<PAGE>
FORM 10-Q
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 20549
(MARK ONE)
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarter ended August 31, 1999
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-_____
RED HAT, INC.
(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)
DELAWARE 06-1364380
(STATE OR OTHER JURISDICTION OF (I.R.S. EMPLOYER
INCORPORATION OR ORGANIZATION) IDENTIFICATION NUMBER)
2600 MERIDIAN PARKWAY
DURHAM, NORTH CAROLINA 27713
(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES) (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 No X
---- ----
Indicate the number of shares outstanding of each of the issuer's
classes of common stock, as of the latest practicable date:
------------------
As of September 30, 1999, there were 68,794,604 shares of common stock
outstanding.
<PAGE>
RED HAT, INC.
TABLE OF CONTENTS
PART I - FINANCIAL INFORMATION:
ITEM 1: FINANCIAL STATEMENTS
<TABLE>
<S> <C>
Consolidated Balance Sheets at August 31, 1999
(unaudited) and February 28, 1999.....................3
Consolidated Statements of Operations for the
Three and Six Months Ended August 31,
1999 and 1998
(unaudited)...........................................4
Consolidated Statements of Cash Flows for the
Six Months Ended August 31, 1999 and 1998
(unaudited)...........................................5
Notes to Consolidated Financial
Statements............................................6
ITEM 2: MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS.....................7
PART II - OTHER INFORMATION:
ITEM 2: CHANGES IN SECURITIES AND USE OF PROCEEDS..................29
ITEM 6: EXHIBITS AND REPORTS ON FORM 8-K...........................29
SIGNATURES
EXHIBIT INDEX
</TABLE>
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<PAGE>
PART I. FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
RED HAT, INC.
CONSOLIDATED BALANCE SHEETS
- --------------------------------------------------------------------------------
<TABLE>
<CAPTION>
ASSETS AUGUST 31, FEBRUARY 28,
1999 1999
(UNAUDITED)
<S> <C> <C>
Current assets:
Cash and cash equivalents $ 7,351,770 $ 10,055,227
Short-term investments 417,124 2,037,992
Accounts receivable, net 1,715,279 1,127,193
Inventory 887,136 345,630
Prepaid expenses 601,360 173,730
Income tax receivable 114,145 114,145
------------- -------------
Total current assets 11,086,814 13,853,917
Property and equipment, net 2,369,799 1,270,576
Other assets, net 787,366 151,310
Investments 95,653,362 --
------------- -------------
Total assets $ 109,897,341 $ 15,275,803
------------- -------------
------------- -------------
LIABILITIES AND STOCKHOLDERS' EQUITY (DEFICIT)
Current liabilities:
Accounts payable $ 3,408,744 $ 2,087,305
Royalties payable 216,963 144,074
Accrued expenses 597,421 379,757
Deferred revenue 3,245,275 33,352
Current portion of capital lease obligations 90,466 108,897
------------- -------------
Total current liabilities 7,558,869 2,753,385
Capital lease obligations 381,403 419,778
Commitments and contingencies -- --
Mandatorily redeemable preferred stock -- 12,107,419
Stockholders' equity (deficit):
Preferred stock -- --
Common stock 6,877 2,385
Additional paid-in capital 115,385,071 427,464
Deferred compensation (7,647,751) --
Accumulated other comprehensive income (72,714) --
Accumulated deficit (5,714,414) (434,628)
------------- -------------
Total stockholders' equity (deficit) 101,957,069 (4,779)
------------- -------------
Total liabilities and stockholders' equity (deficit) $ 109,897,341 $ 15,275,803
------------- -------------
------------- -------------
</TABLE>
The accompanying notes are an integral part of these financial statements.
-3-
<PAGE>
RED HAT, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
- --------------------------------------------------------------------------------
<TABLE>
<CAPTION>
THREE MONTHS ENDED SIX MONTHS ENDED
AUGUST 31, AUGUST 31,
---------------------------- ----------------------------
1999 1998 1999 1998
(UNAUDITED)
<S> <C> <C> <C> <C>
Revenue:
Software and related products $ 3,254,512 $ 2,167,312 $ 5,190,330 $ 3,540,962
Web advertising 105,666 -- 185,716 --
Services and other 1,009,884 70,588 1,791,235 247,903
---------------------------- ----------------------------
Total revenue 4,370,062 2,237,900 7,167,281 3,788,865
---------------------------- ----------------------------
Cost of revenue:
Software and related products 1,519,535 785,243 2,700,439 1,467,658
Web advertising 202,961 -- 325,961 --
Services and other 913,648 -- 1,356,808 --
---------------------------- ----------------------------
Total cost of revenue 2,636,144 785,243 4,383,208 1,467,658
---------------------------- ----------------------------
Gross profit 1,733,918 1,452,657 2,784,073 2,321,207
---------------------------- ----------------------------
Operating expense:
Sales and marketing 2,422,912 482,465 4,051,479 864,123
Research and development 1,664,751 457,713 2,490,875 798,678
General and administrative 1,090,861 330,518 1,915,019 544,169
---------------------------- ----------------------------
Total operating expense 5,178,524 1,270,696 8,457,373 2,206,970
--------------------------- ----------------------------
Income (loss) from operations (3,444,606) 181,961 (5,673,300) 114,237
---------------------------- ----------------------------
Other income (expense):
Interest income 337,561 16,538 487,670 31,761
Interest expense (878) (4,695) (11,683) (4,695)
---------------------------- ----------------------------
Other income (expense), net 336,683 11,843 475,987 27,066
---------------------------- ----------------------------
Income before income taxes (3,107,923) 193,804 (5,197,313) 141,303
Provision for income taxes -- 61,658 -- 61,658
Net income (loss) (3,107,923) 132,146 (5,197,313) 79,645
Accretion on mandatorily redeemable preferred stock (39,393) -- (82,473) --
---------------------------- ----------------------------
Net income (loss) available to common stockholders $ (3,147,316) $ 132,146 $ (5,279,786) $ 79,645
---------------------------- ----------------------------
---------------------------- ----------------------------
Net income (loss) per common share:
Basic (0.09) 0.01 (0.18) 0.00
Diluted (0.09) 0.00 (0.18) 0.00
Weighted average shares outstanding:
Basic 33,649,671 23,500,000 29,016,512 23,500,000
Diluted 33,649,671 40,842,800 29,016,512 40,840,274
</TABLE>
The accompanying notes are an integral part of these financial statements.
-4-
<PAGE>
RED HAT, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
- --------------------------------------------------------------------------------
<TABLE>
<CAPTION>
SIX MONTHS ENDED
AUGUST 31,
-------------------------------
1999 1998
(UNAUDITED)
<S> <C> <C>
Cash flows from operating activities:
Net income (loss) $ (5,197,313) $ 79,645
Adjustments to reconcile net income (loss) to net
cash provided by (used in) operating activities:
Depreciation and amortization 267,135 31,379
Deferred compensation 477,508 --
Provision for doubtful accounts 21,232 --
Provision for inventory obsolescence -- 68,439
Deferred revenue 3,211,923 990
Changes in operating assets and liabilities:
Accounts receivable (609,318) (111,549)
Inventory (541,506) 90,747
Prepaid expenses (427,630) (78,518)
Other assets (638,652) (2,268)
Accounts payable 1,321,439 (16,311)
Royalties payable 72,889 (6,191)
Accrued expenses 217,664 42,040
------------- -------------
Net cash provided by (used in) operating activities (1,824,629) 98,403
------------- -------------
Cash flows from investing activities:
Purchase of investment securities (100,050,322) --
Proceeds from maturity of investment securities 5,945,114 100,000
Purchase of equipment (1,363,762) (107,523)
Net cash used in investing activities (95,468,970) (7,523)
------------- -------------
Cash flows from financing activities:
Proceeds from issuance of mandatorily redeemable preferred stock, net 3,188,035 --
Proceeds from exercise of common stock options and warrants 2,757,892 --
Payments on capital lease obligations (56,806) (8,774)
Proceeds from issuance of common stock, net 88,701,021 --
------------- -------------
Net cash provided by (used in) financing activities 94,590,142 (8,774)
------------- -------------
Net increase (decrease) in cash and cash equivalents (2,703,457) 82,106
Cash and cash equivalents beginning of the period 10,055,227 1,292,562
------------- -------------
Cash and cash equivalents end of period $ 7,351,770 $ 1,374,668
------------- -------------
------------- -------------
</TABLE>
The accompanying notes are an integral part of these financial statements.
-5-
<PAGE>
RED HAT, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
- --------------------------------------------------------------------------------
1. NATURE OF BUSINESS
BUSINESS ACTIVITY
Red Hat, Inc. ("Red Hat" or the "Company") is a leading developer and global
provider of open source software products and services, and has 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.
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
UNAUDITED INTERIM FINANCIAL INFORMATION
The interim consolidated financial statements as of August 31, 1999 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 28, 1999 has been derived from the audited
consolidated financial statements at that date. Operating results for the
three-month and six-month periods ended August 31, 1999 are not necessarily
indicative of the results that may be expected for the year ending February 29,
2000. 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 28, 1999 included in the Company's Registration Statement on
Form S-1 (File No. 333-80051).
USE OF ESTIMATES
The preparation of financial statements in conformity with generally accepted
accounting principles 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 revenue 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.
INVESTMENTS
The Company's investments are all in debt securities which are classified as
held-to-maturity and are carried at amortized cost in accordance with Statement
of Financial Accounting Standards No. 115 "Accounting for Investments in Debt
and Equity Securities" as the Company has both the positive intent and ability
to hold them to maturity. Investments with a maturity period of greater than 90
days but less than one year are classified as short-term investments.
Investments with a maturity period of greater than one year are classified as
long-term investments.
REVENUE RECOGNITION
Revenue from the sale of software products for which no technical support is
provided are generally recognized upon shipment of the products, net of
estimated returns. A reserve for sales returns is recognized for sales of these
-6-
<PAGE>
RED HAT, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
- --------------------------------------------------------------------------------
software products to distributors based on the Company's historical experience
of sell-through to the end-user by the distributor. The Company recognizes
revenue from the sale of software products to new distributors of its software
products based upon sell-through to the end-user until the Company has
sufficient historical experience with the distributor to allow the accurate
estimation of sales returns.
Upon the release of Version 6.0 of Official Red Hat Linux in May 1999, the
Company began providing certain telephone, e-mail and other support and
subscription services for a period of six months from the date of registration
of Version 6.0 of Official Red Hat Linux and Red Hat Secure Web Server for no
additional fee. In accordance with the provisions of Statement of Position No.
97-2, "Software Revenue Recognition", the Company recognizes all of the revenue
from the sale of Version 6.0 of Official Red Hat Linux over the period that the
support and subscription services are provided, as the Company does not sell
these specific support and subscription services separately and therefore does
not have vendor specific objective evidence of the fair value of these services.
This revenue is recognized ratably over the period that the support and
subscription services are provided in proportion to the costs incurred to
provide such support and subscription services as compared to the estimated
total costs to be incurred. As of August 31, 1999 the Company did not provide
support and subscription services as part of the fee for any of its software
products other than Version 6.0 of Official Red Hat Linux and Red Hat Secure Web
Server.
Revenue for on-going maintenance and technical support services sold separately
is deferred and recognized ratably over the term of the agreement, which is
typically twelve months.
Revenue from customer training and other services is recognized as the service
is performed.
Royalty revenue, which is included in services and other 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. Revenue from
the sale of books published by the Company, which is included in software and
related products revenue, is recognized at the date of shipment, net of
estimated returns.
Web advertising revenue 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 impressions delivered over
total guaranteed impressions or the straight line basis over the term of the
contract. If the minimum guaranteed impressions 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 components 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", 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 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 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. The Company recognized $377,207 and
$477,508 in non-cash compensation expense related to amortization of deferred
compensation during the three and six months ended August 31, 1999,
respectively. The Company has adopted the disclosure requirements of Statement
of Financial Accounting
-7-
<PAGE>
RED HAT, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
- --------------------------------------------------------------------------------
Standards No. 123 "Accounting for Stock-Based Compensation," which requires
compensation expense to be recognized for disclosure purposes, based on the fair
value of the options granted at the date of the grant.
SALES AND MARKETING EXPENSE
Sales and marketing expense consists primarily of costs, including salaries and
sales commissions, of all personnel involved in the sales process and related
expenses. Sales and marketing expense also includes costs of advertising and
trade shows.
RESEARCH AND DEVELOPMENT EXPENSE
Research and development expense includes all direct costs, primarily salaries
for Company personnel and outside consultants, related to the development of new
products and significant enhancements to existing products and are charged to
operations as incurred until such time as technological feasibility is achieved.
3. PRO FORMA EARNINGS (LOSS) PER SHARE
Pro forma earnings (loss) per share for the three and six month periods ended
August 31, 1999 and 1998 are presented for informational purposes only and are
not prepared in accordance with generally accepted accounting principles. Pro
forma weighted average common shares outstanding assume completion of the
Company's initial public offering at March 1, 1999.
Pro forma net income (loss) presents the operating results of Red Hat, excluding
charges related to stock-based compensation and accretion on mandatorily
redeemable preferred stock of $416,600 and $559,981 for the three and six month
periods ended August 31, 1999, respectively.
<TABLE>
<CAPTION>
THREE MONTHS ENDED SIX MONTHS ENDED
AUGUST 31, AUGUST 31,
-------------------------- -------------------------
1999 1998 1999 1998
-------------------------- -------------------------
(IN THOUSANDS, EXCEPT PER SHARE DATA)
<S> <C> <C> <C> <C>
Net income (loss) available to common
stockholders, as reported ($3,147,316) $132,146 ($5,279,786) $79,645
Pro forma net income (loss) per common share
Basic ($0.05) $0.01 ($0.08) $0.00
Diluted ($0.05) $0.00 ($0.08) $0.00
Proforma net income (loss), excluding stock
based compensation and accretion on
mandatorily redeemable preferred stock ($2,730,716) $132,146 ($4,719,805) $79,645
Pro forma net income (loss) per common share
Basic ($0.04) $0.01 ($0.07) $0.00
Diluted ($0.04) $0.00 ($0.07) $0.00
Proforma weighted average shares outstanding
Basic 67,835,538 23,500,000 66,532,172 23,500,000
Diluted 67,835,538 40,842,800 66,532,172 40,840,274
</TABLE>
-8-
<PAGE>
RED HAT, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
- --------------------------------------------------------------------------------
4. STOCKHOLDERS' EQUITY
On August 11, 1999, the Company completed an initial public offering of common
stock that resulted in the issuance of 6,000,000 shares of common stock with an
initial public offering price of $14.00 per share. Automatically upon closing of
the initial public offering, all of the then outstanding shares of mandatorily
redeemable preferred stock were converted into 33,945,452 shares of common
stock. In connection with the initial public offering, the Company offered the
underwriters of the offering an option to purchase an additional 900,000 shares
of common stock ("Underwriter's Over-allotment") at the offering's $14.00 per
share offering price. This option was exercised on August 16, 1999. Proceeds to
the Company from its initial public offering and the related Underwriter's
Over-allotment, net of underwriting discounts and costs of the offering, were
approximately $88.7 million.
5. FAIR VALUE OF FINANCIAL INSTRUMENTS
The carrying value of cash and cash equivalents, accounts payable and accounts
receivable at August 31, 1999 and February 28, 1999 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 August
31, 1999 and 1998 approximated their carrying values as these investments were
primarily in short-term U.S. Government obligations.
-9-
<PAGE>
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 MAY CAUSE RED HAT'S
ACTUAL RESULTS TO DIFFER MATERIALLY FROM ANY FORWARD-LOOKING STATEMENTS. FOR
A DETAILED DISCUSSION OF SUCH RISKS, SEE "--FACTORS AFFECTING FUTURE RESULTS".
OVERVIEW
We are a leading developer and provider of open source software products and
services, 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 flows from operations.
Sales of Official Red Hat Linux have represented our principal source of revenue
since its introduction in October 1994. We derive our software and related
products revenue primarily from the sale of software products:
- through distributors to enterprise and retail accounts;
- directly to individual users and enterprises through our
REDHAT.COM web site and our call center; and
- from original equipment manufacturers which license our
software directly.
We recognize revenue from software product sales to distributors and original
equipment manufacturers for which no support and subscription services are
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 of
these distributors' rates of sell-through to the end-user. We recognize revenue
from the sale of software products to new distributors of our software products
based upon sell-through to the end-user until we have sufficient historical
experience with the distributor to allow the accurate estimation of sales
returns.
Upon the release of Version 6.0 of Red Hat Linux, we began selling Official Red
Hat Linux and Red Hat Secure Web Server with six months of support and
subscription services . In accordance with the provisions of Statement of
Position No. 97-2 "Software Revenue Recognition", we are recognizing all of the
revenue from the sale of Version 6.0 of Official Red Hat Linux and Red Hat
Secure Web Server ratably over the period that the support and subscription
services are provided in proportion to the costs incurred to provide such
support and subscription services as compared to estimated total costs to be
incurred.
We have recently added new features, and intend to develop additional features
and functionality, to our REDHAT.COM web site. We intend to develop additional
features for our web site which we believe will result in both a substantial
increase in the number of visitors who access our web site and increased
advertising revenue. Advertising revenue is 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 current fiscal year.
However, we believe that the expected increase in traffic on our web site, along
with our focus on marketing our advertising services, will generate increased
advertising revenue in the future.
Prior to March 1999, we did not provide any service offerings to our customers.
In March 1999, we introduced comprehensive customer support and maintenance,
custom development, consulting and education services.
-10-
<PAGE>
Although these services generated only an insignificant amount of revenue
through February 28, 1999, we earned $1.6 million in service revenue during the
six months ended August 31, 1999, including $1.0 million during the three months
ended August 31, 1999. We believe that because our revenue has historically been
derived from product offerings, this expansion in and active marketing of our
service offerings will cause our services revenue to continue to increase as a
percentage of total revenue during the remainder of the current fiscal year.
Revenue from support and maintenance agreements is deferred and recognized
ratably over the term of the related agreement, which is typically one year.
Revenue from custom development, consulting and education services, which
includes offering training courses and hardware certification services, is
recognized as the services are provided.
Our software products are sold worldwide, with most of our total revenue coming
from North America, except for an insignificant amount of royalties received
from international sources. In June 1999, we established international
operations and had revenue of $0.3 million from these operations in the three
months ended August 31, 1999. We expect that total revenue derived from sales
outside North America will continue to increase as we expand these operations.
We have historically experienced fluctuations in our results of operations
related to the release of major upgrades to Red Hat Linux. We believe that the
anticipation by our customers of the release of these upgrades has 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 in May 1999 of Version 6.0 of Official Red Hat Linux, software
product sales decreased, but after the 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
initiative.
We plan to increase our sales through distributors as well as our direct sales
through our web site. We also plan to enter into additional original equipment
manufacturer relationships during the remainder of the current fiscal year and
therefore expect that our revenue for this fiscal year from original equipment
manufacturers will increase as a percentage of total revenue as compared to the
fiscal year ended February 28, 1999.
We employed 191 people at August 31, 1999, compared to 57 people at August 31,
1998. This increase in headcount resulted primarily from:
- an increase in administrative personnel as we recruited our management
team;
- an increase in support, maintenance, consulting and education personnel
associated with our efforts to develop the infrastructure of our
services organization;
- an increase in research and development personnel; and
- the commencement of international operations.
We expect to continue to increase expenses associated with our sales and
marketing, research and development and general and administrative groups in
anticipation of continued growth and expansion. Given the expected increase in
headcount, we anticipate that we will need to either expand our existing offices
or lease additional office space at a separate location within the next 12 to 18
months. We believe that this expansion will result in an increase in total
facilities costs.
-11-
<PAGE>
RESULTS OF OPERATIONS
THE FOLLOWING TABLE SETS FORTH THE RESULTS OF OPERATIONS FOR RED HAT EXPRESSED
AS A PERCENTAGE OF TOTAL REVENUE. THE HISTORICAL RESULTS ARE NOT NECESSARILY
INDICATIVE OF RESULTS TO BE EXPECTED FOR ANY FUTURE PERIOD.
<TABLE>
<CAPTION>
THREE MONTHS ENDED SIX MONTHS ENDED
AUGUST 31, AUGUST 31,
----------------- ----------------
1999 1998 1999 1998
(UNAUDITED) (UNAUDITED)
<S> <C> <C> <C> <C>
Revenue:
Software and related products 74.5% 96.8% 72.4% 93.5%
Web advertising 2.4% 0.0% 2.6% 0.0%
Services and other 23.1% 3.2% 25.0% 6.5%
----------------- ----------------
Total revenue 100.0% 100.0% 100.0% 100.0%
----------------- ----------------
Cost of revenue:
Software and related products 34.8% 35.1% 37.7% 38.7%
Web advertising 4.6% 0.0% 4.5% 0.0%
Services and other 20.9% 0.0% 18.9% 0.0%
----------------- ----------------
Total cost of revenue 60.3% 35.1% 61.1% 38.7%
----------------- ----------------
Gross profit 39.7% 64.9% 38.9% 61.3%
----------------- ----------------
Operating expense:
Sales and marketing 55.4% 21.6% 56.5% 22.8%
Research and development 38.1% 20.4% 34.8% 21.1%
General and administrative 25.0% 14.7% 26.7% 14.4%
----------------- ----------------
Total operating expense 118.5% 56.7% 118.0% 58.3%
----------------- ----------------
Income (loss) from operations (78.8%) 8.2% (79.1%) 3.0%
----------------- ----------------
Other income (expense):
Interest income 7.7% 0.7% 6.8% 0.8%
Interest expense (0.0%) (0.2%) (0.2%) (0.1%)
----------------- ----------------
Other income (expense), net 7.7% 0.5% 6.6% 0.7%
----------------- ----------------
Income before income taxes (71.1%) 8.7% (72.5%) 3.7%
Provision for income taxes 0.0% 2.8% 0.0% 1.6%
----------------- ----------------
Net income (loss) (71.1%) 5.9% (72.5%) 2.1%
Accretion on mandatorily redeemable preferred stock (0.9%) 0.0% (1.2%) 0.0%
----------------- ----------------
Net income (loss) available to common stockholders (72.0%) 5.9% (73.7%) 2.1%
----------------- ----------------
----------------- ----------------
</TABLE>
-12-
<PAGE>
THREE MONTHS ENDED AUGUST 31, 1999 AND 1998
TOTAL REVENUE
Total revenue increased to $4.4 million in the three months ended August 31,
1999 from $2.2 million in the three months ended August 31, 1998. The majority
of our revenue for the three months ended August 31, 1999 came from customers
located in the United States. However, in August 1999, we commenced
international operations, and expect that our revenue from international sources
will increase in the future.
SOFTWARE AND RELATED PRODUCTS REVENUE
Software and related products revenue is comprised primarily of revenue from
sales of Official Red Hat Linux and related software products and sales of
publications about Linux-based operating systems. Software and related products
revenue increased to $3.3 million or 74.5% of total revenue in the three months
ended August 31, 1999 from $2.2 million or 96.8% of total revenue in the three
months ended August 31, 1998. The decrease in software and related products as a
percentage of total revenue was due to the increase in services and other
revenue.
Software products revenue increased to $3.2 million during the three months
ended August 31, 1999 from $2.1 million for the three months ended August 31,
1998. The increase in software products revenue was due to increased sales of
Official Red Hat Linux as a result of the release of Version 6.0 of Official Red
Hat Linux in May 1999.
Related products revenue, which is comprised of revenue from the sale of books
and other products, decreased to $30,000 during the three months ended August
31, 1999 compared to $0.1 million in the three months ended August 31, 1998.
WEB ADVERTISING REVENUE
Web advertising revenue is comprised of fees generated from short-term contracts
with advertisers to display advertisements on our web site. Web advertising
revenue increased to $0.1 million in the three months ended August 31, 1999 from
zero in the three months ended August 31, 1998. As a percentage of total
revenue, web advertising revenue increased to 2.4% in the three months ended
August 31, 1999 from zero in the three months ended August 31, 1998. These
increases were due to the commencement of our web initiative during the current
fiscal year.
SERVICES AND OTHER REVENUE
Services and other revenue is comprised of support and maintenance fees, custom
development fees, consulting and education fees and royalties received from
licensing our trademarks. Services and other revenue increased to $1.0 million
in the three months ended August 31, 1999 from $71,000 in the three months ended
August 31, 1998. As a percentage of total revenue, services and other revenue
increased to 23.1% in the three months ended August 31, 1999 from 3.2% in the
three months ended August 31, 1998.
Services and other revenue was comprised of $0.9 million in services revenue and
$70,000 in royalties for the three months ended August 31, 1999 as compared to
$15,000 in services revenue and $55,000 in royalties for the three months ended
August 31, 1998. The increase in services revenue resulted primarily from an
increase in consulting and education revenue earned in the three months ended
August 31, 1999 as we expanded our course offerings, and, to a lesser extent,
from an increase in support and maintenance revenue as we began to sell support
and maintenance services in March 1999. We expect services revenue to increase
significantly in dollar amount and as a percentage of revenue as we continue to
develop and expand our support and maintenance, custom development and
consulting and education services and as we actively market these services.
-13-
<PAGE>
COST OF REVENUE
COST OF SOFTWARE AND RELATED PRODUCTS
Cost of software and related products 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. Also included are royalties paid by us for licensing
third-party applications included in our software products. Cost of software and
related products increased to $1.5 million in the three months ended August 31,
1999 from $0.8 million in the three months ended August 31, 1998. The increase
in cost of software and related products was directly related to the increase in
sales of software and related products. As a percentage of software and related
products revenue, cost of software and related products increased to 46.7% in
the three months ended August 31, 1999 from 36.2% in the three months ended
August 31, 1998. This increase in cost of software and related products as a
percentage of software and related products revenue was due to the commencement
of our offering of support and subscription services with the sale of Version
6.0 of Official Red Hat Linux in May 1999.
COST OF WEB ADVERTISING
Cost of web advertising revenue includes the cost of developing the advertising
and supporting the web site. Cost of web advertising revenue increased to $0.2
million in the three months ended August 31, 1999 from zero in the three months
ended August 31, 1998. As a percentage of web advertising revenue, cost of web
advertising revenue increased to 192.0% in the three months ended August 31,
1999, as compared to zero in the three months ended August 31, 1998. These
increases were due to our offering web advertising for the first time during the
current fiscal year.
COST OF SERVICES AND OTHER
Cost of services and other includes salaries of support and maintenance, custom
development, consulting and education personnel and related costs. Cost of
services and other for the three months ended August 31, 1999 was primarily
comprised of costs of salaries and other related costs incurred for our training
and certification programs. We incur no direct costs related to royalties
received from the licensing of our trademarks to third parties. Cost of services
and other increased to $0.9 million in the three months ended August 31, 1999
from zero in the three months ended August 31, 1998. As a percentage of services
and other revenue, cost of services and other increased to 90.5% in the three
months ended August 31, 1999 from zero in the three months ended August 31,
1998.
We expect cost of services and other to continue to increase as we expand our
service offerings and develop our services organization. Cost of services and
other as a percentage of services and other revenue is expected to vary
significantly from period to period depending upon:
- the mix of services we provide;
- whether such services are provided by us or third-party contractors;
and
- the overall utilization rate of our services staff.
GROSS PROFIT
Gross profit increased to $1.7 million in the three months ended August 31, 1999
from $1.5 million in the three months ended August 31, 1998. As a percentage of
total revenue, gross profit decreased to 39.7% in the three months ended August
31, 1999 from 64.9% in the three months ended August 31, 1998. The increase in
gross profit was due to the increased sales of our software products, which was
primarily the result of the release of Version 6.0 of Official Red Hat Linux in
May 1999. The decrease in gross profit as a percentage of revenue was the result
of the increase in costs related to the expansion, development and marketing of
our support service offerings during the current fiscal year.
-14-
<PAGE>
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 to $2.4 million in the three months ended August 31, 1999 from $0.5
million in the three months ended August 31, 1998. As a percentage of total
revenue, sales and marketing expense increased to 55.4% in the three months
ended August 31, 1999 from 21.6% in the three months ended August 31, 1998.
These increases were due to higher advertising and promotional costs incurred to
promote the release of Version 6.0 of Official Red Hat Linux and to promote our
web site and service offerings. These increases were also due to higher costs
resulting from joint marketing arrangements with distributors. We expect sales
and marketing expense to increase in dollar amount in the foreseeable future as
we promote the expansion of our services offerings and web site and expand our
international operations.
RESEARCH AND DEVELOPMENT
Research and development expense consists primarily of personnel and related
costs for our software and web development efforts. Research and development
expense increased to $1.7 million in the three months ended August 31, 1999 from
$0.5 million in the three months ended August 31, 1998. As a percentage of total
revenue, research and development expense increased to 38.1% in the three months
ended August 31, 1999 from 20.4% in the three months ended August 31, 1998.
These increases resulted from increased spending related to the development of
our web initiative and costs incurred to complete the development of Version 6.0
of Official Red Hat Linux. We expect research and development expenses to
continue to increase in dollar amount in the future as we continue to develop
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 to $1.1 million in the three months ended
August 31, 1999 from $0.3 million in the three months ended August 31, 1998. As
a percentage of total revenue, general and administrative expense increased to
25.0% in the three months ended August 31, 1999 from 14.7% in the three months
ended August 31, 1998. The increase in general and administrative expense
resulted from:
- an increase in payroll costs due to an increase in the number of
general and administrative personnel;
- an increase in legal and accounting costs due to our geographic
expansion; and
- an increase in facilities costs due to higher costs associated with our
new headquarters.
We expect general and administrative expense to continue to increase in dollar
amount in the next 12 months as we add administrative personnel to support our
business expansion.
-15-
<PAGE>
OTHER INCOME (EXPENSE), NET
Other income (expense) consists of interest income earned on cash deposited in
money market accounts and other short-term investments, net of interest expense
incurred on capital leases. Other income (expense), net increased to income of
$0.3 million in the three months ended August 31, 1999 from income of $12,000 in
the three months ended August 31, 1998. As a percentage of total revenue, other
income (expense), net increased to 7.7% in the three months ended August 31,
1999 from 0.5% in the three months ended August 31, 1998. These increases
resulted from higher average cash and investment balances in the three months
ended August 31, 1999 as compared to the three months ended August 31, 1998 due
to the receipt of proceeds from the sale of preferred stock in September 1998
and in February, March and April 1999, and proceeds from the sale of our common
stock in our initial public offering in August 1999.
PROVISION FOR INCOME TAXES
Provision for income taxes decreased to zero for the three months ended August
31, 1999 from $62,000 in the three months ended August 31, 1998. The decrease in
the provision for income taxes resulted from the decrease in our taxable income
and an increase in our valuation allowance on our net deferred tax assets due to
uncertainty of realization.
ACCRETION OF MANDATORILY REDEEMABLE PREFERRED STOCK
The increase in the accretion from mandatorily redeemable preferred stock to
$39,000 in the three months ended August 31, 1999 from zero for the three months
ended August 31, 1998 was a result of the fact that we had no outstanding
mandatorily redeemable preferred stock prior to September 1998. 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.
SIX MONTHS ENDED AUGUST 31, 1999 AND 1998
TOTAL REVENUE
Total revenue increased 89% to $7.2 million in the six months ended August 31,
1999 from $3.8 million in the six months ended August 31, 1998. The majority of
our revenue for the six months ended August 31, 1999 originated from customers
located in the United States. However, we commenced our international operations
in August 1999, and accordingly, expect that our revenue from international
sources will increase in the future.
SOFTWARE AND RELATED PRODUCTS REVENUE
Software and related products revenue increased to $5.2 million, or 72.4% of
total revenue, in the six months ended August 31, 1999 from $3.5 million, or
93.5% of total revenue, in the six months ended August 31, 1998. The increase in
software and related products revenue was due to the release of Version 6.0 of
Official Red Hat Linux in May 1999. The decrease in software and related
products as a percentage of total revenue was due to the increase in services
and other revenue.
Software products revenue increased to $5.1 million during the six months ended
August 31, 1999 from $3.3 million for the six months ended August 31, 1998. The
increase in software products revenue was due to increased sales of Official Red
Hat Linux, as a result of the release of Version 6.0 of Official Red Hat Linux
in May 1999.
Related products revenue decreased to $75,000 during the six months ended August
31, 1999 compared to $0.2 million in the six months ended August 31, 1998.
-16-
<PAGE>
WEB ADVERTISING REVENUE
Web advertising revenue increased to $0.2 million in the six months ended August
31, 1999 from zero in the six months ended August 31, 1998. As a percentage of
total revenue, web advertising revenue increased to 2.6% in the six months ended
August 31, 1999 from zero in the six months ended August 31, 1998. These
increases were due to the commencement of our web initiative during the current
fiscal year.
SERVICES AND OTHER REVENUE
Services and other revenue increased to $1.8 million in the six months ended
August 31, 1999 from $0.2 million in the six months ended August 31, 1998. As a
percentage of total revenue, services and other revenue increased to 25.0% in
the six months ended August 31, 1999 from 6.5% in the six months ended August
31, 1998. The increase in services and other revenue resulted primarily from an
increase in consulting and education revenue earned in the six months ended
August 31, 1999 as we expanded our course offerings, and, to a lesser extent, an
increase in support and maintenance revenue as we began to sell support and
maintenance services during the second quarter of the current fiscal year.
COST OF REVENUE
COST OF SOFTWARE AND RELATED PRODUCTS
Cost of software and related products increased to $2.7 million in the six
months ended August 31, 1999 from $1.5 million in the six months ended August
31, 1998. The increase in cost of software and related products was directly
related to the increase in sales of software and related products. As a
percentage of software and related products revenue, cost of software and
related products increased to 52.0% in the six months ended August 31, 1999 from
41.4% in the six months ended August 31, 1998. This increase in cost of software
and related products as a percentage of software and related products revenue
was due to the commencement of our offering of support and subscription services
with the sale of Version 6.0 of Official Red Hat Linux in May 1999.
COST OF WEB ADVERTISING
Cost of web advertising revenue increased to $0.3 million in the six months
ended August 31, 1999 from zero in the six months ended August 31, 1998. As a
percentage of web advertising revenue, cost of web advertising revenue increased
to 175.5% in the six months ended August 31, 1999, as compared to zero in the
six months ended August 31, 1998. These increases were due to the commencement
of our web initiative during the current fiscal year.
COST OF SERVICES AND OTHER
Cost of services and other increased to $1.4 million in the six months ended
August 31, 1999 from zero in the six months ended August 31, 1998. As a
percentage of services and other revenue, cost of services and other increased
to 75.7% in the six months ended August 31, 1999 from zero in the six months
ended August 31, 1998. These increases were primarily due to the high costs
associated with the development and expansion of consulting and education
services and support and maintenance services during this period.
GROSS PROFIT
Gross profit increased to $2.8 million in the six months ended August 31, 1999
from $2.3 million in the six months ended August 31, 1998. As a percentage of
total revenue, gross profit decreased to 38.9% in the six months ended August
31, 1999 from 61.3% in the six months ended August 31, 1998. The increase in
gross profit was due to the increased sales of our software products, which was
primarily the result of the release of Version 6.0 of Official Red Hat Linux in
May 1999 and the increase in services and other revenue related to our
consulting and education program. The decrease in gross profit as a percentage
of revenue was the result of the increase in costs related to the expansion,
development and marketing of our support service offerings.
-17-
<PAGE>
OPERATING EXPENSE
SALES AND MARKETING
Sales and marketing expense increased to $4.1 million in the six months ended
August 31, 1999 from $0.9 million in the six months ended August 31, 1998. As a
percentage of total revenue, sales and marketing expense increased to 56.5% in
the six months ended August 31, 1999 from 22.8% in the six months ended August
31, 1998. These increases were due to higher advertising and promotional costs
incurred to promote the release of Version 6.0 of Official Red Hat Linux, the
development of our web site and the expansion of our service offerings. These
increases were also due to higher costs resulting from joint marketing
arrangements with distributors.
RESEARCH AND DEVELOPMENT
Research and development expense increased to $2.5 million in the six months
ended August 31, 1999 from $0.8 million in the six months ended August 31, 1998.
As a percentage of total revenue, research and development expense increased to
34.8% in the six months ended August 31, 1999 from 21.1% in the six months ended
August 31, 1998. These increases resulted from increased spending related to the
development of our web initiative and costs incurred to complete the development
of Version 6.0 of Official Red Hat Linux.
GENERAL AND ADMINISTRATIVE
General and administrative expense increased to $1.9 million in the six months
ended August 31, 1999 from $0.5 million in the six months ended August 31, 1998.
As a percentage of total revenue, general and administrative expense increased
to 26.7% in the six months ended August 31, 1999 from 14.4% in the six months
ended August 31, 1998. The increase in general and administrative expense
resulted from:
- an increase in payroll costs due to an increase in the number of
general and administrative personnel;
- an increase in legal and accounting costs due to our geographic
expansion; and
- an increase in facilities costs due to higher costs associated with our
new headquarters.
OTHER INCOME (EXPENSE), NET
Other income (expense), net increased to income of $0.5 million in the six
months ended August 31, 1999 from income of $27,000 in the six months ended
August 31, 1998. As a percentage of total revenue, other income (expense), net
increased to 6.6% in the six months ended August 31, 1999 from 0.7% in the six
months ended August 31, 1998. These increases resulted from higher average cash
and investment balances in the six months ended August 31, 1999 as compared to
the six months ended August 31, 1998 due to the receipt of proceeds from the
sale of preferred stock in September 1998 and in February, March and April 1999,
as well as proceeds from the sale of our common stock in our initial public
offering in August 1999.
PROVISION FOR INCOME TAXES
Provision for income taxes decreased to zero for the six months ended August 31,
1999 from $62,000 in the six months ended August 31, 1998. The decrease in the
provision for income taxes resulted from the decrease in our taxable income and
an increase in our valuation allowance on our net deferred tax assets due to
uncertainty of realization.
ACCRETION OF MANDATORILY REDEEMABLE PREFERRED STOCK
The increase in the accretion from mandatorily redeemable preferred stock to
$82,000 in the six months ended August 31, 1999 from zero for the six months
ended August 31, 1998 was a result of the fact that we had no outstanding
mandatorily redeemable preferred stock prior to September 1998.
-18-
<PAGE>
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 public offering, and
from cash flows from operations.
At August 31, 1999, cash and cash equivalents totaled $7.4 million, a decrease
of $2.7 million as compared to February 28, 1999. The decrease in cash and cash
equivalents resulted from the purchase of investments in debt securities of
$93.8 million, cash used by operations of $1.8 million and $1.4 million for the
purchase of office and computer equipment, partially offset by $2.8 million in
proceeds from the exercise of common stock options and warrants, $3.2 million in
net proceeds from issuance of mandatorily redeemable preferred stock in March
1999 and $88.7 million in net proceeds from our initial public offering of
common stock in August 1999.
Cash used by operations of $1.8 million for the six months ended August 31,
1999, represented the net loss of $5.3 million, an increase in accounts
receivable of $0.6 million, partially offset by an increase in accounts payable
of $1.3 million and an increase in deferred revenue of $3.2 million. The
increase in accounts receivable, accounts payable and deferred revenue resulted
from the release of Version 6.0 Official Red Hat Linux to our distributors in
late April 1999. This release resulted in increased sales which resulted in
higher amounts of accounts receivable from distributors at August 31, 1999.
Cash used in investing activities was comprised of the purchase of investments
in debt securities, net of maturities, of $93.8 million and purchases of office
and computer equipment totaling $1.4 million.
Cash from financing activities of $94.6 million for the six months ended August
31, 1999 was comprised of $3.2 million in net proceeds from the sale of our
preferred stock, $2.8 million in proceeds from the exercise of stock options and
warrants and $88.7 million in net proceeds from the sale of our common stock in
our initial public offering in August 1999.
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 initiative. Our capital requirements
during the fiscal year ending February 29, 2000 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;
- 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 initial public offering of common
stock in August 1999, together with our 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 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.
-19-
<PAGE>
YEAR 2000 COMPLIANCE
The "Year 2000 Issue" refers generally to the problems that some software may
have in determining the correct century for the year. For example, software and
computer systems with date-sensitive functions that is not Year 2000 compliant
may not be able to distinguish whether "00" means 1900 or 2000, which may result
in failures or the creation of erroneous results.
We have defined "Year 2000 compliant" as the ability to:
- correctly handle date information needed for the December 31, 1999 to
January 1, 2000 date change;
- function according to the product documentation provided for this date
change, without changes in operation resulting from the advent of a new
century, assuming correct configuration;
- where appropriate, respond to two-digit date input in a way that
resolves the ambiguity as to century in a disclosed, defined, and
predetermined manner;
- if the date elements in interfaces and data storage specify the
century, store and provide output of date information in ways that are
unambiguous as to century; and
- recognize the year 2000 as a leap year.
In November 1998, we formed a committee consisting of our Chief Financial
Officer, our controller, a financial analyst and a systems administrator, as
part of our effort to perform a coordinated audit of:
- our products;
- the software components and applications with which our products are
bundled; and
- the systems upon which we rely for our internal operations.
PRODUCTS
The committee has tested Version 4.2 and later versions of Red Hat Linux by
accelerating the date within these software programs to December 31, 1999 and
observing which software components failed as the date changed to January 1,
2000. These tests revealed that all of these versions of Red Hat Linux were Year
2000 compliant. In addition, in June 1999 we hired an independent contractor to
test Versions 5.2 and 6.0 of Red Hat Linux for Year 2000 readiness. The
independent contractor certified these products as Year 2000 compliant. In light
of the testing results and certification, we do not plan to generate a
contingency plan if either of these products is later found not to be Year 2000
compliant. We have not, however, tested any products other than Red Hat Linux.
The Year 2000 committee plans to test or have these products tested by the end
of November 1999.
If it is later determined that products that we have not tested are not Year
2000 compliant, we believe that we have the resources, either in-house or within
the open source community, to quickly remedy any non-compliant products. If it
is necessary to remedy problems related to the Year 2000 issue, such efforts
could otherwise divert our resources from pursuing our business strategy. In
addition, known or unknown errors or defects in our products could result in the
delay or loss of revenue, diversion of development resources, damage to our
reputation, or increased service and warranty costs, any of which could
materially adversely affect our business, operating results or financial
condition. Furthermore, some commentators have predicted significant litigation
regarding Year 2000 compliance issues, and we are aware of such claims and
actions against other software vendors. Because of the unprecedented nature of
this litigation, it is uncertain whether or to what extent we may be affected by
it.
THIRD-PARTY PRODUCTS
We bundle third-party applications and software components with Official Red Hat
Linux. To date, the committee has made no assessment of and has no knowledge of
third-party Year 2000 readiness. We intend to contact these third parties and
remedy problems on a case-by-case basis, as problems arise. Because we believe
that the costs associated with the failure of third-party products will not be
material to our business, results of operations or financial condition,
-20-
<PAGE>
we do not intend to expend resources to seek out and correct problems before
they arise. Accordingly, it is possible that some of our customers may
experience difficulties related to third-party software, which may affect the
performance of our products and may lead to adverse results such as an unusually
high number of calls to our technical support department or other unusual
requests for information or assistance. Responding to these requests may divert
resources away from the execution of our business strategy. Moreover, failure of
applications bundled with our software may reduce the value of our products,
decrease or delay revenue, diminish our brand, give rise to breach of warranty
claims or divert resources, any of which could materially adversely affect our
business, results of operations and financial condition.
INTERNAL SYSTEMS
In August 1999, we evaluated our mission-critical internal systems for Year 2000
compliance, including computer hardware, software, web server, and other related
equipment and systems, such as phone systems and networking security systems.
Based on certifications from our information systems, telecommunications and
information technology vendors, such as Oracle, Sun Microsystems, Veritas,
Lucent, and Cisco regarding these systems, we believe that their level of Year
2000 preparedness is sufficient to permit us to proceed into the next millennium
without any major disruptions to our internal equipment and systems.
Additionally, the majority of our computer hardware, telecommunications systems,
software, and networking hardware and software is new and all major systems are
covered under manufacturer service warranties and on-support contracts. As a
contingency, however, we are planning a controlled Year 2000 systems test
"century rollover" in November 1999 to pinpoint any potential trouble areas and
take corrective action, if necessary, prior to the end of this calendar year.
The lessor of our corporate headquarters has indicated that our offices are Year
2000 compliant. We currently house substantially all of our communications
hardware and our other computer operations related to our web site on site at
our facilities, although we have back-up and co-location hardware for our web
site located at third-party facilities. The owners of facilities we plan to use
for that purpose have also certified to us that all of their systems and
facilities are Year 2000 compliant.
Since we have just recently opened offices in Ireland, the United Kingdom,
Germany and Japan and may open additional offices in the future, the Year 2000
committee has begun to examine the global impact of Year 2000 issues, such as
telecommunications and networking interfaces with vendors in foreign countries.
Although we have tried to maintain a centralized approach to the management of
distributed computing by establishing a sole-source vendor supplier policy
worldwide, certain localizations and in-country implementations of our
communications systems may require piece-by-piece testing for Year 2000
compliance. We are currently in the process of both seeking vendor Year 2000
vendor certification and end-to-end testing of our global systems, but complete
systems testing will probably not be completed prior to December 31, 1999.
Based upon the foregoing, we do not believe that the costs involved in
continuing to make our internal information technology and non-information
technology systems Year 2000 compliant will be material, nor do we expect to
incur material costs to upgrade or replace any non-compliant systems.
WORST CASE SCENARIO
We have not tested any of our products other than Red Hat Linux and have not
tested software provided by, nor sought certifications from, third-parties
bundling software with Official Red Hat Linux. Our reasonably likely worst case
Year 2000 scenario would be that these products and bundled software from
third-parties fail in the year 2000, resulting in a decreased demand for our
products and damage to the Red Hat brand. In the event of a Year 2000 failure we
would devote resources to correct it. Because we have skilled in-house
developers and relationships with the open source community and third-parties
whose software we bundle with Red Hat Linux, we believe we will be able to
respond promptly to any failures that occur. The costs of such response and the
diversion of resources, however, could have a material adverse effect on our
business, results of operation and financial condition.
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<PAGE>
CONTINGENCY PLANS AND EXPECTED COSTS
The committee is in the process of developing further checklists of software
applications to test and systems upon which we rely and, as we deem appropriate,
we will seek certification documents from the developers and providers regarding
Year 2000 compliance of their systems and products. The committee will develop
contingency plans based on the responses regarding its critical systems that it
receives, or does not receive, from its providers and developers. We presently
expect that we will complete this effort in the fall of 1999.
To date, we have not expended a material amount of capital resources on Year
2000 compliance and do not anticipate future expenditures to be material to our
business, results of operations or financial condition. We have not hired
additional personnel to specifically address our Year 2000 compliance issues,
and presently, we do not expect to do so. Through August 31, 1999, we have
incurred approximately $300,000 in costs to make our internal systems Year 2000
compliant. These costs were primarily incurred to update our accounting and
financial management software and systems. The product and testing expenditures
to date relate primarily to on-going salary costs of personnel, including
committee members, participating at various levels in our compliance efforts, as
well as payments of approximately $30,000 to the independent contractor that
tested Versions 5.2 and 6.0 of Red Hat Linux. All costs related to achieving
Year 2000 readiness are being expensed as incurred, unless they relate to the
cost of new software or hardware for our internal systems.
NEW 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. As issued, this
statement is effective for all fiscal quarters of all fiscal years beginning
after June 15, 1999, with earlier application encouraged. In May 1999, the
Financial Accounting Standards Board delayed the effective date of this
statement for one year, to all fiscal quarters of all fiscal years beginning
after June 15, 2000. 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 Accounting Standards No. 133 will have any impact on our financial
position or results of operations.
In December 1998, the Accounting Standards Executive Committee 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. 97-2
will have any impact on our financial position or results of operations.
-22-
<PAGE>
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
ACCESSED 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 freely to copy and distribute our software. No
other company has built a successful open source business. Few open source
software products have gained widespread commercial acceptance partly due to the
lack of viable open source industry participants to offer adequate service and
support on a long term basis. In addition, open source vendors are not able to
provide industry standard warranties and indemnities for their products, since
these products have been developed largely by independent parties over whom open
source vendors exercise no control or supervision. If open source software
should fail to gain widespread commercial acceptance, we would not be able to
sustain our revenue growth and our business could fail.
WE 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.
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.
-23-
<PAGE>
WE EXPECT TO INCUR SUBSTANTIAL LOSSES IN THE FUTURE
We have incurred operating losses for most of our history, including the last 3
fiscal quarters. We expect to incur significant losses at least through the
fiscal year ending February 28, 2001 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
geographically. 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 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.
OUR FAILURE TO UPDATE AND MODERNIZE OUR INTERNAL SYSTEMS, PROCEDURES AND
CONTROLS MAY PREVENT THE IMPLEMENTATION OF OUR BUSINESS STRATEGIES IN A RAPIDLY
EVOLVING MARKET AND MAY RETARD OUR FUTURE GROWTH
Our operational and financial systems, procedures and controls, which were
adequate for a small private company, have become outdated as we have grown.
Since March 1, 1998, we have more than tripled the number of our employees. 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.
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 President, Matthew Szulik, our Chief Operating
Officer, Tim Buckley and our Chief Marketing Officer, Tom Butta, have been
employed by us for a relatively short period of time. We continue to actively
search for a new Chief Financial Officer and hope to hire one within the next
few months. These individuals have only worked together as a management team for
a relatively short period of time. 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 MAY LACK THE FINANCIAL AND OPERATIONAL RESOURCES NEEDED TO INCREASE OUR
MARKET SHARE AND COMPETE EFFECTIVELY WITH MICROSOFT, OTHER ESTABLISHED OPERATING
SYSTEMS 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
-24-
<PAGE>
Microsystems, The Santa Cruz Operation, AT&T, Compaq, Hewlett-Packard, Olivetti
and Unisys. We do not believe that any of these competitors currently produces
and markets any open source software products.
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.
IF WE FAIL TO ESTABLISH AND MAINTAIN STRATEGIC DISTRIBUTION AND OTHER
COLLABORATIVE RELATIONSHIPS WITH INDUSTRY-LEADING COMPANIES, WE MAY NOT BE ABLE
TO ATTRACT AND RETAIN A LARGER CUSTOMER BASE
Our success depends on our ability to continue to establish and maintain
strategic distribution and other collaborative relationships with
industry-leading hardware manufacturers, distributors, software vendors and
enterprise solutions providers. These relationships allow us to offer our
products and services to a much larger customer base than we would otherwise be
able to through our direct sales and marketing efforts. We may not be able to
maintain these relationships or replace them on attractive terms.
In addition, our existing strategic relationships do not, and any future
strategic relationships may not, afford us any exclusive marketing or
distribution rights. As a result, the companies with which we have strategic
alliances are free to pursue alternative technologies and to develop alternative
products and services in addition to or in lieu of our products and services,
either on their own or in collaboration with others, including our competitors.
Moreover, we cannot guarantee that the companies with which we have strategic
relationships will market our products effectively or continue to devote the
resources necessary to provide us with effective sales, marketing and technical
support.
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 percentage of our total revenue for the fiscal year ended February
28, 1999 and for the six months ended August 31, 1999. 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 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 in Ireland, the UK, Germany
and Japan, and are considering further expansion world-wide. 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.
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 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;
-25-
<PAGE>
- 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;
- we may not be able to hire and train employees who can effectively
conduct business in our new foreign markets;
- changes in import/export duties and quotas could affect the competitive
pricing of our products and services and reduce our market share in
some countries; and
- economic or political instability 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 development, education and support services, from which we
have only begun to derive a significant amount of revenue. We cannot be certain
that our customers will engage our professional services organization to assist
with support, consulting, custom development, training and implementation of our
products. We also cannot be certain that we can attract or retain a sufficient
number of the highly qualified services personnel that the expansion of our
services business will need. In addition, this expansion has required, and will
continue to require, significant additional expenses and development, financial
and operational resources. The need for these additional resources will place
further strain on our management, financial and operational resources and may
make it more difficult for us to achieve and maintain profitability.
WE MAY NOT BE ABLE TO EFFECTIVELY ATTRACT AND PRESERVE RELATIONSHIPS WITH
ENTERPRISE CUSTOMERS, WHICH COULD ADVERSELY AFFECT REVENUE
Historically, we focused our sales and marketing efforts on product sales to
individuals. We are, however, currently investing extensively to attract
enterprise customers. These enterprise customers expect diverse and extensive
service programs, and if we are unable to successfully expand and enhance our
service offerings, we may not be able to meet these customers needs and,
consequently, our revenue will suffer.
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 expand our operations or market presence by entering into 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 needed 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 the amortization of goodwill and
other purchased intangible assets;
-26-
<PAGE>
- 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; and
- our relationships with existing employees, customers and business
partners may be weakened or terminated as a result of these
transactions.
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
Continuing to enhance 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 further enhancing and developing our web site. Our success in
promoting and enhancing the REDHAT.COM web site will also depend on our ability
to provide high quality content, features and functionality. If we fail to
promote our web site successfully or if visitors to our web site or advertisers
do not perceive our services to be useful, current or of high quality, our
ability to generate revenue from our web site will be significantly impaired.
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 this revenue 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
It is 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. These
third-party services, however, may not accurately or completely measure the
demographics of our web
-27-
<PAGE>
site's visitors. If these parties were unable to provide services or do not
provide accurate or complete 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.
RISKS RELATED TO LEGAL UNCERTAINTY
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 Australia, Canada, Japan and other countries.
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.
OUR SOFTWARE PRODUCTS, AS WELL AS THOSE OF OUR CUSTOMERS AND SUPPLIERS, COULD
FAIL AS A RESULT OF THE YEAR 2000 PROBLEM
We have conducted a review of Red Hat Linux and our internal systems to identify
functions that need correction to be "Year 2000 compliant". We have not,
however, tested our other products and have not tested or sought certifications
from third parties bundling software applications and components with Official
Red Hat Linux. Any failure by our products or third-party software bundled with
our products to function in the Year 2000 may decrease the value of our
products, give rise to warranty claims and tarnish the Red Hat brand.
Additionally, the Year 2000 problem may affect us by causing disruptions in the
business operations of, or delay technology purchases by, companies with which
we do business, such as customers and suppliers causing a decrease in our
product revenue. See "Management's Discussion and Analysis of Financial
Condition and Results of Operations--Year 2000 Compliance".
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Most of our cash equivalents, investments and capital lease obligations are at
fixed interest rates, and therefore the fair market value of these instruments
is affected by changes in market interest rates. As of August 31, 1999, all of
our cash equivalents mature within 90 days and we have the ability to liquidate
our investments every 90 days. Because our investment portfolio is primarily
comprised of short-term investments in debt securities, an immediate 10% change
in interest rates would not have a material effect on the fair market value of
our portfolio, therefore, we would not expect our operating results or cash
flows to be affected to any significant degree by the effect of a sudden change
in market interest rates on our securities portfolio.
-28-
<PAGE>
PART II. OTHER INFORMATION
ITEM 2. CHANGES IN SECURITIES AND 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 $88.7 million. As of August
31, 1999, the Company had not spent any proceeds, and has invested all of such
proceeds in investment grade, interest-bearing securities. 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) Exhibits:
<TABLE>
<CAPTION>
EXHIBIT NO. DESCRIPTION
- ----------- -----------
<S> <C>
11.1 Statement Regarding Computation of Per Share Earnings.
27.1 Financial Data Schedule
</TABLE>
(b) There were no reports on Form 8-K filed for the quarter ended
August 31, 1999.
-29-
<PAGE>
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
RED HAT, INC.
Date: October 14, 1999 By: /s/ Robert F. Young
------------------------
Robert F. Young
Chief Executive Officer
-30-
<PAGE>
EXHIBIT INDEX
<TABLE>
<CAPTION>
EXHIBIT NO. DESCRIPTION
- ----------- -----------
<S> <C>
11.1 Statement Regarding Computation of Per Share Earnings.
27.1 Financial Data Schedule
</TABLE>
-31-
<PAGE>
Exhibit 11.1
RED HAT, INC.
COMPUTATION OF NET INCOME (LOSS) PER SHARE
(Unaudited)
<TABLE>
<CAPTION>
Three-Months Ended Six-Months Ended
August 31, August 31,
------------------------- ----------------------
1999 1998 1999 1998
------------------------- ----------------------
<S> <C> <C> <C> <C>
Weighted average common shares
outstanding for the period - basic EPS 33,649,671 23,500,000 29,016,512 23,500,000
Effect of dilutive stock options and warrants (a) -- 3,740,000 -- 3,737,474
Effect of dilutive preferred stock (b) -- 13,602,800 -- 13,602,800
------------------------- ----------------------
Weighted average common shares
outstanding for the period - diluted EPS 33,649,671 40,842,800 29,016,512 40,840,274
------------------------- ----------------------
------------------------- ----------------------
Net income (loss) (3,147,316) 132,146 (5,279,786) 79,645
------------------------- ----------------------
------------------------- ----------------------
Net income (loss) per share - basic (0.0935) 0.0056 (0.1820) 0.0034
------------------------- ----------------------
------------------------- ----------------------
Net income (loss) per share - diluted (0.0935) 0.0032 (0.1820) 0.0020
------------------------- ----------------------
------------------------- ----------------------
</TABLE>
(a) Options to purchase 8,001,015 and 8,209,681 shares of common stock were
outstanding at the three and six-months ended August 31, 1999, respectively, but
were not included in the computation of diluted EPS as their effect was
antidilutive.
(b) Convertible preferred shares of 28,410,867 and 30,904,562 were outstanding
at the three and six-months ended August 31, 1999, respectively, but were not
included in the computation of diluted EPS as their effect was antidilutive.
<TABLE> <S> <C>
<PAGE>
<ARTICLE> 5
<LEGEND>
This schedule contains summary information extracted from SEC Form 10Q and is
qualified in its entirety by reference to such financial statements.
</LEGEND>
<MULTIPLIER> 1,000
<S> <C> <C> <C> <C>
<PERIOD-TYPE> 6-MOS 6-MOS 3-MOS 3-MOS
<FISCAL-YEAR-END> FEB-29-2000 FEB-28-1999 FEB-29-2000 FEB-28-1999
<PERIOD-START> MAR-01-1999 MAR-01-1998 MAR-01-1999 MAR-01-1998
<PERIOD-END> AUG-31-1999 AUG-31-1998 AUG-31-1999 AUG-31-1998
<CASH> 7,352 0 0 0
<SECURITIES> 96,070 0 0 0
<RECEIVABLES> 1,859 0 0 0
<ALLOWANCES> 143 0 0 0
<INVENTORY> 887 0 0 0
<CURRENT-ASSETS> 11,087 0 0 0
<PP&E> 2,980 0 0 0
<DEPRECIATION> 611 0 0 0
<TOTAL-ASSETS> 109,897 0 0 0
<CURRENT-LIABILITIES> 7,559 0 0 0
<BONDS> 381 0 0 0
0 0 0 0
0 0 0 0
<COMMON> 7 0 0 0
<OTHER-SE> 101,950 0 0 0
<TOTAL-LIABILITY-AND-EQUITY> 109,897 0 0 0
<SALES> 5,190 3,541 3,255 2,167
<TOTAL-REVENUES> 7,167 3,789 4,370 2,238
<CGS> 2,700 1,468 1,520 785
<TOTAL-COSTS> 8,435 2,332 3,942 1,268
<OTHER-EXPENSES> 4,406 1,343 2,756 788
<LOSS-PROVISION> 21 0 2 0
<INTEREST-EXPENSE> 12 5 1 5
<INCOME-PRETAX> (5,197) 141 (3,108) 194
<INCOME-TAX> 0 62 0 62
<INCOME-CONTINUING> (5,197) 80 (3,108) 132
<DISCONTINUED> 0 0 0 0
<EXTRAORDINARY> 0 0 0 0
<CHANGES> 0 0 0 0
<NET-INCOME> (5,197) 80 (3,108) 132
<EPS-BASIC> (.182) .003 (.094) .006
<EPS-DILUTED> (.182) .002 (.094) .003
</TABLE>
