for the undelivered elements is recognized as revenue related
to the delivered elements.
Statement of Position No. 98-9 is effective for transactions entered into in
fiscal years beginning after March 15, 1999. Also, the provisions of Statement
of Position No. 97-2 that were deferred by Statement of Position No. 98-4 will
continue to be deferred until the date Statement of Position No. 98-9 becomes
effective. We do not expect that the adoption of Statement of Position No. 98-9
will have any impact on our 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 adoption of SAB 101 is not expected to have a material impact on
the Company's consolidated financial position or results of operations.
22
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 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 SECURITIES AND EXCHANGE COMMISSION, 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 business may not succeed because open source software business models are
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.
23
Our reliance on the support of Linus Torvalds and other prominent Linux
developers could impair our ability to release major product upgrades and
maintain market share
We may not be able to release major product upgrades of Red Hat Linux on a
timely basis because the heart of 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 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
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 Red Hat Linux. If these components are not reliable, 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 to 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 may 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 may not gain widespread commercial acceptance and we may 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.
24
We may not succeed in shifting our business focus from traditional
shrink-wrapped software sales to offering subscription-based product and
services offerings
We have recently begun to focus 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 not prove successful. The
failure to successfully implement this transition of our sales model could
materially adversely affect our operating results.
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, resulting 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 at times 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 Cygnus, HKS, or Bluecurve and
may have difficulty integrating these businesses
The successful integration of the operations, products, services and personnel
of Red Hat, Cygnus, HKS, and Bluecurve 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 Cygnus, HKS, and Bluecurve are successfully
combined with those of Red Hat in a timely and efficient manner. Integration of
the three companies' operations, products, services and personnel may be
hampered because, among other things,
. the products and services offered by Cygnus, HKS, Bluecurve and Red
Hat are highly complex and have been developed independently;
. integration of Cygnus, HKS, Bluecurve and Red Hat product lines will
require the coordination of
25
separate development and engineering teams from each company; and
. Cygnus, which is headquartered in Sunnyvale, California, Bluecurve
which is headquartered in Oakland, California, and Red Hat, which is
headquartered in Durham, North Carolina, are located in disparate
geographical regions.
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. 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 are
adequate for a small private
26
company, are becoming outdated as we grow. During the fiscal year ended February
29, 2000, we 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 and updated 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 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.
Because our headquarters are not located in a major metropolitan area, we may
not be able to recruit and retain qualified professionals, who are currently in
high demand and whose numbers are limited
We compete intensely with other software companies worldwide to recruit and hire
from a limited pool of qualified personnel. Because our headquarters are not
located in a major metropolitan area, many qualified candidates may be unwilling
to relocate to North Carolina and work for Red Hat. If we cannot attract and
hire additional qualified sales and marketing, professional services and
software engineering and development personnel, our business results will
suffer.
We may not be able to generate enough additional revenue from our planned
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 Ireland, the
UK, Germany, Italy, Japan, France 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, including our Chief Executive Officer and President, Matthew
Szulik, our Chief Operating Officer, Tim Buckley and our Chief Financial
Officer, Harold Covert, 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 could lose Robert Young, Matthew Szulik, Harold Covert or Tim Buckley or
other key personnel, which could prevent us from executing our business
strategies
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 Financial Officer,
Harold Covert, and our Chief Operating Officer, Tim Buckley. 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.
27
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.
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.
28
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.
Any disruption in our relationships with our two largest distributors, on whom
we rely for a significant percentage of our product revenue, could cause our
revenue to decline
We are highly dependent on revenue from sales to our two largest distributors,
Frank Kasper & Associates and Ingram Micro, who together accounted for a
significant percent of our total revenue for the fiscal year ended February 29,
2000. These distributors are not obligated to purchase products from us and the
loss of one or both of these distributors, or a reduction in the amount of
product sales generated by them, could significantly reduce our product revenue.
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;
. 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 recently 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
29
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;
. 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
30
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.
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.
31
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 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.
32
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
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.
33
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. The trading
prices of many technology companies' stocks, including our common stock, are at
or near historical highs and these trading prices and multiples are
substantially above historical levels. These trading prices and multiples may
not be sustained. 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.
34
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. The following table presents the fair value balances of the Company's
cash equivalents and short-term and long-term investments that are subject to
interest rate risk by year of expected maturity and average interest rates as of
February 29, 2000:
Year Ended
(in thousands)
February February February
-------- -------- --------
28, 2001 28, 2002 28, 2003 Total
-------- -------- -------- -----
Cash equivalents................ 242,426 242,426
Average interest rate........... 6.0%
Investments..................... 27,460 69,219 3,135 99,814
Average interest rates.......... 6.1% 6.7% 7.26%
Red Hat did not hold derivative financial instruments as of February 29, 2000,
and has never held such investments in the past.
Foreign Currency Risk
Approximately 25% of the Company's revenues for the fiscal year ended February
29, 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.
Based upon the foregoing, the Company began hedging its foreign currency
receivables in the third quarter of 1999 in an effort to reduce its exposure to
currency exchange rates. However, as a matter of procedure, the Company will not
invest in speculative financial instruments as a means of hedging against such
risk. The Company has no outstanding foreign currency hedging contracts at May
31, 2000. The Company's accounting policies for these contracts are based on the
Company's designation of the contracts as hedging transactions. The criteria the
Company uses for designating a contract as a hedge include the contract's
effectiveness in risk reduction and one-to-one matching of derivative
instruments to underlying transactions. Gains and losses on forward foreign
exchange contracts are recognized in income in the same period as gains and
losses on the underlying transactions. If an underlying hedged transaction is
terminated earlier than initially anticipated, the offsetting gain or loss on
the related forward exchange contract would be recognized in income in the same
period. In addition, since the Company enters into forward contracts only as a
hedge, any change in currency rates would not result in any material net gain or
loss, as any gain or loss on the underlying foreign currency denominated balance
would be offset by the gain or loss on the forward contract. Information
regarding the Company's foreign currency forward exchange contracts is set forth
in Note 13 of Item 14(a)(1) of this Annual Report on Form 10-K and is
incorporated herein by reference.
35
PART II - OTHER INFORMATION
ITEM 2: CHANGES IN SECURITIES AND USE OF PROCEEDS
Sales of Unregistered Securities
In May 2000, the Company issued 972,083 shares of its common stock in exchange
for the acquisition of all of the outstanding capital stock of Bluecurve, Inc.
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 May 31, 2000:
Cash and cash equivalents: $57,629,498
Working capital: $30,837,431
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.
---
3.1* Third Amended and Restated Certificate of Incorporation, as amended,
of the registrant (incorporated by reference from Exhibit 3.1 to the
registrant's Registration Statement on Form S-1 (File no. 333-94775)).
3.2* Amended and Restated By-Laws, as amended, of the registrant
(incorporated by reference from Exhibit 3.2 to the registrant's
Registration Statement on Form S-1 (File no. 333-94775)).
4.1* Specimen certificate representing the common stock (incorporated by
reference from Exhibit 4.1 to the registrant's Registration Statement
on Form S-1 (File no. 333-94775)).
11.1 Statement Regarding Computation of Per Share Earnings
19.1* Annual Report on Form 10-K for the fiscal year ended February 29, 2000
filed with the Securities and Exchange Commission on May 25, 2000 and
incorporated herein by reference.
36
27.1 Financial Data Schedule
* Previously filed.
37
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: July 17, 2000 RED HAT, INC.
By: /s/ MATTHEW J. SZULIK
------------------------
Matthew J. Szulik
President and Chief Executive Officer
(Officer on behalf of the Registrant)
By: /s/ HAROLD L. COVERT
-----------------------
Harold L. Covert
Chief Financial Officer
(Principal Financial Officer)
38
EXHIBIT INDEX
Exhibit Description of Exhibit
----------------------
No.
---
3.1* Third Amended and Restated Certificate of Incorporation, as amended,
of the registrant (incorporated by reference from Exhibit 3.1 to the
registrant's Registration Statement on Form S-1 (File no. 333-
94775)).
3.2* Amended and Restated By-Laws, as amended, of the registrant
(incorporated by reference from Exhibit 3.2 to the registrant's
Registration Statement on Form S-1 (File no. 333-94775)).
4.1* Specimen certificate representing the common stock (incorporated by
reference from Exhibit 4.1 to the registrant's Registration
Statement on Form S-1 (File no. 333-94775)).
11.1 Statement Regarding Computation of Per Share Earnings
19.1* Annual Report on Form 10-K for the fiscal year ended February 29,
2000 filed with the Securities and Exchange Commission on May 25,
2000 and incorporated herein by reference.
27.1 Financial Data Schedule
* Previously filed.
39