Edgar Filing: RED HAT INC

Large accelerated filer

Accelerated filer

Non-accelerated filer

Smaller reporting company

Emerging growth company

Document

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)



x	QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended November 30, 2018



¨	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: 001-33162

RED HAT, INC.

(Exact name of registrant as specified in its charter)



Delaware	06-1364380
(State or other jurisdiction of incorporation or organization)	(I.R.S. Employer Identification No.)

100 East Davie Street, Raleigh, North Carolina 27601

(Address of principal executive offices, including zip code)

(919) 754-3700

(Registrant’s telephone number, including area code)

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

Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files). Yes x No ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company” and “emerging growth company” in Rule 12b-2 of the Exchange Act.

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ¨

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

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date:

As of January 2, 2019, there were 176,760,468 shares of common stock outstanding.

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RED HAT, INC.



		Page
CAUTIONARY NOTE ON FORWARD-LOOKING STATEMENTS		3

	PART I FINANCIAL INFORMATION
ITEM 1:	FINANCIAL STATEMENTS
	Consolidated Balance Sheets at November 30, 2018 (unaudited) and February 28, 2018 (derived from audited financial statements)	4
	Consolidated Statements of Operations for the three and nine months ended November 30, 2018 (unaudited) and 2017 (unaudited)	5
	Consolidated Statements of Comprehensive Income for the three and nine months ended November 30, 2018 (unaudited) and 2017 (unaudited)	6
	Consolidated Statements of Cash Flows for the three and nine months ended November 30, 2018 (unaudited) and 2017 (unaudited)	7
	Notes to Consolidated Financial Statements (unaudited)	8
	NOTE 1—Company
	NOTE 2—Summary of Significant Accounting Policies
	NOTE 3—Accounts Receivable
	NOTE 4—Identifiable Intangible Assets
	NOTE 5—Deferred Selling Costs
	NOTE 6—Derivative Instruments
	NOTE 7—Income Taxes
	NOTE 8—Convertible Notes
	NOTE 9—Commitments and Contingencies
	NOTE 10—Legal Proceedings
	NOTE 11—Stockholders’ Equity
	NOTE 12—Deferred Revenue and Performance Obligations
	NOTE 13—Earnings Per Share
	NOTE 14—Share-based Awards
	NOTE 15—Assets and Liabilities Measured at Fair Value on a Recurring Basis
	NOTE 16—Segment Reporting
	NOTE 17—Business Combinations

ITEM 2:	MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS	34
ITEM 3:	QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK	52
ITEM 4:	CONTROLS AND PROCEDURES	54

	PART II OTHER INFORMATION
ITEM 1:	LEGAL PROCEEDINGS	55
ITEM 1A:	RISK FACTORS	55
ITEM 2:	UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS	79
ITEM 6:	EXHIBITS	80

SIGNATURES		81

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CAUTIONARY NOTE ON FORWARD-LOOKING STATEMENTS

Certain statements contained in this report and the documents incorporated by reference in this report, including in Management’s Discussion and Analysis of Financial Condition and Results of Operations, constitute “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. Forward-looking statements provide current expectations of future events based on certain assumptions, and any statement that is not strictly a historical statement could be deemed to be a forward-looking statement (for example, statements regarding current or future financial performance, management’s plans and objectives for future operations, product plans and performance, management’s expectations regarding market risk and market penetration, management’s assessment of market factors, or strategies, objectives and plans of Red Hat, Inc. together with its subsidiaries (“Red Hat”) and its partners). Words such as “anticipate,” “believe,” “estimate,” “expect,” “intend,” “outlook,” “plan,” “project,” “will,” and similar expressions, may also identify such forward-looking statements. Red Hat may also make forward-looking statements in other filings made with the Securities and Exchange Commission (“SEC”), press releases, materials delivered to stockholders and oral statements made by management. Investors are cautioned that these forward-looking statements are inherently uncertain, 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 to differ materially from those found in the forward-looking statements and from historical trends. These risks and uncertainties include the risks and cautionary statements detailed in Part II, Item 1A, “Risk Factors” and elsewhere in this report as well as in Red Hat’s other filings with the SEC, copies of which may be accessed through the SEC’s web site at http://www.sec.gov. Readers are urged to carefully review these risks and cautionary statements. Moreover, Red Hat operates in a rapidly changing and highly competitive environment. It is impossible to predict all risks and uncertainties or assess the impact of any new risk or uncertainty on our business or any forward-looking statement. The forward-looking statements included in this report represent our views as of the date of this report. We specifically disclaim any obligation to update these forward-looking statements in the future. These forward-looking statements should not be relied upon as representing our views as of any date subsequent to the date of this report.

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PART I



ITEM 1.	FINANCIAL STATEMENTS

RED HAT, INC.

CONSOLIDATED BALANCE SHEETS

(in thousands—except share and per share amounts)



	November 30, 2018 (Unaudited)			February 28, 2018 (1)
ASSETS
Current assets:
Cash, cash equivalents and restricted cash	$	1,539,272		$	1,724,132
Investments in debt and equity securities, short-term	387,885			318,358
Accounts receivable, net of allowances for doubtful accounts of $2,805 and $2,167, respectively	732,833			806,744
Prepaid expenses	241,145			267,197
Other current assets	69,356			25,666
Total current assets	2,970,491			3,142,097
Property and equipment, net of accumulated depreciation and amortization of $309,697 and $269,429, respectively	195,249			206,105
Goodwill	1,285,503			1,288,830
Identifiable intangibles, net	203,613			224,953
Investments in debt securities, long-term	295,870			430,442
Deferred tax assets, net	80,958			92,606
Other assets, net	71,330			89,460
Total assets	$	5,103,014		$	5,474,493
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Accounts payable and accrued expenses	$	432,662		$	427,139
Deferred revenue, short-term	1,738,547			1,853,719
Other current obligations	404			843
Convertible notes	191,972			23,806
Total current liabilities	2,363,585			2,305,507
Deferred revenue, long-term	790,577			741,453
Convertible notes	324,153			744,194
Other long-term obligations	201,068			205,215
Commitments and contingencies (NOTES 9 and 10)
Stockholders’ equity:
Preferred stock, $0.0001 per share par value, 5,000,000 shares authorized, none outstanding	—			—
Common stock, $0.0001 per share par value, 300,000,000 shares authorized, 242,609,945 and 238,688,708 shares issued, and 176,759,725 and 177,073,904 shares outstanding, respectively	24			24
Additional paid-in capital	2,614,768			2,416,080
Retained earnings	1,914,574			1,619,688
Treasury stock, at cost, 65,850,220 and 61,614,804 shares, respectively	(3,058,598		)	(2,525,072		)
Accumulated other comprehensive loss	(47,137		)	(32,596		)
Total stockholders’ equity	1,423,631			1,478,124
Total liabilities and stockholders’ equity	$	5,103,014		$	5,474,493

____________________


⁽¹⁾	Derived from audited financial statements except for line items adjusted by the retrospective application of ASC 606. See NOTE 2—Summary of Significant Accounting Policies for detailed information on adoption of ASC 606.

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

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RED HAT, INC.

CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands—except per share amounts)

(Unaudited)



	Three Months Ended						Nine Months Ended
	November 30, 2018			November 30, 2017 (1)			November 30, 2018			November 30, 2017 (1)
Revenue:
Subscriptions	$	740,661		$	656,832		$	2,174,881		$	1,890,902
Training and services	106,134			91,146			308,191			257,227
Total revenue	846,795			747,978			2,483,072			2,148,129
Cost of revenue:
Subscriptions	53,441			47,277			157,545			137,234
Training and services	70,676			64,482			208,201			181,938
Total cost of revenue	124,117			111,759			365,746			319,172
Gross profit	722,678			636,219			2,117,326			1,828,957
Operating expense:
Sales and marketing	353,592			308,083			1,036,787			880,723
Research and development	164,267			145,580			497,081			424,552
General and administrative	95,861			63,838			227,788			180,430
Total operating expense	613,720			517,501			1,761,656			1,485,705
Income from operations	108,958			118,718			355,670			343,252
Interest income	7,334			4,864			23,023			13,469
Interest expense	4,299			6,180			15,426			18,346
Other expense, net	(464		)	(1,187		)	(5,115		)	(3,033		)
Income before provision for income taxes	111,529			116,215			358,152			335,342
Provision for income taxes	17,079			14,606			63,658			61,331
Net income	$	94,450		$	101,609		$	294,494		$	274,011
Net income per share:
Basic	$	0.54		$	0.57		$	1.67		$	1.55
Diluted	$	0.51		$	0.55		$	1.57		$	1.49
Weighted average shares outstanding:
Basic	176,231			177,063			176,762			177,188
Diluted	186,062			186,160			187,501			183,397

____________________


⁽¹⁾	As adjusted to reflect the impact of the retrospective application of ASC 606. See NOTE 2—Summary of Significant Accounting Policies for detailed information on adoption of ASC 606.

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

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RED HAT, INC.

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

(in thousands)

(Unaudited)



	Three Months Ended						Nine Months Ended
	November 30, 2018			November 30, 2017 (1)			November 30, 2018			November 30, 2017 (1)
Net income	$	94,450		$	101,609		$	294,494		$	274,011
Other comprehensive income (loss):
Change in foreign currency translation adjustment	4,724			(1,371		)	(14,566		)	53,160
Available-for-sale securities:
Unrealized (loss) gain on available-for-sale securities during the period	(267		)	(2,206		)	187			(1,052		)
Reclassification for gain realized on available-for-sale securities, reported in Other expense, net	—			(1		)	(125		)	(1		)
Tax benefit (expense)	42			859			(37		)	350
Net change in available-for-sale securities (net of tax)	(225		)	(1,348		)	25			(703		)
Total other comprehensive income (loss)	4,499			(2,719		)	(14,541		)	52,457
Comprehensive income	$	98,949		$	98,890		$	279,953		$	326,468

____________________


⁽¹⁾	As adjusted to reflect the impact of the retrospective application of ASC 606. See NOTE 2—Summary of Significant Accounting Policies for detailed information on adoption of ASC 606.

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

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RED HAT, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

(Unaudited)



	Three Months Ended						Nine Months Ended
	November 30, 2018			November 30, 2017 (1)			November 30, 2018			November 30, 2017 (1)
Cash flows from operating activities:
Net income	$	94,450		$	101,609		$	294,494		$	274,011
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization	26,775			25,588			80,495			71,541
Amortization of debt discount and transaction costs	4,062			5,630			14,470			16,740
Repayments of convertible notes attributable to debt discount	(552		)	—			(33,115		)	—
Deferred income taxes	1,983			273			(1,705		)	7,831
Share-based compensation expense	56,278			52,318			154,969			142,983
Net amortization of bond premium on debt securities available for sale	256			2,113			1,542			6,988
Other	274			(214		)	3,924			1,318
Changes in operating assets and liabilities, net of effects of acquisitions:
Accounts receivable	(219,184		)	(113,898		)	58,206			111,899
Other receivables	(23,310		)	135			(43,555		)	(20,211		)
Prepaid expenses	2,903			(7,062		)	34,565			(6,831		)
Accounts payable and accrued expenses	40,325			35,562			38,620			(17,754		)
Deferred revenue	153,111			57,275			14,733			(29,017		)
Other	(643		)	978			(1,964		)	1,577
Net cash provided by operating activities	136,728			160,307			615,679			561,075
Cash flows from investing activities:
Purchase of investment in debt securities available for sale	(99,890		)	(26,580		)	(217,951		)	(285,773		)
Proceeds from maturities of investment in debt securities available for sale	66,406			130,941			259,460			348,285
Proceeds from sales of investment in debt securities available for sale	—			5,293			8,491			19,617
Proceeds from sales of strategic equity investments	—			—			1,300			—
Acquisition of businesses, net of cash acquired	(11,550		)	—			(11,550		)	(83,965		)
Purchase of developed software and other intangible assets	(1,003		)	(3,426		)	(7,127		)	(12,871		)
Purchase of property and equipment	(18,229		)	(16,587		)	(44,845		)	(68,268		)
Other	—			84			(986		)	(105		)
Net cash (used in) provided by investing activities	(64,266		)	89,725			(13,208		)	(83,080		)
Cash flows from financing activities:
Proceeds from exercise of common stock options	767			711			1,831			4,541
Proceeds from employee stock purchase program	14,409			10,575			43,356			33,288
Payments related to net settlement of share-based compensation awards	(32,873		)	(37,807		)	(127,605		)	(86,230		)
Purchase of treasury stock	(12,791		)	(100,000		)	(412,845		)	(237,002		)
Payments on other borrowings	(201		)	(346		)	(750		)	(1,207		)
Repayments of convertible notes attributable to principal	(4,036		)	(6		)	(241,979		)	(6		)
Net cash used in financing activities	(34,725		)	(126,873		)	(737,992		)	(286,616		)
Effect of foreign currency exchange rates on cash, cash equivalents and restricted cash	(1,980		)	(2,295		)	(49,339		)	48,985
Net increase (decrease) in cash, cash equivalents and restricted cash	35,757			120,864			(184,860		)	240,364
Cash, cash equivalents and restricted cash at beginning of the period	1,503,515			1,210,308			1,724,132			1,090,808
Cash, cash equivalents and restricted cash at end of the period	$	1,539,272		$	1,331,172		$	1,539,272		$	1,331,172
Restricted cash included in cash, cash equivalents and restricted cash	$	1,015		$	3,099		$	1,015		$	3,099

____________________


⁽¹⁾	As adjusted to reflect the impact of the retrospective application of ASC 606. See NOTE 2—Summary of Significant Accounting Policies for detailed information on adoption of ASC 606.

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

RED HAT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

NOTE 1—Company and Merger Agreement

Red Hat, Inc., incorporated in Delaware, together with its subsidiaries (“Red Hat” or the “Company”) is a leading global provider of open source software solutions, using a community-powered approach to develop and offer reliable and high-performing operating system, virtualization, management, middleware, cloud, mobile and storage technologies.

Open source software is an alternative to proprietary software and represents a different model for the development and licensing of commercial software code than that typically used for proprietary software. Because open source software code, generally, is freely shared, there are customarily no licensing fees for the use of open source software. Therefore, the Company does not recognize revenue from the licensing of the code itself. The Company provides value to its customers through the development, aggregation, integration, testing, certification, delivery, maintenance, enhancement and support of its Red Hat technologies, and by providing a level of performance, scalability, flexibility, reliability and security for the technologies the Company packages and distributes. Moreover, because communities of developers not employed by the Company assist with the creation of the Company’s open source offerings, opportunities for further innovation of the Company’s offerings are supplemented by these communities.

The Company derives its revenue and generates cash from customers primarily from two sources: (i) subscription revenue and (ii) training and services revenue. These arrangements typically involve subscriptions to Red Hat technologies. The arrangements with the Company’s customers that produce this revenue and cash are explained in further detail in NOTE 2—Summary of Significant Accounting Policies.

Merger Agreement

On October 28, 2018, the Company entered into an Agreement and Plan of Merger (the “Merger Agreement”) with International Business Machines Corporation, a New York corporation (“IBM”), and Socrates Acquisition Corp., a Delaware corporation and a wholly-owned subsidiary of IBM (“Sub”), pursuant to which, among other things, Sub will merge with and into the Company, with the Company surviving as a wholly-owned subsidiary of IBM (the “Merger”). The board of directors of each of the Company and IBM approved the Merger and the Merger Agreement.

At the effective time of the Merger (the “Effective Time”), subject to the terms and conditions of the Merger Agreement, each share of common stock par value $0.0001 per share, of the Company (the “Company Common Stock”) issued and outstanding immediately prior to the Effective Time (other than (i) canceled shares, (ii) dissenting shares, and (iii) subsidiary converted shares) shall be converted into the right to receive $190.00 in cash, without interest. On December 12, 2018, the Company filed its definitive proxy statement on Schedule 14A (the “Proxy Statement”) with the SEC for a special meeting of its stockholders to be held on January 16, 2019 in connection with the Merger. The transaction is expected to close in the latter half of 2019, subject to certain conditions, including receipt of regulatory approvals. Until the closing, the Company will continue to operate as an independent company. The Company has incurred Merger-related costs of $27.9 million included in General and administrative expenses in the Company’s Consolidated Statement of Operations for the three and nine months ended November 30, 2018.

Consummation of the Merger is subject to certain customary conditions, including, without limitation, (i) the approval by the affirmative vote of the holders of a majority of the outstanding shares of Company Common Stock entitled to vote at a special meeting of the Company’s stockholders to approve the Merger; (ii) the receipt of approvals, or the expiration or termination of the applicable waiting periods, under certain antitrust laws (including the waiting period under the Hart-Scott-Rodino Antitrust Improvements Act of 1976, as amended (the “HSR Act”) and clearance under Council Regulation 134/2004 of the European Union); and (iii) the absence of any temporary restraining order, preliminary or permanent injunction or other judgment or law issued by certain courts of competent jurisdiction or other governmental entity, in each case prohibiting consummation of the Merger, and no action or proceeding by a governmental entity before any court or certain other governmental entities of competent jurisdiction seeking to enjoin, restrain or otherwise prohibit consummation of the Merger. Each party’s obligation to consummate the Merger is subject to certain other customary conditions.

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The Merger Agreement contains certain customary termination rights for the Company and IBM. Subject to certain limitations, the Merger Agreement may be terminated by either IBM or the Company if (i) the Merger is not consummated on or before October 28, 2019, which is subject to extension for two consecutive three month periods by either party if all conditions are satisfied other than receipt of regulatory approvals and absence of legal restraints, (ii) an order having the effect of making the Merger illegal or otherwise prohibiting consummation of the Merger becomes final and non-appealable and (iii) if the stockholder approval is not obtained.

A description of the material terms of the Merger Agreement is available in the Company’s Current Report on Form 8-K filed with the SEC on October 29, 2018. The foregoing description of the Merger Agreement is qualified in its entirety by reference to the full text of the Merger Agreement, which has been filed as Exhibit 2.1 to the Company’s Current Report on Form 8-K filed with the SEC on October 29, 2018 and herewith as Exhibit 2.1.

NOTE 2—Summary of Significant Accounting Policies

Basis of presentation

The unaudited interim consolidated financial statements as of and for the three and nine months ended November 30, 2018 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 for a fair statement of the consolidated balance sheets, consolidated operating results, consolidated other comprehensive income and consolidated cash flows for the periods presented in accordance with accounting principles generally accepted in the U.S. (“U.S. GAAP”). Operating results for the three and nine months ended November 30, 2018 are not necessarily indicative of the results that may be expected for the fiscal year ending February 28, 2019. Certain information and footnote disclosures normally included in annual financial statements prepared in accordance with U.S. GAAP have been omitted in accordance with the SEC’s rules and regulations for interim reporting. These unaudited financial statements should be read in conjunction with the Company’s Consolidated Financial Statements, including notes thereto, included in the Company’s Annual Report on Form 10-K for the fiscal year ended February 28, 2018. Other than the accounting pronouncement adopted during the three months ended May 31, 2018 related to accounting for revenue from contracts with customers as described below, there have been no changes to the Company’s significant accounting policies from those described in NOTE 2—Summary of Significant Accounting Policies to the Consolidated Financial Statements contained in the Company’s Annual Report on Form 10-K for the fiscal year ended February 28, 2018.

The Company adopted Accounting Standards Update 2014-09, Revenue from Contracts with Customers, now commonly referred to as Accounting Standards Codification Topic 606 (“ASC 606”), effective March 1, 2018, using the full retrospective transition method. All amounts and disclosures set forth in this Form 10-Q have been updated to comply with the new standard and such information is designated “as adjusted.”

Certain amounts for the three and nine months ended November 30, 2017 have been reclassified to conform to the current period presentation.

The Company’s fiscal year ends on the last day of February, and the Company identifies fiscal years by the calendar years in which they end. For example, the fiscal year ending February 28, 2019 is referred to as “fiscal 2019.”

Consolidation policy

The accompanying Consolidated Financial Statements include the accounts of the Company and all of its wholly owned subsidiaries. All significant inter-company accounts and transactions are eliminated in consolidation. There are no significant foreign exchange restrictions on the Company’s foreign subsidiaries.

Use of estimates

The preparation of financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the balance sheet dates and the reported amounts of revenue and expenses during the reporting periods. Actual results could differ from such estimates. Estimates are used for, but not limited to, revenue recognition, goodwill and other long-lived assets, share-based compensation, income taxes and loss contingencies.

RED HAT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

Revenue recognition

The Company derives its revenues from subscription contracts and training and service contracts. Revenue is recognized when performance obligations, as stipulated in the contracts, are transferred to a customer for an amount that reflects the consideration the Company expects to receive in exchange for those subscription contracts and training and service contracts.

The Company applies the following five steps to recognize revenue:

1) Identify the contract with a customer. The Company determines that it has a contract with a customer when the contract is approved, the party’s rights regarding the products and services to be transferred can be identified, the payment terms for the products and services are identified, the customer’s ability and intent to pay can be determined, and the contract has commercial substance. Judgment is used to assess the customer’s ability and intent to pay, which is based upon factors including the customer’s historical payment experience or credit and financial information pertaining to the customer.

2) Identify the performance obligations in the contract. The Company’s performance obligations are identified based on the products and services that will be transferred to the customer that are both capable of being distinct and are distinct in the context of the contract and consist of (i) subscription offerings, including non-proprietary open-source software code delivered to the customer, software support subscriptions delivered to the customer, software support subscriptions embedded in partner products and learning subscriptions and (ii) training and services, including professional services sold at a fixed fee, professional services sold on a time-and-material-basis, training courses or units, and consulting units. In limited cases, the option to purchase additional subscription offerings or training and services may be offered at a price representing a material right. In such cases, the option to purchase is considered a distinct performance obligation.

3) Determine the transaction price. The Company determines transaction price based on the consideration expected to be received in exchange for transferring certain performance obligations to the customer. In determining the transaction price, variable consideration, if any, would be considered if, in management’s judgment, it is probable that a significant future reversal of cumulative revenue under the contract will not occur.

The Company’s contracts do not contain significant financing components. Specifically, the Company does not typically extend customer payment terms beyond a standard 30- to 60-day term and as a result the Company has elected the one-year-or-less safe harbor expedient and does not impute any interest.

The Company has elected to exclude all taxes from the transaction price (e.g. sales, use, value-added, etc.). Revenue is recognized net of such taxes.

4) Allocate the transaction price to performance obligations in the contract. When a contract contains a single performance obligation, the entire transaction price is allocated to that one performance obligation. Contracts that contain multiple performance obligations require an allocation of the transaction price to each performance obligation based on a relative standalone selling price (“SSP”). The Company typically determines SSP based on the observable price when the Company sells the subscriptions or training and services separately, taking into consideration the geographical region of the customer, type of offering and sales channel. In instances where SSP is not directly observable, the Company determines SSP either from the renewal rate paid for the performance obligation to the extent it is the same rate as stipulated in the initial customer contract or by using the expected-cost-plus-margin approach.

5) Recognize revenue when or as the performance obligation is satisfied. Revenue is recognized at the time the related performance obligation is satisfied by transferring the promised subscription offerings and training and services to a customer. For each performance obligation, a determination is made as to whether the control is transferred over time or at a point in time. For performance obligations satisfied over time, a method to measure progress toward complete satisfaction is selected, based upon the most faithful depiction of performance. The selected method for each performance obligation type is applied consistently to similar contracts.

RED HAT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

Subscription revenue

Subscription revenue is comprised of direct and indirect sales of subscriptions relating to Red Hat technologies. Accounts receivable and deferred revenue are recorded at the time a customer enters into a binding and non-cancellable subscription agreement for the purchase of a subscription, subscription services are made available to the customer and the customer is billed. The deferred revenue amount is recognized as revenue ratably over the subscription period. Red Hat technologies are generally offered with base subscription periods of either one year or three years; the majority of the Company’s subscriptions have terms of one year. Under these subscription agreements, renewal rates are generally specified for renewal terms of one year or three years. Subscriptions generally entitle the end user to the technology itself and post-contract customer support, generally consisting of varying levels of support services as well as access to security updates, fixes, functionality enhancements, upgrades to the technologies, each on an if and when available basis, and compatibility with an ecosystem of certified hardware and software, during the term of the subscription. The Company sells its offerings through two principal channels: (1) direct, which includes sales by the Company’s sales force as well as web store sales, and (2) indirect, which includes certified cloud and service providers (“CCSPs”), distributors, original equipment manufacturers (“OEMs”), systems integrators and value added resellers.

The Company recognizes revenue from the sale of Red Hat technologies ratably over the period of the subscription beginning on the commencement date of the subscription agreement. The Company has determined that the delivery of software code underlying the subscription is a distinct performance obligation as it is both capable of being distinct and is distinct within the context of a customer contract. The Company uses a non-proprietary open-source development and licensing model to provide its software technologies to customers and therefore the amount of transaction price allocated to the underlying software code is negligible. The Company derives a portion of its revenue from CCSPs that provide public clouds with, and allow users to consume, computing resources as a service. The Company earns revenue based on subscription units consumed by the CCSP or its end users. The Company uses its historical cloud-usage data to estimate the amount of revenue earned and recognized each month and adjusts to actual amounts earned upon receipt of usage reports from the CCSPs in the following month. The differences between actual amounts earned and estimates made have generally been insignificant.

Training and services revenue

Training and services revenue is comprised of revenue for consulting, engineering and customer training courses or units and education services. Consulting services consist of time-based units or fixed-fee arrangements. For time-based arrangements, revenue is recognized over time as these services are performed and for fixed-fee arrangements, revenue is recognized based on the proportion of services performed. Engineering services represent revenue earned under fixed-fee arrangements with the Company’s OEM partners and other customers to provide for significant modification and customization of Red Hat technologies. The Company recognizes revenue for these fixed-fee engineering services based on a proportional performance basis using actual costs incurred to date over the estimated total projected costs, which includes a representative profit margin. A representative profit margin is determined based on analysis of a population of similar contracts by region. Revenue for customer training and education services is recognized on the dates the services are performed.

See NOTE 16—Segment Reporting for further information, including revenue by geographic area and significant product and service offerings.

Contract Balances

Timing of revenue recognition may differ from the timing of invoicing to customers. The Company records a receivable when revenue is recognized prior to invoicing, or deferred revenue when revenue is recognized subsequent to invoicing. For multi-year arrangements, the Company will generally invoice customers upfront or annually at the beginning of each annual coverage period. See below for the accounting policy related to receivables and see NOTE 12—Deferred Revenue and Performance Obligations for further information on deferred revenue balances.

RED HAT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

Accounts receivable and allowance for doubtful accounts

Trade accounts receivable are recorded at the invoiced amount and do not bear interest. The allowance for doubtful accounts is the Company’s estimate of the amount of probable credit losses in the Company’s existing accounts receivable. The Company determines the allowance based on historical write-off experience and other qualitative factors. The Company reviews its allowance for doubtful accounts monthly. Past due balances over 90 days and over a specified amount are reviewed individually for collectability. All other balances are reviewed on a pooled basis by type of receivable. Account balances are charged off against the allowance when the Company determines it is probable the receivable will not be recovered. The Company does not have off-balance sheet credit exposure related to its customers. Unbilled receivables related to subscription and training and services contracts are included in accounts receivable. See NOTE 3—Accounts Receivable for further information on accounts receivable balances.

Deferred selling costs

Deferred commissions are the incremental costs that are directly associated with non-cancellable subscription contracts with customers and consist of sales commissions and certain related fringe benefits earned by the Company’s sales force. The commissions are deferred and amortized on a straight-line basis over a period that approximates the subscription period. In determining the period that approximates the subscription period, the Company utilizes a portfolio approach that allows for the analysis of customer contracts with similar characteristics. The Company has determined that the effects on the financial statements of the portfolio approach would not differ materially from an individual customer contract analysis approach. The commission payments are paid in full subsequent to the month in which the customer’s service commences. The deferred commission amounts are recoverable through the future revenue streams under the non-cancellable customer contracts. In addition, the Company has the ability and intent under the commission plans with its sales force to recover commissions previously paid to its sales force in the event that customers breach the terms of their subscription agreements and do not fully pay for their subscription agreements. See NOTE 5—Deferred Selling Costs for further information on deferred commissions and the related amortization of deferred commissions.

Recent accounting pronouncements

Accounting pronouncements adopted

In February 2018, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update 2018-02, Income Statement—Reporting Comprehensive Income (Topic 220): Reclassification of Certain Tax Effects from Accumulated Other Comprehensive Income (“ASU 2018-02”). The FASB issued ASU 2018-02 to give entities the option to reclassify tax effects stranded in accumulated other comprehensive income as a result of the enactment of the Tax Cuts and Jobs Act (the “Tax Act”) to retained earnings. The Company adopted ASU 2018-02 as of June 1, 2018. The Company opted not to reclassify tax effects stranded in accumulated other comprehensive income as a result of the enactment of the Tax Act to retained earnings.

In January 2016, the FASB issued Accounting Standards Update 2016-01, Financial Instruments—Overall (Subtopic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities (“ASU 2016-01”). The FASB issued ASU 2016-01 to require equity investments with readily determinable fair values to be measured at fair value with changes in fair value recognized in net income. Equity investments that do not have readily determinable fair values are allowed to be remeasured upon the occurrence of an observable price change or upon identification of an impairment. Along with ASU 2016-01, the Company evaluated the Accounting Standards Update 2018-03, Technical Corrections and Improvements to Financial Instruments Overall (Subtopic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities (“ASU 2018-03”), which was issued in February 2018, and Accounting Standards Update 2018-04, Investments—Debt Securities (Topic 320) and Regulated Operations (Topic 980): Amendments to SEC Paragraphs Pursuant to SEC Staff Accounting Bulletin No. 117 and SEC Release No. 33-9273 (“ASU 2018-04”), which was issued in March 2018. The Company adopted ASU 2016-01, ASU 2018-03 and ASU 2018-04 as of March 1, 2018. The adoption of these standards did not significantly impact the Company’s Consolidated Financial Statements.

In May 2014, the FASB issued ASC 606 to clarify the principles for recognizing revenue and to develop a common revenue standard for U.S. GAAP. The standard outlines a single comprehensive model for entities to use in accounting for revenue arising from contracts with customers and supersedes the most current revenue recognition guidance. ASC 606 requires the recognition of revenue when control of performance obligations as stipulated in the contracts, is transferred to a customer for an amount that reflects the consideration the entity expects to receive in exchange promised goods and services. The standard also includes Subtopic 340-40, Other Assets and Deferred Costs—Contracts with Customers, which requires the deferral of incremental costs of obtaining a contract with a customer. Collectively, ASC 606 and Subtopic 340-40 are referred to as “ASC 606.”

RED HAT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

The Company adopted ASC 606 as of March 1, 2018, utilizing the full retrospective method of transition, which requires a restatement of each prior reporting period presented. In adopting ASC 606, the Company used the practical expedient where the transaction price allocated to the remaining performance obligations before the date of the initial application is not disclosed. The Company implemented new policies, processes and systems to enable both the preparation of financial information and internal controls over financial reporting in connection with its adoption of ASC 606. The impact of adopting ASC 606 on the Company’s fiscal 2018 and fiscal 2017 revenue was not material. The primary impact of adopting the standard related to the deferral of incremental commission and other costs of obtaining contracts with customers. Previously, the Company deferred direct and incremental commission costs to obtain a contract and amortized those costs on a straight-line basis over a period that approximated the subscription period, and under ASC 606, the Company now also defers related fringe benefit costs.

Select adjusted unaudited financial statement information, which reflects the Company’s adoption of ASC 606, is set forth below.

Consolidated balance sheets (in thousands):



	February 28, 2018
	As Reported		Adjustments			As Adjusted
Prepaid expenses	$	260,092	$	7,105		$	267,197
Deferred tax assets, net	$	93,300	$	(694	)	$	92,606
Other assets, net	$	87,924	$	1,536		$	89,460
Accounts payable and accrued expenses	$	427,086	$	53		$	427,139
Retained earnings	$	1,611,794	$	7,894		$	1,619,688

Consolidated statements of operations (in thousands, except per share amounts):



	Three Months Ended November 30, 2017							Nine Months Ended November 30, 2017
	As Reported		Adjustments			As Adjusted		As Reported		Adjustments			As Adjusted
Operating expense:
Sales and marketing	$	308,388	$	(305	)	$	308,083	$	883,395	$	(2,672	)	$	880,723
Net income	$	101,306	$	303		$	101,609	$	271,355	$	2,656		$	274,011
Net income per share:
Basic	$	0.57	$	—		$	0.57	$	1.53	$	0.02		$	1.55
Diluted	$	0.54	$	0.01		$	0.55	$	1.48	$	0.01		$	1.49

The Company’s adoption of ASC 606 had no impact on net cash provided by or used in operating, investing or financing activities for any of the periods reported.

Accounting pronouncements being evaluated

In August 2018, the FASB issued Accounting Standards Update 2018-15, Intangibles—Goodwill and Other—Internal-Use Software: Customer’s Accounting for Implementation Costs Incurred in a Cloud Computing Arrangement That Is a Service Contract (a consensus of the FASB Emerging Issues Task Force) (“ASU 2018-15”). The FASB issued ASU 2018-15 to align the requirements for capitalizing implementation costs in a cloud computing arrangement service contract with the requirements for capitalizing implementation costs incurred for an internal-use software license. The guidance is effective for the Company as of the first quarter of its fiscal year ending February 28, 2021, with early adoption permitted. The Company is currently evaluating the impact that this updated standard will have on its consolidated financial statements.

RED HAT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

In February 2016, the FASB issued Accounting Standards Update 2016-02, Leases (Topic 842) (“ASU 2016-02”). The FASB issued ASU 2016-02 to increase transparency and comparability among organizations with respect to accounting for leases. Under ASU 2016-02, lessees will recognize a right-of-use asset and a lease liability for virtually all of their leases (other than leases that meet the definition of a short-term lease). The liability will be equal to the present value of lease payments. The asset will be based on the liability, subject to adjustment, such as for initial direct costs. For income statement purposes, the FASB retained a dual model, requiring leases to be classified as either operating or finance. This guidance is effective for the Company as of the first quarter of its fiscal year ending February 28, 2020. Along with ASU 2016-02, the Company is also evaluating Accounting Standards Update 2018-10, Codification Improvements to Topic 842 Leases (“ASU 2018-10”) and Accounting Standards Update 2018-11, Targeted Improvements to Topic 842 Leases (“ASU 2018-11”). The Company expects to adopt the transition method, which will not require adjustments to comparative periods nor require modified disclosures in those comparative periods. Upon adoption, the Company expects to elect the transition package of practical expedients permitted within the new standard, which among other things, allows the carryforward of the historical lease classification. Further, upon implementation of the new guidance, the Company intends to elect the practical expedients to combine lease and non-lease components for all asset classes, to not recognize right-of-use assets and lease liabilities for short-term leases for all asset classes and to use hindsight in determining the lease term and assessing impairment of right-of-use assets.

The Company continues to assess the impact of ASU 2016-02, ASU 2018-10 and ASU 2018-11, now commonly referred to as Accounting Standards Codification Topic 842 (“ASC 842”), including for example, any potential changes to and investments in the Company’s policies, processes, systems and internal controls over financial reporting that may be required to comply with the new guidance related to identifying and measuring right-of-use assets and lease liabilities. While the Company continues to evaluate the effect of adopting this guidance on its consolidated financial statements and related disclosures, it is expected that the operating leases, as disclosed in NOTE 13—Commitments and Contingencies contained in the Company’s Annual Report on Form 10-K for the fiscal year ended February 28, 2018, will be reported in the consolidated balance sheets upon adoption.

NOTE 3—Accounts Receivable

Accounts receivable are presented net of an allowance for doubtful accounts. Activity in the Company’s allowance for doubtful accounts is presented in the following table (in thousands):



As of	Balance at beginning of period		Charged to (recovery of) expense	Adjustments ⁽¹⁾		Balance at end of period
February 28, 2018	$	2,791	172	(796	)	$	2,167
November 30, 2018	$	2,167	1,405	(767	)	$	2,805

_______________


⁽¹⁾	Represents foreign currency translation adjustments and amounts written-off as uncollectible accounts receivable.

Included in accounts receivable, net of allowance for doubtful accounts, are unbilled receivables of $35.1 million and $25.8 million as of November 30, 2018 and February 28, 2018, respectively.

As of November 30, 2018 and February 28, 2018, no individual customer accounted for 10% or more of the Company’s total accounts receivable.

NOTE 4—Identifiable Intangible Assets

Identifiable intangible assets consist primarily of trademarks, copyrights and patents, purchased technologies, customer and reseller relationships and covenants not to compete, all of which are amortized over the estimated useful life, generally on a straight-line basis, with the exception of customer and reseller relationships, which are generally amortized over the greater of straight-line over the estimated useful life or the related asset’s pattern of economic benefit. Useful lives range from two years to 10 years. As of November 30, 2018 and February 28, 2018, trademarks with an indefinite estimated useful life totaled $11.4 million and $12.0 million, respectively. The following is a summary of identifiable intangible assets (in thousands):



	November 30, 2018							February 28, 2018
	Gross Amount		Accumulated Amortization			Net Amount		Gross Amount		Accumulated Amortization			Net Amount
Trademarks, copyrights and patents	$	172,633	$	(79,824	)	$	92,809	$	167,005	$	(70,749	)	$	96,256
Purchased technologies	209,984		(107,936		)	102,048		208,096		(93,748		)	114,348
Customer and reseller relationships	105,748		(99,498		)	6,250		106,076		(95,558		)	10,518
Covenants not to compete	15,795		(14,551		)	1,244		15,861		(14,324		)	1,537
Other intangible assets	8,833		(7,571		)	1,262		8,833		(6,539		)	2,294
Total identifiable intangible assets	$	512,993	$	(309,380	)	$	203,613	$	505,871	$	(280,918	)	$	224,953

RED HAT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

Amortization expense associated with identifiable intangible assets recognized in the Company’s Consolidated Financial Statements is summarized as follows (in thousands):



	Three Months Ended				Nine Months Ended
	November 30, 2018		November 30, 2017		November 30, 2018		November 30, 2017
Cost of revenue	$	6,209	$	4,674	$	18,913	$	13,524
Sales and marketing	1,396		1,592		4,158		4,634
Research and development	34		34		103		103
General and administrative	2,386		2,084		7,139		6,137
Total amortization expense	$	10,025	$	8,384	$	30,313	$	24,398

NOTE 5—Deferred Selling Costs

Deferred selling costs include commissions paid to the Company’s sales associates that are the incremental costs incurred to obtain contracts with customers. The commissions are deferred and amortized over a period to approximate the period of the subscription term. For further discussion on deferred commissions, see NOTE 2—Summary of Significant Accounting Policies. Current and non-current deferred commissions are included in Prepaid expenses and Other assets, respectively, in the Company’s Consolidated Balance Sheets and are as follows (in thousands):



	November 30, 2018		February 28, 2018 (1)
Deferred commissions, current	$	174,477	$	188,944
Deferred commissions, non-current	35,210		48,653
Total deferred commissions	$	209,687	$	237,597

____________________


⁽¹⁾	As adjusted to reflect the impact of the retrospective application of ASC 606. See NOTE 2—Summary of Significant Accounting Policies for detailed information on adoption of ASC 606.

Amortization of deferred commissions is included in Sales and marketing expense in the Company’s Consolidated Statements of Operations. Amortization expense related to deferred commissions totaled $55.1 million and $46.7 million for the three months ended November 30, 2018 and November 30, 2017, respectively. Amortization expense related to deferred commissions totaled $174.8 million and $132.0 million for the nine months ended November 30, 2018 and November 30, 2017, respectively. There was no impairment loss in relation to the costs capitalized for the periods presented.

RED HAT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

NOTE 6—Derivative Instruments

The Company transacts business in various foreign countries and is, therefore, subject to risk of foreign currency exchange rate fluctuations. From time to time, the Company enters into forward contracts to economically hedge transactional exposure associated with commitments arising from trade accounts receivable, trade accounts payable and fixed purchase obligations denominated in a currency other than the functional currency of the respective operating entity. All derivative instruments are recorded in the Consolidated Balance Sheets at their respective fair values. The Company has elected not to prepare and maintain the documentation required to qualify for hedge accounting treatment and, therefore, changes in fair value are recorded in the Consolidated Statements of Operations. See NOTE 15—Assets and Liabilities Measured at Fair Value on a Recurring Basis for information regarding the fair value hierarchy of derivative instruments.

The effects of derivative instruments on the Company’s Consolidated Financial Statements are as follows (in thousands):



	November 30, 2018						Classification of Gain (Loss) Recognized in Income on Derivatives	Three Months Ended November 30, 2018			Nine Months Ended November 30, 2018
	Balance Sheet Classification	Fair Value			Notional Value			Three Months Ended November 30, 2018			Nine Months Ended November 30, 2018
Assets—foreign currency forward contracts not designated as hedges	Other current assets	$	154		$	68,036	Other expense, net	$	238		$	809
Liabilities—foreign currency forward contracts not designated as hedges	Accounts payable and accrued expenses	(152		)	21,948		Other expense, net	(610		)	(2,060		)
Total		$	2		$	89,984		$	(372	)	$	(1,251	)



	November 30, 2017						Classification of Gain (Loss) Recognized in Income on Derivatives	Three Months Ended November 30, 2017			Nine Months Ended November 30, 2017
	Balance Sheet Classification	Fair Value			Notional Value			Three Months Ended November 30, 2017			Nine Months Ended November 30, 2017
Assets—foreign currency forward contracts not designated as hedges	Other current assets	$	156		$	20,394	Other expense, net	$	309		$	1,589
Liabilities—foreign currency forward contracts not designated as hedges	Accounts payable and accrued expenses	(174		)	35,210		Other expense, net	(678		)	(1,261		)
Total		$	(18	)	$	55,604		$	(369	)	$	328

NOTE 7—Income Taxes

On December 22, 2017, the Tax Cuts and Jobs Act (“Tax Act”) was enacted into law. This new law includes significant changes to the U.S. corporate income tax system, including a permanent reduction in the corporate income tax rate from 35% to 21%, limitations on the deductibility of interest expense and executive compensation, elimination of the domestic production activities deduction and the transition of U.S. international taxation from a worldwide tax system to a territorial tax system.

On November 26, 2018, the Department of the U.S. Treasury and the Internal Revenue Service issued proposed regulations under Section 163(j), which generally limits the amount of business interest expense that can be deducted in the current taxable year. Further, on November 28, 2018, the Department of the U.S. Treasury also issued proposed regulations under and related to foreign tax credits covered in the Internal Revenue Code Sections 78, 861, 901, 904, 954, 960, and 965. The adoption of the proposed regulations did not significantly impact the Company’s Consolidated Financial Statements.

On August 21, 2018, the Internal Revenue Service issued Notice 2018–68 providing guidance regarding amendments to Section 162(m) of the Internal Revenue Code contained in the Tax Act (“IRS Guidance”), which limit tax deductions for compensation granted to certain executives. As a result of this guidance, our provision for income taxes for the three and nine months ended November 30, 2018 includes $18.0 million tax expense to reflect the impact of this tax deduction limitation which was previously recognized during the three months ended August 31, 2018.

RED HAT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

In December 2017, the SEC staff issued Staff Accounting Bulletin 118 (“SAB 118”), which provides guidance on accounting for the tax effects of the Tax Act. SAB 118 provides a measurement period that should not extend beyond one year from the Tax Act enactment date for companies to complete the accounting under ASC Topic 740—Income Taxes (“ASC 740”). The Company has completed its analysis within fiscal 2019 consistent with the guidance provided in SAB 118, and any adjustments during this measurement period have been included in net earnings from continuing operations as an adjustment to income tax expense. The additional tax expense of $18.0 million resulting from the IRS Guidance discussed above was an adjustment during the SAB 118 measurement period.

The effective tax rate for the three and nine months ended November 30, 2018, of 15.3% and 17.8%, respectively, differed from the U.S. federal statutory rate of 21% primarily due to excess tax benefits from share-based compensation, research tax credits and the impact from the Tax Act. Tax expense for the three and nine months ended November 30, 2018 included net discrete tax benefits of $6.5 million and $17.6 million, respectively, primarily related to the impact from share-based compensation. Net discrete tax benefits of $17.6 million for the nine months ended November 30, 2018 is inclusive of the $18.0 million adjustment pursuant to SAB 118.

For the three and nine months ended November 30, 2017, the Company’s then-effective tax rate of 12.6%⁽¹⁾and 18.3%⁽¹⁾, respectively, differed from the U.S. federal statutory rate of 35% primarily due to excess tax benefits from share-based compensation, foreign income taxed at lower rates, research tax credits and the domestic-production-activities deduction. Tax expense for the three and nine months ended November 30, 2017, included net discrete tax benefits of $15.5 million and $28.5 million, respectively, primarily related to net excess tax benefits from share-based compensation.

The Company files a consolidated U.S. federal income tax return, as well as separate and combined income tax returns in numerous state and international jurisdictions. The Company is currently subject to examination by various taxing jurisdictions. The Company regularly assesses the potential outcomes of both ongoing and future examinations for the current and prior years, and believes that its provision for income taxes is adequate. The outcome of any one examination is not expected to have a material impact on the Company’s consolidated financial statements. The Company believes that some of these audits and negotiations may conclude during the next 12 months.

As of November 30, 2018, it is reasonably possible that total unrecognized tax benefits may be reduced by less than $1.0 million within the next 12 months primarily as a result of statute of limitation expirations in various tax jurisdictions, some of which would affect the Company’s effective tax rate.

____________________


⁽¹⁾	As adjusted to reflect the impact of the retrospective application of ASC 606. See NOTE 2—Summary of Significant Accounting Policies for detailed information on adoption of ASC 606.

NOTE 8—Convertible Notes

Convertible note offering

On October 7, 2014, the Company completed its offering of $805.0 million aggregate principal amount of the convertible notes. The convertible notes were sold in a private placement under a purchase agreement, dated as of October 1, 2014, entered into by and among the Company and the initial purchasers, for resale to qualified institutional buyers pursuant to Rule 144A under the Securities Act of 1933, as amended. For additional information, see NOTE 11—Convertible Notes to the Consolidated Financial Statements contained in the Company’s Annual Report on Form 10-K for the fiscal year ended February 28, 2018.

Indenture

On October 7, 2014, the Company entered into an indenture (the “Indenture”) with respect to the convertible notes with U.S. Bank National Association, as trustee (the “Trustee”). Under the Indenture, the convertible notes are senior unsecured obligations of the Company and bear interest at a rate of 0.25% per year, payable semiannually in arrears on April 1 and October 1 of each year, beginning on April 1, 2015. The convertible notes will mature on October 1, 2019, unless previously purchased or converted.

The convertible notes are convertible into shares of the Company’s common stock at an initial conversion rate of 13.6219 shares per $1,000 principal amount of the convertible notes (which is equivalent to an initial conversion price of approximately $73.41 per share), subject to adjustment upon the occurrence of certain events. Upon conversion of the convertible notes, holders will receive cash or shares of the Company’s common stock or a combination thereof, at the Company’s election.

RED HAT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

At their option, holders may convert their convertible notes prior to the close of business on the business day immediately preceding April 1, 2019, only upon the occurrence of certain circumstances. For example, during any fiscal quarter commencing after the fiscal quarter ended on November 30, 2014 (and only during such fiscal quarter), if the last reported sale price of the Company’s common stock for at least 20 trading days (whether or not consecutive) during the period of 30 consecutive trading days ending on the last trading day of the immediately preceding fiscal quarter is greater than or equal to 130% of the conversion price, the convertible notes become convertible at the holders’ option. The price of the Company’s common stock was greater than or equal to 130% of the conversion price, which is $95.43, for at least 20 trading days during the 30 consecutive trading days ending on the last trading day of each of the fiscal quarters ended August 31, 2017 through November 30, 2018. Therefore, as of November 30, 2018, the convertible notes remain convertible at the holders’ option until February 28, 2019.

On and after April 1, 2019, holders may convert their convertible notes at any time until the close of business on the second scheduled trading day immediately preceding the maturity date of the convertible notes.

During the third quarter of the fiscal year ending February 28, 2019, the Company settled notices of conversion with respect to $4.6 million aggregate principal amount of the convertible notes and elected to settle such conversions by paying cash for the principal amount and issuing 30,257 shares of common stock for the excess conversion value. During the third quarter of the fiscal year ending February 28, 2019, the Company recognized insignificant losses on settled conversions and $1.7 million of losses for the nine months ended November 30, 2018. Total settled conversions as of November 30, 2018 amounted to $275.1 million aggregate principal amount of the convertible notes. The Company expects to settle conversions of $197.1 million in principal amount of the convertible notes in the fourth quarter of the fiscal year ending February 28, 2019 by paying cash for the principal amount and issuing shares of common stock for the excess conversion value. The Company continues to receive conversion requests and as of January 2, 2019, such incremental requests totaled $26.4 million in principal amount of the convertible notes. The aggregate principal amount of the convertible notes remaining is expected to be $306.4 million after the expected conversion settlements as discussed above and the incremental conversion requests received as of January 2, 2019.

Based on the closing price of the Company’s common stock of $178.56 on the last trading day of the third quarter of the fiscal year ending February 28, 2019, the if-converted value of the convertible notes as of November 30, 2018 exceeded their principal amount by approximately $758.9 million.

The Company continues to classify the net carrying amount of the convertible notes as a long-term liability, except for $192.0 million, classified as current and expected to be cash-settled within the next fiscal quarter. The equity component of the convertible notes will continue to be classified as additional paid-in capital because the Company has the option to settle the principal amount in shares. However, it is the Company’s intent to settle the principal amount of the convertible notes in cash.

The conversion rate is subject to customary anti-dilution adjustments. If certain corporate events described in the Indenture occur prior to the maturity date, the conversion rate will be increased for a holder who elects to convert its convertible notes in connection with such corporate event in certain circumstances.

The convertible notes are not redeemable prior to maturity, and no sinking fund is provided for the notes. If the Company undergoes a “fundamental change,” as defined in the Indenture, subject to certain conditions, holders may require the Company to purchase for cash all or any portion of their convertible notes. The fundamental change purchase price will be 100% of the principal amount of the convertible notes to be purchased plus any accrued and unpaid interest up to but excluding the fundamental change purchase date. If the Merger with IBM is consummated, it will constitute a “fundamental change” under the Indenture.

The Indenture contains customary terms and covenants, including that upon certain events of default occurring and continuing, either the Trustee or the holders of at least 25% in principal amount of the outstanding convertible notes may declare 100% of the principal of, and accrued and unpaid interest, if any, on, all the convertible notes to be due and payable.

RED HAT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

In accounting for the issuance of the convertible notes, the Company separated the convertible notes into liability and equity components. The Company allocated the total transaction costs incurred to the liability and equity components based on their relative fair values. Issuance costs attributable to the liability component are being amortized to interest expense over the term of the convertible notes. The excess of the face value of the convertible notes as a whole over the carrying amount of the liability component (the “debt discount”) is being amortized to interest expense over the term of the convertible notes. In addition, the debt discount is impacted by the derecognition of the original debt discount on early settlements of convertible notes. The convertible notes consisted of the following (in thousands):



	November 30, 2018			February 28, 2018
Liability component:
Principal	$	529,865		$	804,966
Less: debt issuance costs	(2,448		)	(4,695		)
Less: debt discount	(11,292		)	(32,271		)
Net carrying amount	$	516,125		$	768,000
Equity component ⁽¹⁾	$	63,775		$	96,890
__________
⁽¹⁾ Recognized in the Consolidated Balance Sheets in Additional paid-in capital.

The following table includes total interest expense recognized related to the convertible notes (in thousands):

Three Months Ended

Nine Months Ended

November 30, 2018

November 30, 2017

November 30, 2018

November 30, 2017