UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
(Mark One)
X QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the quarter ended August 31, 2000
OR
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the transition period from to .
Commission File Number: 0-26281
RED HAT, INC.
(Exact name of registrant as specified in its charter)
Delaware
(State of Incorporation)
06-1364387
(I.R.S. Employer Identification No.)
2600 Meridian Parkway, Durham, North Carolina 27713
(Address of principal executive offices, including Zip Code)
(919) 547-0012
(Registrant's telephone number, including area code)
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. Yes X No
Indicate the number of shares outstanding of each of the issuer's classes of
common stock, as of the latest practicable date:
As of September 30, 2000, there were 160,782,621 shares of common stock
outstanding.
<PAGE>
RED HAT, INC.
TABLE OF CONTENTS
<TABLE>
<CAPTION>
Page
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<S> <C>
PART I - FINANCIAL INFORMATION:
ITEM 1: FINANCIAL STATEMENTS
Consolidated Balance Sheets at August 31, 2000 (unaudited) and
February 29, 2000 3
Consolidated Statements of Operations for the three and six months
ended August 31, 2000 and 1999 (unaudited) 4
Consolidated Statements of Cash Flows for the three and six months
ended August 31, 2000 and 1999 (unaudited) 5
Notes to Consolidated Financial Statements 6
ITEM 2: MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS 13
ITEM 3: QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK 37
PART II - OTHER INFORMATION:
ITEM 2: CHANGES IN SECURITIES AND USE OF PROCEEDS 38
ITEM 4: SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS 38
ITEM 6: EXHIBITS AND REPORTS ON FORM 8-K 39
SIGNATURES
EXHIBIT INDEX
</TABLE>
2
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PART I - FINANCIAL INFORMATION
ITEM 1: FINANCIAL STATEMENTS
RED HAT, INC.
CONSOLIDATED BALANCE SHEETS
<TABLE>
<CAPTION>
ASSETS
August 31, February 29,
2000 2000
(unaudited)
------------- -------------
<S> <C> <C>
Current assets:
Cash and cash equivalents $ 108,202,836 $ 242,426,032
Short-term investments 66,058,915 27,460,222
Accounts receivable, net 13,558,930 7,893,936
Inventory 134,365 488,977
Prepaid expenses and other current assets 2,177,289 1,874,973
------------- -------------
Total current assets 190,132,335 280,144,140
Property and equipment, net 12,654,421 7,909,103
Goodwill and intangibles, net 115,890,139 58,267,419
Long-term investments 145,906,583 72,354,212
Other assets, net 7,540,997 4,859,958
------------- -------------
Total assets $ 472,124,475 $ 423,534,832
============= =============
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable $ 4,052,092 $ 10,774,546
Royalties payable 38,105 115,117
Accrued expenses 15,363,089 7,571,058
Deferred revenue 10,527,739 11,030,337
Current portion of capital lease obligations 356,162 366,062
------------- -------------
Total current liabilities 30,337,187 29,857,120
Capital lease obligations 148,643 230,516
Commitments and contingencies - -
Stockholders' equity:
Preferred stock, $.0001 par value, 5,000,000 shares authorized, none outstanding - -
Common stock, $.0001 par value, 225,000,0000 shares authorized,
158,920,962 and 153,333,621 shares issued and outstanding
at August 31, 2000 and February 29, 2000, respectively 15,890 15,334
Additional paid-in capital 550,326,394 477,781,234
Shareholder receivables - (66,899)
Deferred compensation (28,990,685) (35,159,127)
Accumulated deficit (79,171,809) (48,607,478)
Accumulated other comprehensive income (loss) (541,145) (515,868)
------------- -------------
Total stockholders' equity 441,638,645 393,447,196
------------- -------------
Total liabilities and stockholders' equity $ 472,124,475 $ 423,534,832
============= =============
</TABLE>
The accompanying notes are an integral part of these consolidated
financial statements.
3
<PAGE>
RED HAT, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
<TABLE>
<CAPTION>
Three Months Ended
-------------------------------------
August 31, August 31,
2000 1999
(unaudited) (unaudited)
------------- -------------
<S> <C> <C>
Revenue:
Subscription $ 9,250,825 $ 5,886,659
Services 7,803,046 4,543,747
Web 1,439,518 105,666
------------- -------------
Total revenue 18,493,389 10,536,072
------------- -------------
Cost of revenue:
Subscription 3,552,275 3,231,841
Services 4,184,587 2,319,415
Web 58,437 202,962
------------- -------------
Total cost of revenue 7,795,299 5,754,218
------------- -------------
Gross profit 10,698,090 4,781,854
------------- -------------
Operating expense:
Sales and marketing (excludes $1,567,323 and $114,436 in stock-based 8,490,114 4,924,035
compensation during the three month periods ending August 31, 2000
and 1999, respectively, and $3,074,873 and $114,436 during the six month
periods ending August 31, 2000 and 1999, respectively)
Research and development (excludes $223,076 and $318,360 in stock-based 3,671,818 2,421,511
compensation during the three month periods ending August 31, 2000
and 1999, respectively, and $508,530 and $567,099 during the six month
periods ending August 31, 2000 and 1999, respectively)
General and administrative (excludes $1,704,345 and $151,643 in stock-based 7,340,881 1,969,589
compensation during the three month periods ending August 31, 2000
and 1999, respectively, and $3,629,094 and $274,529 during the six month
periods ending August 31, 2000 and 1999, respectively)
Amortization of goodwill and intangibles 9,028,648 1,298
Stock-based compensation 3,494,744 584,439
------------- -------------
Total operating expense 32,026,205 9,900,872
------------- -------------
Loss from operations (21,328,115) (5,119,018)
------------- -------------
Interest income (expense):
Interest income 5,672,523 522,527
Interest expense (22,725) (107,942)
------------- -------------
Interest income, net 5,649,798 414,585
------------- -------------
Loss before income taxes (15,678,317) (4,704,433)
Provision for income taxes 34,556 140,293
------------- -------------
Net loss (15,712,873) (4,844,726)
Accretion of mandatorily redeemable preferred stock - (39,393)
------------- -------------
Net loss available to common stockholders $ (15,712,873) $ (4,884,119)
============= =============
Net loss per common share:
Basic (0.10) (0.07)
Diluted (0.10) (0.07)
Weighted average shares outstanding:
Basic 157,661,054 68,647,928
Diluted 157,661,054 68,647,928
<CAPTION>
Six Months Ended
----------------------------------
August 31, August 31,
2000 1999
(unaudited) (unaudited)
------------ ------------
<S> <C> <C>
Revenue:
Subscription $ 17,788,326 $ 10,208,199
Services 14,063,380 8,376,205
Web 2,670,381 185,716
------------ ------------
Total revenue 34,522,087 18,770,120
------------ ------------
Cost of revenue:
Subscription 7,240,818 5,467,742
Services 7,813,821 3,935,305
Web 119,687 325,962
------------ ------------
Total cost of revenue 15,174,326 9,729,009
------------ ------------
Gross profit 19,347,761 9,041,111
------------ ------------
Operating expense:
Sales and marketing (excludes $1,567,323 and $114,436 in stock-based 17,983,521 8,664,894
compensation during the three month periods ending August 31, 2000
and 1999, respectively, and $3,074,873 and $114,436 during the six month
periods ending August 31, 2000 and 1999, respectively)
Research and development (excludes $223,076 and $318,360 in stock-based 6,943,002 4,803,293
compensation during the three month periods ending August 31, 2000
and 1999, respectively, and $508,530 and $567,099 during the six month
periods ending August 31, 2000 and 1999, respectively)
General and administrative (excludes $1,704,345 and $151,643 in stock-based 14,471,055 3,989,166
compensation during the three month periods ending August 31, 2000
and 1999, respectively, and $3,629,094 and $274,529 during the six month
periods ending August 31, 2000 and 1999, respectively)
Amortization of goodwill and intangibles 14,260,035 2,596
Stock-based compensation 7,212,497 956,064
------------ ------------
Total operating expense 60,870,110 18,416,013
------------ ------------
Loss from operations (41,522,349) (9,374,902)
------------ ------------
Interest income (expense):
Interest income 11,087,904 969,667
Interest expense (30,916) (327,155)
------------ ------------
Interest income, net 11,056,988 642,512
------------ ------------
Loss before income taxes (30,465,361) (8,732,390)
Provision for income taxes 98,970 201,869
------------ ------------
Net loss (30,564,331) (8,934,259)
Accretion of mandatorily redeemable preferred stock - (82,473)
------------ ------------
Net loss available to common stockholders $ (30,564,331) $ (9,016,732)
============= =============
Net loss per common share:
Basic (0.20) (0.15)
Diluted (0.20) (0.15)
Weighted average shares outstanding:
Basic 156,162,959 59,286,920
Diluted 156,162,959 59,286,920
</TABLE>
The accompanying notes are an integral part of these consolidated
financial statements.
4
<PAGE>
RED HAT, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
<TABLE>
<CAPTION>
Three Months Ended
---------------------------------------
August 31, August 31,
2000 1999
(unaudited) (unaudited)
--------------- -------------
<S> <C> <C>
Cash flows from operating activities:
Net loss $ (15,712,873) $ (4,844,726)
Adjustments to reconcile net loss to net cash used in operating activities:
Depreciation and amortization 10,120,162 435,039
Stock-based compensation expense 3,075,723 563,003
Provision for doubtful accounts 515,265 32,120
Provision for inventory obsolescence 379,152 -
Loss on sale of property and equipment 32,687 -
Deferred revenue (1,503,168) (482,398)
Changes in operating assets and liabilities:
Accounts receivable (3,591,954) 1,301,600
Inventory 830,299 187,054
Prepaid expenses 9,326 (309,627)
Intangibles and other assets (210,475) (276,224)
Accounts payable (1,958,732) 498,954
Royalties payable (2,717) 124,963
Accrued expenses 1,561,860 624,101
--------------- -------------
Net cash used in operating activities (6,455,445) (2,146,141)
--------------- -------------
Cash flows from investing activities:
Purchase of investment securities (1,296,954) (100,050,322)
Proceeds from sales and maturities of investment securities 15,250,000 4,930,640
Proceeds from sale of equipment 29,528 -
Cost of acquisitions, net of cash and cash equivalents acquired (514,697) -
Purchase of property and equipment (4,716,115) (804,259)
--------------- -------------
Net cash (used in) provided by investing activities 8,751,762 (95,923,941)
--------------- -------------
Cash flows from financing activities:
Decrease in stockholders' notes receivable - -
Repayments of notes payable (507,291) (118,363)
Proceeds from issuance of common stock, net - 88,701,021
Proceeds from issuance of mandatorily redeemable preferred stock, net - -
Proceeds from issuance of preferred stock - -
Payment of offering costs (52,095) -
Proceeds from issuance of common stock under Employee Stock Purchase Plan - -
Proceeds from exercise of common stock options and warrants 1,013,663 1,063,725
Payments on capital lease obligations (51,993) (29,396)
--------------- -------------
Net cash provided by financing activities 402,284 89,616,987
--------------- -------------
Effect of foreign currency exchange rates on cash and cash equivalents (545,929) -
Net increase in cash and cash equivalents 2,152,672 (8,453,095)
Cash and cash equivalents at beginning of the year 106,050,164 25,959,508
--------------- -------------
Cash and cash equivalents at end of period $ 108,202,836 $ 17,506,413
=============== =============
<CAPTION>
Six Months Ended
-------------------------------------
August 31, August 31,
2000 1999
(unaudited) (unaudited)
--------------- ------------
<S> <C> <C>
Cash flows from operating activities:
Net loss $ (30,564,331) $ (8,934,259)
Adjustments to reconcile net loss to net cash used in operating activities:
Depreciation and amortization 16,240,609 649,040
Stock-based compensation expense 6,230,942 870,543
Provision for doubtful accounts 1,037,729 152,246
Provision for inventory obsolescence 544,672 -
Loss on sale of property and equipment 73,655 2,749
Deferred revenue 713,936 2,578,475
Changes in operating assets and liabilities:
Accounts receivable (8,302,629) (1,188,069)
Inventory (190,060) (541,506)
Prepaid expenses (266,301) (734,698)
Intangibles and other assets (3,110,881) (577,385)
Accounts payable (6,943,499) 1,766,763
Royalties payable (77,012) 72,889
Accrued expenses 5,971,771 812,985
--------------- ------------
Net cash used in operating activities (18,641,399) (5,070,227)
--------------- ------------
Cash flows from investing activities:
Purchase of investment securities (228,091,718) (100,050,322)
Proceeds from sales and maturities of investment securities 116,363,082 5,945,114
Proceeds from sale of equipment 29,528 -
Cost of acquisitions, net of cash and cash equivalents acquired (25,936) -
Purchase of property and equipment (6,659,950) (1,436,343)
--------------- ------------
Net cash (used in) provided by investing activities (118,384,994) (95,541,551)
--------------- ------------
Cash flows from financing activities:
Decrease in stockholders' notes receivable 66,899 5,969
Repayments of notes payable (507,291) (1,245,226)
Proceeds from issuance of common stock, net - 88,701,021
Proceeds from issuance of mandatorily redeemable preferred stock, net - 3,188,035
Proceeds from issuance of preferred stock - 5,148,448
Payment of offering costs (52,095) -
Proceeds from issuance of common stock under Employee Stock Purchase Plan 96,674 -
Proceeds from exercise of common stock options and warrants 3,738,488 2,904,577
Payments on capital lease obligations (91,773) (70,219)
--------------- ------------
Net cash provided by financing activities 3,250,902 98,632,605
--------------- ------------
Effect of foreign currency exchange rates on cash and cash equivalents (447,705) -
Net increase in cash and cash equivalents (134,223,196) (1,979,173)
Cash and cash equivalents at beginning of the year 242,426,032 19,485,586
--------------- ------------
Cash and cash equivalents at end of period $ 108,202,836 $ 17,506,413
=============== =============
</TABLE>
The accompanying notes are an integral part of these consolidated financial
statements.
5
<PAGE>
NOTE 1-Organization
Red Hat, Inc. and its subsidiaries ("Red Hat" or the "Company") are a leading
developer and global provider of open source software products and services, and
have built a comprehensive web site dedicated to the open source software
community. Red Hat, Inc. was incorporated in Connecticut in March 1993 as ACC
Corp., Inc. In September 1995 ACC Corp., Inc. changed its name to Red Hat
Software, Inc. In September 1998, Red Hat Software, Inc. reincorporated in
Delaware. In June 1999, Red Hat Software, Inc. changed its name to Red Hat, Inc.
On January 7, 2000, Red Hat acquired Cygnus Solutions, Inc. in a transaction
accounted for using the pooling of interests method of accounting. All prior
period financial statements of Red Hat have been restated to reflect this
combination.
NOTE 2-Summary of Significant Accounting Policies
Unaudited Interim Financial Information
The interim consolidated financial statements as of August 31, 2000 have been
prepared by the Company pursuant to the rules and regulations of the Securities
and Exchange Commission (the "SEC") for interim financial reporting. These
consolidated statements are unaudited and, in the opinion of management, include
all adjustments (consisting of normal recurring adjustments and accruals)
necessary to present fairly the consolidated balance sheets, consolidated
operating results, and consolidated cash flows for the periods presented in
accordance with generally accepted accounting principles. The consolidated
balance sheet at February 29, 2000 has been derived from the audited
consolidated financial statements at that date. Operating results for the three
month period ended August 31, 2000 are not necessarily indicative of the results
that may be expected for the year ended February 28, 2001. Certain information
and footnote disclosures normally included in financial statements prepared in
accordance with generally accepted accounting principles have been omitted in
accordance with the rules and regulations of the SEC. These interim consolidated
financial statements should be read in conjunction with the consolidated
financial statements and notes thereto for the year ended February 29, 2000.
Principles of Consolidation
The accompanying consolidated financial statements include the accounts of the
Company and all of its wholly-owned subsidiaries. All significant intercompany
accounts and transactions are eliminated in consolidation.
Use of Estimates
The preparation of financial statements in conformity with accounting principles
generally accepted in the United States requires management to make estimates
and assumptions that affect the reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities at the date of the financial
statements and the reported amounts of revenues and expenses during the
reporting period. Actual results could differ from those estimates.
Cash and Cash Equivalents
The Company considers investments purchased with a maturity period of three
months or less at the date of purchase to be cash equivalents.
6
<PAGE>
Accounts Receivable
The Company's accounts receivable include $3,768,304 and $2,433,095 in unbilled
receivables at August 31, 2000 and February 29, 2000, respectively. Unbilled
receivables arise as revenues for custom development services are recognized
under the percentage-of-completion method. These amounts are billable at
specified dates, which do not necessarily coincide with timing of revenue
recognition.
Investments
The Company's investments at August 31, 2000 and February 29, 2000 are in
government and debt securities which are classified as available for sale and
carried at market value in accordance with Statement of Financial Accounting
Standards No. 115 "Accounting for Certain Investments in Debt and Equity
Securities" ("SFAS 115"). The Company's investments are considered available for
sale as these securities could potentially be sold in response to needs for
liquidity, changes in the availability of and the yield on alternative
instruments or changes in funding sources or terms. The Company has an
unrealized loss of $153,219 and $575,647 related to these investments at August
31, 2000 and February 29, 2000, respectively, which is recorded as other
comprehensive income (loss), a separate component of stockholders' equity.
Inventory
The costs incurred for duplicating the computer software, documentation, and
training materials sold by the Company from the product masters and for
packaging the product for distribution are capitalized as inventory using the
weighted average method and charged to cost of sales when revenue from the sale
of units is recognized. Management periodically evaluates the realizability of
inventory based on planned release dates of product updates and records a
reserve for obsolescence when necessary. The reserve for inventory obsolescence
was $474,152 and $335,000 at August 31, 2000 and February 29, 2000,
respectively.
Capitalized Software Costs
Capitalization of software development costs begins upon the establishment of
technological feasibility and ceases when the product is available for general
release. The establishment of technological feasibility and the ongoing
assessment of recoverability of capitalized software development costs requires
considerable judgment by management concerning certain external factors
including, but not limited to, technological feasibility, anticipated future
gross revenue, estimated economic life and changes in software and hardware
technologies. As a result of the Company's practice of releasing source code
that it has developed on a weekly basis for unrestricted download on the
Internet, there is generally no passage of time between achievement of
technological feasibility and the availability of the Company's product for
general release. Therefore, the Company has no capitalized software development
costs at August 31, 2000 and February 29, 2000.
Property and Equipment
Property and equipment is primarily comprised of furniture and computer
equipment which are recorded at cost and depreciated using the straight-line
method over their estimated useful lives which range from 3 to 10 years.
Expenditures for maintenance and repairs are charged to operations as incurred;
major expenditures for renewals and betterments are capitalized and depreciated.
Property and equipment acquired under capital leases are being depreciated over
their estimated useful lives or the respective lease term, if shorter.
Goodwill and Intangibles
Goodwill and intangible assets, which represent the excess of acquisition cost
over the tangible net
7
<PAGE>
assets acquired in business combinations, is amortized over its estimated useful
life which is three years. Costs incurred for acquiring certain intangible
assets such as trademarks, copyrights and patents are capitalized and amortized
using the straight-line method over their estimated useful lives, which range
from 5 to 15 years.
Other Assets
Other assets includes security deposits which are expected to be refunded to the
Company upon termination of certain leases, investments in other companies
accounted for using the cost method of accounting and the long-term portion of
the Company's prepaid directors' and officers' insurance premiums, which is
amortized to general and administrative expense over the term of the insurance
policy.
Impairment of Long-Lived Assets
The Company evaluates the recoverability of its property and equipment, and
other assets in accordance with Statement of Financial Accounting Standards No.
121, "Accounting for the Impairment of Long-Lived Assets to be Disposed of"
("SFAS 121"). SFAS 121 requires recognition of impairment of long-lived assets
in the event the net book value of such assets exceeds the estimated future
undiscounted cash flows attributable to such assets or the business to which
such intangible assets relate. No impairments were required to be recognized
during the three and six month periods ended August 31, 2000 and 1999.
Revenue Recognition
Revenues from the sale of software products for which no technical support is
provided are generally recognized upon shipment of the products, net of a
reserve for estimated returns. A reserve for sales returns is recognized for
sales of software products to distributors, who have a right of return, based on
the Company's historical experience of sell-through to the end user by the
distributor. The Company recognizes revenues from the sale of software products
to new distributors of its software products based upon sell-through to the end
user until the Company has sufficient historical experience with the distributor
to allow the accurate estimation of sales returns.
Upon the release of Version 6.0 of Official Red Hat Linux in May 1999, the
Company began providing certain telephone and e-mail technical support services
with Official Red Hat Linux and Red Hat Secure Web Server for a period of 90
days from the date of registration of the software products for no additional
fee. In June 1999, the Company also began to provide to purchasers of Official
Red Hat Linux and Red Hat Secure Web Server subscription services for a period
of six months from the date of registration of the software products. In October
1999, the Company released Version 6.1 of Red Hat Linux and began to include the
Secure Web Server product in the "professional" version of Version 6.1 of
Official Red Hat Linux. In March 2000, the Company released Version 6.2 of Red
Hat Linux. In accordance with the provisions of Statement of Opinion No. 97-2,
"Software Revenue Recognition" ("SOP 97-2") as amended by SOP 98-4 and SOP 98-9,
the Company is recognizing all of the revenue from the sale of Versions 6.0, 6.1
and 6.2 Official Red Hat Linux over the period that the technical support and
subscription services are provided as the Company does not sell these technical
support and subscription services separately and therefore does not have vendor
specific objective evidence of the fair value of these services. For Versions
6.0, 6.1 and 6.2, these revenues are recognized ratably over the period that the
technical support and subscription services are provided in proportion to the
costs incurred to provide such technical support and subscription services.
Revenue from sale of books published by the Company, which is included in
subscription revenue, is recognized at the date of shipment, net of estimated
returns.
Service revenues consist of revenue for technical support and maintenance
services, other than installation support, and customer training and education,
revenue for software compiling, debugging and optimization contracts
("Development Contracts") and royalty revenue. Revenue for technical support and
maintenance services, other than installation support, is deferred and
recognized ratably over the
8
<PAGE>
term of the agreement, which is typically twelve months. Revenues for
development contracts are recognized on the percentage-of-completion method
provided that the fee for such engineering services is fixed or determinable and
the collection of the resulting receivable is probable. Revenue from customer
training and education and other services is recognized at the date the services
are performed.
Royalty revenue, which is included in services revenue, is comprised primarily
of royalties received from the sale of rights to the Company's brand and
trademark and royalties received from international distributors of the
Company's products. Royalty revenue is recognized when received.
Web revenue related to advertising is recognized ratably in the period in which
the advertisement is displayed, provided that the Company has no significant
remaining obligations, at the lesser of the ratio of connections to the
advertiser's website delivered over total guaranteed connections to the
advertiser's website or the straight line basis over the term of the contract.
If minimum guaranteed connections are not met, the Company defers recognition of
the corresponding revenue until the guaranteed connections are achieved.
Royalty Costs
Royalties that the Company is required to pay on applications licensed from
third parties that are a component of the software products sold by the Company
are expensed as cost of sales on a per unit basis as software products are sold.
Royalties paid in advance of the sale of the Company's software products are
included in prepaid expenses and recorded as expense when the related software
products are sold.
Stock-Based Compensation
The Company accounts for stock-based compensation based on the provisions of
Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to
Employees" ("APB 25"), which states that no compensation expense is recorded for
stock options or other stock-based awards to employees that are granted with an
exercise price equal to or above the estimated fair value per share of the
Company's common stock on the grant date. In the event that stock options are
granted with an exercise price below the estimated fair market value of the
Company's common stock at the grant date, the difference between the fair market
value of the Company's common stock and the exercise price of the stock option
is recorded as deferred compensation. Deferred compensation is amortized to
compensation expense over the vesting period of the stock option. Stock-based
compensation also includes the amortization of deferred compensation related to
the value of certain shares of common stock to be issued to certain HKS
shareholders contingent on their continued employment with the Company for a
period of three years after the date of acquisition. The Company recognized
$3,494,744 and $584,439 in non-cash compensation expense related to amortization
of deferred compensation during the three month periods ended August 31, 2000
and 1999, respectively, and $7,212,497 and $956,064 during the six month periods
ended August 31, 2000 and 1999, respectively. In addition, the Company also
classifies the employer portion of tax liabilities paid upon exercise of
non-qualified stock options and warrants as stock-based compensation. The
Company has adopted the disclosure requirements of Statement of Financial
Accounting Standards No. 123, "Accounting for Stock-Based Compensation" ("SFAS
123"), which requires compensation expense to be disclosed based on the fair
value of the options granted at the date of the grant.
Sales and Marketing Expenses
Sales and marketing expenses consist primarily of costs, including salaries and
sales commissions, of all personnel involved in the sales process and related
expenses. Sales and marketing expenses also include costs of advertising and
trade shows. All costs of advertising, including cooperative marketing
arrangements, the software products, books and related services offered by the
Company are expensed as incurred.
9
<PAGE>
Development Costs
Development costs include expenses incurred by the Company to develop, enhance,
manage, monitor and operate the Company's web sites and costs of managing and
integrating data on the Company's web sites. In March 1998, the Accounting
Standards Executive Committee of the American Institute of Certified Public
Accountants ("AICPA") issued Statement of Position No. 98-1 "Accounting for the
Costs of Computer Software Developed or Obtained for Internal Use," ("SOP 98-1")
which provides guidance regarding when software developed or obtained for
internal use should be capitalized. SOP 98-1 is effective for fiscal years
beginning after December 15, 1998. The Company adopted SOP 98-1 effective March
1, 1999. With the adoption of this standard, the Company began accounting for
the software development component of product development costs associated with
internal use software in accordance with SOP 98-1, which requires that certain
costs incurred during the application development stage be capitalized, while
costs incurred during the preliminary project stage and post
implementation/operation stage should be expensed as incurred. Capitalized
product development costs are amortized over the estimated life of the related
application. The adoption of SOP 98-1 did not have a material impact on the
Company's consolidated financial statements.
Income Taxes
The Company accounts for income taxes using the liability method which requires
the recognition of deferred tax assets or liabilities for the temporary
differences between financial reporting and tax bases of the Company's assets
and liabilities and for tax carryforwards at enacted statutory tax rates in
effect for the years in which the differences are expected to reverse. The
effect on deferred taxes of a change in tax rates is recognized in income in the
period that includes the enactment date. In addition, valuation allowances are
established when necessary to reduce deferred tax assets to the amounts expected
to be realized.
Foreign Currency Translation
The majority of the Company's international sales are currently denominated in
U.S. dollars. The U.S. dollar has been determined to be the functional currency
for the Company's European operations and local currencies have been determined
to be the functional currencies for the Company's Asian operations. Foreign
exchange gains and losses, which result from the process of remeasuring foreign
currency financial statements into U.S. dollars are included in the statements
of operations. Foreign exchange gains and losses which result from the
translation of foreign currency financial statements into U.S. dollars where the
local currency is the functional currency is included as a separate component of
stockholders' equity.
Net Loss Per Common Share
The Company computes net loss per common share in accordance with Statement of
Financial Accounting Standards No. 128, "Earnings Per Share," ("SFAS 128") and
SEC Staff Accounting Bulletin No. 98 ("SAB 98"). Under the provisions of SFAS
128 and SAB 98, basic net loss per common share ("Basic EPS") is computed by
dividing net loss available to common stockholders by the weighted average
number of common shares outstanding. Diluted net loss available to common
stockholders per common share ("Diluted EPS") is computed by dividing net loss
by the weighted average number of common shares and dilutive potential common
share equivalents then outstanding. Potential common shares consist of shares
issuable upon the exercise of stock options and warrants and shares issuable
upon conversion of outstanding mandatorily redeemable preferred stock. The
calculation of net loss per share available to common stockholders does not
include 15,977,029 and 72,366,682 potential shares of common stock equivalents
for the three month periods ended August 31, 2000 and 1999, respectively, and
16,280,885 and 77,591,658 potential shares of common stock equivalents for the
six month periods ended August 31, 2000 and 1999, respectively, as their impact
would be antidilutive.
10
<PAGE>
Segment Reporting
In June 1997, the Financial Accounting Standards Board, ("FASB") issued
Statement of Financial Accounting Standards No. 131, "Disclosures About Segments
of an Enterprise and Related Information" ("SFAS 131"). This statement requires
companies to report information about operating segments in interim and annual
financial statements. It also requires segment disclosures about products and
services, geographic areas and major customers. The Company adopted SFAS 131
effective for its fiscal year ended February 28, 1998. Required segment
disclosures are presented below:
The Company has international offices in the United Kingdom, Ireland, Germany,
France, Italy, Singapore, Australia, and Japan. The following disclosure
aggregates individually immaterial international operations and separately
discloses the significant international operations at and for the three and six
month periods ended August 31, 2000.
<TABLE>
<CAPTION>
North America Europe Asia Pacific Total
and Japan
------------- ------------- ------------- -------------
Three Months Ended August 31, 2000
----------------------------------
<S> <C> <C> <C> <C>
Revenues from
unaffiliated
customers ......................................... $ 14,908,890 $ 2,203,190 $ 1,381,309 $ 18,493,389
Net Loss .............................................. $ (13,752,004) $ (912,750) $ (1,048,119) $ (15,712,873)
Total Assets .......................................... $ 461,962,786 $ 7,268,672 $ 2,893,017 $ 472,124,475
Six Months Ended August 31, 2000
--------------------------------
Revenues from
unaffiliated
customers .......................................... $ 27,860,536 $ 4,275,747 $ 2,385,804 $ 34,522,087
Net Loss ............................................... $ (26,559,905) $ (1,913,906) $ (2,090,520) $ (30,564,331)
Total Assets ........................................... $ 461,962,786 $ 7,268,672 $ 2,893,017 $ 472,124,475
</TABLE>
Internal Use Software
In March 1998, the Accounting Standards Executive Committee of the American
Institute of Certified Public Accountants issued Statement of Position No. 98-1
"Accounting for the Costs of Computer Software Developed or Obtained for
Internal Use" "SOP 98-1" which provides guidance regarding when software
developed or obtained for internal use should be capitalized. The Company
adopted SOP 98-1 effective March 1, 1999.
Comprehensive Income
In June 1997, the FASB issued Statement of Financial Accounting Standards No.
130, "Reporting Comprehensive Income" ("SFAS 130"). SFAS 130 establishes
standards for reporting and display of comprehensive income and its components
in a full set of general-purpose financial statements. SFAS 130 is effective for
financial statements for fiscal years beginning after December 15, 1997. The
Company's items of other comprehensive income (loss) during the three months
ended August 31, 2000 totaled $541,145 and are comprised of an unrealized loss
on investments in marketable securities of $153,219 and a foreign currency
translation adjustment of $387,926. The Company had no items of other
comprehensive income during the three month period ended August 31, 1999.
Recent Accounting Pronouncements
In June 1998, the FASB issued Statement of Financial Accounting Standards No.
133, "Accounting for
11
<PAGE>
Derivative Instruments and Hedging Activities" ("SFAS 133"). SFAS 133
establishes accounting and reporting standards for derivative instruments,
including certain derivative instruments embedded in other contracts
(collectively referred to as derivatives), and for hedging activities. SFAS 133,
as amended by SFAS 137, is effective for all fiscal quarters of all fiscal years
beginning after June 15, 2000, with earlier application encouraged. The Company
does not currently nor does it intend in the future to use derivative
instruments and therefore does not expect that the adoption of SFAS 133 will
have any impact on its financial position or results of operations.
In December 1999, the Securities and Exchange Commission issued Staff Accounting
Bulletin No. 101, "Revenue Recognition in Financial Statements" ("SAB 101")
which addresses certain criteria for revenue recognition. SAB 101, as amended by
SAB 101A and SAB 101B, outlines the criteria that must be met to recognize
revenue and provides guidance for disclosures related to revenue recognition
policies. The adoption of SAB 101 is not expected to have a material impact on
the consolidated financial position or results of operation.
NOTE 3-Business Combinations
In July 2000, the Company completed the acquisition of all of the outstanding
common stock of WireSpeed Communications Corporation, Inc. ("WireSpeed") in
exchange for the issuance of 1,461,119 shares of the Company's common stock, and
the assumption of all of the outstanding stock options valued, in the aggregate,
at $35,832,638, plus the assumption of $741,525 in net liabilities. The
acquisition of Wirespeed has been accounted for using the purchase method of
accounting in accordance with APB 16 and, accordingly, the excess of purchase
price over the fair values of the net assets acquired of $36,574,163 has been
recorded as goodwill, which is being amortized on a straight-line basis over
three years. In addition to the above, additional shares may be issued, with a
market value as defined in the agreement, if certain performance objectives are
met. The number and value of these shares will be determined and recorded as
goodwill as the performance objectives are met.
NOTE 4-Fair Value of Financial Instruments
The carrying value of cash and cash equivalents, accounts receivable, and
accounts payable at August 31, 2000 and February 29, 2000 approximated their
fair value due to the short-term nature of these items. The fair value of the
Company's short-term and long-term investments at August 31, 2000 and February
29, 2000, differed from their historical cost by $153,219 and $575,647,
respectively. The Company had $97,497 and $67,827 of realized gains or losses,
respectively, on investments during the three month period ended August 31,
2000. The Company did not have any realized gains or losses during the three
month period ended August 31, 1999. The Company had $97,497 and $67,827 of
realized gains or losses, respectively, on investments during the six month
period ended August 31, 2000. The Company did not have any realized gains or
losses during the six month period ended August 31, 1999.
NOTE 5-Subsequent Event
On September 5, 2000, the Company completed its acquisition of all of the
outstanding capital stock and assumed all of the outstanding stock options of
C2Net Software, Inc. ("C2Net"). At closing, Red Hat issued 974,567 shares of
common stock, and reserved 1,018,276 shares for issuance upon exercise of
assumed options. C2Net is the developer of the Apache-based Stronghold (R)
secure web server. The acquisition will be accounted for using the purchase
method of accounting. Accordingly, a portion of the purchase price will be
allocated to net tangible and intangible assets acquired based on their
estimated fair market values. The balance of the purchase price will be recorded
as goodwill.
12
<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 and uncertainties may
cause Red Hat's actual results to differ materially from any forward-looking
statements. These risks and uncertainties include, without limitation, the risks
detailed below and in Red Hat's other filings with the Securities and Exchange
Commission, copies of which may be accessed through the SEC's web site at
http://www.sec.gov.
Overview
We are a leading global developer and provider of open source software and
solutions, and have built a comprehensive web site dedicated to the open source
software community. We were incorporated in Connecticut in March 1993 as ACC
Corp., Inc. In September 1995, we changed our name to Red Hat Software, Inc. In
September 1998, we reincorporated in Delaware. In June 1999, we changed our name
to Red Hat, Inc. We have financed our activities to date through proceeds from
the sale of equity securities and cash flow from operations.
In January 2000, we acquired Cygnus in a transaction accounted for as a pooling
of interests. As a result of this acquisition, our historical financial
statements have been restated to include the results of operations and accounts
of Cygnus for all periods presented. In January 2000, we acquired HKS in a
transaction accounted for in accordance with the purchase method of accounting.
As a result, our results of operations include the results of operations of HKS
from the date of the acquisition.
Sales of Official Red Hat Linux have historically represented our principal
source of revenue. We derive our subscription revenue primarily from the sale of
software products and technical support contracts:
o through distributors to enterprise and retail accounts;
o directly to individual users and enterprises through our
redhat.com web site, our call center, and our direct sales
force; and
o from original equipment manufacturers which license our
software and support services directly.
We recognize revenue from software product sales to distributors and original
equipment manufacturers for which no technical support is provided at the time
our products are shipped, net of a reserve for estimated sales returns. This
reserve is recognized based on our historical experience with these
distributors' rates of sell-through to the end user. Revenue from the sale of
software products to individual users and enterprises for which no technical
support is provided is recognized on the date we ship the software products.
Upon the release of Version 6.0 of Red Hat Linux in May 1999, we began selling
Official Red Hat Linux and Red Hat Secure Web Server with 30 days of free
telephone technical support, 90 days of free e-mail technical support and 180
days of subscription services. In accordance with the provisions of Statement of
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 subsequent
versions ratably over the period that the technical support and subscription
services are provided in proportion to the costs incurred to provide such
technical support and subscription services as compared to estimated total costs
to be incurred.
Cygnus recognized revenue on the sale of its software products at the date such
products were shipped to the distributor or customer net of a reserve for
estimated sales returns. This reserve was recognized based on each individual
distributor's right of return under the distribution agreement and Cygnus'
historical experience of sales returns of its software products. Cygnus used the
same method of revenue recognition for product sales for which no technical
support is provided as we do, and we have continued
13
<PAGE>
to use this method for these sales.
We have recently added new features to our redhat.com web site and intend to
develop additional features which we believe will result in an increase in both
the number of visitors who access our web site and in revenue generated through
our web site, including through
o the sale of our own software and solutions;
o the sale of third-party products;
o the sale of products co-branded or bundled with third-party
products; and
o the sale of advertising.
Web revenue is currently derived principally from short-term advertising
contracts in which we typically guarantee a minimum number of impressions to be
delivered to users over a specified period of time for a fixed fee. Advertising
rates are typically measured on a cost per thousand impressions basis.
Advertising revenue is recognized ratably in the period in which the
advertisement is displayed, provided that we have no significant remaining
obligations, at the lesser of the ratio of impressions delivered over total
guaranteed impressions or the straight line basis over the term of the contract.
If we do not meet minimum guaranteed impressions requirements, we defer
recognition of the corresponding revenue until the minimum number of guaranteed
impressions is achieved. We did not generate revenue from the sale of
advertising on our web site until the first quarter of the fiscal year ended
February 29, 2000.
Prior to March 1999, we provided only minimal service offerings to our
customers. In March 1999, we developed and expanded our service offerings to
include comprehensive technical support and maintenance, developer support,
custom development, consulting, training and education and hardware
certification services. Revenue from technical support and maintenance
arrangements is deferred and recognized ratably over the term of the related
agreement, which is typically one year. Revenue from custom development,
consulting, training and education services, developer support and hardware
certification services, is recognized as the services are provided.
Cygnus provides custom development services for integrated device manufacturers
and also provides engineering services and developer support services for
microprocessor and product manufacturing companies. Cygnus recognizes revenue on
its service arrangements on the percentage of completion method over the term of
the related development agreement. These custom development arrangements
generally have a term of three to six months. Support and maintenance
arrangements typically have terms of three months to two years. Revenue from
ongoing technical support and maintenance services was recognized ratably over
the term of the related technical support and maintenance agreement. We have
continued to use this method of revenue recognition for these services.
We have historically experienced fluctuations in our results of operations
related to the release of new versions of Red Hat Linux. We believe our
customers' anticipation of the release of these new versions has historically
resulted in, and will continue to result in, a decline in sales for several
months prior to the release and an increase in sales immediately following the
release. Prior to our release of Version 6.0 of Official Red Hat Linux in May
1999 and of Version 6.1 of Official Red Hat Linux in October 1999, software
product sales decreased, but after each release we experienced an immediate
significant increase in both the volume and dollar amount of software product
sales. In addition, we believe that revenue from the sale of Official Red Hat
Linux and related products will decline as a percentage of total revenue in the
future as we continue to expand our services offerings and execute our web
initiatives.
14
<PAGE>
Results of Operations
The following table sets forth the results of operations for Red Hat expressed
as a percentage of total revenue.
<TABLE>
<CAPTION>
Three Months Ended Six Months Ended
August 31, August 31,
------------------------ -----------------------
2000 1999 2000 1999
-------- -------- -------- --------
(Unaudited) (Unaudited)
<S> <C> <C> <C> <C>
Revenue:
Subscription 50.0% 55.9% 51.5% 54.4%
Services 42.2% 43.1% 40.7% 44.6%
Web 7.8% 1.0% 7.8% 1.0%
-------- -------- -------- --------
Total revenue 100.0% 100.0% 100.0% 100.0%
-------- -------- -------- --------
Cost of revenue:
Subscription 19.2% 30.7% 21.0% 29.1%
Services 22.7% 22.0% 22.6% 21.0%
Web 0.3% 1.9% 0.4% 1.7%
-------- -------- -------- --------
Total cost of revenue 42.2% 54.6% 44.0% 51.8%
-------- -------- -------- --------
Gross profit 57.8% 45.4% 56.0% 48.2%
-------- -------- -------- --------
Operating expense:
Sales and marketing 45.9% 46.7% 52.1% 46.2%
Research and development 19.9% 23.0% 20.1% 25.6%
General and administrative 39.7% 18.7% 41.9% 21.3%
Amortization of goodwill and intangibles 48.8% 0.0% 41.3% 0.0%
Stock-based compensation 18.9% 5.6% 20.9% 5.1%
-------- -------- -------- --------
Total operating expense 173.2% 94.0% 176.3% 98.2%
-------- -------- -------- --------
Loss from operations -115.4% -48.6% -120.3% -50.0%
-------- -------- -------- --------
Interest income (expense), net 30.6% 3.9% 32.0% 3.4%
-------- -------- -------- --------
Loss before income taxes -84.8% -44.7% -88.3% -46.6%
Provision for income taxes 0.2% 1.3% 0.3% 1.1%
-------- -------- -------- --------
Net loss -85.0% -46.0% -88.6% -47.7%
Accretion of mandatorily redeemable preferred stock 0.0% -0.4% 0.0% -0.4%
-------- -------- -------- --------
Net loss available to common stockholders -85.0% -46.4% -88.6% -48.1%
======== ======== ======== ========
</TABLE>
Three Months Ended August 31, 2000 and August 31, 1999
Total revenue
Total revenue increased 75.5% to $18.5 million in the three months ended August
31, 2000 from $10.5 million in the three months ended August 31, 1999. Revenue
from international operations totaled $3.6 million during the three months ended
August 31, 2000. We established international operations for sale of our
software products in August 1999. Prior to August 1999, our international
revenue was limited to revenue generated from custom development services
performed for international customers.
Subscription revenue
Subscription revenue is comprised primarily of revenue from sales of Official
Red Hat Linux and related software products, sales of publications about
Linux-based operating systems, sales of software development tools, and
technical support and maintenance. Subscription revenue increased 57.1% to $9.3
million in the three months ended August 31, 2000 from $5.9 million in the three
months ended August 31, 1999. This increase was primarily due to the release of
Version 6.2 of Official Red Hat Linux in March 2000 and an increase in technical
support and maintenance revenue as a result of our focus on providing these
services beginning subsequent to August 1999. As a percentage of total revenue,
subscription revenue decreased to 50.0% in the three months ended August 31,
2000 from 55.9% in the three months ended August 31, 1999. The decrease in
subscription revenue as a percentage of total revenue is primarily a result of
the expansion of our web initiatives and the growth in our services revenue.
Services revenue
Services revenue is primarily comprised of custom development fees, training and
education fees, and short-term consulting contracts. Services revenue increased
71.7% to $7.8 million in the three months ended August 31, 2000 from $4.5
million in the three months ended August 31, 1999. The increase in services
revenue resulted primarily from an increase in custom development revenue due to
an increase in the number, size and scope of custom development contracts and an
increase in training and education revenue due to the expansion of our course
offerings. As a percentage of total revenue, services revenue decreased to 42.2%
in the three months ended August 31, 2000 from 43.1% in the three months ended
August 31, 1999. The decrease in services revenue as a percentage of total
revenue is primarily a result of the expansion of our web initiatives.
Web revenue
Web revenue is comprised primarily of fees generated from contracts with
advertisers to display advertisements on our web site. Web revenue increased to
$1.4 million in the three months ended August 31, 2000 from $0.1 million in the
three months ended August 31, 1999. As a percentage of total revenue, web
revenue increased to 7.8% in the three months ended August 31, 2000 from 1.0% in
the three months ended August 31, 1999. These increases were due to the
commencement of our web initiatives during the fiscal year ending February 29,
2000. We expect web revenue to increase as a percentage of revenue in the future
as advertising revenue and royalties from the sale of third-party
15
<PAGE>
products and products co-branded or bundled with third-party products continues
to grow.
Cost of revenue
Cost of subscription revenue
Cost of subscription revenue consists of expenses we incur to manufacture,
package and distribute our products and related documentation. These costs
include expenses for physical media, literature and packaging, fulfillment and
shipping, and labor related costs to provide technical support and maintenance.
Cost of subscription revenue increased 9.9% to $3.6 million in the three months
ended August 31, 2000 from $3.2 million in the three months ended August 31,
1999. This increase was directly related to the increase in sales volumes as a
result of the release of Version 6.2 of Official Red Hat Linux in March 2000 and
costs incurred to provide technical support and maintenance services. As a
percentage of subscription revenue, cost of subscription revenue increased to
45.6% in the three months ended August 31, 2000 from 40.3% in the three months
ended August 31, 1999. This increase was due to an increase in sales volumes in
the three months ended August 31, 2000. We expect the costs of subscription
revenue to decrease as a percentage of revenue in the future as sales volumes
increase.
Cost of services revenue
Cost of services revenue is primarily comprised of salaries and related costs
incurred for custom development, training and education, and hardware
certification services. We incur no direct costs related to royalties received
from the licensing of our trademarks to third parties. Cost of services revenue
increased 80.4% to $4.2 million in the three months ended August 31, 2000 from
$2.3 million in the three months ended August 31, 1999. This increase was
primarily due to the addition of personnel to provide custom development,
training and education, and hardware certification services, and the development
of our services organization. As a percentage of services revenue, cost of
services revenue increased to 53.6% in the three months ended August 31, 2000
from 51.0% in the three months ended August 31, 1999. This increase was
primarily due to cost of services revenue increasing at a higher rate than
services revenue.
We expect cost of services to increase as we further expand our service
offerings. Cost of services as a percentage of services revenue is expected to
vary significantly from period to period depending upon:
o the mix of services we provide;
o the number and scope of custom development contracts;
o whether such services are provided by us or third-party
partners and contractors;
o the overall utilization rate of our services staff; and
o the use of our redhat.com web site to deliver these services
Cost of web revenue
Cost of web revenue includes the cost of developing advertising on our web site.
Cost of web revenue decreased 71.2% to $58,000 in the three months ended August
31, 2000 from $0.2 million in the three months ended August 31, 1999. As a
percentage of web revenue, cost of web revenue decreased to 4.1% in the three
months ended August 31, 2000 from 192.1% in three months ended August 31, 1999.
These decreases were due to the development of our web advertising group and
initial expenses related to our offering of web advertising for the first time
during the fiscal year ended February 29, 2000.
16
<PAGE>
Gross Profit
Gross profit increased 123.7% to $10.7 million in the three months ended August
31, 2000 from $4.8 million in the three months ended August 31, 1999. As a
percentage of total revenue, gross profit increased to 57.8% in the three months
ended August 31, 2000 from 45.4% in the three months ended August 31, 1999.
These increases were primarily the result of the increases in sales of software
products, due to the release of Version 6.2 of Official Red Hat Linux in March
2000, and web advertisements which were at a higher proportion relative to the
associated cost of revenue. These revenue increases were partially offset by
increased costs of services resulting from the addition of personnel to provide
custom development, training and education, and hardware certification services,
and the development of our services organization.
Operating expense
Sales and marketing
Sales and marketing expense consists primarily of salaries and other related
costs for sales and marketing personnel, sales commissions, travel, public
relations and marketing materials and tradeshows. Sales and marketing expense
increased 72.4% to $8.5 million in the three months ended August 31, 2000 from
$4.9 million in the three months ended August 31, 1999. As a percentage of total
revenue, sales and marketing expense decreased to 45.9% in the three months
ended August 31, 2000 from 46.7% in the three months ended August 31, 1999. The
increase in sales and marketing expense was due primarily to higher advertising
and promotional costs incurred to promote the release of Version 6.2 of Official
Red Hat Linux, our web advertising and service offerings and, to a lesser
extent, our new software development tools. The increase was also due to higher
costs resulting from joint marketing arrangements with distributors. We expect
sales and marketing expense to continue to increase in dollar amount as we
promote the expansion of our services offerings and web site and expand our
international subscription operations.
Research and development
Research and development expense consists primarily of personnel and related
costs for development of our software products and web site. Research and
development expense increased 51.6% to $3.7 million in the three months ended
August 31, 2000 from $2.4 million in the three months ended August 31, 1999. As
a percentage of total revenue, research and development expense decreased to
19.9% in the three months ended August 31, 2000 from 23.0% in the three months
ended August 31, 1999. The increase in research and development expense resulted
from increased spending related to the development of our web initiatives and
costs incurred to complete the development of Version 6.2 of Official Red Hat
Linux, partially offset by a decrease in spending related to the development of
software development tools as these products were completed during the year
ended February 29, 2000. We expect research and development expense to continue
to increase in dollar amount as we continue to add content to our web site and
create additional features for Red Hat Linux.
General and administrative
General and administrative expense consists primarily of personnel and related
costs for general corporate functions, including finance, accounting, legal,
human resources, facilities and information systems expenses and merger and
acquisition costs. General and administrative expense increased 272.7% to $7.3
million in the three months ended August 31, 2000 from $2.0 million in the three
months ended August 31, 1999. This increase resulted from:
o an increase in merger and acquisition costs to $1.3 million in
the three months ended August 31, 2000 from zero in the three
months ended August 31, 1999. This increase was primarily due
to the number of acquisitions completed thus far in fiscal
2001. Merger and acquisition
17
<PAGE>
expense consists of costs incurred in connection with
investigating potential acquisitions, the cost of acquisitions
accounted for using the pooling of interests method of
accounting, and other one-time nonrecurring expenses.
o an increase in payroll costs due to an increase in the number
of general and administrative personnel to support the growth
of our business;
o an increase in legal and accounting costs due to our initial
public offering and our geographic expansion; and
o an increase in insurance costs as a result of our becoming a
public company.
As a percentage of total revenue, general and administrative expense increased
to 32.8% in the three months ended August 31, 2000 from 18.7% in the three
months ended August 31, 1999. We expect general and administrative expense to
continue to increase in dollar amount and decrease as a percentage of revenue as
we add administrative personnel to support our business expansion and continue
to incur costs related to our merger and acquisition activity.
Amortization of goodwill and intangibles
Amortization of goodwill and intangibles expense consists of the amortization of
goodwill and other intangible assets. Goodwill, which represents the excess of
acquisition cost over the net assets acquired in business combinations, is
amortized over its estimated useful life which is three years. Costs incurred
for acquiring trademarks, copyrights and patents are capitalized and amortized
using the straight line method over their estimated useful lives, which range
from 5 to 15 years. Amortization of goodwill and intangibles expense increased
to $9.0 million in the three months ended August 31, 2000 from $1,000 in the
three months ended August 31, 1999. As a percentage of total revenue,
amortization of goodwill and intangibles expense increased to 48.8% in the three
months ended August 31, 2000 from 0.0% in the three months ended August 31,
1999. These increases were primarily due to the acquisitions of HKS in January
2000, Bluecurve, Inc. in May 2000, and WireSpeed in July 2000.
Stock-based compensation
Stock-based compensation expense consists of the amortization of deferred
compensation related to stock options granted to employees, primarily new
members of our management team that were recruited immediately prior to our
initial public offering in August 1999, with an exercise price below the fair
market value of our common stock at the date of grant. Deferred compensation is
amortized over the vesting period of the related stock options, which is
generally four years. Stock-based compensation also includes the amortization of
deferred compensation related to the value of certain shares of common stock to
be issued to certain HKS shareholders contingent on their continued employment
with the Company for a period of three years after the date of acquisition, as
well as, the employer portions of tax liabilities paid upon exercise of
non-qualified stock options and warrants. Stock-based compensation expense
increased to $3.5 million in the three months ended August 31, 2000 from $0.6
million in the three months ended August 31, 1999. As a percentage of total
revenue, stock based compensation expense increased to 18.9% in the three months
ended August 31, 2000 from 5.6% in the three months ended August 31, 1999.
Stock-based compensation is expected to be approximately $13.5 million, $13.5
million, and $11.9 million in fiscal years 2001, 2002, and 2003, respectively.
Other income (expense), net
Other income (expense), net consists of interest income earned on cash deposited
in money market accounts and other short-term investments, net of interest
expense incurred on capital leases. Other income (expense), net increased to
income of $5.7 million in the three months ended August 31, 2000 from income of
$0.4 in the three months ended August 31, 1999. As a percentage of total
revenue, other income (expense), net increased to 30.6% in the three months
ended August 31, 2000 from 3.9% in the three months ended August 31, 1999. These
increases resulted from higher average cash and
18
<PAGE>
investment balances in the three months ended August 31, 2000 as compared to the
three months ended August 31, 1999 due primarily to the receipt of proceeds from
the sale of common stock in our initial and secondary public offerings in August
1999 and February 2000, respectively.
Provision for income taxes
Provision for income taxes decreased to $35,000 for the three months ended
August 31, 2000 from $140,000 in the three months ended August 31, 1999. The
decrease in provision for income taxes for the three months ended August 31,
2000 was primarily due to a decrease in our taxable income.
Accretion of mandatorily redeemable preferred stock
Accretion of mandatorily redeemable preferred stock decreased to zero in the
three months ended August 31, 2000 from $39,000 in the three months ended August
31, 1999. Accretion of mandatorily redeemable preferred stock ceased with the
completion of our initial public offering in August 1999 when all outstanding
mandatorily redeemable preferred stock converted to common stock.
Six Months Ended August 31, 2000 and August 31, 1999
Total revenue
Total revenue increased 83.9% to $34.5 million in the six months ended August
31, 2000 from $18.8 million in the six months ended August 31, 1999. Revenue
from international operations totaled $6.7 million during the six months ended
August 31, 2000. We established international operations for sale of our
software products in August 1999. Prior to August 1999, our international
revenue was limited to revenue generated from custom development services
performed for international customers.
Subscription revenue
Subscription revenue increased 74.3% to $17.8 million in the six months ended
August 31, 2000 from $10.2 million in the six months ended August 31, 1999. This
increase was primarily due to the release of Version 6.2 of Official Red Hat
Linux in March 2000 and an increase in technical support and maintenance revenue
as a result of our focus on providing these services beginning subsequent to
August 1999. As a percentage of total revenue, subscription revenue decreased to
51.5% in the six months ended August 31, 2000 from 54.4% in the six months ended
August 31, 1999. This decrease in subscription revenue as a percentage of total
revenue is primarily a result of the expansion of our web initiatives and the
growth in our services revenue.
Services revenue
Services revenue increased 67.9% to $14.1 million in the six months ended August
31, 2000 from $8.4 million in the six months ended August 31, 1999. The increase
in services revenue resulted primarily from an increase in custom development
revenue due to an increase in the number, size and scope of custom development
contracts and an increase in training and education revenue due to the expansion
of our course offerings in the six months ended August 31, 2000. As a percentage
of total revenue, services revenue decreased to 40.7% in the six months ended
August 31, 2000 from 44.6% in the six months ended August 31, 1999. The decrease
in services revenue as a percentage of total revenue is primarily a result of
the expansion of our web initiatives and the growth in our subscription revenue.
Web revenue
Web revenue increased to $2.7 million in the six months ended August 31, 2000
from $0.2 million in the six months ended August 31, 1999. As a percentage of
total revenue, web revenue increased to 7.7% in
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the six months ended August 31, 2000 from 1.0% in the six months ended August
31, 1999. These increases were due to the commencement of our web initiatives
during the fiscal year ending February 29, 2000. We expect web revenue to
increase as a percentage of revenue in the future as advertising revenue and
royalties from the sale of third-party products and products co-branded or
bundled with third-party products continues to grow.
Cost of revenue
Cost of subscription revenue
Cost of subscription revenue increased 32.4% to $7.2 million in the six months
ended August 31, 2000 from $5.5 million in the six months ended August 31, 1999.
This increase was directly related to the increase in costs to provide telephone
support and subscription services upon the release of Version 6.0 of Official
Red Hat Linux and the increase in sales volumes as a result of the release of
Version 6.2 of Official Red Hat Linux in March 2000 and costs incurred to
provide technical support and maintenance services. As a percentage of
subscription revenue, cost of subscription revenue decreased to 40.7% in the six
months ended August 31, 2000 from 53.6% in the six months ended August 31, 1999.
This decrease was due to an increase in sales volumes, which resulted in a
decrease in cost per unit, and use of the internet as a delivery mechanism for
the technical support and maintenance of our products in the six months ended
August 31, 2000. We expect the costs of subscription revenue to continue to
decrease as a percentage of revenue in the future as sales volumes increase.
Cost of services revenue
Cost of services revenue increased 98.6% to $7.8 million in the six months ended
August 31, 2000 from $3.9 million in the six months ended August 31, 1999. This
increase was primarily due to the addition of personnel to provide custom
development, training and education, and hardware certification services, and
the development of our services organization. As a percentage of services
revenue, cost of services revenue increased to 55.6% in the six months ended
August 31, 2000 from 47.0% in the six months ended August 31, 1999. This
increase was primarily due to cost of services revenue increasing at a higher
rate than services revenue.
We expect cost of services to increase as we further expand our service
offerings. Cost of services as a percentage of services revenue is expected to
vary significantly from period to period depending upon:
o the mix of services we provide;
o the number and scope of custom development contracts;
o whether such services are provided by us or third-party
partners and contractors;
o the overall utilization rate of our services staff; and
o the use of our redhat.com web site to deliver these services
Cost of web revenue
Cost of web revenue decreased 63.3% to $0.1 million in the six months ended
August 31, 2000 from $0.3 million in the six months ended August 31, 1999. As a
percentage of web revenue, cost of web revenue decreased to 4.5% in the six
months ended August 31, 2000 from 175.5% in six months ended August 31, 1999.
These decreases were due to the development of our web advertising group and
initial expenses related to our offering of web advertising for the first time
during the six months ended August 31, 1999.
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Gross Profit
Gross profit increased 114.0% to $19.3 million in the six months ended August
31, 2000 from $9.0 million in the six months ended August 31, 1999. As a
percentage of total revenue, gross profit increased to 56.0% in the six months
ended August 31, 2000 from 48.2% in the six months ended August 31, 1999. These
increases were primarily the result of the increases in sales of software
products, due to the release of Version 6.2 of Official Red Hat Linux in March
2000, and web advertisements which were at a higher proportion relative to the
associated cost of revenue. These revenue increases were partially offset by
increased costs of services resulting from the addition of personnel to provide
custom development, training and education, and hardware certification services,
and the development of our services organization.
Operating expense
Sales and marketing
Sales and marketing expense increased 107.5% to $18.0 million in the six months
ended August 31, 2000 from $8.7 million in the six months ended August 31, 1999.
As a percentage of total revenue, sales and marketing expense increased to 52.1%
in the six months ended August 31, 2000 from 46.2% in the six months ended
August 31, 1999. These increases were due primarily to higher advertising and
promotional costs incurred to promote the release of Version 6.2 of Official Red
Hat Linux, our web advertising and service offerings and, to a lesser extent,
our new software development tools. These increases were also due to higher
costs resulting from joint marketing arrangements with distributors. We expect
sales and marketing expense to continue to increase in dollar amount as we
promote the expansion of our services offerings and web site and expand our
international subscription operations.
Research and development
Research and development expense increased 44.5% to $6.9 million in the six
months ended August 31, 2000 from $4.8 million in the six months ended August
31, 1999. As a percentage of total revenue, research and development expense
decreased to 20.1% in the six months ended August 31, 2000 from 25.6% in the six
months ended August 31, 1999. The increase in research and development expense
resulted from increased spending related to the development of our web
initiatives and costs incurred to complete the development of Version 6.2 of
Official Red Hat Linux, partially offset by a decrease in spending related to
the development of software development tools as these products were completed
during the year ended February 29, 2000. We expect research and development
expense to continue to increase in dollar amount as we continue to add content
to our web site and create additional features for Red Hat Linux.
General and administrative
General and administrative expense increased 262.8% to $14.5 million in the six
months ended August 31, 2000 from $4.0 million in the six months ended August
31, 1999. This increase resulted from:
o an increase in merger and acquisition costs to $4.6 million in
the six months ended August 31, 2000 from zero in the six
months ended August 31, 1999. This increase was primarily due
to the number of acquisitions completed thus far in fiscal
2001.
o an increase in payroll costs due to an increase in the number
of general and administrative personnel to support the growth
of our business;
o an increase in legal and accounting costs due to our initial
public offering in August 1999 and our geographic expansion;
and
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o an increase in insurance costs as a result of our becoming a
public company.
As a percentage of total revenue, general and administrative expense increased
to 28.5% in the six months ended August 31, 2000 from 21.3% in the six months
ended August 31, 1999.
Amortization of goodwill and intangibles
Amortization of goodwill and intangibles expense increased to $14.2 million in
the six months ended August 31, 2000 from $3,000 in the six months ended August
31, 1999. As a percentage of total revenue, amortization of goodwill and
intangibles expense increased to 41.3% in the six months ended August 31, 2000
from 0.0% in the six months ended August 31, 1999. These increases were
primarily due to the acquisitions of HKS in January 2000, Bluecurve, Inc. in May
2000, and WireSpeed in July 2000.
Stock-based compensation
Stock-based compensation expense increased to $7.2 million in the six months
ended August 31, 2000 from $1.0 million in the six months ended August 31, 1999.
As a percentage of total revenue, stock based compensation expense increased to
20.9% in the six months ended August 31, 2000 from 5.1% in the six months ended
August 31, 1999. Stock-based compensation is expected to be approximately $13.5
million, $13.5 million, and $11.9 million in fiscal years 2001, 2002, and 2003,
respectively.
Other income (expense), net
Other income (expense), net consists of interest income earned on cash deposited
in money market accounts and other short-term investments, net of interest
expense incurred on capital leases. Other income (expense), net increased to
income of $11.1 million in the six months ended August 31, 2000 from income of
$0.6 in the six months ended August 31, 1999. As a percentage of total revenue,
other income (expense), net increased to 32.0% in the six months ended August
31, 2000 from 3.4% in the six months ended August 31, 1999. These increases
resulted from higher average cash and investment balances in the six months
ended August 31, 2000 as compared to the six months ended August 31, 1999 due
primarily to the receipt of proceeds from the sale of common stock in our
initial and secondary public offerings in August 1999 and February 2000,
respectively.
Provision for income taxes
Provision for income taxes decreased to $99,000 for the six months ended August
31, 2000 from $0.2 million in the six months ended August 31, 1999. The decrease
in provision for income taxes for the six months ended August 31, 2000 was
primarily due to a decrease in our taxable income.
Accretion of mandatorily redeemable preferred stock
Accretion of mandatorily redeemable preferred stock decreased to zero in the six
months ended August 31, 2000 from $83,000 in the six months ended August 31,
1999. Accretion of mandatorily redeemable preferred stock ceased with the
completion of our initial public offering in August 1999 when all outstanding
mandatorily redeemable preferred stock converted to common stock.
Historical Liquidity and Capital Resources
We have historically derived a significant portion of our liquidity and
operating capital from the sale of equity securities, including private sales of
preferred stock and the sale of common stock in our initial
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and secondary public offerings, and from cash flows from operations.
At August 31, 2000, cash and cash equivalents totaled $108.2 million, a decrease
of $134.2 million as compared to February 29, 2000. The decrease in cash and
cash equivalents resulted from the purchase of net investments in debt and
equity securities of $111.7 million, cash used by operations of $18.6 million
during the six months ended August 31, 2000, $6.7 million for the purchase of
office and computer equipment, and repayment of notes payable of $0.5 million.
This was partially offset by the receipt of $3.7 million in proceeds from
exercise of stock options and warrants during the six months ended August 31,
2000.
Cash used by operations of $18.6 million in the six months ended August 31,
2000, represented the net loss of $30.6 million, an increase in accounts
receivable of $8.3 million, an increase in intangibles and other assets of $3.1
million, and a decrease in accounts payable of $6.9 million, partially offset by
an increase in accrued expenses of $6.0 million, a decrease in deferred revenue
of $0.7 million, and net non cash charges of $24.1 million. The increase in
accounts receivable, accrued expenses and deferred revenue resulted primarily
from the release of Version 6.2 of Official Red Hat Linux to our distributors in
March 2000.
Cash used in investing activities for the six months ended August 31, 2000 was
comprised of the purchase of investments in debt securities, net of maturities,
of $111.7 million, and purchases of property and equipment totaling $6.7
million.
Cash from financing activities of $3.3 million for the six months ended August
31, 2000 was primarily comprised of $3.7 million in proceeds from the exercise
of stock options and warrants and repayment of notes payable of $0.5 million.
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Recent Developments
On September 5, 2000, the Company completed its acquisition of all of the
outstanding capital stock and assumed all of the outstanding stock options of
C2Net Software, Inc. ("C2Net"). At closing, Red Hat issued 974,567 shares of the
Company's Stock and reserved 1,018,276 shares for issuance upon exercise of
assumed options. C2Net is the developer of the Apache-based Stronghold (R)
secure web server. The acquisition will be accounted for using the purchase
method of accounting. Accordingly, a portion of the purchase price will be
allocated to net tangible and intangible assets acquired based on their
estimated fair market values. The balance of the purchase price will be recorded
as goodwill.
Recent Accounting Pronouncements
In June 1998, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standards No. 133, "Accounting for Derivative Instruments
and Hedging Activities". This statement establishes accounting and reporting
standards for derivative instruments, including certain derivative instruments
embedded in other contracts, and for hedging activities. Statement of Financial
Accounting Standards No. 133 as amended by Statement of Financial Accounting
Standards No. 137, is effective for all fiscal quarters of all fiscal years
beginning after June 15, 2000, with earlier application encouraged. We do not
currently, nor do we intend in the future, to use derivative instruments and
therefore do not expect that the adoption of Statement of Financial Accounting
Standards No. 133 will have any impact on our financial position or results of
operations.
In December 1998, the Accounting Standards Executive Committee of the American
Institute of Certified Public Accountants issued Statement of Position No. 98-9,
"Modification of Statement of Position No. 97-2, Software Revenue Recognition,
with Respect to Certain Transactions". Statement of Position No. 98-9 amends
Statement of Position No. 97-2 to require recognition of revenue using the
"residual method" in circumstances outlined in Statement of Position No. 98-9.
Under the residual method, revenue is recognized as follows:
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o 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
o the difference between the total arrangement fee and the
amount deferred for the undelivered elements is recognized as
revenue related to the delivered elements.
Statement of Position No. 98-9 is effective for transactions entered into in
fiscal years beginning after March 15, 1999. Also, the provisions of Statement
of Position No. 97-2 that were deferred by Statement of Position No. 98-4 will
continue to be deferred until the date Statement of Position No. 98-9 becomes
effective. We do not expect that the adoption of Statement of Position No. 98-9
will have any impact on our financial position or results of operations.
In December 1999, the Securities and Exchange Commission issued Staff Accounting
Bulletin No. 101, "Revenue Recognition in Financial Statements" ("SAB 101")
which addresses certain criteria for revenue recognition. SAB 101, as amended by
SAB 101A and SAB 101B, outlines the criteria that must be met to recognize
revenue and provides guidance for disclosures related to revenue recognition
policies. The adoption of SAB 101 is not expected to have a material impact on
the consolidated financial position or results of operation.
Year 2000 Compliance
Year 2000 Readiness Disclosure
By the end of 1999, we had evaluated our Year 2000 readiness in preparation for
issues that could result from computer programs being written using two digits
to define the applicable year rather than four to define the applicable year and
century. We believe that we were prepared for the transition to the Year 2000
and did not experience any significant Year 2000 problems with respect to our
products, third party products that we bundle with official Red Hat Linux or our
internal management information systems or other systems, applications or
infrastructure.
Since January 1, 2000, our internal management information systems and
non-information systems have functioned properly. In addition, we have not
experienced any material Year 2000 issues related to our interaction with third
parties. We have not experienced any material disruption in our ability to
provide our products and services to our customers, collect payments or report
accurate data to management or any other business interruptions due to Year 2000
issues. While we will continue to monitor our products and systems and those of
third parties with whom we have material business relationships to ensure that
no unexpected Year 2000 issues develop, we have no reason to expect any of these
issues.
Factors Affecting Future Results
FORWARD-LOOKING STATEMENTS IN THIS QUARTERLY REPORT ON FORM 10-Q ARE MADE
PURSUANT TO THE SAFE HARBOR PROVISIONS OF SECTION 21E OF THE SECURITIES EXCHANGE
ACT OF 1934. INVESTORS ARE CAUTIONED THAT STATEMENTS IN THIS QUARTERLY REPORT ON
FORM 10-Q THAT ARE NOT STRICTLY HISTORICAL STATEMENTS, INCLUDING, WITHOUT
LIMITATION, STATEMENTS REGARDING CURRENT OR FUTURE FINANCIAL PERFORMANCE,
MANAGEMENT'S PLANS AND OBJECTIVES FOR FUTURE OPERATIONS, PRODUCT PLANS AND
PERFORMANCE, MANAGEMENT'S ASSESSMENT OF MARKET FACTORS, AND STATEMENTS REGARDING
THE STRATEGY AND PLANS OF RED HAT AND ITS STRATEGIC PARTNERS, CONSTITUTE
FORWARD-LOOKING STATEMENTS. THESE
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FORWARD-LOOKING STATEMENTS ARE NOT GUARANTEES OF RED HAT'S FUTURE PERFORMANCE
AND ARE SUBJECT TO A NUMBER OF RISKS AND UNCERTAINTIES THAT COULD CAUSE RED
HAT'S ACTUAL RESULTS IN THE FUTURE MATERIALLY TO DIFFER FROM THE FORWARD-LOOKING
STATEMENTS. THESE RISKS AND UNCERTAINTIES INCLUDE, WITHOUT LIMITATION, THE RISKS
DETAILED BELOW AND IN RED HAT'S OTHER FILINGS WITH THE SECURITIES AND EXCHANGE
COMMISSION, COPIES OF WHICH MAY BE ASSESSED THROUGH THE SEC'S WEB SITE AT
HTTP://WWW.SEC.GOV.
Risks Related to our Linux-based Open Source Business Model
Our open source software business model is unproven
We have not demonstrated the success of our open source business model, which
gives our customers the right to freely copy and distribute our software. No
other company has built a successful open source business. Few open source
software products have gained widespread commercial acceptance partly due to the
lack of viable open source industry participants to offer adequate service and
support on a long term basis. In addition, open source vendors are not able to
provide industry standard warranties and indemnities for their products, since
these products have been developed largely by independent parties over whom open
source vendors exercise no control or supervision. If open source software
should fail to gain widespread commercial acceptance, we would not be able to
sustain our revenue growth and our business could fail.
We depend on the support of Linus Torvalds and other prominent Linux developers
to release major product upgrades and maintain market share
We may not be able to release major product upgrades of Red Hat Linux on a
timely basis because the heart of Red Hat Linux, the Linux kernel, is maintained
by third parties. Linus Torvalds, the original developer of the Linux kernel,
and a small group of independent engineers are primarily responsible for the
development and evolution of the Linux kernel. If this group of developers fails
to further develop the Linux kernel or if Mr. Torvalds or other prominent Linux
developers, such as Alan Cox, David Miller or Stephen Tweedie, were to join one
of our competitors or no longer work on the Linux kernel, we will have to either
rely on another party to further develop the kernel or develop it ourselves. We
cannot predict whether enhancements to the kernel would be available from
reliable alternative sources. We could be forced to rely to a greater extent on
our own development efforts, which would increase our development expenses and
may delay our product release and upgrade schedules. In addition, any failure on
the part of the kernel developers to further develop and enhance the kernel
could stifle the development of additional Linux-based applications.
We may not be able to effectively assemble and test our software because it
consists largely of code developed by independent third parties over whom we
exercise no control, which could result in unreliable products and damage to our
reputation
Red Hat Linux, in compressed form, consists of approximately 546 megabytes of
code. Of that total, approximately 500 megabytes have been developed by
independent third parties, including approximately 10 megabytes of code
contained in the Linux kernel. Included within the 546 megabytes of code are
approximately 700 distinct software components developed by thousands of
individual programmers which we must assemble and test before we can release a
new version of Red Hat Linux. If these components are not reliable, Red Hat
Linux could fail, resulting in serious damage to our reputation and potential
litigation. Although we attempt to assemble only the best available components,
we cannot be sure that we will be able to identify the highest quality and most
reliable components or successfully assemble and test them. In addition, if
these components were no longer available, we would have to develop them
ourselves, which would significantly increase our development expenses.
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The scarcity of software applications for Linux-based operating systems could
prevent commercial adoption of our products
Our products will not gain widespread commercial adoption until there are more
third-party software applications designed to operate on Linux-based operating
systems. These applications include word processors, databases, accounting
packages, spreadsheets, e-mail programs, Internet browsers, presentation and
graphics software and personal productivity applications. We intend to encourage
the development of additional applications that operate on Linux-based operating
systems by attracting third-party developers to the Linux platform, by providing
open source tools to create these applications and by maintaining our existing
developer relationships through marketing and technical support for third-party
developers. If we are not successful in achieving these goals, however, our
products will not gain widespread commercial acceptance and we will not be able
to maintain our product sales growth.
We may not be able to generate revenue from sales of Official Red Hat Linux if
users can more quickly download it from the Internet
Anyone can download a free copy of Red Hat Linux from the Internet. However,
because this download can take up to 36 hours using a standard telephone
connection, many of our users choose to buy the shrink-wrapped version of
Official Red Hat Linux. If hardware and data transmission technology advances in
the future to the point where increased bandwidth allows users to more quickly
download our products from the Internet, users may no longer choose to purchase
Official Red Hat Linux. This could lead to a significant loss of product
revenue.
We may not succeed in shifting our business focus from traditional shrink-
wrapped software sales to offering subscription-based product and services
offerings
We are focusing our sales and marketing efforts on providing subscription-based
products and services as opposed to relying on sales of shrink-wrapped software.
This change has required us to expend significant financial and managerial
resources and may ultimately prove unsuccessful. The failure to successfully
implement this transition of our sales model could materially adversely affect
our operating results.
Our customers may find it difficult to install and implement Red Hat Linux,
which could lead to customer dissatisfaction and damage our reputation
Installation and implementation of Red Hat Linux often involves a significant
commitment of resources, financial and otherwise, by our customers. This process
can be lengthy due to the size and complexity of our products and the need to
purchase and install new applications. The failure by us to attract and retain
services personnel to support our customers, the failure of companies with which
we have strategic alliances to commit sufficient resources towards the
installation and implementation of our products, or a delay in implementation
for any other reason could result in dissatisfied customers. This could damage
our reputation and the Red Hat brand and result in decreased revenue.
We may be unable to predict the future course of open source technology
development, which could reduce the market appeal of our products and damage our
reputation
We do not exercise control over many aspects of the development of open source
technology. Historically, different groups of open source software programmers
have competed with each other to develop new technology. Typically one of those
groups develops the technology that becomes more widely used than that developed
by others. If we adopt new technology and incorporate it into our products, and
competing technology becomes more widely used, the market appeal of our products
may be reduced, which could harm our reputation, diminish the Red Hat brand and
result in decreased revenue.
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Risks Related to our Financial Results and Condition
Our limited operating history in the new and developing market for Linux-based
operating systems makes it difficult to evaluate our business
Red Hat was formed in March 1993. We began offering Red Hat Linux in October
1994. Our limited operating history makes it difficult to evaluate the risks and
uncertainties that we face. Our failure to address these risks and uncertainties
could cause our business results to suffer and result in the loss of all or part
of your investment.
We have limited combined operating history with the companies we have acquired
since our initial public offering and may have difficulty integrating these
businesses
The successful integration of the operations, products, services and personnel
of Red Hat and the five companies we have acquired since our initial public
offering -- Cygnus Solutions, Hell's Kitchen Systems, Inc., Bluecurve, Inc.,
WireSpeed Communications Corporation and C2Net Software, Inc. -- is important to
the future financial performance of the combined enterprise. The anticipated
benefits of these acquisitions may not be achieved unless, among other things,
the operations, products, services and personnel of the acquired companies are
successfully combined with those of Red Hat in a timely and efficient manner.
Integration of these companies' operations, products, services and personnel may
be hampered because, among other things:
o the products and services offered by each of the acquired companies and
Red Hat are highly complex and have been developed independently;
o integration of the product lines of Red Hat and each of the acquired
companies will require the coordination of separate development and
engineering teams from each company; and
o the employees and management of the acquired companies and Red Hat are
located in disparate geographical regions.
In addition, the costs associated with integrating these companies' operations,
products, services and personnel may be substantial and could include, among
other things:
o employee redeployment or relocation; and
o the combination of research and development teams and processes.
Any of these difficulties and costs encountered in the transition process, could
divert the attention of management, and could have an adverse impact on the
revenues and operating results of the combined enterprise.
We expect to incur substantial losses for the foreseeable future
We have incurred operating losses in five of our previous six fiscal years,
including our most recent fiscal year ended February 29, 2000. We expect to
incur significant losses for the foreseeable future, as we substantially
increase our sales and marketing, research and development and administrative
expenses. In addition, we are investing considerable resources in our web
initiative and to expand our professional services offerings. As a result, we
cannot be certain when or if we will achieve sustained profitability. Failure to
become and remain profitable may adversely affect the market price of our common
stock and our ability to raise capital and continue operations.
You should not rely on our quarterly results of operations as an indication of
our future results because they fluctuate significantly and are difficult to
forecast
Due to our limited combined operating history and the unpredictability of our
business, our revenue and operating results may fluctuate significantly from
quarter to quarter and are difficult to forecast. We base
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our current and projected future expense levels in part on our estimates of
future revenue. Our expenses are, to a large extent, fixed in the short term. We
may not be able to adjust our spending quickly if our revenue falls short of our
expectations. Accordingly, a revenue shortfall in a particular quarter would
have a disproportionate adverse effect on our operating results for that
quarter. You should not rely on quarter-to-quarter comparisons of our results of
operations as an indication of our future performance. Our future operating
results may fall below expectations of securities analysts or investors, which
would likely cause the market price of our common stock to decline
significantly.
We may not be able to effectively attract additional enterprise customers and
preserve relationships with current enterprise customers, which could adversely
affect revenue
Historically, we focused our sales and marketing efforts on product sales to
individuals. We have recently, however, begun to focus our efforts on expanding
our enterprise customer base. To this end, we have invested extensively to
attract enterprise customers. In addition, we have gained a significant number
of enterprise customers through our acquisition of Cygnus Solutions. These
enterprise customers expect diverse and extensive service programs, and if we
are unable to continue to successfully expand and enhance our service offerings,
we may not be able to meet these customers' needs or attract new customers, and,
consequently, our revenue would suffer.
Our failure to update and modernize our internal systems, procedures and
controls may prevent the implementation of our business strategies in a rapidly
evolving market and may retard our future growth
Our operational and financial systems, procedures and controls, which were
adequate for a small private company, are becoming outdated as we grow. Since
March 1, 1999 we have increased the number of employees more than tenfold. To
accommodate this growth, we have evaluated our financial and operational
systems, procedures and controls. Although we have revised or are in the process
of revising and updating most of them, if we continue our rapid growth, we may
not be able to improve our transaction processing and reporting systems and
procedures, or expand and train our expanding workforce quickly enough to
maintain a competitive position in our markets. In addition, failure to quickly
replace obsolete systems, procedures and controls could impede our management's
decision-making abilities. This, in turn, may impair our ability to pursue
business opportunities and may hamper future growth.
We may not be able to generate enough additional revenue from our international
expansion to offset the costs associated with establishing and maintaining
foreign operations
A key component of our growth strategy is to expand our presence in foreign
markets. We have recently established subsidiaries or offices in Canada,
Ireland, the United Kingdom, Germany, Italy, Japan, France, Singapore and
Australia, and are considering further expansion worldwide. We may also enter
other markets as opportunities arise. It will be costly to establish
international facilities and operations, promote our brand internationally, and
develop localized web sites and other systems. Revenue from international
activities may not offset the expense of establishing and maintaining these
foreign operations. In addition, because we have little experience in marketing
and distributing products or services for these markets, we may not benefit from
any first-to-market advantages.
Our management team may not be able to successfully implement our business
strategies because it has only recently begun to work together
Our business is highly dependent on the ability of our management to work
together effectively to meet the demands of our growth. Several members of our
senior management have been employed by us for a relatively short period of
time. These individuals have not previously worked together as a management
team. In addition, the members of our management team who have been with us
since 1997 or earlier have had only limited experience managing a rapidly
growing company on either a public or private basis. The failure of our
management team to work together effectively could prevent efficient decision-
making by our executive team, affecting product development and sales and
marketing efforts,
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<PAGE>
which would negatively impact our operating results.
We depend on our key personnel
Our future success depends on the continued services of a number of key
directors and officers, including our Chairman, Robert Young, our Chief
Executive Officer and President, Matthew Szulik, and our Chief Operating
Officer, Tim Buckley. The loss of the technical knowledge and industry expertise
of any of these people could seriously impede our success. Moreover, the loss of
one or a group of our key employees, particularly to a competitor, and any
resulting loss of customers could reduce our market share and diminish the Red
Hat brand.
We may lack the financial and operational resources needed to increase our
market share and compete effectively with Microsoft, other established operating
systems developers, software development tools developers and other service and
support providers
In the market for operating systems, we face significant competition from larger
companies with greater financial resources and name recognition than we have.
These competitors, which offer hardware-independent multi-user operating systems
for Intel platforms and/or UNIX-based operating systems, include Microsoft,
Novell, IBM, Sun Microsystems, The Santa Cruz Operation, AT&T, Compaq, Hewlett-
Packard, Olivetti and Unisys. Some of these competitors currently, or may in the
future, produce and market open source operating systems.
With our acquisition of Cygnus, we now face competition in the market for
software development tools and operating systems for special purpose computing.
Our competitors in this market, some of which have greater market share than we
do, include Wind River Systems, Integrated Systems Incorporated, Green Hills
Software, and the Metrowerks subsidiary of Motorola. Some of these companies
currently produce or use open source software as part of their product
offerings. We may not be able to compete effectively in this market if customers
choose proprietary solutions. If the demand for open source solutions in this
market expands, however, we could lose market share as existing competitors
reposition or new companies emerge to address the opportunity.
As we increase our services offerings, we may face competition from larger and
more capable companies that currently service and support other operating
systems, particularly UNIX-based operating systems, due to the fact that Linux-
and UNIX-based operating systems share many common features. These companies may
be able to leverage their existing service organizations and provide higher
levels of support on a more cost-effective basis than we can. We may not be able
to compete successfully with these current or potential competitors.
We may not be able to match the promotional activities and pricing policies
offered by other suppliers of Linux-based and other open source operating
systems, which could result in a loss of market share
In the new and rapidly-evolving market for Linux-based operating systems, we
face intense competition from a number of other suppliers of Linux-based
operating systems. We also face competition to a lesser extent from developers
of non-Linux-based open source operating systems such as BSD-based operating
systems. BSD-based operating systems such as FreeBSD, NetBSD and OpenBSD are
open source operating systems produced by communities of developers working
together via the Internet, and which are published and distributed by Walnut
Creek CD-ROM, among others. We expect competition in broader open source
operating systems and the Linux-based operating systems market to intensify. In
addition, companies like Sun Microsystems and Corel, which are more established
and have larger customer bases than we do, have indicated a growing interest in
the market for Linux-based operating systems. These companies may be able to
undertake more extensive promotional activities, adopt more aggressive pricing
policies, and offer more attractive terms to their customers than we can.
Furthermore, because Linux-based operating systems can be downloaded from the
Internet for free or purchased at a nominal cost and modified and re-sold with
few restrictions, traditional barriers to entry are minimal. Accordingly, it is
possible that new competitors or alliances among existing competitors may emerge
and
30
<PAGE>
rapidly acquire significant market share.
If we fail to establish and maintain strategic distribution and other
collaborative relationships with industry-leading companies, we may not be able
to attract and retain a larger customer base
Our success depends on our ability to continue to establish and maintain
strategic distribution and other collaborative relationships with industry-
leading hardware manufacturers, distributors, software vendors and enterprise
solutions providers. These relationships allow us to offer our products and
services to a much larger customer base than we would otherwise be able to
through our direct sales and marketing efforts. We may not be able to maintain
these relationships or replace them on attractive terms. In addition, our
existing strategic relationships do not, and any future strategic relationships
may not, afford us any exclusive marketing or distribution rights. As a result,
the companies with which we have strategic alliances are free to pursue
alternative technologies and to develop alternative products and services in
addition to or in lieu of our products and services, either on their own or in
collaboration with others, including our competitors. Moreover, we cannot
guarantee that the companies with which we have strategic relationships will
market our products effectively or continue to devote the resources necessary to
provide us with effective sales, marketing and technical support.
We may not be able to meet the operational and financial challenges that we will
encounter as our international operations expand
As we expand our international operations, we will face a number of additional
challenges associated with the conduct of business overseas. For example:
o we may have difficulty managing and administering a globally-dispersed
business;
o fluctuations in exchange rates may negatively affect our operating
results;
o we may not be able to repatriate the earnings of our foreign
operations;
o we have to comply with a wide variety of foreign laws with which we are
not familiar;
o 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;
o 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;
o export controls could prevent us from shipping our products into and
from some markets;
o multiple and possibly overlapping tax structures could significantly
reduce the financial performance of our foreign operations;
o 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
o 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.
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<PAGE>
Expanding our services business will be costly and may not result in any benefit
to us
We have expanded our strategic focus to place additional emphasis on consulting,
custom engineering and development, education and support services, from which
we have historically derived an insignificant amount of revenue. We cannot be
certain that our customers will engage our professional services organization to
assist with support, consulting, custom development, training and implementation
of our products. We also cannot be certain that we can attract or retain a
sufficient number of the highly qualified services personnel that the expansion
of our services business will need. In addition, this expansion has required,
and will continue to require, significant additional expenses and development,
financial and operational resources. The need for these additional resources
will place further strain on our management, financial and operational resources
and may make it more difficult for us to achieve and maintain profitability.
Attempts to expand by means of business combinations and strategic alliances may
not be successful and may harm our operational efficiency, financial performance
and relationships with employees and third parties
We may continue to expand our operations or market presence by entering into
additional business combinations, investments, joint ventures or other strategic
alliances with hardware manufacturers, software vendors, Internet companies,
open source software developers or other companies both in the United States and
internationally. Our ability to expand in this way may be limited due to the
many financial and operational risks accompanying these transactions. For
example:
o we may have difficulty assimilating the operations, technology and
personnel of the combined companies;
o our business may be disrupted by the allocation of resources to
consummate these transactions;
o we may have problems retaining key technical and managerial personnel
from acquired companies;
o we may experience one-time in-process research and development charges
and ongoing expenses associated with amortization of goodwill and other
purchased intangible assets;
o our stockholders will suffer dilution if we issue equity to fund these
transactions;
o acquired businesses may initially be unprofitable resulting in our
assumption of operating losses and increased expenses;
o our reputation may be harmed if the open source development community
does not approve of these transactions;
o our relationships with existing employees, customers and business
partners may be weakened or terminated as a result of these
transactions; and
o our investment activities, particularly with respect to emerging-growth
technology companies, are inherently risky and we may not realize any
benefit from such activities.
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<PAGE>
Risks Related to our Internet Strategy
We may fail to promote and enhance our web site effectively, which may prevent
us from attracting new visitors, advertisers or electronic commerce partners to
our web site
Enhancing the redhat.com web site is critical to our ability to increase our
revenue. In order to attract and retain Internet users, advertisers and
electronic commerce partners, we intend to substantially increase our
expenditures for enhancing and further developing our web site. Our success in
promoting and enhancing the redhat.com web site will also depend on our ability
to provide high quality content, features and functionality. If we fail to
promote our web site successfully or if visitors to our web site or advertisers
do not perceive our services to be useful, current or of high quality, our
ability to generate revenue from our web site will be significantly impaired.
Visitors to our web site could experience delays and decreased performance
during periods of heavy traffic, which could result in dissatisfaction with our
web site and damage to our reputation
Our web site must accommodate a high volume of traffic and deliver frequently
updated information. Our web site has in the past experienced slower response
times or decreased traffic for a variety of reasons. These occurrences have not
had a material impact on our business. These types of occurrences in the future,
however, could materially adversely affect our reputation and brand name and
could cause users to perceive our web site as not functioning properly. Under
these circumstances, our users might choose another web site or other methods to
obtain Linux-based operating systems or Linux-related information.
Because there is no industry standard for the measurement of the effectiveness
of Internet advertising, advertisers may not increase or even maintain their
current levels of Internet advertising, which would prevent us from generating a
significant amount of revenue from our web site
As we execute our Internet strategy, we expect to derive an increasing
percentage of our revenue from sponsorships and advertising on our web site. We
may not generate these revenues if advertisers do not maintain or increase their
current levels of Internet advertising. As there is no industry standard for the
measurement of the effectiveness of Internet advertising, advertisers that
currently advertise on the Internet may reduce or eliminate this form of
advertising and advertisers that have traditionally relied upon other
advertising media may be reluctant to begin to advertise on the Internet.
Moreover, widespread adoption of currently available software programs that
limit or prevent advertisements from being delivered to an Internet user's
computer would negatively affect the commercial viability of Internet
advertising and would further deter advertisers from increasing or maintaining
current levels of Internet advertising. Our ability to successfully execute our
Internet strategy will be adversely affected if the market for Internet
advertising fails to develop or develops more slowly than expected.
We may not be able to respond quickly to new pricing models for advertising,
which could prevent us from attracting quality sponsors to our web site
Different pricing models are used to sell advertising on the Internet. It is
difficult to predict which, if any, will emerge as the industry standard. If we
cannot quickly and successfully respond to changes in pricing models for
Internet advertising, or identify and adopt any industry standards that may
emerge, we will not be able to attract a sufficient number of quality sponsors
and our Internet advertising strategy will fail.
We may be unable to adequately measure the demographics of visitors to our web
site, which is critical to our ability to attract advertising revenue
We expect that it will be important to our advertisers that we accurately
measure the demographics of the visitors to our web site. While we have not
committed significant resources to the measurement of demographics to date, we
are currently implementing systems designed to record demographic data on our
web site's visitors. This implementation may be costly, and if not done
effectively, may not permit us to accurately measure the demographic
characteristics of our web site's visitors. Until these new systems are
functional, we will continue to rely on third parties to provide some of these
measurement services. If these parties were unable to provide these services, we
would need to obtain them from
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other providers, which might not be readily available. Companies may choose not
to advertise on our web site or may pay less for advertising if they do not
perceive our measurements or measurements made by third parties to be reliable.
Our Internet strategy will fail if the infrastructure of the Internet is not
continually developed and maintained
The success of our Internet strategy will depend in large part on the continued
development and maintenance of the infrastructure of the Internet. Because
global commerce and the online exchange of information is new and evolving, we
cannot predict with any certainty that the Internet will be a viable commercial
marketplace in the long term. The Internet has experienced, and we expect it to
continue to experience, significant growth in the number of users and amount of
traffic. If the Internet continues to experience an increased number of users,
frequency of use or increased bandwidth requirements of users, it may not be
able to support the demands placed upon it by this growth, and its performance
and reliability may suffer. Furthermore, the Internet has experienced a variety
of outages and other delays as a result of damage to portions of its
infrastructure, and could face similar outages and delays in the future. Any
outage or delay could affect the level of Internet usage, as well as the volume
of traffic on our web site. In addition, the Internet could lose its viability
due to increased governmental regulation and delays in the development or
adoption of new standards and protocols to handle increased levels of activity.
If the necessary infrastructure, standards or protocols or complementary
products, services or facilities are not developed, or if the Internet does not
become a viable commercial marketplace, our Internet strategy will not succeed.
We are vulnerable to unexpected network interruptions caused by system failures,
which may result in reduced visitor traffic on our web site, decreased revenue
and harm to our reputation
Substantially all of our communications hardware and other hardware related to
our web site is located at our facilities, although we have back-up and co-
location hardware for our web site located at third-party facilities. Fire,
floods, hurricanes, tornadoes, earthquakes, power loss, telecommunications
failures, break-ins and similar events could damage these systems. In addition,
although we have implemented network security measures, our servers are
vulnerable to computer viruses, electronic break-ins, human error and other
similar disruptive problems which could adversely affect our systems and web
site. Although we try to prevent unauthorized access to our systems, we cannot
eliminate this risk entirely. We could lose revenue and suffer damage to our
reputation if our systems were affected by any of these occurrences. Our
insurance policies may not adequately compensate us for any losses that may
occur due to failures or interruptions in our systems. We do not presently have
any secondary "off-site" systems or a formal disaster recovery plan.
Risks Related to Legal Uncertainty
We could be prevented from selling or developing our products if the GNU General
Public License and similar licenses under which our products are developed and
licensed are not enforceable
The Linux kernel and the Red Hat Linux operating system have been developed and
licensed under the GNU General Public License and similar licenses. These
licenses state that any program licensed under them may be liberally copied,
modified and distributed. We know of no circumstance under which these licenses
have been challenged or interpreted in court. Accordingly, it is possible that a
court would hold these licenses to be unenforceable in the event that someone
were to file a claim asserting proprietary rights in a program developed and
distributed under them. Any ruling by a court that these licenses are not
enforceable, or that Linux-based operating systems, or significant portions of
them, may not be liberally copied, modified or distributed, would have the
effect of preventing us from selling or developing our products.
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<PAGE>
Our products may contain defects that may be costly to correct, delay market
acceptance of our products and expose us to litigation
Despite testing by us and our customers, errors have been and may continue to be
found in our products after commencement of commercial shipments. This risk is
exacerbated by the fact that most of the code in our products is developed by
independent parties over whom we exercise no supervision or control. If errors
are discovered, we may have to make significant expenditures of capital to
eliminate them and yet may not be able to successfully correct them in a timely
manner or at all. Errors and failures in our products could result in a loss of,
or delay in, market acceptance of our products and could damage our reputation
and our ability to convince commercial users of the benefits of Linux-based
operating systems and other open source software products.
In addition, failures in our products could cause system failures for our
customers who may assert warranty and other claims for substantial damages
against us. Although our license agreements with our customers typically contain
provisions designed to limit our exposure to potential product liability claims,
it is possible that these provisions may not be effective or enforceable under
the laws of some jurisdictions. Our insurance policies may not adequately limit
our exposure to this type of claim. These claims, even if unsuccessful, could be
costly and time consuming to defend.
We are vulnerable to claims that our products infringe third-party intellectual
property rights particularly because our products are comprised of many distinct
software components developed by thousands of independent parties
We may be exposed to future litigation based on claims that our products
infringe the intellectual property rights of others. This risk is exacerbated by
the fact that most of the code in our products is developed by independent
parties over whom we exercise no supervision or control. Claims of infringement
could require us to reengineer our products or seek to obtain licenses from
third parties in order to continue offering our products. In addition, an
adverse legal decision affecting our intellectual property, or the use of
significant resources to defend against this type of claim, could place a
significant strain on our financial resources and harm our reputation.
Our efforts to protect our trademarks may not be adequate to prevent third
parties from misappropriating our intellectual property rights
Our most valuable intellectual property is our collection of trademarks. The
protective steps we have taken in the past have been, and may in the future
continue to be, inadequate to deter misappropriation of our trademark rights.
Although we do not believe that we have suffered any material harm from
misappropriation to date, we may be unable to detect the unauthorized use of, or
take appropriate steps to enforce, our trademark rights. We have registered some
of our trademarks in the United States, Europe and Australia and have other
trademark applications pending in the United States, Europe, Australia, Canada,
Europe and Japan. Effective trademark protection may not be available in every
country in which we offer or intend to offer our products and services. Failure
to adequately protect our trademark rights could damage or even destroy the Red
Hat brand and impair our ability to compete effectively. Furthermore, defending
or enforcing our trademark rights could result in the expenditure of significant
financial and managerial resources.
We may be sued as a result of information published or posted on or accessible
from our redhat.com web site
We may be subjected to claims for defamation, negligence, copyright or trademark
infringement or other claims relating to the information we publish on our web
site. These types of claims have been brought, sometimes successfully, against
online services in the past, and can be costly to defend. We may also be
subjected to claims based on content that is accessible from our web site
through links to other web sites or through content and materials that may be
posted by visitors to our web site. We believe that the scope and amount of our
commercial and general liability insurance is appropriate, given our current
financial position. However, this insurance may not adequately protect us
against these types of claims.
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We have not been a party to any lawsuit of this type to date.
Risks Related to the Market for Our Common Stock
Our stock price has been extremely volatile and you may not be able to resell
your shares at or above the offering price
The trading price of our common stock has been and is likely to continue to be
highly volatile and could be subject to wide fluctuations in response to factors
such as:
o actual or anticipated variations in quarterly operating results;
o new products or services offered by Red Hat or our competitors;
o changes in financial estimates by securities analysts;
o conditions or trends in the Internet, Linux and software industries;
o changes in the economic performance and/or market valuations of other
Internet, Linux and software industries;
o announcements by us or our competitors of significant acquisitions,
strategic partnerships, joint ventures or capital commitments;
o additions or departures of key personnel;
o sales of common stock; and
o other events or factors, many of which are beyond our control.
In addition, the stock market in general, and the Nasdaq National Market and the
market for Internet-related and technology companies in particular, has
experienced extreme price and volume fluctuations that have often been unrelated
or disproportionate to the operating performance of such companies. In addition,
broad market and industry factors may materially adversely affect the market
price of our common stock, regardless of our actual operating performance. In
the past, following periods of volatility in the market price of a company's
securities, securities class-action litigation has often been instituted against
such companies. Such litigation, if instituted, could result in substantial
costs and a diversion of management's attention and resources, which would
materially adversely affect our business, financial condition and operating
results.
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ITEM 3. Quantitative and Qualitative Disclosures about Market Risk
Interest Rate Risk
The primary objective of Red Hat's investment activities is to preserve
principal while at the same time maximizing yields without significantly
increasing risk. To achieve this objective, the Company maintains its portfolio
of cash equivalents, short-term and long-term investments in a variety of
securities, including both government and corporate obligations and money market
funds. The following table presents the fair value balances of the Company's
cash equivalents and short-term and long-term investments that are subject to
interest rate risk by year of expected maturity and average interest rates as of
February 29, 2000:
<TABLE>
<CAPTION>
Year Ended
(in thousands)
February 28, February 28, February 28,
2001 2002 2003 Total
------- ------- -------- --------
<S> <C> <C> <C> <C>
Cash equivalents................ 242,426 242,426
Average interest rate........... 6.0%
Investments..................... 27,460 69,219 3,135 99,814
Average interest rates.......... 6.1% 6.7% 7.26%
</TABLE>
Red Hat did not hold derivative financial instruments as of August 31, 2000,
and has never held such investments in the past.
Foreign Currency Risk
Approximately 19% of the Company's revenues for the six months ended August 31,
2000 were generated by sales outside the United States. The Company is exposed
to significant risks of foreign currency fluctuation primarily from receivables
denominated in foreign currency and are subject to transaction gains and losses,
which are recorded as a component in determining net income. Additionally, the
assets and liabilities of the Company's non-U.S. operations are translated into
U.S. dollars at exchange rates in effect as of the applicable balance sheet
dates, and revenue and expense accounts of these operations are translated at
average exchange rates during the month the transactions occur. Unrealized
translation gains and losses will be included as an adjustment to stockholders'
equity.
Based upon the foregoing, the Company began hedging its foreign currency
receivables in the third quarter of 1999 in an effort to reduce its exposure to
currency exchange rates. However, as a matter of procedure, the Company will not
invest in speculative financial instruments as a means of hedging against such
risk. The Company has no outstanding foreign currency hedging contracts at
August 31, 2000. The Company's accounting policies for these contracts are based
on the Company's designation of the contracts as hedging transactions. The
criteria the Company uses for designating a contract as a hedge include the
contract's effectiveness in risk reduction and one-to-one matching of derivative
instruments to underlying transactions. Gains and losses on forward foreign
exchange contracts are recognized in income in the same period as gains and
losses on the underlying transactions. If an underlying hedged transaction is
terminated earlier than initially anticipated, the offsetting gain or loss on
the related forward exchange contract would be recognized in income in the same
period. In addition, since the Company enters into forward contracts only as a
hedge, any change in currency rates would not result in any material net gain or
loss, as any gain or loss on the underlying foreign currency denominated balance
would be offset by the gain or loss on the forward contract. Information
regarding the Company's foreign currency forward exchange contracts is set forth
in Note 13 of Item 14(a)(1) of this Annual Report on Form 10-K and is
incorporated herein by reference.
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<PAGE>
PART II - OTHER INFORMATION
ITEM 2: CHANGES IN SECURITIES AND USE OF PROCEEDS
Sales of Unregistered Securities
On July 27, 2000, the Company completed its acquisition of WireSpeed. In
connection with the acquisition, the Company issued base consideration
comprised, in part, of 1,531,232 shares of common stock. The offering and sale
of Red Hat common stock was made in reliance upon the exemption from
registration provided by Section 3(a)(10) of the Securities Act of 1933, as
amended. A fairness hearing for the transaction was held by the Office of the
North Carolina Secretary of State pursuant to Section 78A-30 of the General
Statutes of North Carolina.
Use of Proceeds
On August 11, 1999 the Securities and Exchange Commission declared effective the
Company's Registration Statement on Form S-1 (File number 333-80051), relating
to the initial public offering of the Company's Common Stock, $.0001 par value.
The offering commenced on August 11, 1999 and all shares covered by the
Registration Statement were sold. The proceeds to the Company, net of
underwriting discounts and costs, was approximately $88.5 million. The following
are the uses of such proceeds from the effective date of the registration
statement (August 11, 1999) through August 31, 2000:
Cash and cash equivalents: $51,128,936
Working capital: $37,337,993
None of the net proceeds from the IPO were used to pay, directly or indirectly,
directors, officers, persons owning ten percent or more of the Company's equity
securities, or affiliates of the Company.
ITEM 4: SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
The Annual Meeting of Stockholders of the Company (the "Meeting") was held on
August 3, 2000. At the Meeting, the following nominees were re-elected as
directors for the Company to serve until the Annual Meeting of Stockholders of
the Company in 2003 and until their successors shall have been elected and
qualified and received the votes set forth after their names below:
Name of Nominee For Withheld
Eric Hahn 120,019,139 177,320
The terms of office of the following directors continued after the Meeting:
Robert F. Young, Matthew J. Szulik, Kevin Harvey, William S. Kaiser, Eugene
McDonald.
Also at the Meeting, the stockholders of the Company approved the reappointment
of PricewaterhouseCoopers LLP and the Company's independent accountants. The
results of the voting on such matters were as follows:
For Against Abstentions or Broker Non-Votes
119,970,956 137,477 88,026
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ITEM 6: EXHIBITS AND REPORTS ON FORM 8-K
a. List of Exhibits:
<TABLE>
<CAPTION>
Exhibit Description of Exhibit
No.
------- ----------------------
<S> <C>
2.1* Stock Purchase Agreement, dated June 13, 2000, by and among Red Hat, Inc., WireSpeed Communications Corporation and
Andrew Bailey, as Securityholder Agent (incorporated by reference from Red Hat, Inc. `s Current Report on Form 8-K,
filed August 11, 2000)
2.2* Amendment to Stock Purchase Agreement, dated July 27, 2000, by and among Red Hat, Inc., WireSpeed Communications
Corporation and Andrew Bailey, as Securityholder Agent (incorporated by reference from Red Hat, Inc. `s Current Report
on Form 8-K, filed August 11, 2000)
11.1 Statement Regarding Computation of Per Share Earnings
27.1 Financial Data Schedule
</TABLE>
* Previously filed.
b. Reports on Form 8-K.
1. Current Report on Form 8-K, dated June 26, 2000, reporting the
Company's entry into a definitive agreement to acquire WireSpeed.
2. Current Report on Form 8-K, dated August 11, 2000, reporting the
completion of the WireSpeed acquisition; and
3. Current Report on Form 8-K, dated August 23, 2000, reporting the
Company's entry into a definitive agreement to acquire C2Net.
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SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934,
the registrant has duly caused this report to be signed on its behalf by the
undersigned, thereunto duly authorized.
Date: October 16, 2000 RED HAT, INC.
By: /s/ MATTHEW J. SZULIK
--------------------------
Matthew J. Szulik
President and Chief Executive Officer
(Officer on behalf of the Registrant)
By: /s/ KEVIN B. THOMPSON
--------------------------
Kevin B. Thompson
Vice President of Operations
(Principal Financial Officer)
40
<PAGE>
EXHIBIT INDEX
<TABLE>
<CAPTION>
Exhibit Description of Exhibit
No.
------- ----------------------
<S> <C>
2.1* Stock Purchase Agreement, dated June 13, 2000, by and among Red Hat, Inc., WireSpeed Communications Corporation and
Andrew Bailey, as Securityholder Agent (incorporated by reference from Red Hat, Inc. `s Current Report on Form 8-K,
filed August 11, 2000)
2.2* Amendment to Stock Purchase Agreement, dated July 27, 2000, by and among Red Hat, Inc., WireSpeed Communications
Corporation and Andrew Bailey, as Securityholder Agent (incorporated by reference from Red Hat, Inc. `s Current Report
on Form 8-K, filed August 11, 2000)
11.1 Statement Regarding Computation of Per Share Earnings
27.1 Financial Data Schedule
</TABLE>
* Previously filed.
