Edgar Filing: RED HAT INC

Large accelerated filer

Accelerated filer

Non-accelerated filer

Smaller reporting company

10-Q

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 August 31, 2016

¨	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 and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted 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 and post such files). Yes x No ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 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 September 30, 2016, there were 179,596,072 shares of common stock outstanding.

RED HAT, INC.


		Page
CAUTIONARY NOTE ON FORWARD-LOOKING STATEMENTS			3

	PART I FINANCIAL INFORMATION
ITEM 1:	FINANCIAL STATEMENTS
	Consolidated Balance Sheets at August 31, 2016 (unaudited) and February 29, 2016 (derived from audited financial statements)		4
	Consolidated Statements of Operations for the three and six months ended August 31, 2016 (unaudited) and 2015 (unaudited)		5
	Consolidated Statements of Comprehensive Income for the three and six months ended August 31, 2016 (unaudited) and 2015 (unaudited)		6
	Consolidated Statements of Cash Flows for the three and six months ended August 31, 2016 (unaudited) and 2015 (unaudited)		7
	Notes to Consolidated Financial Statements (unaudited)		8
ITEM 2:	MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS		30
ITEM 3:	QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK		48
ITEM 4:	CONTROLS AND PROCEDURES		51

	PART II OTHER INFORMATION
ITEM 1:	LEGAL PROCEEDINGS		52
ITEM 1A:	RISK FACTORS		52
ITEM 2:	UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS		75
ITEM 6:	EXHIBITS		76

SIGNATURES			77

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.

RED HAT, INC.

CONSOLIDATED BALANCE SHEETS

(In thousands—except share and per share amounts)


	August 31, 2016 (Unaudited)			February 29, 2016 (1)
ASSETS
Current assets:
Cash and cash equivalents	$	970,569		$	927,778
Investments in debt securities, short-term		365,128			281,142
Accounts receivable, net of allowances for doubtful accounts of $2,456 and $2,798, respectively		359,893			509,715
Prepaid expenses		149,226			150,877
Other current assets		3,404			2,921

Total current assets		1,848,220			1,872,433
Property and equipment, net of accumulated depreciation and amortization of $221,364 and $194,819, respectively		172,312			166,886
Goodwill		1,053,872			1,027,277
Identifiable intangibles, net		142,794			146,071
Investments in debt securities, long-term		706,948			786,470
Deferred tax assets, net		122,131			111,456
Other assets, net		54,479			44,506

Total assets	$	4,100,756		$	4,155,099

LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Accounts payable and accrued expenses	$	273,568		$	284,802
Deferred revenue, short-term		1,233,762			1,272,908
Other current obligations		1,950			1,467

Total current liabilities		1,509,280			1,559,177
Deferred revenue, long-term		446,890			449,636
Convertible notes		734,700			723,942
Other long-term obligations		91,490			87,912
Commitments and contingencies (NOTES 12 and 13)
Stockholders’ equity:
Preferred stock, 5,000,000 shares authorized, none outstanding		—			—
Common stock, $0.0001 per share par value, 300,000,000 shares authorized, 235,937,811 and 234,896,137 shares issued, and 179,573,270 and 181,185,861 shares outstanding at August 31, 2016 and February 29, 2016, respectively		24			23
Additional paid-in capital		2,215,856			2,162,264
Retained earnings		1,219,246			1,099,738
Treasury stock at cost, 56,364,541 and 53,710,276 shares at August 31, 2016 and February 29, 2016, respectively		(2,047,008	)		(1,853,144	)
Accumulated other comprehensive loss		(69,722	)		(74,449	)

Total stockholders’ equity		1,318,396			1,334,432

Total liabilities and stockholders’ equity	$	4,100,756		$	4,155,099

(1)	Derived from audited financial statements.

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

RED HAT, INC.

CONSOLIDATED STATEMENTS OF OPERATIONS

(In thousands—except per share amounts)

(Unaudited)


	Three Months Ended					Six Months Ended
	August 31, 2016		August 31, 2015			August 31, 2016			August 31, 2015
Revenue:
Subscriptions	$	531,209	$	441,526		$	1,032,874		$	866,319
Training and services		68,596		62,622			134,829			118,830

Total subscription and training and services revenue		599,805		504,148			1,167,703			985,149

Cost of subscription and training and services revenue:
Cost of subscriptions		39,678		30,996			76,222			60,843
Cost of training and services		47,993		44,968			95,496			86,519

Total cost of subscription and training and services revenue		87,671		75,964			171,718			147,362

Gross profit		512,134		428,184			995,985			837,787

Operating expense:
Sales and marketing		253,255		205,101			496,503			403,973
Research and development		121,265		102,488			236,281			199,919
General and administrative		55,730		44,125			105,954			86,496

Total operating expense		430,250		351,714			838,738			690,388

Income from operations		81,884		76,470			157,247			147,399
Interest income		3,392		2,895			6,821			5,611
Interest expense		5,925		5,733			11,811			11,448
Other income (expense), net		84		(1,245	)		(468	)		(1,448	)

Income before provision for income taxes		79,435		72,387			151,789			140,114
Provision for income taxes		20,663		20,992			31,832			40,633

Net income	$	58,772	$	51,395		$	119,957		$	99,481

Basic net income per common share	$	0.33	$	0.28		$	0.66		$	0.54
Diluted net income per common share	$	0.32	$	0.28		$	0.65		$	0.53
Weighted average shares outstanding
Basic		180,322		183,179			180,745			183,155
Diluted		183,346		186,750			183,750			186,493

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

RED HAT, INC.

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

(In thousands)

(Unaudited)


	Three Months Ended						Six Months Ended
	August 31, 2016			August 31, 2015			August 31, 2016			August 31, 2015
Net income	$	58,772		$	51,395		$	119,957		$	99,481
Other comprehensive income (loss):
Change in foreign currency translation adjustment		(2,472	)		2,623			3,445			(3,006	)
Available-for-sale securities:
Unrealized gain (loss) on available-for-sale securities during the period		708			(2,138	)		1,946			(2,544	)
Reclassification for (gain) loss realized on available-for-sale securities, reported in Other income (expense), net		—			(2	)		(9	)		3
Tax benefit (expense)		(211	)		672			(655	)		719

Net change in available-for-sale securities (net of tax)		497			(1,468	)		1,282			(1,822	)

Total other comprehensive income (loss)		(1,975	)		1,155			4,727			(4,828	)

Comprehensive income	$	56,797		$	52,550		$	124,684		$	94,653

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

RED HAT, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands)

(Unaudited)


	Three Months Ended						Six Months Ended
	August 31, 2016			August 31, 2015			August 31, 2016			August 31, 2015
Cash flows from operating activities:
Net income	$	58,772		$	51,395		$	119,957		$	99,481
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization		21,160			18,538			41,862			37,085
Amortization of debt discount and transaction costs		5,393			5,222			10,758			10,417
Share-based compensation expense		45,357			40,537			86,632			77,059
Deferred income taxes		(5,467	)		(3,843	)		(7,619	)		(1,929	)
Excess tax benefits from share-based payment arrangements		1,185			2,812			9,135			9,231
Net amortization of bond premium on debt securities available for sale		3,294			3,139			6,834			5,736
Other		328			1,078			(437	)		1,908
Changes in operating assets and liabilities, net of effects of acquisitions:
Accounts receivable		(30,684	)		(17,908	)		159,645			161,479
Prepaid expenses		8,883			13,077			(490	)		12,651
Accounts payable and accrued expenses		18,578			34,415			(19,558	)		(17,932	)
Deferred revenue		(26,953	)		(25,017	)		(73,046	)		(56,579	)
Other		(3,044	)		(356	)		(4,574	)		(340	)

Net cash provided by operating activities		96,802			123,089			329,099			338,267

Cash flows from investing activities:
Purchase of investment in debt securities available for sale		(163,043	)		(196,613	)		(297,644	)		(602,824	)
Proceeds from sales and maturities of investment in debt securities available for sale		177,528			170,617			294,710			353,200
Acquisition of businesses, net of cash acquired		(28,667	)		(1,700	)		(28,667	)		(1,700	)
Purchase of other intangible assets		(3,521	)		(2,068	)		(6,389	)		(5,997	)
Purchase of property and equipment		(15,539	)		(10,277	)		(33,192	)		(20,973	)
Other		—			(1,159	)		(111	)		(3,158	)

Net cash used in investing activities		(33,242	)		(41,200	)		(71,293	)		(281,452	)

Cash flows from financing activities:
Proceeds from exercise of common stock options		689			480			2,068			2,589
Payments related to net settlement of share-based compensation awards		(6,398	)		(7,726	)		(37,476	)		(32,937	)
Purchase of treasury stock		(127,386	)		(70,079	)		(193,864	)		(70,079	)
Payments on other borrowings		(463	)		(385	)		(906	)		(737	)
Other		415			—			913			—

Net cash used in financing activities		(133,143	)		(77,710	)		(229,265	)		(101,164	)

Effect of foreign currency exchange rates on cash and cash equivalents		8,587			(3,494	)		14,250			(11,517	)

Net increase (decrease) in cash and cash equivalents		(60,996	)		685			42,791			(55,866	)
Cash and cash equivalents at beginning of the period		1,031,565			990,922			927,778			1,047,473

Cash and cash equivalents at end of the period	$	970,569		$	991,607		$	970,569		$	991,607

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

RED HAT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

NOTE 1—Company

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 is often 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 to the Consolidated Financial Statements contained in the Company’s Annual Report on Form 10-K for the fiscal year ended February 29, 2016.

NOTE 2—Summary of Significant Accounting Policies

Basis of presentation

The unaudited interim consolidated financial statements as of and for the three and six months ended August 31, 2016 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 United States of America. Operating results for the three and six months ended August 31, 2016 are not necessarily indicative of the results that may be expected for the fiscal year ending February 28, 2017. Certain information and footnote disclosures normally included in annual financial statements prepared in accordance with accounting principles generally accepted in the United States of America 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 29, 2016. Other than the accounting pronouncement adopted during the three months ended May 31, 2016 related to accounting for share-based compensation 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 29, 2016. These unaudited financial statements should be read in conjunction with the financial statements included in the Annual Report on Form 10-K.

RED HAT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

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 have been eliminated in consolidation. There are no significant foreign currency exchange restrictions on the Company’s foreign subsidiaries.

Use of estimates

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America 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.

Accounting pronouncement adopted

In March 2016, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update 2016-09, Compensation-Stock Compensation (Topic 718): Improvements to Employee Share-Based Payment Accounting (“ASU 2016-09”), to simplify several aspects of the accounting for share-based compensation, including the income tax consequences. This guidance is effective for the Company as of the first quarter of the fiscal year ending February 28, 2018. However, the Company elected to early adopt ASU 2016-09 effective March 1, 2016.

Impact to Consolidated Statements of Operations

One of the more significant impacts of adopting ASU 2016-09 is the required change in how the Company recognizes the excess tax benefits (“windfalls”) or deficiencies (“shortfalls”) related to share-based compensation. For example, prior to adopting ASU 2016-09 such windfalls and shortfalls were credited or charged, respectively, to additional paid-in capital in the Company’s Consolidated Balance Sheets. Under ASU 2016-09, these windfalls and shortfalls are recognized as a discrete tax benefit or discrete tax expense, respectively, in the Company’s Consolidated Statements of Operations. For the three and six months ended August 31, 2016, the Company recognized a discrete tax benefit of $1.0 million and $8.9 million, respectively, related to net windfall tax benefits from share-based compensation.

ASU 2016-09 requires companies to adopt the amendment related to accounting for windfalls and shortfalls on a prospective basis only. As a result, no change has been made to the Consolidated Statement of Operations for the three and six months ended August 31, 2015 related to the $2.9 million and $8.4 million, respectively, of net windfall tax benefits the Company recognized as additional paid-in capital during the three and six months ended August 31, 2015. Net windfall tax benefits of $8.4 million recognized as additional paid-in-capital during the six months ended August 31, 2015 includes gross windfall tax benefits of $9.2 million net of $0.8 million shortfall tax expense. During the three months ended August 31, 2015, shortfall tax expense was less than $0.1 million.

Impact to Consolidated Statements of Cash Flows

In addition to the income tax consequences described above, under ASU 2016-09 all windfall tax benefits related to share-based payments are reported as cash flows from operating activities along with all other income tax cash flows. Previously, windfall tax benefits from share-based payment arrangements were reported as cash flows from financing activities.

With respect to the classification of windfall tax benefits on the statement of cash flows, ASU 2016-09 allows companies to elect either a prospective or retrospective application. The Company has elected to apply

RED HAT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

this classification amendment retrospectively. As a result, $2.8 million and $9.2 million, respectively, of windfall tax benefits previously reported as cash flows from financing activities on the Company’s Consolidated Statement of Cash Flows for the three and six months ended August 31, 2015 have been reclassified as cash flows from operating activities.

Impact to Consolidated Balance Sheets

ASU 2016-09 requires that certain other amendments relevant to the Company be applied using a modified-retrospective transition method by means of a cumulative-effect adjustment to retained earnings as of the beginning of the period in which the guidance is adopted. As a result of adopting ASU 2016-09 during the three months ended May 31, 2016, the Company adjusted retained earnings for amendments related to (i) the timing of when unrealized net windfall tax benefits are recognized and (ii) an entity-wide accounting policy election to recognize share-based award forfeitures only as they occur rather than estimate by applying a forfeiture rate. The following table summarizes the impact to the Company’s Consolidated Balance Sheet, including the net amount charged to retained earnings as of March 1, 2016 (in thousands):


	As of March 1, 2016
	Balance Sheet Classification	Amount
Increase to additional paid-in capital resulting from the Company’s election to recognize forfeitures as they occur rather than applying an estimated forfeiture rate	Additional paid-in capital	$	2,369
Recognition of deferred tax assets related to cumulative-effect adjustment from the Company’s election to recognize forfeitures as they occur	Deferred tax assets, net	$	603
Recognition of deferred tax assets related to certain unrealized net windfall tax benefits from share-based compensation	Deferred tax assets, net	$	1,316
Net charge to retained earnings for cumulative-effect adjustment from adoption of ASU 2016-09	Retained earnings	$	450

Accounting pronouncements being evaluated

In August 2016, the FASB issued Accounting Standards Update 2016-15, Statement of Cash Flows (Topic 230): Classification of Certain Cash Receipts and Cash Payments (“ASU 2016-15”). The FASB issued ASU 2016-15 to decrease the diversity in practice in how certain cash receipts and cash payments are presented and classified in the statement of cash flows. The amendments in this update provide guidance on eight specific cash flow issues. This guidance is effective for the Company as of the first quarter of its fiscal year ending February 28, 2019 and should be applied using the retrospective transition method to each period presented. Early adoption is permitted but all amendments must be adopted in the same period. The Company is currently evaluating the impact that this updated standard will have on its consolidated financial statements.

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, 2019. 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 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. This guidance is effective for the Company as of the first quarter of the fiscal year ending February 28, 2019. The Company is currently evaluating the impact that this updated standard will have on its consolidated financial statements.

In May 2014, the FASB issued Accounting Standards Update 2014-09, Revenue from Contracts with Customers (“ASU 2014-09”). The FASB issued ASU 2014-09 to clarify the principles for recognizing revenue and to develop a common revenue standard for generally accepted accounting principles (“GAAP”) and International Financial Reporting Standards. 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. This guidance is effective for the Company beginning the first quarter of its fiscal year ending February 28, 2019. The standard must be adopted using either a full retrospective approach for all periods presented in the period of adoption or a modified retrospective approach. The Company has initiated an assessment of its systems, data and processes related to the implementation of this accounting standard. This assessment is expected to be completed during the fiscal year ending February 28, 2017. Additionally, the Company is currently evaluating the potential impact that the implementation of this updated standard will have on its consolidated financial statements.

NOTE 3—Changes in Equity

The following table summarizes the changes in the Company’s stockholders’ equity during the three months ended August 31, 2016 (in thousands):


	Common Stock		Additional Paid-In Capital			Retained Earnings		Treasury Stock			Accumulated Other Comprehensive Income (Loss)			Total Stockholders’ Equity
Balance at May 31, 2016	$	24	$	2,176,208		$	1,160,472	$	(1,919,622	)	$	(67,747	)	$	1,349,335
Net income		—		—			58,772		—			—			58,772
Other comprehensive loss, net of tax		—		—			—		—			(1,975	)		(1,975	)
Exercise of common stock options		—		689			—		—			—			689
Common stock repurchase (see NOTE 10)		—		—			—		(127,386	)		—			(127,386	)
Share-based compensation expense		—		45,357			—		—			—			45,357
Minimum tax withholdings paid by the Company on behalf of employees related to net settlement of employee share-based awards		—		(6,398	)		—		—			—			(6,398	)
Other adjustments		—		—			2		—			—			2

Balance at August 31, 2016	$	24	$	2,215,856		$	1,219,246	$	(2,047,008	)	$	(69,722	)	$	1,318,396

RED HAT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

The following table summarizes the changes in the Company’s stockholders’ equity during the three months ended August 31, 2015 (in thousands):


	Common Stock		Additional Paid-In Capital			Retained Earnings		Treasury Stock			Accumulated Other Comprehensive Income (Loss)			Total Stockholders’ Equity
Balance at May 31, 2015	$	23	$	2,058,046		$	948,459	$	(1,590,501	)	$	(66,604	)	$	1,349,423
Net income		—		—			51,395		—			—			51,395
Other comprehensive income, net of tax		—		—			—		—			1,155			1,155
Exercise of common stock options		—		480			—		—			—			480
Common stock repurchase		—		—			—		(70,079	)		—			(70,079	)
Share-based compensation expense		—		40,537			—		—			—			40,537
Net tax benefits related to share-based awards		—		2,865			—		—			—			2,865
Minimum tax withholdings paid by the Company on behalf of employees related to net settlement of employee share-based awards		—		(7,726	)		—		—			—			(7,726	)

Balance at August 31, 2015	$	23	$	2,094,202		$	999,854	$	(1,660,580	)	$	(65,449	)	$	1,368,050

The following table summarizes the changes in the Company’s stockholders’ equity during the six months ended August 31, 2016 (in thousands):


	Common Stock		Additional Paid-In Capital			Retained Earnings			Treasury Stock			Accumulated Other Comprehensive Income (Loss)			Total Stockholders’ Equity
Balance at February 29, 2016	$	23	$	2,162,264		$	1,099,738		$	(1,853,144	)	$	(74,449	)	$	1,334,432
Net income		—		—			119,957			—			—			119,957
Other comprehensive income, net of tax		—		—			—			—			4,727			4,727
Exercise of common stock options		1		2,067			—			—			—			2,068
Common stock repurchase (see NOTE 10)		—		—			—			(193,864	)		—			(193,864	)
Share-based compensation expense		—		86,632			—			—			—			86,632
Minimum tax withholdings paid by the Company on behalf of employees related to net settlement of employee share-based awards		—		(37,476	)		—			—			—			(37,476	)
Other adjustments		—		—			1			—			—			1
Cumulative-effect adjustment from adoption of ASU 2016-09		—		2,369			(450	)		—			—			1,919

Balance at August 31, 2016	$	24	$	2,215,856		$	1,219,246		$	(2,047,008	)	$	(69,722	)	$	1,318,396

RED HAT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

The following table summarizes the changes in the Company’s stockholders’ equity during the six months ended August 31, 2015 (in thousands):


	Common Stock		Additional Paid-In Capital			Retained Earnings		Treasury Stock			Accumulated Other Comprehensive Income (Loss)			Total Stockholders’ Equity
Balance at February 28, 2015	$	23	$	1,963,851		$	900,373	$	(1,515,288	)	$	(60,621	)	$	1,288,338
Net income		—		—			99,481		—			—			99,481
Other comprehensive loss, net of tax		—		—			—		—			(4,828	)		(4,828	)
Exercise of common stock options		—		2,589			—		—			—			2,589
Common stock repurchase		—		75,000			—		(145,079	)		—			(70,079	)
Share-based compensation expense		—		77,059			—		—			—			77,059
Net tax benefits related to share-based awards		—		8,427			—		—			—			8,427
Minimum tax withholdings paid by the Company on behalf of employees related to net settlement of employee share-based awards		—		(32,937	)		—		—			—			(32,937	)
Other adjustments		—		213			—		(213	)		—			—

Balance at August 31, 2015	$	23	$	2,094,202		$	999,854	$	(1,660,580	)	$	(65,449	)	$	1,368,050

Accumulated other comprehensive loss

The following is a summary of accumulated other comprehensive loss as of August 31, 2016 and February 29, 2016 (in thousands):


	As of August 31, 2016			As of February 29, 2016
Accumulated loss from foreign currency translation adjustment	$	(70,331	)	$	(73,776	)
Accumulated unrealized gain (loss), net of tax, on available-for-sale securities		609			(673	)

Accumulated other comprehensive loss	$	(69,722	)	$	(74,449	)

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, 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 related asset’s pattern of economic benefit or on a straight-line basis if a straight-line basis results in a greater amount of amortization for the period reported. Useful lives range from two to ten years. As of August 31, 2016 and February 29, 2016, trademarks with an indefinite estimated useful life totaled $11.3 million and $11.1 million, respectively.

RED HAT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

The following is a summary of identifiable intangible assets (in thousands):


	As of August 31, 2016							As of February 29, 2016
	Gross Amount		Accumulated Amortization			Net Amount		Gross Amount		Accumulated Amortization			Net Amount
Trademarks, copyrights and patents	$	145,089	$	(54,541	)	$	90,548	$	138,106	$	(49,876	)	$	88,230
Purchased technologies		100,581		(75,533	)		25,048		96,105		(70,940	)		25,165
Customer and reseller relationships		104,950		(84,596	)		20,354		104,593		(80,329	)		24,264
Covenants not to compete		14,007		(11,522	)		2,485		13,240		(9,875	)		3,365
Other intangible assets		8,833		(4,474	)		4,359		8,833		(3,786	)		5,047

Total identifiable intangible assets	$	373,460	$	(230,666	)	$	142,794	$	360,877	$	(214,806	)	$	146,071

Amortization expense associated with identifiable intangible assets recognized in the Company’s Consolidated Financial Statements for the three and six months ended August 31, 2016 and August 31, 2015 is summarized as follows (in thousands):


	Three Months Ended				Six Months Ended
	August 31, 2016		August 31, 2015		August 31, 2016		August 31, 2015
Cost of revenue	$	4,190	$	2,963	$	8,157	$	5,880
Sales and marketing		1,905		2,009		3,820		4,014
Research and development		34		292		69		542
General and administrative		1,848		1,160		3,601		2,212

Total amortization expense	$	7,977	$	6,424	$	15,647	$	12,648

NOTE 5—Income Taxes

The following table summarizes the Company’s tax provision for the three and six months ended August 31, 2016 and August 31, 2015 (in thousands):


	Three Months Ended						Six Months Ended
	August 31, 2016			August 31, 2015			August 31, 2016			August 31, 2015
Income before provision for income taxes	$	79,435		$	72,387		$	151,789		$	140,114
Estimated annual effective tax rate		27	%		29	%		27	%		29	%

Provision for income taxes before discrete tax items		21,447			20,992			40,983			40,633
Discrete tax benefits related to net excess tax benefits from share-based payments		(1,002	)		—			(8,940	)		—
Other discrete tax expense (benefits)		218			—			(211	)		—

Provision for income taxes	$	20,663		$	20,992		$	31,832		$	40,633

For the three and six months ended August 31, 2016, the Company’s estimated annual effective tax rate of 27% differed from the U.S. federal statutory rate of 35% principally due to foreign income taxed at lower rates, research tax credits and the domestic production activities deduction. Tax expense for the three and six months

RED HAT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

ended August 31, 2016 included a discrete tax benefit of $1.0 million and $8.9 million, respectively, related to net excess tax benefits from share-based payments resulting from the Company’s early adoption of ASU 2016-09. See NOTE 2—Summary of Significant Accounting Policies for more details regarding the adoption of ASU 2016-09.

For the three and six months ended August 31, 2015, the Company’s then-estimated annual effective tax rate of 29% differed from the U.S. federal statutory rate of 35%, principally due to foreign income taxed at lower rates, state income taxes net of federal benefits and the domestic production activities deduction.

NOTE 6—Assets and Liabilities Measured at Fair Value on a Recurring Basis

Fair value is defined as the exchange price that would be received for the purchase of an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for such asset or liability in an orderly transaction between market participants on the measurement date. Valuation techniques used to measure fair value should maximize the use of observable inputs and minimize the use of unobservable inputs. To measure fair value, the Company uses the following fair value hierarchy based on three levels of inputs, of which the first two are considered observable and the last unobservable:

Level 1—Quoted prices in active markets for identical assets or liabilities.

Level 2—Inputs other than Level 1 that are observable, either directly or indirectly, such as quoted prices for similar assets or liabilities; quoted prices in markets that are not active; or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the assets or liabilities.

Level 3—Unobservable inputs that are supported by little or no market activity and are significant to the fair value of the assets or liabilities.

The Company’s investments are comprised primarily of debt securities that are classified as available for sale and recorded at their fair market values. Liquid investments with effective maturities of three months or less at the date of purchase are classified as cash equivalents. Investments with remaining effective maturities of twelve months or less from the balance sheet date are classified as short-term investments. Investments with remaining effective maturities of more than twelve months from the balance sheet date are classified as long-term investments. The Company’s Level 1 financial instruments are valued using quoted prices in active markets for identical instruments. The Company’s Level 2 financial instruments, including derivative instruments, are valued using quoted prices for identical instruments in less active markets or using other observable market inputs for comparable instruments.

Unrealized gains and temporary losses on investments classified as available for sale are included within accumulated other comprehensive income, net of any related tax effect. Upon realization, such amounts are reclassified from accumulated other comprehensive income to Other income (expense), net. Realized gains and losses and other than temporary impairments, if any, are reflected in the consolidated statements of operations as Other income (expense), net. The Company does not recognize changes in the fair value of its investments in income unless a decline in value is considered other than temporary. The vast majority of the Company’s investments are priced by pricing vendors. These pricing vendors use the most recent observable market information in pricing these securities or, if specific prices are not available for these securities, use other observable inputs. In the event observable inputs are not available, the Company assesses other factors to determine the security’s market value, including broker quotes or model valuations. Independent price verifications of all holdings are performed by pricing vendors, which are then reviewed by the Company. In the event a price fails a pre-established tolerance check, it is researched so that the Company can assess the cause of the variance to determine what the Company believes is the appropriate fair market value.

RED HAT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

The Company minimizes its credit risk associated with investments by investing primarily in investment grade, liquid securities. The Company’s policy is designed to limit exposures to any one issuer depending on credit quality. Periodic evaluations of the relative credit standing of those issuers are considered in the Company’s investment strategy.

The following table summarizes the composition and fair value hierarchy of the Company’s financial assets and liabilities at August 31, 2016 (in thousands):


	As of August 31, 2016			Quoted Prices In Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)			Significant Unobservable Inputs (Level 3)
Assets:
Available-for-sale securities (1):
Money markets	$	196,182		$	196,182	$	—		$	—
U.S. agency securities		314,490			—		314,490			—
Corporate securities		757,586			—		757,586			—
Foreign currency derivatives (2)		51			—		51			—
Liabilities:
Foreign currency derivatives (3)		(89	)		—		(89	)		—

Total	$	1,268,220		$	196,182	$	1,072,038		$	—

(1)	Included in Cash and cash equivalents, Investments in debt securities, short-term or Investments in debt securities, long-term in the Company’s Consolidated Balance Sheet at August 31, 2016, in addition to $774.4 million of cash.

(2)	Included in Other current assets in the Company’s Consolidated Balance Sheet at August 31, 2016.

(3)	Included in Accounts payable and accrued expenses in the Company’s Consolidated Balance Sheet at August 31, 2016.

The following table summarizes the composition and fair value hierarchy of the Company’s financial assets and liabilities at February 29, 2016 (in thousands):


	As of February 29, 2016			Quoted Prices In Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)			Significant Unobservable Inputs (Level 3)
Assets:
Available-for-sale securities (1):
Money markets	$	221,970		$	221,970	$	—		$	—
U.S. agency securities		331,117			—		331,117			—
Corporate securities		736,495			—		736,495			—
Foreign currency derivatives (2)		566			—		566			—
Liabilities:
Foreign currency derivatives (3)		(452	)		—		(452	)		—

Total	$	1,289,696		$	221,970	$	1,067,726		$	—

(1)	Included in Cash and cash equivalents, Investments in debt securities, short-term or Investments in debt securities, long-term in the Company’s Consolidated Balance Sheet at February 29, 2016, in addition to $705.8 million of cash.

RED HAT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

(2)	Included in Other current assets in the Company’s Consolidated Balance Sheet at February 29, 2016.

(3)	Included in Accounts payable and accrued expenses in the Company’s Consolidated Balance Sheet at February 29, 2016.

The following table represents the Company’s available-for-sale investments measured at fair value as of August 31, 2016 (in thousands):


	Amortized		Gross Unrealized					Aggregate		Balance Sheet Classification
	Amortized		Gross Unrealized					Aggregate		Cash Equivalent Marketable Securities		Investments in debt securities, short-term		Investments in debt securities, long-term
	Cost		Gains		Losses (1)			Fair Value		Cash Equivalent Marketable Securities		Investments in debt securities, short-term		Investments in debt securities, long-term
Money markets	$	196,182	$	—	$	—		$	196,182	$	196,182	$	—	$	—
U.S. agency securities		314,997		128		(635	)		314,490		—		60,357		254,133
Corporate securities		756,555		1,581		(550	)		757,586		—		304,771		452,815

Total	$	1,267,734	$	1,709	$	(1,185	)	$	1,268,258	$	196,182	$	365,128	$	706,948

(1)	As of August 31, 2016, there were $0.3 million of accumulated unrealized losses related to investments that have been in a continuous unrealized loss position for 12 months or longer.

The following table represents the Company’s available-for-sale investments measured at fair value as of February 29, 2016 (in thousands):


	Amortized		Gross Unrealized					Aggregate		Balance Sheet Classification
										Cash Equivalent Marketable Securities		Investments in debt securities, short-term		Investments in debt securities, long-term


	Cost		Gains		Losses (1)			Fair Value
Money markets	$	221,970	$	—	$	—		$	221,970	$	221,970	$	—	$	—
U.S. agency securities		331,302		160		(345	)		331,117		—		50,453		280,664
Corporate securities		737,723		994		(2,222	)		736,495		—		230,689		505,806

Total	$	1,290,995	$	1,154	$	(2,567	)	$	1,289,582	$	221,970	$	281,142	$	786,470

(1)	As of February 29, 2016, there were $0.9 million of accumulated unrealized losses related to investments that have been in a continuous unrealized loss position for 12 months or longer.

NOTE 7—Derivative Instruments

The Company transacts business in various foreign countries and is, therefore, subject to risk of foreign currency exchange rate fluctuations. The Company from time to time 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 on the Consolidated Balance Sheets at their respective fair market values. The Company does not designate these forward contracts as hedging instruments under applicable accounting guidance and, therefore, changes in fair value are recorded in the Consolidated Statements of Operations.

RED HAT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

The effects of derivative instruments on the Company’s Consolidated Financial Statements are as follows as of August 31, 2016 and for the three and six months then ended (in thousands):


							Classification of Gain (Loss) Recognized in Income on Derivatives	Three Months Ended August 31, 2016			Six Months Ended August 31, 2016
	As of August 31, 2016							Three Months Ended August 31, 2016			Six Months Ended August 31, 2016
	As of August 31, 2016							Amount of Gain (Loss) Recognized
	Balance Sheet Classification	Fair Value			Notional Value			in Income on Derivatives
Assets—foreign currency forward contracts not designated as hedges	Other current assets	$	51		$	15,188	Other income (expense), net	$	1,204		$	2,403
Liabilities—foreign currency forward contracts not designated as hedges	Accounts payable and accrued expenses		(89	)		18,783	Other income (expense), net		(321	)		(999	)

Total		$	(38	)	$	33,971		$	883		$	1,404

The effects of derivative instruments on the Company’s Consolidated Financial Statements are as follows as of August 31, 2015 and for the three and six months then ended (in thousands):


							Classification of Gain (Loss) Recognized in Income on Derivatives	Three Months Ended August 31, 2015			Six Months Ended August 31, 2015
	As of August 31, 2015							Three Months Ended August 31, 2015			Six Months Ended August 31, 2015
	As of August 31, 2015							Amount of Gain (Loss) Recognized
	Balance Sheet Classification	Fair Value			Notional Value			in Income on Derivatives
Assets—foreign currency forward contracts not designated as hedges	Other current assets	$	263		$	32,302	Other income (expense), net	$	592		$	1,272
Liabilities—foreign currency forward contracts not designated as hedges	Accounts payable and accrued expenses		(67	)		3,607	Other income (expense), net		(437	)		(1,246	)

Total		$	196		$	35,909		$	155		$	26

NOTE 8—Share-based Awards

The Company measures share-based compensation cost at the grant date, based on the estimated fair value of the award and recognizes the cost over the employee requisite service period, typically on a straight-line basis. The Company estimates the fair value of stock options using the Black-Scholes-Merton valuation model. The fair value of nonvested share awards, nonvested share units and performance share units are measured at their underlying closing share price on the day of grant. Effective March 1, 2016, the Company adopted ASU 2016-09. Upon adoption of ASU 2016-09 the Company made an accounting policy election to account for forfeitures as they occur rather than apply an estimated forfeiture rate. See NOTE 2—Summary of Significant Accounting Policies for more details regarding the adoption of ASU 2016-09.

RED HAT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

The following summarizes share-based compensation expense recognized in the Company’s Consolidated Financial Statements for the three and six months ended August 31, 2016 and August 31, 2015 (in thousands):


	Three Months Ended				Six Months Ended
	August 31, 2016		August 31, 2015		August 31, 2016		August 31, 2015
Cost of revenue	$	4,054	$	4,151	$	8,359	$	7,877
Sales and marketing		20,361		16,782		38,802		32,194
Research and development		12,969		12,022		24,971		22,897
General and administrative		7,973		7,582		14,500		14,091

Total share-based compensation expense	$	45,357	$	40,537	$	86,632	$	77,059

Share-based compensation expense qualifying for capitalization was insignificant for each of the three and six months ended August 31, 2016 and August 31, 2015. Accordingly, no share-based compensation expense was capitalized during the three and six months ended August 31, 2016 and August 31, 2015.

During the three and six months ended August 31, 2016 and August 31, 2015, the Company granted the following share-based awards:


	Three Months Ended
	August 31, 2016					August 31, 2015
	Shares and Shares Underlying Awards			Weighted Average Per Share Award Fair Value		Shares and Shares Underlying Awards		Weighted Average Per Share Award Fair Value
Service-based shares and share units		133,550		$	72.80		118,881	$	80.58
Performance share units—target		1,826	(1)	$	72.80		112,360	$	80.59
Performance share awards		—		$	—		56,180	$	80.59

Total awards		135,376		$	72.80		287,421	$	80.59


	Six Months Ended
	August 31, 2016					August 31, 2015
	Shares and Shares Underlying Awards			Weighted Average Per Share Award Fair Value		Shares and Shares Underlying Awards		Weighted Average Per Share Award Fair Value
Service-based shares and share units		1,068,440		$	75.12		926,477	$	75.55
Performance share units—target		362,502	(1)	$	76.68		370,478	$	78.28
Performance share awards		140,182	(2)	$	76.70		154,705	$	78.48

Total awards		1,571,124		$	75.62		1,451,660	$	76.56

(1)

Certain executives and senior management were awarded a target number of performance share units (“PSUs”). PSU grantees may earn up to 200% of the target number of PSUs. Half of the target number of PSUs can be earned by the grantees depending upon the Company’s financial performance measured against the financial performance of specified peer companies during a three-year performance period beginning on March 1, 2016. The remaining target number of PSUs can be earned by the grantees depending upon the Company’s total shareholder return performance measured against the total shareholder return performance of specified peer companies during a three-year period beginning on March 1, 2016.

RED HAT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

(2)

Certain executives were granted restricted stock awards. These shares were awarded subject to the achievement of a specified dollar amount of revenue for FY2017 (the “RSA Performance Goal”). If the Company fails to achieve the RSA Performance Goal for FY2017, then all such shares are forfeited. If the Company achieves the RSA Performance Goal for FY2017, then 25% of the restricted stock vests on or about July 16, 2017, and the remainder vests ratably on a quarterly basis over the course of the subsequent three-year period, provided that the grantee’s business relationship with the Company has not ceased.

NOTE 9—Earnings Per Share

The Company computes basic net income per common share by dividing net income available to common stockholders by the weighted average number of common shares outstanding. Diluted net income per common share is computed by dividing net income by the weighted average number of common shares and dilutive potential common share equivalents then outstanding. Potential common share equivalents consist of shares issuable upon the exercise of stock options or vesting of share-based awards.

The following table reconciles the numerators and denominators of the earnings per share (“EPS”) calculation for the three and six months ended August 31, 2016 and August 31, 2015 (in thousands, except per share amounts):


	Three Months Ended				Six Months Ended
	August 31, 2016		August 31, 2015		August 31, 2016		August 31, 2015
Net income, basic and diluted	$	58,772	$	51,395	$	119,957	$	99,481

Weighted average common shares outstanding		180,322		183,179		180,745		183,155
Incremental shares attributable to assumed vesting or exercise of outstanding equity award shares		2,829		2,986		2,923		3,009
Dilutive effect of convertible notes		195		585		82		329

Diluted shares		183,346		186,750		183,750		186,493

Diluted net income per share	$	0.32	$	0.28	$	0.65	$	0.53

With respect to the Company’s convertible notes, the Company has the option to pay cash or deliver, as the case may be, either cash, shares of its common stock or a combination of cash and shares of its common stock for the aggregate amount due upon conversion of the convertible notes. The Company’s intent is to settle the principal amount of the convertible notes in cash upon conversion. As a result, upon conversion of the convertible notes, only the amounts payable in excess of the principal amounts of the convertible notes would be considered in diluted earnings per share under the treasury stock method. See NOTE 15—Convertible Notes for detailed information on the convertible notes.

Warrants to purchase 10,965,630 shares of the Company’s common stock at $101.65 per share were outstanding during the three and six months ended August 31, 2016 and August 31, 2015 but were not included in the computation of diluted EPS because the warrants’ exercise price was greater than the average market price of the Company’s common stock during the related period.

RED HAT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

The following employee share awards were not included in the computation of diluted earnings per share because the aggregate value of proceeds considered received upon either exercise or vesting was greater than the average market price of the Company’s common stock during the related periods and the effect of including such share awards in the computation would be anti-dilutive (in thousands):

Three Months Ended

Six Months Ended

August 31,
2016

August 31,
2015

August 31,
2016

August 31,
2015

Number of shares considered anti-dilutive for calculating diluted EPS

158

105

307

NOTE 10—Share Repurchase Programs

On March 25, 2015, the Company announced that its Board of Directors (the “Board”) had authorized the repurchase of up to $500 million of Red Hat’s common stock from time to time on the open market or in privately negotiated transactions. The program was discontinued by the Board effective June 30, 2016.

From March 1, 2016 through its discontinuation on June 30, 2016, the Company repurchased 1,291,733 shares of its common stock for $94.4 million under this repurchase program.

On June 22, 2016, the Company announced that its Board authorized the repurchase of up to $1.0 billion of Red Hat’s common stock from time to time on the open market or in privately negotiated transactions. The new program commenced on July 1, 2016, and will expire on the earlier of (i) June 30, 2018 or (ii) a determination by the Board, Chief Executive Officer or Chief Financial Officer to discontinue the program. The new program replaced the previous $500 million repurchase program, which was discontinued by the Board effective June 30, 2016.

From its commencement on July 1, 2016 through August 31, 2016, the Company repurchased 1,362,532 shares of its common stock for $99.5 million under this repurchase program.

As of August 31, 2016, the amount available under this program for the repurchase of the Company’s common stock was $900.5 million.

RED HAT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

NOTE 11—Segment Reporting

The following summarizes revenue from unaffiliated customers and income (loss) from operations for the three and six months ended August 31, 2016 and August 31, 2015 and total cash, cash equivalents and available-for-sale investment securities and total assets as of August 31, 2016 and August 31, 2015, by geographic segment (in thousands):


	Americas		EMEA		Asia Pacific		Corporate (1)			Consolidated

	Three Months Ended August 31, 2016
Revenue from unaffiliated customers	$	385,529	$	127,467	$	86,809	$	—		$	599,805
Income (loss) from operations	$	71,595	$	28,210	$	27,436	$	(45,357	)	$	81,884

	Three Months Ended August 31, 2015
Revenue from unaffiliated customers	$	332,204	$	108,454	$	63,490	$	—		$	504,148
Income (loss) from operations	$	73,944	$	27,012	$	16,051	$	(40,537	)	$	76,470

	Six Months Ended August 31, 2016
Revenue from unaffiliated customers	$	751,252	$	251,766	$	164,685	$	—		$	1,167,703
Income (loss) from operations	$	141,352	$	53,898	$	48,629	$	(86,632	)	$	157,247
Total cash, cash equivalents and available-for-sale investment securities	$	1,113,971	$	634,013	$	294,661	$	—		$	2,042,645
Total assets	$	2,714,088	$	944,290	$	442,378	$	—		$	4,100,756

	Six Months Ended August 31, 2015
Revenue from unaffiliated customers	$	654,037	$	205,927	$	125,185	$	—		$	985,149
Income (loss) from operations	$	149,475	$	43,419	$	31,564	$	(77,059	)	$	147,399
Total cash, cash equivalents and available-for-sale investment securities	$	1,294,633	$	490,607	$	210,590	$	—		$	1,995,830
Total assets	$	2,735,505	$	760,412	$	305,554	$	—		$	3,801,471

(1)	Amounts represent share-based compensation expense for each of the three and six months ended August 31, 2016 and August 31, 2015, which was not allocated to geographic segments.

Supplemental information about geographic areas

The following table lists, for each of the three and six months ended August 31, 2016 and August 31, 2015, revenue from unaffiliated customers in the United States, the Company’s country of domicile, and revenue from unaffiliated customers from foreign countries (in thousands):


	Three Months Ended				Six Months Ended
	August 31, 2016		August 31, 2015		August 31, 2016		August 31, 2015
United States, the Company’s country of domicile	$	343,766	$	300,649	$	672,295	$	588,110
Foreign		256,039		203,499		495,408		397,039

Total revenue from unaffiliated customers	$	599,805	$	504,148	$	1,167,703	$	985,149

RED HAT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

Total tangible long-lived assets, net of accumulated depreciation, located in the United States, the Company’s country of domicile, and similar tangible long-lived assets, net of accumulated depreciation, held outside the United States are summarized in the following table as of August 31, 2016 and February 29, 2016 (in thousands):


	As of August 31, 2016		As of February 29, 2016
United States, the Company’s country of domicile	$	126,955	$	126,937
Foreign		45,357		39,949

Total tangible long-lived assets	$	172,312	$	166,886

Supplemental information about major customers

Major customer revenues and receivables were as follows:

For each of the three and six months ended August 31, 2016 and August 31, 2015, the U.S. government and its agencies represented in the aggregate approximately 10% of the Company’s total revenue.

At August 31, 2016, the Company had two customers whose accounts receivable balance individually represented 10% and 11%, respectively, of total accounts receivable. As of February 29, 2016, no individual customer accounted for 10% or more of our total accounts receivable.

Supplemental information about products and services

The following table, for each of the three and six months ended August 31, 2016 and August 31, 2015, provides further detail, by type, of the Company’s subscription and services revenues. Infrastructure-related offerings subscription revenue includes subscription revenue generated from Red Hat Enterprise Linux and related technologies such as Red Hat Satellite and Red Hat Enterprise Virtualization. Subscription revenue generated from the Company’s Application development-related and other emerging technology offerings includes Red Hat JBoss Middleware, Red Hat Storage, Red Hat Mobile and Red Hat cloud offerings such as Red Hat OpenStack Platform and OpenShift by Red Hat (in thousands):


	Three Months Ended				Six Months Ended
	August 31, 2016		August 31, 2015		August 31, 2016		August 31, 2015
Subscription revenue:
Infrastructure-related offerings	$	427,035	$	362,926	$	830,216	$	716,667
Application development-related and other emerging technology offerings		104,174		78,600		202,658		149,652

Total subscription revenue		531,209		441,526		1,032,874		866,319

Training and services revenue:
Consulting services		51,277		47,266		101,586		90,466
Training		17,319		15,356		33,243		28,364

Total training and services revenue		68,596		62,622		134,829		118,830

Total subscription and training and services revenue	$	599,805	$	504,148	$	1,167,703	$	985,149

RED HAT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

NOTE 12—Commitments and Contingencies

Operating leases

As of August 31, 2016, the Company had leases of office space and certain equipment under various non-cancelable operating leases. Rent expense under operating leases for the three months ended August 31, 2016 and August 31, 2015 was $9.2 million and $7.8 million, respectively. Rent expense under operating leases for the six months ended August 31, 2016 and August 31, 2015 was $17.7 million and $15.5 million, respectively.

Product indemnification

The Company is a party to a variety of agreements pursuant to which it may be obligated to indemnify the other party from losses arising in connection with the Company’s services or products, or from losses arising in connection with certain events defined within a particular contract, which may include litigation or claims relating to intellectual property infringement, certain losses arising from damage to property or injury to persons or other matters. In each of these circumstances, payment by the Company is conditioned on the other party making a claim pursuant to the procedures specified in the particular contract, which procedures typically allow the Company to challenge the other party’s claims. Further, the Company’s obligations under these agreements may in certain cases be limited in terms of time and/or amount, and in some instances, the Company may have recourse against third-parties for certain payments made by the Company.

It is not possible to predict the maximum potential amount of future payments under these or similar agreements due to the conditional nature of the Company’s obligations and the facts and circumstances involved in each particular agreement. The Company does not record a liability for claims related to indemnification unless the Company concludes that the likelihood of a material claim is probable and estimable. Historically, payments pursuant to these indemnifications have been immaterial.

NOTE 13—Legal Proceedings

The Company experiences routine litigation in the normal course of its business, including patent litigation. The Company presently believes that the outcome of this routine litigation will not have a material adverse effect on its financial position, results of operations or cash flows.

NOTE 14—Business Combinations

Acquisition of 3scale, Inc.

On June 24, 2016, the Company completed its acquisition of all of the shares of 3scale, Inc. (“3scale”), a provider of application programming interface (API) management technology. By adding 3scale to its existing portfolio, including Red Hat JBoss Middleware, Red Hat OpenShift and Red Hat Mobile Application Platform, the Company strengthens its enablement of the API economy with simplified cloud integration and microservices-based architectures.

The consideration paid was $29.1 million in cash. Based on management’s provisional assessment of the acquisition-date fair value of the assets acquired and liabilities assumed, the total consideration transferred of $29.1 million has been allocated to the Company’s assets and liabilities on a preliminary basis as follows: $24.3 million to goodwill, $6.4 million to identifiable intangible assets and $1.6 million to working capital as a net current liability.

RED HAT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

The Company incurred approximately $1.8 million in transaction costs, including legal and accounting fees, relating to the acquisition. These transaction costs have been expensed as incurred and included in general and administrative expense on the Company’s Consolidated Statements of Operations for the three and six months ended August 31, 2016.

Acquisition of Ansible, Inc.

On October 16, 2015, the Company completed its acquisition of all of the shares of Ansible, Inc. (“Ansible”). Ansible is a provider of IT automation solutions that allows its users to manage applications across hybrid cloud environments. The acquisition is intended to augment the Company’s management portfolio and help customers to deploy and manage applications across private and public clouds, speed service delivery through development and operations initiatives, streamline OpenStack installations and upgrades and accelerate container adoption by simplifying orchestration and configuration.

The consideration paid was $126.0 million and includes $125.2 million of cash. Based on management’s provisional assessment of the acquisition-date fair value of the assets acquired and liabilities assumed, the total consideration transferred of $126.0 million has been allocated to the Company’s assets and liabilities on a preliminary basis as follows: $102.4 million to goodwill, $25.1 million to identifiable intangible assets and $1.5 million to working capital as a net current liability.

During February 2016, the Company completed its valuation of the identifiable intangible assets acquired from Ansible. As a result of the valuation, the Company reduced its preliminary estimate of identifiable intangible assets by $17.3 million to $25.1 million as of February 29, 2016 from $42.4 million as of November 30, 2015. The $17.3 million measurement-period adjustment resulted in an increase to goodwill of $10.8 million and a decrease to deferred taxes of $6.5 million. This adjustment had no significant impact on the Company’s financial results. Management expects to finalize its assessment of the acquisition-date fair value of Ansible’s other assets and liabilities, primarily deferred income taxes, in early fiscal 2017.

Pro forma consolidated financial information

The following unaudited pro forma consolidated financial information reflects the results of operations of the Company for the three and six months ended August 31, 2015 (in thousands, except per share amounts) as if the acquisitions of 3scale and Ansible had closed on March 1, 2015, after giving effect to certain purchase accounting adjustments. These pro forma results are not necessarily indicative of what the Company’s operating results would have been had the acquisitions actually taken place at the beginning of the period. Pro forma consolidated financial information for the three and six months ended August 31, 2016 has not been provided because the acquisition of 3scale would not have had a significant impact on consolidated operating results if the acquisition had closed on March 1, 2016.


	Three Months Ended August 31, 2015		Six Months Ended August 31, 2015
Revenue	$	505,917	$	1,170,825
Net income	$	48,117	$	113,610
Basic net income per common share	$	0.26	$	0.63
Diluted net income per common share	$	0.26	$	0.62

RED HAT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

Goodwill

The following is a summary of changes in goodwill for the six months ended August 31, 2016 (in thousands):


Balance at February 29, 2016	$	1,027,277
Acquisition of 3scale		24,254
Impact of foreign currency fluctuations and other adjustments		2,341

Balance at August 31, 2016	$	1,053,872

The excess of purchase price paid for 3scale, Ansible and other acquisitions over the fair value of the net assets acquired was recognized as goodwill. Goodwill comprises the majority of the purchase price paid for each of the acquired businesses because these businesses were focused on emerging technologies such as development and operations automation, mobile technologies, cloud-enabling technologies and software-defined storage technologies, which consequently—at the time of acquisition—generated relatively little revenue. However, these acquired businesses, with their assembled, highly-specialized workforces and community of contributors, are expected to both expand the Company’s existing technology portfolio and advance the Company’s market position overall in open source solutions.

NOTE 15—Convertible Notes

Convertible notes offering

On October 7, 2014, the Company completed its offering of $805.0 million aggregate principal amount of its 0.25% Convertible Senior Notes due 2019 (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 Morgan Stanley & Co. LLC, Merrill Lynch, Pierce, Fenner & Smith Incorporated, Citigroup Global Markets Inc. and J.P. Morgan Securities LLC as representatives of the several initial purchasers named therein (collectively, the “Initial Purchasers”), for resale to qualified institutional buyers pursuant to Rule 144A under the Securities Act of 1933, as amended.

The Company used $148.0 million of the net proceeds from the offering of the convertible notes to pay the cost of the privately-negotiated convertible note hedge transactions described below. The Company received proceeds of $79.8 million from the sale of warrants pursuant to the warrant transactions described below.

In addition, the Company used $375.0 million of the net proceeds from the offering of the convertible notes to repurchase shares of its common stock under an accelerated share repurchase program pursuant to an agreement that the Company entered into on October 1, 2014 and completed on February 27, 2015.

The Company intends to use the remaining net proceeds from the offering for working capital and other general corporate purposes, which may include capital expenditures, potential acquisitions or strategic transactions.

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

RED HAT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

will be 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, and began 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 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. The initial conversion price represents a premium of approximately 30% to the $56.47 per share closing price of the Company’s common stock on October 1, 2014. 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.

Prior to April 1, 2019, the convertible notes will be convertible only upon the occurrence of certain circumstances, and will be convertible thereafter at any time until the close of business on the second scheduled trading day immediately preceding the maturity date of the convertible notes.

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 convertible 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 special interest up to but excluding the fundamental change purchase date.

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.

In accounting for the issuance of the convertible notes, the Company separated the convertible notes into liability and equity components. The carrying amount of the liability component was calculated by measuring the estimated fair value of a similar liability that does not have an associated convertible feature. The carrying amount of the equity component representing the conversion option was determined by deducting the fair value of the liability component from the face value of the convertible notes as a whole. 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 amortized to interest expense over the term of the convertible notes using the effective interest method with an effective interest rate of 2.86% per annum. The equity component is not remeasured as long as it continues to meet the conditions for equity classification.

RED HAT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

As of August 31, 2016 and February 29, 2016, the convertible notes consisted of the following (in thousands):


	As of August 31, 2016			As of February 29, 2016
Liability component:
Principal	$	805,000		$	805,000
Less: debt issuance costs		(8,755	)		(10,029	)
Less: debt discount		(61,545	)		(71,029	)

Net carrying amount	$	734,700		$	723,942

Equity component (1)	$	96,890		$	96,890

(1)	Recorded in the Consolidated Balance Sheet in Additional paid-in capital.

In accounting for the transaction costs related to the convertible note issuance, the Company allocated the total amount incurred of $15.2 million to the liability and equity components based on their relative fair values. Issuance costs attributable to the liability component totaled $13.4 million and are being amortized to interest expense over the term of the convertible notes using the effective interest method. The remaining $1.8 million of issuance costs have been allocated to the equity component and are included in Additional paid-in capital on the Company’s Consolidated Balance Sheet as of August 31, 2016. Additionally, the Company recorded a deferred tax asset of $0.7 million related to the $1.8 million equity component of transactional costs that are deductible for tax purposes.

The following table includes total interest expense recognized related to the convertible notes for the three and six months ended August 31, 2016 and August 31, 2015 (in thousands):


	Three Months Ended				Six Months Ended
	August 31, 2016		August 31, 2015		August 31, 2016		August 31, 2015
Coupon rate 0.25% per year, payable semiannually	$	503	$	503	$	1,006	$	1,006
Amortization of convertible note issuance costs—liability component		640		602		1,274		1,198
Accretion of debt discount		4,753		4,620		9,484		9,219

Total interest expense related to convertible notes	$	5,896	$	5,725	$	11,764	$	11,423

The fair value of the convertible notes, which was determined based on inputs that are observable in the market (Level 2), and the carrying value of the convertible notes (the carrying value excludes the equity component of the convertible notes classified in equity) are as follows (in thousands):


	As of August 31, 2016
	Fair Value		Carrying Value
Convertible notes	$	735,729	$	734,700

Convertible note hedge transactions and warrant transactions

On October 1, 2014, the Company entered into convertible note hedge transactions and warrant transactions with certain of the Initial Purchasers of the convertible notes or their respective affiliates.

RED HAT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

The convertible note hedge transactions are expected to offset the potential dilution with respect to shares of the Company’s common stock upon any conversion of the convertible notes and/or offset any cash payments the Company is required to make in excess of the principal amount of the converted notes, as the case may be. To partially offset the $148.0 million cost of the convertible note hedge transactions, the Company issued warrants and received proceeds of $79.8 million. The number of shares of the Company’s common stock underlying the warrants total 10,965,630, the same number of shares underlying the convertible notes and the convertible note hedge transactions. The combination of the convertible note hedge transactions and the warrant transactions effectively increases the initial conversion price of the convertible notes from $73.41 per share to $101.65 per share. As a result, the warrant transactions will have a dilutive effect with respect to the Company’s common stock to the extent that the market price per share of the Company’s common stock, as measured under the terms of the warrant transactions, exceeds the $101.65 strike price of the warrants. However, subject to certain conditions, the Company may elect to settle all of the warrants in cash. The $101.65 strike price of the warrants represents a premium of approximately 80% over the $56.47 per share closing price of the Company’s common stock on October 1, 2014.

The purchase of convertible note hedges and proceeds from issuance of warrants were recorded in stockholders’ equity and will continue to be classified as stockholders’ equity.

ITEM 2.

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

OVERVIEW

We are 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 is often freely shared, there are customarily no licensing fees for the use of open source software. Therefore, we do not recognize revenue from the licensing of the code itself. We provide value to our customers through the development, aggregation, integration, testing, certification, delivery, maintenance, enhancement and support of our Red Hat technologies, and by providing a level of performance, scalability, flexibility, reliability and security for the technologies we package and distribute. Moreover, because communities of developers not employed by us assist with the creation of our open source offerings, opportunities for further innovation of our offerings are supplemented by these communities.

We market our offerings primarily to customers in the form of annual or multi-year subscriptions, and we recognize revenue over the period of the subscription agreements with our customers. Our technologies are also offered by certified cloud and service providers (“CCSPs”) as a service available on demand, and this revenue is recognized by us upon delivery.

We derive our revenue and generate 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. Our revenue is affected by, among other factors, corporate, government and consumer spending levels. In evaluating the performance of our business, we consider a number of factors, including total revenue, deferred revenue, operating income, operating margin and cash flows from operations. The arrangements with our customers that produce this revenue and cash are explained in further detail in Part II, Item 7 under “Critical Accounting Estimates” and in NOTE 2—Summary of Significant Accounting Policies to the Consolidated Financial Statements of our Annual Report on Form 10-K for the fiscal year ended February 29, 2016.

We believe our success is influenced by: (i) the extent to which we can expand the breadth and depth of our offerings, (ii) our ability to enhance the value of our offerings through frequent and continuing innovation while maintaining stable platforms over multi-year periods, (iii) the extent to which adoption of our emerging technology offerings by enterprises and similar institutions continues to increase, (iv) our involvement and leadership in key open source communities, which enable us to develop, enhance and maintain our offerings, (v) our ability to generate increasing revenue directly and through partners and other strategic relationships, including CCSPs, distributors, embedded technology partners, independent hardware vendors (“IHVs”), independent software vendors (“ISVs”), original equipment manufacturers (“OEMs”), systems integrators, and value added resellers, (vi) our ability to generate new and recurring revenue for our offerings, (vii) the widespread and increasing deployment of open source technologies by enterprises and similar institutions, (viii) our software, hardware, application and cloud service certification programs, which are intended to create an ecosystem of technologies that are compatible with our offerings and supported by us, and (ix) our ability to provide customers with consulting and training services that generate additional subscription revenue.

In our fiscal year ended February 29, 2016 we focused on and in our fiscal year ending February 28, 2017 we expect to focus on, among other things: (i) driving the widespread adoption of our offerings, (ii) expanding our portfolio of technology offerings that enable cloud computing, (iii) investing in the development of open source technologies and promoting the use of our technologies by software developers globally, (iv) pursuing strategic acquisitions and alliances, (v) increasing revenue from our existing customer base, (vi) increasing

revenue by promoting a range of services to help our customers derive additional value, (vii) expanding routes to market, and (viii) growing our presence in international markets.

Revenue

For the three months ended August 31, 2016, total revenue increased 19.0%, or $95.7 million, to $599.8 million from $504.1 million for the three months ended August 31, 2015. Excluding the impact of foreign currency exchange rate fluctuations, total revenue increased by 18.3% for the three months ended August 31, 2016, as detailed in the following table.

The growth rates of subscription revenue by offering type, training and services revenue and total revenue, as reported and excluding the impact of foreign currency exchange rate fluctuations, for the three and six months ended August 31, 2016 versus the three and six months ended August 31, 2015 are as follows (in thousands):


	Three Months Ended (1)								Six Months Ended (1)
	August 31, 2016			August 31, 2015		Year-Over- Year Growth Rate			August 31, 2016			August 31, 2015		Year-Over- Year Growth Rate
Infrastructure-related subscription revenue, as reported	$	427,035		$	362,926		17.7	%	$	830,216		$	716,667		15.8	%
Adjustment for foreign currency exchange rates		(3,824	)		—					(5,572	)		—

Infrastructure-related subscription revenue, excluding foreign currency impact		423,211			362,926		16.6	%		824,644			716,667		15.1	%

Application development-related and other emerging technology subscription revenue, as reported		104,174			78,600		32.5	%		202,658			149,652		35.4	%
Adjustment for foreign currency exchange rates		(629	)		—					(894	)		—

Application development-related and other emerging technology subscription revenue, excluding foreign currency impact		103,545			78,600		31.7	%		201,764			149,652		34.8	%

Total subscription revenue, as reported		531,209			441,526		20.3	%		1,032,874			866,319		19.2	%
Adjustment for foreign currency exchange rates		(4,453	)		—					(6,466	)		—

Total subscription revenue, excluding foreign currency impact		526,756			441,526		19.3	%		1,026,408			866,319		18.5	%

Total training and services revenue, as reported		68,596			62,622		9.5	%		134,829			118,830		13.5	%
Adjustment for foreign currency exchange rates		974			—					1,577			—

Total training and services revenue, excluding foreign currency impact		69,570			62,622		11.1	%		136,406			118,830		14.8	%

Total subscription and training and services revenue, as reported		599,805			504,148		19.0	%		1,167,703			985,149		18.5	%
Adjustment for foreign currency exchange rates		(3,479	)		—					(4,889	)		—

Total subscription and training and services revenue, excluding foreign currency impact	$	596,326		$	504,148		18.3	%	$	1,162,814		$	985,149		18.0	%

(1)

Revenue from our non-U.S. operations has been translated into U.S. dollars using the average foreign currency exchange rates for each month of the three and six months ended August 31, 2016. In an effort to provide a comparable framework for assessing how our business performed when compared to the three and six months ended August 31, 2015 in light of the effect of exchange rate differences, we believe it is helpful to exclude the impact of foreign currency exchange rate fluctuations by translating revenue from our non-U.S. operations for the three and six months ended August 31, 2016 using the average foreign currency exchanges rates for the three and six months ended August 31, 2015.

Subscription revenue

Our enterprise technologies are delivered primarily under subscription agreements. These agreements typically have a one- or three-year subscription period. A subscription generally entitles a customer to, among other things, a specified level of support, as well as security updates, fixes, functionality enhancements, upgrades to the technologies, each if and when available, and compatibility with an ecosystem of certified hardware and software. Subscription revenue increased sequentially for the first and second quarters of fiscal 2017 and for each quarter of fiscal 2016 and fiscal 2015 and was driven primarily by the increased use of our offerings by customers and our expansion of sales channels and geographic footprint during these periods.

Subscription revenue increased 20.3%, or $89.7 million, for the three months ended August 31, 2016 as compared to the three months ended August 31, 2015. Excluding the impact of foreign currency exchange rate fluctuations, subscription revenue increased by 19.3% for the three months ended August 31, 2016. The increase in subscription revenue is driven primarily by additional subscriptions related to our principal Red Hat Enterprise Linux and Red Hat JBoss Middleware offerings, which continue to gain broader market acceptance in mission-critical areas of computing, and our expansion of sales channels and geographic footprint. The increase is, in part, a result of the continued migration of enterprises in industries such as financial services, government, technology and telecommunications to our open source solutions from proprietary technologies.

Training and services revenue

Training and services revenue increased 9.5%, or $6.0 million, for the three months ended August 31, 2016 as compared to the three months ended August 31, 2015. Excluding the impact of foreign currency exchange rates, training and services revenue increased by 11.1%. The increase is driven primarily by customer interest in new products and increased demand for our open source solutions.

Deferred revenue and billings proxy

Year-to-date deferred revenue

Our deferred revenue, current and long-term, balance at August 31, 2016 was $1.68 billion. Total deferred revenue at August 31, 2016 decreased 2.4%, or $41.9 million, as compared to the balance of $1.72 billion at February 29, 2016. Excluding the impact of foreign currency exchange rate fluctuations, total deferred revenue decreased by 4.2% or $73.0 million from February 29, 2016 to August 31, 2016. The decrease in deferred revenue is primarily attributable to our typically lower seasonal first and second quarter billings. Because of our subscription model and revenue recognition policies, deferred revenue improves predictability of future revenue. For example, current deferred revenue provides a baseline for revenue to be recognized over the next twelve months. Similarly, long-term deferred revenue provides a baseline for revenue to be recognized beyond twelve months. Revenue derived from CCSPs for the delivery of our technologies as a service available on demand is recognized by us in the period earned and billed in arrears. As a result, revenue derived from CCSPs has no associated deferred revenue.

The decrease in deferred revenue reported on our Consolidated Balance Sheets of $41.9 million differs from the decrease of $73.0 million we reported on our Consolidated Statements of Cash Flows for the six months ended August 31, 2016 as the amount reported on our Consolidated Statements of Cash Flows for the six months ended August 31, 2016 excludes (i) the impact of changes in foreign currency exchange rates used to translate deferred revenue balances from our foreign subsidiaries’ functional currency into U.S. dollars and (ii) deferred revenue acquired as part of a business combination.

Year-over-year deferred revenue

Total deferred revenue increased by 18.9%, or $267.2 million, to $1.68 billion at August 31, 2016 from $1.41 billion at August 31, 2015. Excluding the impact of foreign currency exchange rate fluctuations, total

deferred revenue increased by 17.3%, or $244.7 million, from August 31, 2015 to August 31, 2016. This increase in deferred revenue of $244.7 million is the summation of the changes in deferred revenue that we reported on our Consolidated Statements of Cash Flows for each quarter of the four-fiscal-quarter period ended August 31, 2016, plus $0.7 million related to deferred revenue acquired from business combinations during the same period.

Current deferred revenue increased by 17.8%, or $186.0 million, to $1.23 billion at August 31, 2016 from $1.05 billion at August 31, 2015 and long-term deferred revenue increased by 22.2%, or $81.2 million, to $446.9 million at August 31, 2016 from $365.7 million at August 31, 2015. Excluding the impact of foreign currency exchange rate fluctuations, current deferred revenue increased by 16.2%, or $169.3 million, and long-term deferred revenue increased by 20.6%, or $75.5 million, from August 31, 2015 to August 31, 2016.

Billings proxy

We approximate our quarterly billings by adding revenue recognized on our Consolidated Statements of Operations to the change in total deferred revenue reported on our Consolidated Statements of Cash Flows. We use the change in deferred revenue as reported on our Consolidated Statements of Cash Flows because the amount has been adjusted for the impact of changes in foreign currency exchange rates used to translate deferred revenue balances from our foreign subsidiaries’ functional currencies into U.S. dollars.

For the four-fiscal-quarter period ended August 31, 2016, our rolling average billings proxy increased by 14.9%, or $80.4 million, to $619.7 million from $539.3 million for the four-fiscal-quarter period ended August 31, 2015. Using the average foreign currency exchange rates for each quarter of our four-fiscal-quarter period ended August 31, 2015, our rolling average billings proxy for the four-fiscal-quarter period ended August 31, 2016 would have increased by approximately 16.8%, or $90.4 million. For information regarding seasonality, see Part II, Item 7 under “Overview” of our Annual Report on Form 10-K for the fiscal year ended February 29, 2016.

Revenue by geography

For the three months ended August 31, 2016, approximately $256.0 million, or 42.7%, of our revenue was generated outside the U.S. compared to approximately $203.5 million, or 40.4%, for the three months ended August 31, 2015. The relative increase in the percentage of revenue generated outside the U.S. for the three months ended August 31, 2016 compared to the percentage of revenue generated outside the U.S. for the three months ended August 31, 2015 is due to foreign currency exchange rate fluctuations. Our international operations are expected to grow as our international sales force and channels become more mature and as we enter new locations outside the U.S. or expand our presence in existing international locations. As of August 31, 2016, we had offices in more than 85 locations throughout the world.

We operate our business in three geographic regions: the Americas (U.S., Latin America and Canada); EMEA (Europe, Middle East and Africa); and Asia Pacific (principally Australia, China, India, Japan, Singapore and South Korea). Revenue generated by the Americas, EMEA and Asia Pacific for the three months ended August 31, 2016 and the three months ended August 31, 2015 was as follows (in thousands):


	Americas		EMEA		Asia Pacific		Consolidated
Three Months Ended August 31, 2016	$	385,529	$	127,467	$	86,809	$	599,805
Three Months Ended August 31, 2015	$	332,204	$	108,454	$	63,490	$	504,148

Year-over-year revenue growth rates in U.S. dollars for our three geographical regions were as follows for the three months ended August 31, 2016 and three months ended August 31, 2015:


	Americas			EMEA			Asia Pacific			Consolidated
Three Months Ended August 31, 2016		16.1	%		17.5	%		36.7	%		19.0	%
Three Months Ended August 31, 2015		17.7	%		4.8	%		5.4	%		13.1	%

Excluding the impact of changes in foreign currency exchange rates, year-over-year revenue growth rates for our three geographical regions were as follows for the three months ended August 31, 2016 and the three months ended August 31, 2015:


	Americas			EMEA			Asia Pacific			Consolidated
Three Months Ended August 31, 2016		17.0	%		17.0	%		27.4	%		18.3	%
Three months ended August 31, 2015 (1)		19.0	%		27.2	%		22.0	%		21.3	%

(1)	Revenue growth rates from our non-U.S. operations have been calculated by translating revenue from our non-U.S. operations for the three months ended August 31, 2015 into U.S. dollars using the average foreign currency exchanges rates for the three months ended August 31, 2014.

As we expand further within each region, we anticipate revenue growth rates in local currencies to become more similar among our geographic regions due to the similarity of products and services offered and the similarity in customer types or classes.

Gross profit margin

Gross profit margin increased to 85.4% for the three months ended August 31, 2016 from 84.9% for the three months ended August 31, 2015. A slight increase in cost to deliver our subscription revenue was more than offset by a higher mix of subscription revenue relative to training and services revenue for the three months ended August 31, 2016 from the three months ended August 31, 2015. Subscription revenue was 88.6% and 87.6% of total revenue for the three months ended August 31, 2016 and August 31, 2015, respectively.

Gross profit margin by geography

Gross profit margins by our geographic regions for the three months ended August 31, 2016 and August 31, 2015 were as follows:


	Americas			EMEA			Asia Pacific			Consolidated (1)
Three Months Ended August 31, 2016		86.0	%		87.1	%		84.8	%		85.4	%
Three Months Ended August 31, 2015		85.8	%		86.8	%		83.6	%		84.9	%

(1)

Consolidated gross margin includes corporate (non-allocated) share-based compensation expense for the three months ended August 31, 2016 and August 31, 2015 of $4.1 million and $4.2 million, respectively. For additional information, see NOTE 11—Segment Reporting to our Consolidated Financial Statements.

Regional year-over-year variations in gross profit margins are primarily due to slight product mix shifts between subscriptions and services.

As we continue to expand our sales and support services within our geographic regions, we expect gross profit margins across geographic regions to further converge over the long run due to the similarity of products and services offered, similarity in production and distribution methods and the similarity in customer types or classes. These geographic profit margins exclude the impact of share-based compensation expense, which was not allocated to our geographic regions.

Income from operations

Operating income as a percentage of revenue decreased to 13.7% for the three months ended August 31, 2016 from 15.2% for the three months ended August 31, 2015. The decrease was primarily driven by an increase in operating expenses related to accelerated hiring to support our Application Development-related and other emerging technologies and the closing and integration of our recent business acquisitions.

Income from operations by geography

Operating income as a percentage of revenue generated by our geographic regions for the three months ended August 31, 2016 and the three months ended August 31, 2015 was as follows:


	Americas			EMEA			Asia Pacific			Consolidated (1)
Three Months Ended August 31, 2016		18.6	%		22.1	%		31.6	%		13.7	%
Three Months Ended August 31, 2015		22.3	%		24.9	%		25.3	%		15.2	%

(1)

Consolidated operating income as a percentage of revenue includes corporate (non-allocated) share-based compensation expense for the three months ended August 31, 2016 and August 31, 2015 of $45.4 million and $40.5 million, respectively. For additional information, see NOTE 11—Segment Reporting to our Consolidated Financial Statements.

Operating margin for Americas and EMEA decreased for the three months ended August 31, 2016 as compared to the three months ended August 31, 2015 primarily as a result of an increase in operating expenses related to accelerated hiring to support our Application Development-related and other emerging technologies and closing and integrating the 3scale and Ansible acquisitions. APAC operating margin increased for the three months ended August 31, 2016 as compared to the three months ended August 31, 2015 primarily as a result of growing revenue, which increased 36.7%.

These geographic operating margins exclude the impact of share-based compensation expense, which was not allocated to our geographic segments.

Cash, cash equivalents, investments in debt securities and cash flow from operations

Cash, cash equivalents and short-term and long-term available-for-sale investments in debt securities balances at August 31, 2016 totaled $2.04 billion. Cash generated from operating activities for the three months ended August 31, 2016 totaled $96.8 million, which represents a decrease of 21.4% in operating cash flow as compared to the three months ended August 31, 2015. This decrease is primarily due to (i) an increase in operating expenses related to accelerated hiring to support our Application Development-related and other emerging technologies and (ii) the timing of our billings, of which a larger dollar value of transactions were executed during the last weeks of the quarter ended August 31, 2016 as compared to the quarter ended August 31, 2015, which affected our ability to bill and collect cash from our customers in such transactions.

Our significant cash and investment balances give us a measure of flexibility to take advantage of opportunities such as acquisitions, increasing investment in our international operations and repurchasing our common stock.

Foreign currency exchange rates’ impact on results of operations

Approximately 42.7% of our revenue for the three months ended August 31, 2016 came from sales outside the U.S. We are 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 of net income. The income statements of our non-U.S. operations are translated into U.S. dollars at the average exchange rates for each applicable month in a period. To the extent the U.S. dollar weakens against foreign currencies, the translation of these foreign-currency-denominated transactions results in increased revenue and operating expenses from operations for our non-U.S. operations. Similarly, our revenue and operating expenses will decrease for our non-U.S. operations if the U.S. dollar strengthens against foreign currencies.

Three months ended August 31, 2016

August 31, 2016 would have been lower and higher than we reported by approximately $3.5 million and $2.3 million, respectively, which would have resulted in income from operations being lower by $5.8 million.

Six Months Ended August 31, 2016

Using the average foreign currency exchange rates for the six months ended August 31, 2015, our revenue and operating expenses from non-U.S. operations for the six months ended August 31, 2016 would have been lower and higher than we reported by approximately $4.9 million and $5.1 million, respectively, which would have resulted in income from operations being lower by $10.0 million.

Business combinations

Acquisition of 3scale

On June 22, 2016, we completed our acquisition of all of the shares of 3scale for $29.1 million. 3scale is a provider of application programming interface (API) management technology. The acquisition is intended to extend our existing portfolio, including Red Hat JBoss Middleware, Red Hat OpenShift and Red Hat Mobile Application Platform, and strengthen our enablement of the API economy with simplified cloud integration and microservices-based architectures.

We incurred approximately $1.8 million in transaction costs, including legal and accounting fees, relating to the acquisition. These transaction costs have been expensed as incurred and included in general and administrative expense on our Consolidated Statement of Operations for the three and six months ended August 31, 2016.

Acquisition of Ansible

On October 16, 2015, we completed our acquisition of all of the shares of Ansible for approximately $126.0 million. Ansible is a provider of IT automation solutions that allows its users to manage applications across hybrid cloud environments. The acquisition is intended to augment our management portfolio and help customers to deploy and manage applications across private and public clouds, speed service delivery through development and operations initiatives, streamline OpenStack installations and upgrades and accelerate container adoption by simplifying orchestration and configuration.

RESULTS OF OPERATIONS

Three months ended August 31, 2016 and August 31, 2015

The following table is a summary of our results of operations for the three months ended August 31, 2016 and August 31, 2015 (in thousands):


	Three Months Ended (Unaudited)
	August 31, 2016			August 31, 2015			$ Change			% Change
Revenue:
Subscriptions	$	531,209		$	441,526		$	89,683			20.3	%
Training and services		68,596			62,622			5,974			9.5

Total subscription and training and services revenue		599,805			504,148			95,657			19.0

Cost of subscription and training and services revenue:
Cost of subscriptions		39,678			30,996			8,682			28.0
As a % of subscription revenue		7.5	%		7.0	%
Cost of training and services		47,993			44,968			3,025			6.7
As a % of training and services revenue		70.0	%		71.8	%

Total cost of subscription and training and services revenue		87,671			75,964			11,707			15.4
As a % of total revenue		14.6	%		15.1	%

Total gross profit		512,134			428,184			83,950			19.6

Operating expense:
Sales and marketing		253,255			205,101			48,154			23.5
Research and development		121,265			102,488			18,777			18.3
General and administrative		55,730			44,125			11,605			26.3

Total operating expense		430,250			351,714			78,536			22.3

Income from operations		81,884			76,470			5,414			7.1
Interest income		3,392			2,895			497			17.2
Interest expense		5,925			5,733			192			3.3
Other income (expense), net		84			(1,245	)		1,329			106.7

Income before provision for income taxes		79,435			72,387			7,048			9.7
Provision for income taxes (1)		20,663			20,992			(329	)		(1.6	)

Net income	$	58,772		$	51,395		$	7,377			14.4	%

Gross profit margin-subscriptions		92.5	%		93.0	%
Gross profit margin-training and services		30.0	%		28.2	%
Gross profit margin		85.4	%		84.9	%
As a % of total revenue:
Subscription revenue		88.6	%		87.6	%
Training and services revenue		11.4	%		12.4	%
Sales and marketing expense		42.2	%		40.7	%
Research and development expense		20.2	%		20.3	%
General and administrative expense		9.3	%		8.8	%
Total operating expenses		71.7	%		69.8	%
Income from operations		13.7	%		15.2	%
Income before provision for income taxes		13.2	%		14.4	%
Net income		9.8	%		10.2	%
Estimated annual effective income tax rate (1)		27.0	%		29.0	%

(1)

Provision for income taxes for the three months ended August 31, 2016 includes net discrete tax benefits of $0.8 million, of which $1.0 million are related to net excess tax benefits from share-based compensation. Our estimated annual effective tax rate is 27%. Our calculated tax rate for the three months ended August 31, 2016, including net discrete tax benefits, is 26%. See NOTE 5—Income Taxes to our Consolidated Financial Statements for further discussion.

Revenue

Subscription revenue

Subscription revenue, which is primarily comprised of direct and indirect sales of Red Hat offerings, increased by 20.3%, or $89.7 million, to $531.2 million for the three months ended August 31, 2016 from $441.5 million for the three months ended August 31, 2015.

Revenue derived from the sale of subscriptions supporting our Infrastructure-related offerings increased by 17.7%, or $64.1 million, to $427.0 million for the three months ended August 31, 2016 from $362.9 million for the three months ended August 31, 2015. The increase in subscription revenue is primarily due to increases in volumes sold, including additional subscriptions attributable to geographic expansion and the continued migration of customers to our open source Linux platform from proprietary operating systems.

Revenue derived from the sale of subscriptions supporting our Application development-related and other emerging technology offerings increased by 32.5%, or $25.6 million, to $104.2 million for the three months ended August 31, 2016 from $78.6 million for the three months ended August 31, 2015. The increase is primarily due to additional subscriptions for Red Hat JBoss Middleware offerings. We expect the growth rate of revenue derived from our Application development-related and other emerging technology offerings to exceed the growth rate of revenue derived from our Infrastructure-related offerings as our Application development-related and other emerging technology offerings continue to gain broader market acceptance in the enterprise IT environment.

Training and services revenue

Training revenue includes fees paid by our customers for delivery of educational materials and instruction. Services revenue includes fees received from customers for consulting services regarding our offerings, deployment of Red Hat technologies and for delivery of added functionality to Red Hat technologies for our major customers and OEM partners. Total training and services revenue increased by 9.5%, or $6.0 million, to $68.6 million for the three months ended August 31, 2016 from $62.6 million for the three months ended August 31, 2015. The increase is due to both services and training. Services revenue increased by 8.5%, or $4.0 million, as a result of an increase in consulting engagements driven by increased demand for our open source solutions. Training revenue increased by 12.8%, or $2.0 million as a result of increased adoption of our Red Hat Learning Subscriptions (“RHLS”). Combined training and services revenue as a percentage of total revenue was 11.4% and 12.4%, respectively, for the three months ended August 31, 2016 and August 31, 2015.

Cost of revenue

Cost of subscription revenue

The cost of subscription revenue primarily consists of expenses we incur to support, distribute and package Red Hat offerings. These costs include labor-related costs to provide technical support, security updates and fixes, as well as costs for fulfillment. Cost of subscription revenue increased by 28.0%, or $8.7 million, to $39.7 million for the three months ended August 31, 2016 from $31.0 million for the three months ended August 31, 2015. The increase is primarily due to the expansion of our technical staff in order to meet the demands of our growing subscriber base for support, security updates and fixes, and includes additional compensation of $5.4 million. The remaining increase was driven primarily by incremental amortization expense related to the acquisitions of Ansible and 3scale. Gross profit margin on subscriptions was 92.5% and 93.0%, respectively, for the three months ended August 31, 2016 and August 31, 2015. As the number of our open source technology subscriptions continues to increase, we expect associated support costs will continue to increase, although we anticipate this will occur at a rate slower than that of subscription revenue growth due to economies of scale.

Cost of training and services revenue

Cost of training and services revenue is mainly comprised of personnel and third-party consulting costs for the design, development and delivery of custom engineering, training courses and professional services provided to various types of customers. Cost of training and services revenue increased by 6.7%, or $3.0 million, to $48.0 million for the three months ended August 31, 2016 from $45.0 million for the three months ended August 31, 2015. Costs to deliver our services revenue increased by 7.1%, or $2.6 million, and relate to additional employee compensation and travel associated with additions to our emerging technologies staff. Total costs to deliver training and services as a percentage of training and services revenue decreased to 70.0% for the three months ended August 31, 2016 from 71.8% for the three months ended August 31, 2015 primarily as a result of increased revenue generated from our RHLS offering.

Gross profit margin

Operating expenses

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 trade shows. Sales and marketing expense increased by 23.5%, or $48.2 million, to $253.3 million for the three months ended August 31, 2016 from $205.1 million for the three months ended August 31, 2015. This increase was primarily due to a $37.2 million increase in selling costs, which includes $30.2 million of additional employee compensation expense attributable to the expansion of our sales force from the prior year. The remaining increase relates to marketing costs, which grew 20.5%, or $11.0 million, for the three months ended August 31, 2016 as compared to the three months ended August 31, 2015 and includes incremental employee compensation and marketing program costs of $8.0 million and $1.6 million, respectively. Sales and marketing expense increased as a percentage of revenue to 42.2% for the three months ended August 31, 2016 from 40.7% for the three months ended August 31, 2015.

Research and development

Research and development expense consists primarily of personnel and related costs for development of software technologies and systems management offerings. Research and development expense increased by 18.3%, or $18.8 million, to $121.3 million for the three months ended August 31, 2016 from $102.5 million for the three months ended August 31, 2015. The increase in research and development costs primarily resulted from the expansion of our engineering group as a result of both direct hires and business combinations as we continue investing in our Application Development-related and other emerging technologies. Employee compensation increased by $17.2 million. Research and development expense was 20.2% and 20.3% of total revenue for the three months ended August 31, 2016 and August 31, 2015, respectively.

General and administrative

General and administrative expense consists primarily of personnel and related costs for general corporate functions, including information systems, finance, accounting, legal, human resources and facilities expense. General and administrative expense increased by 26.3%, or $11.6 million, to $55.7 million for the three months ended August 31, 2016 from $44.1 million for the three months ended August 31, 2015. General and

administrative expenses include increased compensation-related expense of $3.2 million, infrastructure and facilities costs of $4.2 million and outside professional services of $3.8 million. General and administrative expense as a percentage of revenue was 9.3% and 8.8% for the three months ended August 31, 2016 and August 31, 2015, respectively. We expect general and administrative costs to decrease relative to revenue as we leverage benefits from investments made during the current fiscal year to expand and enhance our corporate processes and technology infrastructure.

Interest income

Interest income increased by 17.2%, or $0.5 million, for the three months ended August 31, 2016 as compared to the three months ended August 31, 2015. The increase in interest income for the three months ended August 31, 2016 is attributable to slightly higher yields earned on larger cash and investment balances.

Interest expense

Interest expense increased by $0.2 million, for the three months ended August 31, 2016 as compared to the three months ended August 31, 2015. Interest expense is primarily attributable to the issuance of convertible notes, which is described in NOTE 15—Convertible Notes to our Consolidated Financial Statements.

Other income (expense), net

Other income (expense), net increased by $1.3 million, for the three months ended August 31, 2016 as compared to the three months ended August 31, 2015. The increase is primarily due to net losses recognized from the settlement of foreign currency transactions during the three months ended August 31, 2015.

Income taxes

During the three months ended August 31, 2016, we recorded $20.7 million of income tax expense, which is based on an estimated annual effective tax rate of 27%. Our estimated annual effective tax rate of 27% was less than the U.S. federal statutory rate of 35% primarily due to foreign income taxed at lower rates, research tax credits and the domestic production activities deduction. Tax expense for the three months ended August 31, 2016 included a discrete tax benefit of $1.0 million, related to excess tax benefits from share-based compensation resulting from the early adoption of ASU 2016-09. See NOTE 2—Summary of Significant Accounting Policies to our Consolidated Financial Statements for additional information.

During the three months ended August 31, 2015, we recorded $21.0 million of income tax expense, which was based on a then estimated annual effective tax rate of 29%. Our estimated annual effective tax rate of 29% was less than the U.S. federal statutory rate of 35% principally due to foreign income taxed at lower rates, state income taxes net of federal benefits and the domestic production activities deduction.

Six months ended August 31, 2016 and August 31, 2015

The following table is a summary of our results of operations for the six months ended August 31, 2016 and August 31, 2015 (in thousands):


	Six Months Ended (Unaudited)
	August 31, 2016			August 31, 2015			$ Change			% Change
Revenue:
Subscriptions	$	1,032,874		$	866,319		$	166,555			19.2	%
Training and services		134,829			118,830			15,999			13.5

Total subscription and training and services revenue		1,167,703			985,149			182,554			18.5

Cost of subscription and training and services revenue:
Cost of subscriptions		76,222			60,843			15,379			25.3
As a % of subscription revenue		7.4	%		7.0	%
Cost of training and services		95,496			86,519			8,977			10.4
As a % of training and services revenue		70.8	%		72.8	%

Total cost of subscription and training and services revenue		171,718			147,362			24,356			16.5
As a % of total revenue		14.7	%		15.0	%

Total gross profit		995,985			837,787			158,198			18.9

Operating expense:
Sales and marketing		496,503			403,973			92,530			22.9
Research and development		236,281			199,919			36,362			18.2
General and administrative		105,954			86,496			19,458			22.5

Total operating expense		838,738			690,388			148,350			21.5

Income from operations		157,247			147,399			9,848			6.7
Interest income		6,821			5,611			1,210			21.6
Interest expense		11,811			11,448			363			3.2
Other income (expense), net		(468	)		(1,448	)		980			67.7

Income before provision for income taxes		151,789			140,114			11,675			8.3
Provision for income taxes		31,832			40,633			(8,801	)		(21.7	)

Net income	$	119,957		$	99,481		$	20,476			20.6	%

Gross profit margin-subscriptions		92.6	%		93.0	%
Gross profit margin-training and services		29.2	%		27.2	%
Gross profit margin		85.3	%		85.0	%
As a % of total revenue:
Subscription revenue		88.5	%		87.9	%
Training and services revenue		11.5	%		12.1	%
Sales and marketing expense		42.5	%		41.0	%
Research and development expense		20.2	%		20.3	%
General and administrative expense		9.1	%		8.8	%
Total operating expenses		71.8	%		70.1	%
Income from operations		13.5	%		15.0	%
Income before provision for income taxes		13.0	%		14.2	%
Net income		10.3	%		10.1	%
Estimated annual effective income tax rate (1)		27.0	%		29.0	%

(1)

Provision for income taxes for the six months ended August 31, 2016 includes net discrete tax benefits of $9.2 million, of which $8.9 million are related to net excess tax benefits from share-based compensation. Our estimated annual effective tax rate is 27%. Our calculated tax rate for the six months ended August 31, 2016, including net discrete tax benefits, is 21%. See NOTE 5—Income Taxes to our Consolidated Financial Statements for further discussion.

Revenue

Subscription revenue

Subscription revenue increased by 19.2%, or $166.6 million, to $1,032.9 million for the six months ended August 31, 2016 from $866.3 million for the six months ended August 31, 2015.

Revenue derived from the sale of subscriptions supporting our Infrastructure-related offerings increased by 15.8%, or $113.5 million, to $830.2 million for the six months ended August 31, 2016 from $716.7 million for the six months ended August 31, 2015. The increase in subscription revenue is primarily due to increases in volumes sold, including additional subscriptions attributable to geographic expansion and the continued migration of customers to our open source Linux platform from proprietary operating systems.

Revenue derived from the sale of subscriptions supporting our Application development-related and other emerging technology offerings increased by 35.4%, or $53.0 million, to $202.7 million for the six months ended August 31, 2016 from $149.7 million for the six months ended August 31, 2015. The increase is primarily due to additional subscriptions for Red Hat JBoss Middleware offerings. We expect the growth rate of revenue derived from our Application development-related and other emerging technology offerings to exceed the growth rate of revenue derived from our Infrastructure-related offerings as our Application development-related and other emerging technology offerings continue to gain broader market acceptance in the enterprise IT environment.

Training and services revenue

Total training and services revenue increased by 13.5%, or $16.0 million, to $134.8 million for the six months ended August 31, 2016 from $118.8 million for the six months ended August 31, 2015. The increase is due to both services and training. Services revenue increased by 12.3%, or $11.1 million as a result of an increase in consulting engagements driven by increased demand for our open source solutions. Training revenue increased by 17.2%, or $4.9 million as a result of increased adoption of our RHLS. Combined training and services revenue decreased as a percentage of total revenue to 11.5% for the six months ended August 31, 2016 from 12.1% for the six months ended August 31, 2015.

Cost of revenue

Cost of subscription revenue

Cost of subscription revenue increased by 25.3%, or $15.4 million, to $76.2 million for the six months ended August 31, 2016 from $60.8 million for the six months ended August 31, 2015. The increase is primarily due to the expansion of our technical staff in order to meet the demands of our growing subscriber base for support, security updates and fixes, and includes additional compensation of $9.8 million. The remaining increase was driven primarily by incremental amortization expense related to the acquisitions of Ansible and 3scale. Gross profit margin on subscriptions was 92.6% and 93.0%, respectively, for the six months ended August 31, 2016 and August 31, 2015. As the number of our open source technology subscriptions continues to increase, we expect associated support costs will continue to increase, although we anticipate this will occur at a rate slower than that of subscription revenue growth due to economies of scale.

Cost of training and services revenue

Cost of training and services revenue increased by 10.4%, or $9.0 million, to $95.5 million for the six months ended August 31, 2016 from $86.5 million for the six months ended August 31, 2015. Costs to deliver our services revenue increased by 10.7%, or $7.6 million, and relate to additional employee compensation and travel associated with additions to our emerging technologies staff. Total costs to deliver training and services as a percentage of training and services revenue was 70.8% and 72.8%, respectively, for the six months ended August 31, 2016 and August 31, 2015.

Gross profit margin

Gross profit margin increased to 85.3% for the six months ended August 31, 2016 from 85.0% for the six months ended August 31, 2015. A slight increase in cost to deliver our subscription revenue was more than offset by a higher mix of subscription revenue relative to training and services revenue for the six months ended August 31, 2016 from the six months ended August 31, 2015. Subscription revenue was 88.5% and 87.9% of total revenue for the six months ended August 31, 2016 and August 31, 2015, respectively.

Operating expenses

Sales and marketing

Sales and marketing expense increased by 22.9%, or $92.5 million, to $496.5 million for the six months ended August 31, 2016 from $404.0 million for the six months ended August 31, 2015. This increase was primarily due to a $73.7 million increase in selling costs, which includes $56.9 million of additional employee compensation expense attributable to the expansion of our sales force from the prior year. The remaining increase relates to marketing costs, which grew 18.9%, or $18.8 million, for the six months ended August 31, 2016 as compared to the six months ended August 31, 2015 and includes incremental employee compensation and marketing program costs of $13.3 million and $2.5 million, respectively. Primarily as a result of expanded sales and marketing staffing, sales and marketing expense increased as a percentage of revenue to 42.5% for the six months ended August 31, 2016 from 41.0% for the six months ended August 31, 2015.

Research and development

Research and development expense increased by 18.2%, or $36.4 million, to $236.3 million for the six months ended August 31, 2016 from $199.9 million for the six months ended August 31, 2015. The increase in research and development costs primarily resulted from the expansion of our engineering group as a result of both direct hires and business combinations as we continue investing in our Application Development-related and other emerging technologies. Employee compensation increased by $33.1 million. Research and development expense was 20.2% and 20.3% of total revenue for the six months ended August 31, 2016 and August 31, 2015, respectively.

General and administrative

General and administrative expense increased by 22.5%, or $19.5 million, to $106.0 million for the six months ended August 31, 2016 from $86.5 million for the six months ended August 31, 2015. General and administrative expenses include increased compensation-related expense of $5.8 million, infrastructure and facilities costs of $7.5 million and outside professional services of $6.1 million. General and administrative expense increased as a percentage of revenue to 9.1% for the six months ended August 31, 2016 from 8.8% for the six months ended August 31, 2015. We expect general and administrative costs to decrease relative to revenue as we leverage benefits from investments made during the current fiscal year to expand and enhance our corporate processes and technology infrastructure.

Interest income

Interest income increased by 21.6%, or $1.2 million, for the six months ended August 31, 2016 as compared to the six months ended August 31, 2015. The increase in interest income for the six months ended August 31, 2016 is attributable to slightly higher yields earned on larger cash and investment balances.

Interest expense

Interest expense increased by $0.4 million, for the six months ended August 31, 2016 as compared to the six months ended August 31, 2015. Interest expense is primarily attributable to the issuance of convertible notes, which is described in NOTE 15—Convertible Notes to our Consolidated Financial Statements.

Other income (expense), net

Other income (expense), net increased by $1.0 million, for the six months ended August 31, 2016 as compared to the six months ended August 31, 2015. The increase is primarily due to miscellaneous losses recognized during the six months ended August 31, 2015 not repeated during the six months ended August 31, 2016.

Income taxes

During the six months ended August 31, 2016, we recorded $31.8 million of income tax expense, which is based on an estimated annual effective tax rate of 27%. Our estimated annual effective tax rate of 27% was less than the U.S. federal statutory rate of 35% primarily due to foreign income taxed at lower rates, research tax credits and the domestic production activities deduction. Tax expense for the six months ended August 31, 2016 included a discrete tax benefit of $8.9 million, related to excess tax benefits from share-based compensation resulting from the early adoption of ASU 2016-09. See NOTE 2—Summary of Significant Accounting Policies to our Consolidated Financial Statements for additional information.

During the six months ended August 31, 2015, we recorded $40.6 million of income tax expense, which was based on a then estimated annual effective tax rate of 29%. Our estimated annual effective tax rate of 29% was less than the U.S. federal statutory rate of 35% principally due to foreign income taxed at lower rates, state income taxes net of federal benefits and the domestic production activities deduction.

LIQUIDITY AND CAPITAL RESOURCES

We derive our liquidity and operating capital primarily from cash flows from operations. Historically, we also received cash from the sale of equity securities, including private sales of preferred stock and the sale of common stock in our initial and follow-on public offerings, and the issuance of convertible notes, including our issuance of convertible notes with par value totaling $805.0 million described in detail in NOTE 15—Convertible Notes to our Consolidated Financial Statements. At August 31, 2016, we had total cash and investments of $2.04 billion, which was comprised of $970.6 million in cash and cash equivalents, $365.1 million of short-term, available-for-sale, fixed-income investments and $706.9 million of long-term, available-for-sale fixed-income investments. This compares to total cash and investments of $2.00 billion at February 29, 2016.

With $970.6 million in cash and cash equivalents on hand, we believe our cash and cash equivalent balances, together with our ability to generate additional cash from operations, should be sufficient to satisfy our cash requirements for the next twelve months and for the foreseeable future. However, we may take advantage of favorable capital market conditions that may arise from time to time to raise additional capital. We presently do not intend to liquidate our short- and long-term investments in debt securities prior to their scheduled maturity dates. However, in the event that we liquidate these investments prior to their scheduled maturities and there are adverse changes in market interest rates or the overall economic environment, we could be required to recognize a realized loss on those investments when we liquidate those investments. At August 31, 2016, net accumulated unrealized gains on our available-for-sale debt securities totaled $0.5 million, versus accumulated unrealized losses of $1.4 million as of February 29, 2016.

Cash flows for six months ended August 31, 2016

Cash flows—overview

At August 31, 2016, cash and cash equivalents totaled $970.6 million, an increase of $42.8 million as compared to February 29, 2016. The increase in cash and cash equivalents for the six months ended August 31, 2016 is primarily the result of cash provided by operations, which generated $329.1 million for the six months ended August 31, 2016. Partially offsetting cash provided by operations was the repurchase of 2,654,265 shares

of our common stock for $193.9 million, payments made in return for common shares received from employees to satisfy employees’ minimum tax withholding obligations related to share awards vesting of $37.5 million, investments in property and equipment of $33.2 million and the acquisition of 3scale, net of cash acquired, of $28.7 million.

Cash flows from operations

Cash provided by operations of $329.1 million during the six months ended August 31, 2016 includes net income of $120.0 million, adjustments to exclude the impact of non-cash income and expenses, which totaled a $147.2 million net source of cash, and changes in operating assets and liabilities, which totaled a $62.0 million net source of cash. Cash provided by changes in operating assets and liabilities for the six months ended August 31, 2016 was primarily the result of collections on our billings.

Cash flows from investing

Cash used in investing activities of $71.3 million for the six months ended August 31, 2016 includes net purchases of available-for-sale debt securities of $2.9 million, investments in property and equipment of $33.2 million, which primarily relate to information technology infrastructure and leasehold improvements and the acquisition of 3scale, which used $28.7 million of cash during the six months ended August 31, 2016. Investments in other intangible assets, primarily patents, totaled $6.4 million during the six months ended August 31, 2016.

Cash flows from financing

Cash used in financing activities of $229.3 million for the six months ended August 31, 2016 includes $193.9 million to repurchase 2,654,265 shares of our common stock and $37.5 million of payments made in return for common shares received from employees to satisfy employees’ minimum tax withholding obligations related to restricted share awards vesting during the six months ended August 31, 2016. Partially offsetting financing activities using cash were proceeds from employees’ exercise of common stock options, which totaled $2.1 million.

Investments in debt securities

Our investments are comprised primarily of debt securities that are classified as available for sale and recorded at their fair market values. At August 31, 2016 and February 29, 2016, the vast majority of our investments were priced with the assistance of pricing vendors. These pricing vendors use the most recent observable market information in pricing these securities or, if specific prices are not available for these securities, use other observable inputs. In the event observable inputs are not available, we assess other factors to determine the securities’ market values, including broker quotes or model valuations. Independent price verifications of all of our holdings are performed by the pricing vendors, which we review. In the event a price fails a pre-established tolerance check, it is researched so that we can assess the cause of the variance to determine what we believe is the appropriate fair market value.

Capital requirements

We have experienced a substantial increase in our operating expenses since our inception in connection with the growth of our operations, the development of our technologies, the expansion of our services operations and our acquisition activity. Our capital requirements during the fiscal year ending February 28, 2017 will depend on numerous factors, including the amount of resources we devote to:

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funding the continued development of our technology offerings;

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improving and extending our services and the technologies used to market and deliver these services to our customers and support our business;

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pursuing strategic acquisitions and alliances;

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investing in or acquiring businesses, products and technologies; and

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investing in enhancements to the systems we use to run our business and the expansion of our office facilities.

We have utilized, and will continue from time to time to utilize, cash and investments to fund, among other potential uses, purchases of our common stock, purchases of fixed assets, purchases of intangible assets (primarily patents) and mergers and acquisitions. Given our historically strong operating cash flow and the $2.04 billion of cash and investments held at August 31, 2016, we believe our cash and cash equivalent balances, together with our ability to generate additional cash from operations, should be sufficient to satisfy our cash requirements for the next twelve months and for the foreseeable future. However, we may take advantage of favorable capital market conditions that may arise from time to time to raise additional capital.

We believe that our ability to generate additional cash from operations will continue; however, there can be no assurances that we will be able to generate cash from operations at a level equal to the current rate or that such cash flows will be adequate to fund other investments or acquisitions that we may choose to make or that cash may be located in or generated in the appropriate geographic region where we can effectively use such cash. We may choose to accelerate the expansion of our business from our current plans, which may require us to raise additional funds through the sale of equity or debt securities or through other financing means. There can be no assurances that any such financing would occur in amounts or on terms favorable to us, if at all.

As of August 31, 2016, our cash, cash equivalents and available-for-sale investment securities totaled $2.04 billion, of which $991.6 million was held outside the U.S. Our intent is to reinvest the earnings of foreign subsidiaries indefinitely outside the U.S. to fund both organic growth and acquisitions. From time to time, however, we may remit a portion of these earnings to the extent it is economically prudent. For further discussion related to geographic segments, see NOTE 11—Segment Reporting to our Consolidated Financial Statements.

With $1.05 billion, or 51.5%, of our available cash, cash equivalents and available-for-sale investments held within the U.S. as of August 31, 2016, we do not anticipate a need to repatriate any foreign earnings for the foreseeable future. However, if cash held outside the U.S. were needed to fund our U.S. operations, under current tax law we would be subject to additional taxes on the portion related to repatriated earnings of our foreign subsidiaries. As of February 29, 2016, cumulative undistributed foreign earnings totaled $537.7 million. For further discussion, see NOTE 11—Income Taxes to our Consolidated Financial Statements contained in our Annual Report on Form 10-K for the year ended February 29, 2016.

Off-balance sheet arrangements

As of August 31, 2016 and February 29, 2016, we have no off-balance sheet financing arrangements and do not utilize any “structured debt”, “special purpose” or similar unconsolidated entities for liquidity or financing purposes.

RECENT ACCOUNTING PRONOUNCEMENTS

For discussion of accounting pronouncements recently adopted and accounting pronouncements being evaluated, and the impact of these pronouncements on our consolidated financial statements, see NOTE 2—Summary of Significant Accounting Policies to our Consolidated Financial Statements.

ITEM 3.

QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

We are exposed to the impact of interest rate changes, foreign currency exchange rate fluctuations and changes in the market value of our investments.

Interest rate risk

Our exposure to market rate risk for changes in interest rates relates primarily to our investment portfolio. The primary objective of our investment activities is to preserve principal and liquidity while at the same time maximizing yields without significantly increasing risk. To achieve this objective, we maintain our portfolio of short-term and long-term investments in a variety of available-for-sale fixed and floating rate debt securities, including both government and corporate obligations and money market funds. Investments in both fixed rate and floating rate interest earning instruments carry a degree of interest rate risk. Fixed rate securities may have their fair market value adversely impacted due to a rise in prevailing interest rates, while floating rate securities may produce less income than expected if interest rates fall. Due in part to these factors, our future investment income related to these securities may fall short of expectations due to changes in interest rates, or we may suffer losses in principal if forced to sell securities that have declined in market value due to changes in interest rates or perceived credit risk related to the securities’ issuers. A hypothetical one-half percentage point change in interest rates, assuming a parallel shift of all interest rates, would result in an approximate $0.6 million change in annual interest income derived from investments in our portfolio as of August 31, 2016. For further discussion related to our investments as of August 31, 2016 and February 29, 2016, see NOTE 6—Assets and Liabilities Measured at Fair Value on a Recurring Basis to our Consolidated Financial Statements.

Investment risk

The fair market value of our available-for-sale investment portfolio is subject to interest rate risk. Based on a sensitivity analysis performed on this investment portfolio, a hypothetical one percentage point increase in prevailing interest rates would result in an approximate $10.4 million decrease in the fair value of our available-for-sale investment securities as of August 31, 2016. For further discussion related to our investments as of August 31, 2016 and February 29, 2016, see NOTE 6—Assets and Liabilities Measured at Fair Value on a Recurring Basis to our Consolidated Financial Statements.

Credit risk

Investments in debt and equity securities

The fair market values of our investment portfolio and cash balances are exposed to counterparty credit risk. Accordingly, while we periodically review our portfolio in an effort to mitigate counterparty risk, the principal values of our cash balances, money market accounts and investments in available-for-sale securities could suffer a loss of value.

Accounts receivable

Foreign currency risk

Approximately 42.7% of our revenue for the three months ended August 31, 2016 was produced by sales outside the United States. We are 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 of net income. The income statements of our non-U.S. operations are translated into U.S. dollars

at the average exchange rates for each applicable month in a period. To the extent the U.S. dollar weakens against foreign currencies, the translation of these foreign currency statements results in increased revenue and operating expenses for our non-U.S. operations. Similarly, our revenue and operating expenses for our non-U.S. operations decreases if the U.S. dollar strengthens against foreign currencies.

Using the average foreign currency exchange rates from the second quarter of our prior fiscal year ended February 29, 2016, our revenue and operating expenses from non-U.S. operations for the three months ended August 31, 2016 would have been lower and higher than we reported by approximately $3.5 million and $2.3 million, respectively, which would have resulted in income from operations being lower by $5.8 million.

Convertible notes

In October 2014, we issued $805.0 million of 0.25% convertible notes due 2019. The convertible notes have a fixed annual interest rate of 0.25%, and therefore we do not have economic interest rate exposure on the convertible notes. However, the fair market value of the convertible notes is exposed to interest rate risk. Generally, the fair market value of the convertible notes will increase as interest rates fall and decrease as interest rates rise. For further discussion regarding the fair value of the convertible notes, see NOTE 15—Convertible Notes to our Consolidated Financial Statements.

In connection with the sale of the convertible notes, we entered into convertible note hedge transactions and warrant transactions. The convertible note hedge transactions are expected to offset the potential dilution with respect to shares of our common stock upon any conversion of the convertible notes and/or offset any cash payments that we are required to make in excess of the principal amount of the converted notes, as the case may be. The warrant transactions will have a dilutive effect with respect to our common stock to the extent that the market price per share of our common stock, as measured under the terms of the warrant transactions, exceeds the applicable strike price of the warrants. However, subject to certain conditions, we may elect to settle all of the warrants in cash. The initial strike price of the warrants is $101.65 per share. The number of shares of our common stock underlying the warrants is 10,965,630 shares, subject to anti-dilution adjustments. The convertible note hedge and warrants are both considered indexed to our common stock and classified as equity; therefore, the convertible note hedge and warrants are not accounted for as derivative instruments.

Derivative instruments

We transact business in various foreign countries and are, therefore, subject to risk of foreign currency exchange rate fluctuations. From time to time we enter 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 on the Consolidated Balance Sheets at their respective fair market values. We have elected not to prepare and maintain the documentation required to qualify our forward contracts for hedge accounting treatment and, therefore, changes in fair value are recorded in our Consolidated Statements of Operations. For further discussion related to our management of foreign currency risk see NOTE 7—Derivative Instruments to our Consolidated Financial Statements.

The aggregate notional amount of outstanding forward contracts at August 31, 2016 was $34.0 million. The fair value of these outstanding contracts at August 31, 2016 was a gross less than $0.1 million asset and a gross less than $0.1 million liability, and is recorded in Other current assets and Accounts payable and accrued expenses, respectively, on our Consolidated Balance Sheets. The forward contracts generally expire within three

months of the period ended August 31, 2016. The forward contracts will settle in Euros, Hong Kong dollars, Japanese yen, Norwegian krona, Singapore dollars, Swedish krona, Swiss francs and U.S. dollars.

The aggregate notional amount of outstanding forward contracts at February 29, 2016 was $72.6 million. The fair value of these outstanding contracts at February 29, 2016 was a gross $0.6 million asset and a gross $0.5 million liability, and is recorded in Other current assets and Accounts payable and accrued expenses, respectively, on our Consolidated Balance Sheets. The forward contracts generally expired within three months of the period ended February 29, 2016. The forward contracts settled in Australian dollars, Hong Kong dollars, Japanese yen, Norwegian krona, Singapore dollars, Swedish krona, Swiss francs and U.S. dollars.

ITEM 4.

CONTROLS AND PROCEDURES

Role of Controls and Procedures

Our management, including our chief executive officer and chief financial officer, does not expect that our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934) or our internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) under the Securities Exchange Act of 1934) will prevent all errors and all fraud. A control system, no matter how well designed and operated, can provide only reasonable, not absolute, assurance that the control system’s objectives will be met. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of the controls must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within a company have been detected. These inherent limitations include the realities that judgments in decision-making can be faulty and that breakdowns can occur because of simple error and mistake. Controls can also be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of the controls. The design of any system of controls is based in part on certain assumptions about the likelihood of future events. Because of the inherent limitations in a cost-effective control system, misstatements due to error or fraud may occur and not be detected. Also projections of any evaluation of effectiveness of controls and procedures to future periods are subject to the risk that the controls and procedures may become inadequate because of changes in conditions, or that the degree of compliance with the controls and procedures may have deteriorated.

Evaluation of Disclosure Controls and Procedures

Our management, with the participation of our chief executive officer and chief financial officer, evaluated the effectiveness of our disclosure controls and procedures as of the end of the period covered by this report. Based on this evaluation, our chief executive officer and chief financial officer concluded that, as of the end of the period covered by this report, our disclosure controls and procedures were effective at a reasonable assurance level.

Changes in Internal Control Over Financial Reporting

No changes in our internal control over financial reporting occurred during the fiscal quarter covered by this report that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

PART II

ITEM 1.

LEGAL PROCEEDINGS

ITEM 1A.

RISK FACTORS

Set forth below are certain risks and cautionary statements, which supplement other disclosures in this report. Please carefully consider the following risks and cautionary statements. If any event related to the following risk factors occurs, our business, financial condition, operating results and cash flows could be materially adversely affected.

RISKS RELATED TO BUSINESS UNCERTAINTY

We face intense competition.

The enterprise software industry is rapidly evolving and intensely competitive, and is subject to changing technologies, shifting customer needs, and frequent introductions of new products and services. We compete based on our ability to provide our customers with enterprise software and related service offerings that best meet their needs at a compelling price. We expect that competition will continue to be intense, and there is a risk that our competitors’ products may provide better performance or include additional features when compared to our offerings. Competitive pressures could also affect the prices we may charge or the demand for our offerings, resulting in reduced profit margins and loss of market share.

Our current and potential competitors range from large and well-established companies to emerging start-ups. Some of our competitors have significantly greater financial resources and name recognition, larger development and sales staffs and more extensive marketing and distribution capabilities. Certain competitors also bundle hardware and software offerings, making it more difficult for us to penetrate their customer bases. As the enterprise software industry evolves, the competitive pressure for us to innovate encompasses a wider range of products and services, including new offerings that require different expertise than our current offerings. Some competitors may be able to innovate and provide products and services faster than we can. Moreover, if we are unable to effectively communicate the value of our subscription model, we may not compete effectively in attracting new, and maintaining existing, customers.

Given the rapid evolving nature of the enterprise software industry, the competitive landscape and the nature of the competition is constantly changing. Industry consolidation may affect competition by creating larger and potentially stronger competitors in the markets in which we compete. Moreover, other companies may currently be planning to or are under pressure by stockholders to divest businesses. These divestitures may result in additional competitors that may have an advantage by focusing on a single product or service. We also compete in certain areas with our partners and potential partners, and this may adversely impact our relationship with an individual partner or a number of partners.

Our efforts to compete effectively may not be sufficient, which may adversely affect our business, financial condition, operating results and cash flows.

Our continued success depends on our ability to adapt to a rapidly changing industry. Investment in new offerings, business strategies and initiatives could disrupt our ongoing business and may present risks not originally contemplated.

We operate in highly competitive markets that are characterized by rapid technological change, such as the transition of many of our enterprise customers to cloud computing environments and frequent new product and

service announcements. Our continued success will depend on our ability to adapt to rapidly changing technologies and user preferences, to adapt our offerings to evolving industry standards, to predict user preferences and industry changes and to improve the performance and reliability of our offerings. Our failure to adapt to such changes could harm our business, and our efforts to adapt to such changes could require substantial expenditures on our part to modify our offerings or infrastructure. Delays in developing, completing or delivering new or enhanced offerings and technologies could result in delayed or reduced revenue for those offerings and could also adversely affect customer acceptance of those offerings and technologies. The success of new and enhanced offering introductions depends on several factors, including our ability to invest significant resources in research and development in order to enhance our existing offerings and introduce new offerings in a timely manner, successfully promote the offerings, manage the risks associated with the offerings, make sufficient resources available to support the offerings and address any quality or other defects in the early stages of introduction. Even if we are able to enhance our existing offerings or introduce new offerings that are well perceived by the market, if our marketing or sales efforts do not generate interest in or sales for these offerings they may be unsuccessful.

Moreover, we believe that our continued success depends on our investing in new business strategies or initiatives that complement our strategic direction and technology road map. Such endeavors may involve significant risks and uncertainties, including distraction of management’s attention away from other business operations, and insufficient revenue generation to offset liabilities and expenses undertaken with such strategies and initiatives. Because these endeavors may be inherently risky, no assurance can be given that such endeavors will not adversely affect our business, financial condition, operating results and cash flows.

If we fail to continue to establish and maintain strategic relationships with industry-leading companies, we may not be able to attract and retain a larger customer base.

Our success depends in part on our ability to continue to establish and maintain strategic relationships with industry-leading cloud service providers, hardware original equipment manufacturers, independent software vendors (“ISVs”) and system integrators, such as Amazon.com, Inc., Cisco Systems, Inc., Dell Inc., Fujitsu Limited, Hewlett Packard Enterprise Company, International Business Machines Corporation, Microsoft Corporation, NEC Corporation, Oracle Corporation, SAP AG and others. Many of these strategic partners have engineered and certified that their technologies run on or with our offerings and, in some cases, have built their products and solutions using our offerings. We may not be able to maintain these relationships or replace them on attractive terms in the future. Some of our strategic partners offer competing products and services. As a result of these factors, many of the companies with which we have strategic alliances may choose to pursue alternative technologies and develop alternative products and services in addition to or in lieu of our offerings, 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 offerings effectively or continue to devote the resources necessary to provide us with effective sales, marketing and technical support. As our agreements with strategic partners terminate or expire, we may be unable to renew or replace these agreements on comparable terms, or at all.

We rely, to a significant degree, on indirect sales channels for the distribution of our offerings, and disruption within these channels could adversely affect our business, financial condition, operating results and cash flows.

We use a variety of different indirect distribution methods for our offerings, including channel partners, such as certified cloud service providers, distributors, embedded technology partners, hardware original equipment manufacturers, ISVs, system integrators and value added resellers. A number of these partners in turn distribute via their own networks of channel partners with whom we have no direct relationship. These relationships allow us to offer our technologies to a much larger customer base than we would otherwise be able through our direct sales and marketing efforts.

We rely, to a significant degree, on each of our channel partners to select, screen and maintain relationships with its distribution network and to distribute our offerings in a manner that is consistent with applicable law and

regulatory requirements and our quality standards. If our channel partners or a partner in its distribution network violate applicable law or regulatory requirements or misrepresent the functionality of our offerings, our reputation could be damaged and we could be subject to potential liability. Furthermore, our channel partners may offer their own products and services or the products and services of other companies that compete with our offerings or may not distribute and market our offerings effectively. Moreover, our existing channel partner relationships do not, and any future channel partner relationships may not, provide for any exclusivity regarding marketing or distribution. In addition, if a channel partner is acquired by a competitor, its business units are reorganized or divested or its financial conditions were to weaken, our revenue derived from that partner may be adversely impacted.

Recruiting and retaining qualified channel partners and training them in the use of our enterprise technologies requires significant time and resources. If we fail to devote sufficient resources to support and expand our network of channel partners, our business may be adversely affected. In addition, because we rely on channel partners for the indirect distribution of our enterprise technologies, we may have little or no contact with the ultimate end-users of our technologies, thereby making it more difficult for us to establish brand awareness, ensure proper delivery and installation of our software, support ongoing customer requirements, estimate end-user demand, respond to evolving customer needs and obtain subscription renewals from end-users.

A portion of our sales to government entities have been made indirectly through our channel partners. Government entities may have statutory, contractual, or other legal rights to terminate contracts with our channel partners for convenience or due to a default, and any such termination may adversely impact our future operating results. Governments routinely investigate and audit government contractors’ administrative processes, and any unfavorable audit could result in the government refusing to continue buying our offerings, a reduction of revenue or fines or civil or criminal liability if the audit uncovers improper or illegal activities.

If our indirect distribution channel is disrupted, we may be required to devote more resources to distribute our offerings directly and support our customers, which may not be as effective and could lead to higher costs, reduced revenue and growth that is slower than expected.

The duration and extent of economic downturns, regional financial instability, and economic and market conditions in general could adversely affect our business, financial condition, operating results and cash flows.

Economic weakness and uncertainty, tightened credit markets and constrained IT spending from time to time contribute to slowdowns in the technology industry, as well as in the industries of our customers and the geographic regions in which we operate, which may result in reduced demand and increased price competition for our offerings. Our operating results in one or more geographic regions or customer industries may also be affected by uncertain or changing economic conditions within that region or industry. Continuing uncertainty about future economic conditions may, among other things, negatively impact our current and prospective customers and result in delays or reductions in technology purchases or lengthen our sales cycle. Adverse economic conditions also may negatively impact our ability to obtain payment for outstanding debts owed to us by our customers or other parties with whom we do business. In addition, such conditions may impact our investment portfolio, and we could determine that some of our investments have experienced an other-than-temporary decline in fair value, requiring an impairment charge that could adversely impact our financial condition and operating results. Also, such conditions may make it more difficult to forecast operating results. If global economic conditions, or economic conditions in the U.S., Europe, Asia or in other key geographic regions or customer industries, were to remain uncertain or persist, spread or deteriorate further, current and prospective customers may delay or reduce their IT spending, which could adversely affect our business, financial condition, operating results and cash flows.

We have entered into and may continue to enter into or seek to enter into business combinations and acquisitions, which may be difficult to complete and integrate, disrupt our business, divert management’s attention, adversely affect our business, financial condition, operating results and cash flows or dilute stockholder value.

As part of our business strategy, we have in the past entered into business combinations and acquisitions, and we may continue to do so in the future. These types of transactions can increase the expense of running our business and present significant challenges and risks, including:

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identifying acquisition targets that complement our strategic direction and technology road map;

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integrating the acquired business’ accounting, financial reporting, management, information and information security, human resource and other administrative systems to permit effective management and reporting, and the lack of control if such integration is delayed or not implemented;

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gathering full information regarding a business or technology prior to a transaction, including the identification and assessment of liabilities, claims or other circumstances that could result in litigation or regulatory exposure, unfavorable accounting treatment, unexpected tax implications and other adverse effects on our business;

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increasing or additional operating expenses related to the acquired business or technology;

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maintaining or establishing acceptable standards, controls, procedures and policies;

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disrupting of our ongoing business and distraction of management;

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impairing relationships with our employees, partners or customers as a result of any integration of new management and other personnel, products or technology or as a result of the changes in the competitive landscape affected by the transaction;

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maintaining good relationships with customers or business partners of the acquired business;

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effectively evaluating talent at an acquired business or cultural challenges associated with integrating employees from the acquired business into our organization;

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losing key employees of the acquired business;

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incorporating and further developing acquired products or technology into our offerings and maintaining quality standards consistent with our brands;

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achieving the expected benefits of the transaction, which may include generating greater market acceptance of our technologies, increasing our revenues or integrating the assets acquired into one or more of our current offerings;

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incurring expenses related to the transaction;

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assuming claims and liabilities from the acquired business or technology, or that are otherwise related to the transaction

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entering into new markets in which we have little or no experience or in which competitors may have stronger market positions;

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impairing of intangible assets and goodwill acquired in transactions; and

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for foreign transactions, managing additional risks related to the integration of operations across different cultures and languages, and the economic, political, compliance and regulatory risks associated with specific countries.

There can be no assurance that we will manage these challenges and risks successfully. Moreover, if we are not successful in completing transactions that we have pursued or may pursue, our business may be adversely affected, and we may incur substantial expenses and divert significant management time and resources. In addition, in pursuing and completing such transactions, we could use substantial portions of our available cash as all or a portion of the purchase price for these transactions or as retention incentives to employees of the acquired

business, or we may incur substantial debt. We could also issue additional securities as all or a portion of the purchase price for these transactions or as retention incentives to employees of the acquired business, which could cause our stockholders to suffer significant dilution. Any transaction may not generate additional revenue or profit for us, or may take longer to do so than expected, which may adversely affect our business, financial condition, operating results and cash flows.

If we fail to effectively manage our growth, our business, financial condition, operating results and cash flows could be adversely affected.

We have expanded our operations rapidly in recent years. For example, our total revenue increased from $1.79 billion for the fiscal year ended February 28, 2015 to $2.05 billion for the fiscal year ended February 29, 2016. Moreover, the total number of our employees increased from approximately 7,300 as of February 28, 2015 to approximately 8,800 as of February 29, 2016. In addition, we continue to explore ways to extend our offerings and geographic reach. Our growth has placed and will likely continue to place a strain on our management systems, information systems, resources and internal controls. Our ability to successfully provide our offerings and implement our business plan requires adequate information systems and resources, internal controls and oversight from our senior management. As we expand in international markets, these challenges increase as a result of the need to support a growing business in an environment of multiple languages, cultures, customs, legal systems, dispute resolution systems, regulatory systems and commercial practices. As we grow, (i) we may not be able to adequately screen and hire or adequately train, supervise, manage or develop sufficient personnel, and (ii) we may not be able to develop or effectively manage our controls, oversight functions or information systems. If we are unable to effectively manage our growth, our business, financial condition, operating results and cash flows could be adversely affected.

Industry consolidation and divestitures may lead to increased competition and may adversely affect our business, financial condition, operating results and cash flows.

There has been a trend of both consolidation and divestitures in the technology industry. We expect these trends to continue as companies attempt to strengthen or hold their market positions in an evolving industry. For example, as the computing, networking, storage, and software technologies that comprise the enterprise data center converge, many companies seek to position themselves as key or single-source vendors providing end-to-end technology solutions for the data center. Also, some of our current and potential competitors have made acquisitions or announced new strategic alliances designed to position them as a key or single-source vendor. As a result of these developments, we face greater competition, including competition from entities that are among our key business partners. This increased competition could adversely affect our business, financial condition, operating results and cash flows.

We depend on our key non-management employees, and our inability to attract and retain such employees could adversely affect our business or diminish our brands.

Competition in our industry for qualified employees, especially technical employees, is intense and our competitors directly target our employees. Our inability to attract and retain key employees could hinder our influence in open source projects and seriously impede our success. Moreover, the loss of these individuals, particularly to a competitor, some of which may be in a position to offer greater compensation, and any resulting loss of customers could reduce our market share and diminish our brands. We have from time to time in the past experienced, and we may experience in the future, difficulty in hiring and retaining highly skilled employees with appropriate qualifications. Also, to the extent we hire personnel from competitors, we may be subject to allegations that they have been improperly solicited, that they have divulged proprietary or other confidential information, or that their former employers own their inventions or other work product.

A number of our key employees have become, or will become, vested in a significant amount of their equity compensation awards. Employees may be more likely to leave us after a significant portion of their equity compensation awards fully vest, especially if the shares underlying the equity awards have significantly appreciated in value. Additionally, as we grow, there may be less equity compensation to award per employee. If

we do not succeed in attracting and retaining key personnel, our business, financial performance, operating results and cash flows may be adversely affected.

We may not be able to continue to attract and retain capable management.

Our future success depends on the continued services and effectiveness of a number of key management personnel. The loss of these individuals, particularly to a competitor, some of which may be in a position to offer greater compensation, could adversely affect our business or stock price.

Our ability to retain key management personnel or hire capable new management personnel as we grow may be challenged to the extent that other companies are able to offer more attractive opportunities to the individuals we seek to hire or retain. In addition, historically we have used share-based compensation as a key component of our compensation packages. Changes in the accounting for share-based compensation could adversely affect our earnings or make it more beneficial for us to use more cash compensation to attract and retain capable personnel. If the price of our common stock falls, the value of our share-based awards to recipients is reduced. Such events, or if we are unable to secure stockholder approval for increases in the number of shares eligible for share-based compensation grants, could adversely affect our ability to successfully attract and retain key management personnel. Effective succession planning is also important to our long-term success. Failure to ensure effective transfer of knowledge and smooth transitions involving key management personnel could hinder our strategic planning and execution.

Because of the characteristics of open source software, there are few technology barriers to entry into the open source market by new competitors and it may be relatively easy for competitors, some of which may have greater resources than we have, to enter our markets and compete with us.

One of the characteristics of open source software is that anyone may modify and redistribute the existing open source software and use it to compete with us. Such competition can develop without the degree of overhead and lead time required by traditional proprietary software companies. It is possible for competitors with greater resources than ours to develop their own open source solutions or acquire a smaller business that has developed open source offerings that compete with our offerings, potentially reducing the demand for, and putting price pressure on, our offerings. In addition, some competitors make their open source software available for free download and use on an ad hoc basis or may position their open source software as a loss leader. We cannot guarantee that we will be able to compete successfully against current and future competitors or that competitive pressure and/or the availability of open source software will not result in price reductions, reduced operating margins and loss of market share. Additionally, any failure by us to provide high-quality technical support, or the perception that we do not provide high-quality technical support, could harm our reputation and negatively impact our ability to sell subscriptions for our open source offerings to existing and prospective customers. If we are unable to differentiate our open source offerings from those of our competitors or compete effectively with other open source offerings, our business, financial condition, operation results and cash flows could be adversely affected.

Our corporate culture has contributed to our success, and if we cannot maintain this culture as we grow, we could lose the innovation, creativity and collaboration fostered by our culture, and our business may be adversely affected.

We believe that a critical contributor to our success has been our corporate culture, which we believe fosters innovation, creativity and collaboration. As our organization grows, our employees (including remote workers) and our resources become more globally dispersed and our organizational management structures become more complex, we may find it increasingly difficult to maintain these beneficial aspects of our corporate culture. If we are unable to maintain our corporate culture, we may find it difficult to attract and retain motivated employees, continue to perform at current levels or execute on our business strategy. As a result, our business, financial condition, operating results and cash flows could be adversely affected.

Our emerging technology offerings are based on developing technologies and business models, and the potential market for these offerings remains uncertain.

Our emerging technology offerings, which include our cloud, mobile and storage offerings, are based on developing technologies and business models, the success of which will depend on the technological and operational benefits and cost savings associated with the adoption of these technologies. These technologies are rapidly evolving, and their development is a complex and uncertain process requiring high levels of innovation and investment as well as the accurate anticipation of technology trends, market demand and customer needs. We expect competition to remain intense and, as with many emerging IT sectors, these technologies may be subject to a “first mover” effect pursuant to which certain product offerings rapidly capture a significant portion of market share and developer attention. Moreover, we may make errors in reacting to relevant business trends and predicting which technologies are successful or otherwise develop into industry standards.

Adoption of emerging technologies may occur more slowly or less pervasively than we expect and the revenue growth associated with these offerings may be slower than currently expected. Moreover, even if emerging technologies are adopted widely by enterprises, our offerings in these areas may not attract a sufficient number of users or generate attractive financial results. We incur expenses associated with these offerings in advance of our ability to generate associated revenue. Demand for our emerging technology offerings may unfavorably impact demand for our other offerings, including software subscriptions and related professional services. If the market for our emerging technologies offerings fails to develop adequately, it could have an adverse effect on our business, financial condition, operating results and cash flows.

Our business model may encounter customer resistance or we may experience a decline in the demand for our offerings.

We provide Red Hat enterprise technologies primarily under annual or multi-year subscriptions. A subscription generally entitles a customer to, among other things, a specified level of support, as well as security updates, fixes, functionality enhancements, upgrades to the technologies, each, if and when available, and compatibility with an ecosystem of certified hardware and software. While we believe this practice complies with the requirements of the GNU General Public License, and while we have reviewed this practice with the Free Software Foundation, the organization that maintains and provides interpretations of the GNU General Public License, customers may fail to honor the terms of our subscription agreements.

Demand for our offerings depends substantially on the general demand for enterprise software, which fluctuates based on numerous factors, including the spending levels and growth of our current and prospective customers, and general economic conditions. In addition, our customers generally undertake a significant evaluation process that may result in a lengthy sales cycle. We spend substantial time, effort, and money on our sales efforts, including developing and implementing appropriate go-to-market strategies and training our sales force and channel partners in order to effectively market new offerings, without any assurance that our efforts will produce any sales. The purchase of our offerings may be discretionary and can involve significant expenditures. If our current and prospective customers cut costs, then they may significantly reduce their enterprise software expenditures.

As technologies and the markets for our enterprise offerings change, our annual or multi-year subscription-based business model may no longer meet the needs of our customers. For example, a business model based on annual or multi-year subscriptions may no longer be competitive in an environment where disruptive technologies (such as cloud computing) enable customers to consume computing resources on an hourly basis or for free. We also develop and offer these disruptive technologies with consumption-based pricing, which may have an effect on the demand for our subscription-based offerings.

An increased focus on developing and providing emerging technology offerings may require a greater focus on marketing more holistic solutions, rather than individual offerings. Consequently, we may need to develop appropriate marketing and pricing strategies for our offerings, our customers’ purchasing decisions may become more complex and require additional levels of approval and the duration of sales cycles for our offerings may increase.

If we are unable to adapt our business model to changes in the marketplace or if demand for our offerings declines, our business, financial condition, operating results and cash flows could be adversely affected.

If our customers do not renew their subscription agreements with us, or if they renew on less favorable terms, our business, financial results, operating results and cash flows may be adversely affected.

Our customers may not renew their subscriptions after the expiration of their subscription agreements and in fact some customers elect not to do so. In addition, our customers may opt for a lower-priced edition of our offerings or for fewer subscriptions. We have limited historical data with respect to rates of customer subscription renewals, so we cannot accurately predict customer renewal rates. Our customers’ renewal rates may decline or fluctuate as a result of a number of factors, including their level of satisfaction with our services and their ability to continue their operations and spending levels. Government contracts could be subject to future funding that may affect the extension or termination of programs and generally are subject to the right of the government to terminate for convenience or non-appropriation. If we experience a decline in the renewal rates for our customers or they opt for lower-priced editions of our offerings or fewer subscriptions, our business, financial condition, operating results and cash flows may be adversely affected.

If third-party enterprise hardware and software providers do not continue to make their products and services compatible with our offerings, our software may cease to be competitive and our business, financial condition, operating results and cash flows may be adversely affected.

The competitive position of our offerings is dependent on their compatibility with products and services of third-party enterprise hardware and software companies. To the extent that a hardware or software vendor might have or develop products and services that compete with ours, the vendor may have an incentive to seek to limit the performance, functionality or compatibility of our offerings when used with one or more of the vendor’s offerings. In addition, these vendors may fail to support or issue statements of compatibility or certification of our offerings when used with their offerings. We intend to encourage the development of additional applications that operate on both current and new versions of our offerings by, among other means, attracting third-party developers to our offerings, providing open source tools to create these applications and maintaining our existing developer relationships through marketing and technical support. We intend to encourage the compatibility of our software with various third-party hardware and software offerings by maintaining and expanding our relationships, both business and technical, with relevant independent hardware and software vendors. If we are not successful in achieving these goals, however, our offerings may not be competitive and our business, financial condition, operating results and cash flows may be adversely affected.

If open source software programmers, most of whom we do not employ, do not continue to develop and enhance open source technologies, we may be unable to develop new technologies, adequately enhance our existing technologies or meet customer requirements for innovation, quality and price.

We rely to a significant degree on a number of largely informal communities of independent open source software programmers to develop and enhance our enterprise technologies. For example, Linus Torvalds, a prominent open source software developer, and a relatively small group of software engineers, many of whom are not employed by us, are primarily responsible for the development and evolution of the Linux kernel, which is the heart of the Red Hat Enterprise Linux operating system. If these groups of programmers fail to adequately further develop and enhance open source technologies, we would have to rely on other parties to develop and enhance our offerings or we would need to develop and enhance our offerings with our own resources. We cannot predict whether further developments and enhancements to these technologies would be available from reliable alternative sources. In either event, our development expenses could be increased and our technology release and upgrade schedules could be delayed. Moreover, if third-party software programmers fail to adequately further develop and enhance open source technologies, the development and adoption of these technologies could be stifled and our offerings could become less competitive. Delays in developing, completing or delivering new or enhanced offerings could result in delayed or reduced revenue for those offerings and could also adversely affect customer acceptance of those offerings.

Our offerings may contain defects that may be costly to correct, delay market acceptance of our enterprise technologies and expose us to claims and litigation.

Despite our testing procedures, errors have been and may continue to be found in our offerings after deployment. This risk is increased by the fact that much of the code in our offerings 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 and devote significant technical resources to analyze, correct, eliminate or work around them, and we may not be able to successfully do so in a timely manner or at all. Errors and failures in our offerings could result in a loss of, or delay in, market acceptance of our enterprise technologies, loss of existing or potential customers and delayed or lost revenue and could damage our reputation and our ability to convince enterprise users of the benefits of our technologies.

In addition, errors in our technologies could cause system failures, loss of data or other adverse effects for our customers who may assert warranty and other claims for substantial damages against us. Although our agreements with our customers often contain provisions which seek 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. While we seek to insure against these types of claims, our insurance policies may not adequately limit our exposure to such claims. These claims, even if unsuccessful, could be costly and time-consuming to defend and could adversely affect our business, financial conditions, operating results and cash flows.

Our continued success depends on our ability to maintain and enhance strong brands.

We believe that the brand identities that we have developed have contributed significantly to the success of our business. We also believe that maintaining and enhancing our brands is important to expanding our customer and partner base and attracting talented employees. In order to maintain and enhance our brands, we may be required to make further investments that may not be successful. Maintaining our brands will depend in part on our ability to remain a leader in open source technology and our ability to continue to provide high-quality offerings. If we fail to promote and maintain our brands, or if we incur excessive costs in doing so, our business, financial condition, operating results and cash flows may be adversely affected.

Security breaches and data loss may expose us to liability, harm our reputation and adversely affect our business.

Our business involves the production and distribution of enterprise software technologies, as well as hosting applications. As part of our business, we (or third parties with whom we contract) receive, store and process our data, as well as our customers’ and partners’ data. While we take security and testing measures relating to our offerings and operations, those measures may not prevent security breaches and data loss that could harm our business or the businesses of our customers and partners. Advances in computer capabilities, new discoveries in the field of cryptography, inadequate technology or facility security measures or other factors may result in data loss or a compromise or breach of our systems and the data we receive, store and process (or systems and the data received, stored and processed by third parties with whom we contract). These security measures may be breached or data lost as a result of actions by third parties, employee error (such as weak passwords or unencrypted devices), malfeasance or vulnerabilities or security bugs found in software code. A party who is able to circumvent security measures or exploit inadequacies in security measures, could, among other things, misappropriate proprietary information (including information about our employees, customers and partners, our customers’ information, financial data and data that others could use to compete against us), cause the loss or disclosure of some or all of this information, cause interruptions or denial of service in our or our customers’ operations, cause delays in development efforts or expose customers (and their customers) to computer viruses or other disruptions or vulnerabilities. A compromise to these systems could remain undetected for an extended period of time, exacerbating the impact of that compromise. These risks may increase as we continue to grow our cloud, mobile and services offerings and as we receive, store and process more of our customers’ data. Actual or perceived vulnerabilities may lead to regulatory investigations, claims against us by customers, partners or other third parties, or costs, such as those related to providing customer notifications and fraud monitoring. While our

customer agreements typically contain provisions that seek to limit our liability, there is no assurance these provisions will be enforceable and effective under applicable law. In addition, the cost and operational consequences of implementing further data protection measures could be significant. Moreover, because the techniques used to obtain unauthorized access, disable or degrade service or sabotage systems change frequently and often are not recognized until launched against a target, we may be unable to anticipate these techniques or to implement adequate preventative measures. Any loss of data or compromise of our systems or the data we receive, store or process (or systems and the data received, stored and processed by third parties with whom we contract) could result in a loss of confidence in the security of our offerings, damage our reputation, loss of channel or strategic partners, lead to legal liability and adversely affect our business, financial condition, operating results and cash flows.

We are vulnerable to technology infrastructure failures, which could harm our reputation and adversely affect our business.

We rely on our technology infrastructure, and the technology infrastructure of third parties, for many functions, including selling our offerings, supporting our partners, fulfilling orders and billing, and collecting and making payments. This technology infrastructure may be vulnerable to damage or interruption from natural disasters, power loss, telecommunication failures, terrorist attacks, computer intrusions, vulnerabilities and viruses, software errors, computer denial-of-service attacks and other events. A significant number of the systems making up this infrastructure are not redundant, and our disaster recovery planning may not be sufficient for every eventuality. This technology infrastructure may fail or be vulnerable to damage or interruption because of actions by third parties or employee error or malfeasance. We may not carry business interruption insurance sufficient to protect us from all losses that may result from interruptions in our services as a result of technology infrastructure failures or to cover all contingencies. Any interruption in the availability of our websites and on-line interactions with customers or partners may cause a reduction in customer or partner satisfaction levels, which in turn could cause additional claims, reduced revenue or loss of customers or partners. Despite any precautions we may take, such problems could result in, among other consequences, a loss of data, loss of confidence in the stability and reliability of our offerings, damage to our reputation, and legal liability, all of which may adversely affect our business, financial condition, operating results and cash flows interruptions.

A decline in or reprioritization of funding in the U.S. or foreign government budgets or delays in the budget process could adversely affect our business, financial condition, operating results and cash flows.

We derive, and expect to continue to derive, a portion of our revenue from U.S. and foreign governments. Government deficit reduction and austerity measures, along with continued economic challenges, continue to place pressure on U.S. and foreign government spending. The termination of, or delayed or reduced funding for, government-sponsored programs and contracts from which we derive revenue could adversely affect our business, financial condition, operating results and cash flows.

We may be unable to predict the future course of open source technology development, which could reduce the market appeal of our offerings, damage our reputation and adversely affect our business, financial condition, operating results and cash flows.

We do not exercise control over many aspects of the development of open source technology. Different groups of open source software programmers compete with one another to develop new technology. Typically, the technology developed by one group will become more widely used than that developed by others. If we acquire or adopt new technology and incorporate it into our offerings but competing technology becomes more widely used or accepted, the market appeal of our offerings may be reduced and that could harm our reputation, diminish our brands and adversely affect our business, financial condition, operating results and cash flows.

We include software licensed from other parties in our offerings, the loss of which could increase our costs and delay availability of our offerings.

We utilize various types of software licensed from unaffiliated third parties in our offerings. Aspects of our business could be disrupted if any of the software we license from others or functional equivalents of this software were no longer available to us, no longer offered to us on commercially reasonable terms or changed in ways or included defects that make the third-party software unsuitable for our use. In these cases, we would be required to either redesign our technologies to function with software available from other parties, develop these components ourselves or eliminate the functionality, which could result in increased costs, the need to mitigate customer issues, delays in delivery of our offerings and the release of new offerings and limit the features available in our current or future offerings.

RISKS RELATED TO LEGAL UNCERTAINTY

If our technologies are found or alleged to infringe third-party intellectual property rights, we may be required to take costly and time-consuming actions to meet our commitments to customers.

We regularly commit to our subscription customers that if portions of our offerings are found to infringe third-party intellectual property rights we will, at our expense and option: (i) obtain the right for the customer to continue to use the technology consistent with their subscription agreement with us; (ii) modify the technology so that its use is non-infringing; or (iii) replace the infringing component with a non-infringing component, and defend them against specified infringement claims. Although we cannot predict whether we will need to satisfy these commitments and we often have limitations on these commitments, satisfying these commitments could be costly, be time-consuming, divert the attention of technical and management personnel, and adversely affect our business, financial condition, operating results and cash flows. In addition, our insurance policies would likely not adequately cover our exposure to this type of claim. Finally, because we have agreed to defend our subscription customers against specified infringement claims arising from the use of our offerings, we could become involved in litigation brought against such customers if our services and technology are allegedly implicated.

We are vulnerable to claims that our technologies infringe third-party intellectual property rights and an unfavorable legal decision affecting our intellectual property could adversely affect our business.

We are vulnerable to claims that our technologies infringe third-party intellectual property rights, including patents, copyrights, trademarks and trade secrets, because our technologies are comprised of software components, many of which are developed by numerous independent parties. We are also unlikely to be able to assess adequately the relevance of patents to our technologies, and may be unable to take appropriate responsive action in a timely or economic manner because, among other reasons, the scope of software patent protection is often not well defined or readily determinable, patent applications in the U.S. are not publicly disclosed at the time of filing, and the number of software patents that are issued each year is significant and growing. Our exposure to risks associated with the use of intellectual property may increase as a result of acquisitions. In addition, third parties may make infringement and similar or related claims after we have acquired technology that had not been asserted prior to our acquisition of such technology.

In the past, our technologies have been subject to intellectual property infringement claims. Some of these claims have been brought by entities that do not design, manufacture, or distribute products or services or that acquire intellectual property like patents for the sole purpose of monetizing their acquired intellectual property through asserting claims of infringement. As these entities do not have operating businesses of their own and therefore have limited risk of counterclaims for damages or injunctive relief, it may be difficult to deter them from bringing intellectual property infringement claims. We expect to face the possibility of more intellectual property infringement claims as our prominence increases, business activities expand, market share and revenue grow, the number of products and competitors in our industry grows and the functionality of products in different portions of the industry overlap. We may not be able to accurately assess the risk related to these suits, and we may be unable to accurately assess our level of exposure.

Defending patent and other intellectual property claims, even claims without significant merit, can be time-consuming, costly and can divert the attention of technical and management personnel. We may receive unfavorable preliminary or interim rulings in the course of litigation, and there can be no assurances that favorable final outcomes will be obtained in all cases. We may decide to settle certain lawsuits and disputes on terms that are disadvantageous to us. Similarly, if any litigation to which we are a party is resolved adversely, we may be subject to an unfavorable judgment that may not be reversed upon appeal. The terms of such a settlement or judgment may require us to cease offering certain of our technologies or pay substantial amounts to the other party. In addition, we may have to seek a license to continue offering technologies found to be in violation of a third party’s rights, which may not be available on reasonable terms, or at all, and may significantly increase our operating costs and expenses. As a result, we may also be required to develop alternative non-infringing technology or practices or discontinue the practices. The development of alternative non-infringing technology or practices could require significant effort and expense or may not be feasible.

An unfavorable legal decision regarding the intellectual property in and to our technology and other offerings could adversely affect our business, financial condition, operating results and cash flows. See Part II, Item 1, “Legal Proceedings” for additional information.

Our activities, or the activities of our partners, may violate anti-corruption laws and regulations that apply to us.

In many foreign countries, particularly in certain developing economies, it is not uncommon to engage in business practices that are prohibited by regulations that may apply to us, such as the U.S. Foreign Corrupt Practices Act and similar laws. Although we have policies and procedures designed to help promote compliance with these laws, our employees, contractors, partners and agents, as well as those companies to which we outsource certain of our business operations, may take actions in violation of our policies and procedures. Any violation of these laws and regulations could result in fines, criminal sanctions against us, our officers, or our employees, prohibitions on the conduct of our business, and damage to our reputation.

Governmental regulations affecting the import or export of software could adversely impact our business.

Due to the global nature of our business, we are subject to import and export restrictions and regulations, including the Export Administration Regulations administered by the U.S. Commerce Department’s Bureau of Industry and Security (“BIS”) and the trade and economic sanctions regulations administered by the U.S. Treasury Department’s Office of Foreign Assets Control (“OFAC”). The U.S., through the BIS and OFAC, places restrictions on the sale or export of certain products and services to certain countries and persons (“denied parties”). Violators of these export control and sanctions laws may be subject to significant penalties, which may include significant monetary fines, criminal proceedings against them and their officers and employees, a denial of export privileges, and suspension or debarment from selling products or services to the federal government. Any such penalties could have an adverse effect on our business, financial condition, operating results and cash flows. In addition, the political and media scrutiny surrounding any governmental investigation of us could cause us significant expense and reputational harm and distract senior executives from managing our normal day-to-day operations.

Our products could also be shipped to denied parties by third parties, including our channel partners. Even though we take precautions to ensure that our channel partners comply with all relevant import and export regulations, any failure by our channel partners to comply with such regulations could have negative consequences for us, including reputational harm, government investigations and penalties.

We could be prevented from selling or developing our software if the GNU General Public License and similar licenses under which our technologies are developed and licensed are not enforceable or are modified so as to become incompatible with other open source licenses.

A number of our offerings, including Red Hat Enterprise Linux, have been developed and licensed under the GNU General Public License and similar open source licenses. These licenses state that any program licensed

under them may be liberally copied, modified and distributed. It is possible that a court would hold these licenses to be unenforceable or that someone could assert a claim for proprietary rights in a program developed and distributed under them. Additionally, if any of the open source components of our offerings may not be liberally copied, modified or distributed, then our ability to distribute or develop all or a portion of our offerings could be adversely impacted. In addition, licensors of open source software employed in our offerings may, from time to time, modify the terms of their license agreements in such a manner that those license terms may become incompatible with other open source licenses in our offerings or our end user license agreement, and thus could, among other consequences, prevent us from distributing the software code subject to the modified license.

Our efforts to protect our trademarks may not be adequate to prevent third parties from misappropriating our intellectual property rights in our trademarks.

Our collection of trademarks is valuable and important to our business. The protective steps we have taken in the past may have been, and may in the future continue to be, inadequate to protect and deter misappropriation of our trademark rights. We may be unable to detect the unauthorized use of, or take appropriate steps to enforce, our trademark rights in a timely manner. We have registered some of our trademarks in countries in North America, South America, Europe, Asia, Africa and Australia and have other trademark applications pending in various countries around the world. Effective trademark protection may not be available in every country in which we offer or intend to distribute our offerings. We may be unable to prevent third parties from acquiring domain names that are similar to, infringe upon, or diminish the value of our trademarks and other proprietary rights. Failure to adequately protect our trademark rights could damage or even destroy one or more of our brands 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.

Efforts to assert intellectual property ownership rights in our technologies could impact our standing in the open source community, which could limit our technology innovation capabilities and adversely affect our business.

When we undertake actions to protect and maintain ownership and control over our intellectual property, including patents, copyrights and trademark rights, our standing in the open source community could be adversely affected as the community supports the ability to write and share code freely. This in turn could limit our ability to continue to rely on this community, upon which we are dependent, as a resource to help develop and improve our technologies and further our research and development efforts, and could adversely affect our business.

Our “Patent Promise” on software patents limits our ability to enforce our patent rights in certain circumstances.

As part of our commitment to the open source community, we provide our Patent Promise on software patents. Under our Patent Promise, we agree, subject to certain limitations, to not enforce our patent rights against users of open source software covered by certain open source licenses, including the GNU General Public License version 2.0 and version 3.0, GNU Lesser General Public License version 2.1 and version 3.0, IBM Public License version 1.0, Common Public License version 1.0, Q Public License version 1.0, Open Software License version 3.0 and any other open source license granted by Red Hat. While we may be able to claim protection of our intellectual property under other rights, such as trade secrets or contractual rights, our Patent Promise effectively limits our ability to assert our patent rights against these third parties (even if we were to conclude that their use infringes our patents with competing offerings), unless any such third party asserts its patent rights against us. This limitation on our ability to assert our patent rights against others could harm our business and ability to compete.

We are, and may become, involved in disputes and lawsuits that could adversely affect our business.

Lawsuits or legal proceedings may be commenced against us. These disputes and proceedings may involve significant expense and divert the attention of management and other employees. If we do not prevail in these

matters, we could be required to pay substantial damages or settlement costs, which could adversely affect our business, financial condition, operating results and cash flows. See Part II, Item 1, “Legal Proceedings” for additional information.

If we fail to comply with laws and regulations regarding data privacy and protection, our business could be adversely affected.

Our business is subject to a variety of federal, state and international laws and regulations that apply to the collection, use, retention, protection, disclosure, transfer and processing of personal data. These data privacy- and protection-related laws and regulations are evolving, with new or modified laws and regulations proposed and implemented frequently and existing laws and regulations subject to new or different interpretations. For example, in October 2015, the European Court of Justice invalidated the U.S.-EU Safe Harbor Framework. The Safe Harbor Framework had established a lawful method for the transfer of personal data from the European Economic Area (“EEA”) to the U.S. The decision of the European Court of Justice has resulted in increased uncertainty and greater complexity and risk relating to transfers of personal data from the EEA to the U.S.

Any failure by us to comply with data privacy- and protection-related laws and regulations could result in enforcement actions, significant penalties or other legal actions against us or our customers or suppliers. An actual or alleged failure to comply, which could result in negative publicity, reduce demand for our offerings, increase the cost of compliance, require changes in business practices that result in reduced revenue, restrict our ability to provide our offerings in certain locations, result in our customers’ inability to use our offerings and prohibit data transfers or result in other claims, liabilities or sanctions, including fines, could have an adverse effect on our business, financial condition, operating results and cash flows.

If we fail to comply with our customer contracts or government contracting regulations, our business could be adversely affected.

Our contracts with our customers may include specialized performance requirements. In particular, our contracts with federal, state, provincial and local governmental customers are subject to various government certification requirements, procurement regulations, contract provisions and other requirements relating to their formation, administration and performance. Any failure by us or our channel partners to comply with the specific provisions in our customer contracts or any violation of government contracting regulations by us or our channel partners could result in the imposition of various civil and criminal penalties, which may include termination of contracts, forfeiture of profits, suspension of payments and, in the case of our government contracts, fines and suspension from future government contracting. In addition, we may be subject to qui tam litigation, the process by which a private individual sues or prosecutes on behalf of the government relating to government contracts and shares in the proceeds of any successful litigation or settlement, which could include claims for up to treble damages. Further, any negative publicity related to our customer contracts or any proceedings surrounding them, regardless of its accuracy, may damage our business and affect our ability to compete for new contracts. There is increased pressure for governments and their agencies, both domestically and internationally, to reduce spending. If our customer contracts are terminated, if we are suspended from government work, if we are unable to meet government certification requirements, or if our ability to compete for new contracts is adversely affected, we could suffer an adverse effect on our business, financial condition, operating results and cash flows.

We may be subject to legal liability associated with providing online services or content.

We provide offerings, such as OpenShift by Red Hat, that enable users to exchange information, advertise products and services, conduct business, and engage in various online activities. The law relating to the liability of providers of these online offerings for activities of their users is relatively unsettled and still developing both in the U.S. and internationally and may be significantly different from jurisdiction to jurisdiction. Claims could be brought against us based on the nature and content of information that we publish or to which we provide links or that may be posted online or generated by us or by third parties, including our customers. In addition, we could be subject to domestic or international actions alleging that certain content we have generated or third-party content that we have made available within our services violates applicable law.

RISKS RELATED TO FINANCIAL UNCERTAINTY

Our quarterly and annual operating results may not be a reliable indicator of our future financial performance.

Due to the unpredictability of the IT spending environment, among other reasons, our revenue and operating results have fluctuated and may continue to fluctuate. We base our current and projected future expense levels, in part, on our estimates of future revenue. Our expenses are, to a large extent, fixed in the short term. Accordingly, we may not be able to adjust our spending quickly enough to protect our projected operating results for a quarter if our revenue in that quarter falls short of our expectations. Additionally, a significant portion of our quarterly sales typically occur during the last weeks of the quarter and our revenue and operating results may be adversely impacted if we are unable to process an increasing number of transactions by the end of the quarter. If, among other considerations, our future financial performance falls below the expectations of securities analysts or investors or we are unable to increase or maintain profitability, the market price of our common stock may decline.

We may not be able to meet the financial and operational challenges that we will encounter as our international operations, which represented approximately 40.9% of our total revenue for the fiscal year ended February 29, 2016, continue to expand.

Our international operations accounted for approximately 40.9% of total revenue for the fiscal year ended February 29, 2016. As we expand our international operations, we may have difficulty managing and administering a globally dispersed business and we may need to expend additional funds to, among other activities, reorganize our sales force and technical support services team, outsource or supplement general and administrative functions, staff key management positions, obtain additional information technology infrastructure and successfully localize offerings for a significant number of international markets, which may adversely affect our operating results. Additional challenges associated with the conduct of our business globally that may adversely affect our operating results include:

•

fluctuations in exchange rates;

•

pricing environments;

•

longer payment cycles and less financial stability of customers;

•

economic, political, compliance and regulatory risks associated with specific countries;

•

laws and policies of the U.S. and other jurisdictions affecting trade, foreign investment, loans, and taxes;

•

difficulty selecting and monitoring channel partners;

•

differing technology standards and customer requirements;

•

lower levels of availability or use of the Internet, through which our software is often delivered;

•

difficulty protecting our intellectual property rights globally due to, among other reasons, the uncertainty of laws and enforcement in certain countries relating to the protection of intellectual property rights;

•

difficulty in staffing, developing and managing foreign operations as a result of distance, language, legal, cultural and other differences;

•

different employee/employer relationships and the existence of works councils and labor unions;

•

difficulty maintaining quality standards consistent with the our brands;

•

export and import laws and regulations that could prevent us from delivering our offerings into and from certain countries;

•

public health risks and natural disasters, particularly in areas in which we have significant operations;

•

limitations on the repatriation and investment of funds and foreign currency exchange restrictions;

•

changes in import/export duties, quotas or other trade barriers that could affect the competitive pricing of our offerings and reduce our market share in some countries; and

•

economic or political instability or terrorist acts in some international markets that could adversely affect our business in those markets or result in the loss or forfeiture of some foreign assets and the loss of sums spent developing and marketing those assets and the revenue associated with them.

Any failure by us to effectively manage the challenges associated with the international expansion of our operations could adversely affect our business, financial condition, operating results and cash flows.

On June 23, 2016, the United Kingdom (the “U.K.”) held a referendum in which voters approved an exit from the European Union (the “E.U.”), commonly referred to as “Brexit”. As a result of the referendum, it is expected that the British government will begin negotiating the terms of the U.K.’s withdrawal from the E.U. A withdrawal could, among other outcomes, disrupt the free movement of goods, services and people between the U.K. and the E.U., undermine bilateral cooperation in key policy areas and significantly disrupt trade between the U.K. and the E.U. In addition, Brexit could lead to legal uncertainty and potentially divergent national laws and regulations as the U.K. determines which E.U. laws to replace or replicate. Given the lack of comparable precedent, it is unclear what financial, political and legal implications the withdrawal of the U.K. from the E.U. would have and how such withdrawal would affect us.

The announcement of Brexit caused significant volatility in global stock markets and currency exchange rate fluctuations that resulted in the strengthening of the U.S. dollar against foreign currencies in which we conduct business. The strengthening of the U.S. dollar relative to other currencies may adversely affect our operating results. The announcement of Brexit and the withdrawal of the U.K. from the E.U. may also create global economic uncertainty, which may cause our customers to closely monitor their costs and reduce their spending budgets. Any of these effects of Brexit, among others, could adversely affect our business, financial condition, operating results and cash flows.

A substantial portion of our revenue is derived from our Red Hat Enterprise Linux platform.

During our fiscal year ended February 29, 2016, a substantial portion of our subscription revenue was derived from our Red Hat Enterprise Linux offerings. Although we are continuing to develop other offerings, we expect that revenue from Red Hat Enterprise Linux will constitute a majority of our revenue for the foreseeable future. Declines and variability in demand for Red Hat Enterprise Linux could occur as a result of:

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competitive products and pricing;

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failure to release new or enhanced versions of Red Hat Enterprise Linux on a timely basis, or at all;

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technological change that we are unable to address with Red Hat Enterprise Linux; or

•

future economic conditions.

Additionally, as more customers and potential customers virtualize their data centers and move computing projects to cloud environments, demand for operating systems such as Red Hat Enterprise Linux may decline. Moreover, as data centers become more virtualized and move to cloud environments, we may experience a decline in growth if we are unsuccessful in adapting our business model and offerings accordingly. Due to the concentration of our revenue from Red Hat Enterprise Linux, our business, financial condition, operating results and cash flows could be adversely affected by a decline in demand for Red Hat Enterprise Linux.

We are subject to risks of currency fluctuations and related hedging operations.

A portion of our business is conducted in currencies other than the U.S. dollar. Changes in exchange rates among other currencies and the U.S. dollar may affect our revenue, operating expenses and operating margins,

which are reported in U.S. dollars. We cannot predict the impact of future exchange rate fluctuations. As we expand international operations, our exposure to exchange rate fluctuations may increase. We use financial instruments, primarily forward purchase contracts, to economically hedge currency commitments arising from trade accounts receivable, trade accounts payable and fixed purchase obligations. If these hedging activities are not successful or we change or reduce these hedging activities in the future, we may experience significant unexpected expenses from fluctuations in exchange rates. For information regarding our hedging activity, see Part I, Item 3, “Quantitative and Qualitative Disclosures About Market Risk”.

If our growth rate slows, our stock price could be adversely affected.

As the markets for our offerings mature and the scale of our business increases, our rate of revenue, deferred revenue and operating cash flow growth may be lower than the growth rates we experienced in earlier periods. In addition, to the extent that the adoption of our offerings occurs more slowly or is less pervasive than we expect, our growth rates may slow or decline, which could adversely affect our stock price. Historical period-to-period comparisons of our revenue, deferred revenue and operating cash flow may not be meaningful and are not guarantees of our future performance.

We may be subject to greater tax liabilities.

We are subject to income and other taxes in the U.S. and in numerous foreign jurisdictions. Our domestic and foreign tax liabilities are subject to the allocation of revenue and expenses in different jurisdictions. Additionally, the amount of taxes paid is subject to our interpretation of applicable tax laws in the jurisdictions in which we operate. Changes in tax laws, or in judicial or administrative interpretations of tax laws, could have an adverse effect on our business, financial condition, operating results and cash flows. Significant judgment is required in determining our worldwide provision for income taxes. In the ordinary course of our business, there are many transactions and calculations where the ultimate tax determination is uncertain. We are regularly subject to audits by tax authorities. Although we believe our tax estimates are reasonable, the final determination of tax audits and any related litigation could be materially different from our historical income tax provisions and accruals. Economic and political pressures to increase tax revenue in various jurisdictions may make resolving tax disputes more difficult. The results of an audit or litigation could adversely affect our financial statements in the period or periods for which that determination is made.

We earn a significant amount of our operating income from outside the U.S., and any repatriation of funds currently held in foreign jurisdictions may result in higher effective tax rates for the company. In addition, there have been proposals to change U.S. tax laws that would significantly impact how U.S. multinational corporations are taxed on foreign earnings. Although we cannot predict whether or in what form this proposed legislation may pass, if enacted it could adversely affect our operating results and cash flows.

Because we recognize revenue from subscriptions for our service over the term of the subscription, downturns or upturns in sales may not be immediately reflected in our operating results.

We generally recognize subscription revenue from customers ratably over the term of their subscription agreements, which are generally 12 to 36 months. As a result, much of the revenue we report in each quarter is deferred revenue from subscription agreements entered into during previous quarters. Consequently, a decline in subscriptions in any one quarter will not necessarily be fully reflected in the revenue in that quarter and will negatively affect our revenue in future quarters. In addition, we may be unable to adjust our cost structure to reflect this reduced revenue. Accordingly, the effect of significant downturns in sales and market acceptance of our service, and potential changes in our rate of renewals, may not be fully reflected in our operating results until future periods. Our subscription model also makes it difficult for us to rapidly increase our revenue through additional sales in any period, as revenue from new customers must be recognized over the applicable subscription term.

If our goodwill or amortizable intangible assets become impaired, we may be required to record a significant charge to earnings.

Under generally accepted accounting principles, we review our amortizable intangible assets for impairment when events or changes in circumstances indicate the carrying value may not be recoverable. Goodwill is required to be tested for impairment at least annually. Factors that may be considered a change in circumstances indicating that the carrying value of our goodwill or amortizable intangible assets may not be recoverable include a decline in stock price and market capitalization, reduced future cash flow estimates and slower growth rates in our industry. We may be required to record a significant charge to earnings in our financial statements during the period in which any impairment of our goodwill or amortizable intangible assets is determined, which could adversely affect our operating results.

We may be exposed to potential risks if we do not have an effective system of disclosure controls or internal controls.

We must comply, on an on-going basis, with the requirements of the Sarbanes-Oxley Act of 2002, including those provisions that establish the requirements for both management and auditors of public companies with respect to reporting on internal control over financial reporting. We cannot be certain that measures we have taken, and will take, will be sufficient or timely completed to meet these requirements on an on-going basis, or that we will be able to implement and maintain adequate disclosure controls and controls over our financial processes and reporting in the future, particularly in light of our rapid growth, international expansion and changes in our offerings, which are expected to result in on-going changes to our control systems and areas of potential risk.

If we fail to maintain an effective system of disclosure controls or internal control over financial reporting, including satisfaction of the requirements of the Sarbanes-Oxley Act, we may not be able to accurately or timely report on our financial results or adequately identify and reduce fraud. As a result, the financial condition of our business could be adversely affected; current and potential future stockholders could lose confidence in us and/or our reported financial results, which may cause a negative effect on our trading price; and we could be exposed to litigation or regulatory proceedings, which may be costly or divert management attention.

Changes in accounting principles and guidance, or their interpretation, could result in unfavorable accounting charges or effects, including changes to previously filed financial statements, which could cause our stock to decline.

We prepare our consolidated financial statements in accordance with accounting principles generally accepted in the U.S. These principles are subject to interpretation by the Securities and Exchange Commission and various bodies formed to interpret and create appropriate accounting principles and guidance. A change in these principles or guidance, or in their interpretations, may have a significant effect on our reported results and may retroactively affect previously reported results.

Our investment portfolio is subject to credit and liquidity risks and fluctuations in the market value of our investments and interest rates. These risks may result in an impairment of, or the loss of all or a portion of, the value of our investments, an inability to sell our investments or a decline in interest income.

We maintain an investment portfolio of various holdings, types and maturities. Our portfolio as of February 29, 2016 consisted primarily of money market funds, U.S. government and agency securities, European sovereign and agency securities with a rating of AA or higher, certificates of deposit, and corporate securities. Although we follow an established investment policy and seek to minimize the risks associated with our investments by investing primarily in investment grade, highly liquid securities and by limiting the amounts invested with any one institution, type of security or issuer, we cannot give assurances that the assets in our investment portfolio will not lose value or become impaired, or that our interest income will not decline.

A significant part of our investment portfolio consists of U.S. government and agency securities. If global credit and equity markets experience prolonged periods of decline, or if there is a default or downgrade of U.S.

government or agency debt, our investment portfolio may be adversely impacted and we could determine that some of our investments have experienced an other-than-temporary decline in fair value, requiring impairment charges that could adversely affect our financial condition and operating results.

Future fluctuations and uncertainty in economic and market conditions could adversely affect the market value of our investments, and we could record additional impairment charges and lose some or all of the principal value of investments in our portfolio. A total loss of an investment or a significant decline in the value of our investment portfolio could adversely affect our financial condition and operating results. For information regarding the sensitivity of and risks associated with the market value of portfolio investments and interest rates, see Part I, Item 3, “Quantitative and Qualitative Disclosures About Market Risk”.

Our investments in private companies are subject to risk of loss of investment capital. Some of these investments may have been made to further our strategic objectives and support our key business initiatives. Our investments in private companies are inherently risky because the markets for the technologies they have under development are typically in the early stages and may never materialize. We could lose the value of our entire investment in these companies.

Epidemics, geo-political events, Internet and power outages or natural disasters could adversely affect our business, financial condition, operating results and cash flows.

The occurrence of one or more epidemics, geo-political events (such as civil unrest or terrorist attacks), Internet and power outages or natural disasters in a country in which we operate or in which technology industry suppliers or our customers are located, could adversely affect our business, financial condition, operating results and cash flows. Such events could result in physical damage to, or the complete loss of, one or more of our facilities, the lack of an adequate work force in a market, the inability of our customers to access our offerings, the inability of our associates to reach or have transportation to our facilities or our customers’ facilities directly affected by such events, the evacuation of the populace from areas in which our facilities are located, changes in the purchasing patterns of our customers, the temporary or long-term disruption in the supply of computer hardware and related components, the disruption or delay in the manufacture and transport of goods globally, the disruption of utility services to our facilities or to suppliers, partners or customers, or disruption in our communications with our customers.

RISKS RELATED TO THE CONVERTIBLE NOTES

The convertible notes are effectively subordinated to any secured debt we incur in the future and to any liabilities of our subsidiaries.

In October 2014, we issued $805.0 million of 0.25% Convertible Senior Notes due 2019 (the “convertible notes”). The convertible notes will rank senior in right of payment to any of our indebtedness that is expressly subordinated in right of payment to the convertible notes; equal in right of payment to any of our existing and future indebtedness and other liabilities that are not so subordinated; effectively junior in right of payment to any of our secured indebtedness to the extent of the value of the assets securing such indebtedness; and structurally junior to all existing and future indebtedness and other liabilities of our subsidiaries (including trade payables). In the event of our bankruptcy, liquidation, reorganization or other winding up, our assets that secure debt ranking senior in right of payment to the convertible notes will be available to pay obligations on the convertible notes only after the secured debt has been repaid in full from these assets, and the assets of our subsidiaries will be available to pay obligations on the convertible notes only after all claims senior to the convertible notes have been repaid in full. There may not be sufficient assets remaining to pay amounts due on any or all of the convertible notes then outstanding.

We may still incur substantially more debt or take other actions that could diminish our ability to make payments on the convertible notes.

We and our subsidiaries may be able to incur substantial additional debt in the future, subject to the restrictions contained in our future debt instruments, some of which may be secured debt. We are not restricted under the terms of the indenture governing the convertible notes from incurring additional debt, securing existing or future debt, recapitalizing our debt or taking a number of other actions that are not limited by the terms of the indenture governing the convertible notes that could have the effect of diminishing our ability to make payments on the convertible notes when due.

We may not have the ability to raise the funds necessary to settle conversions of the convertible notes in cash, repay the convertible notes at maturity or repurchase the convertible notes upon a fundamental change, and our future debt may contain limitations on our ability to pay cash upon conversion or repurchase of the convertible notes.

Holders of the convertible notes will have the right to require us to repurchase all or a portion of their convertible notes upon the occurrence of a fundamental change at a repurchase price equal to 100% of the principal amount of the convertible notes to be repurchased, plus accrued and unpaid interest, if any. In addition, upon conversion of the convertible notes, unless we elect to deliver solely shares of our common stock to settle such conversion (other than paying cash in lieu of delivering any fractional share), we will be required to make cash payments in respect of the convertible notes being converted. However, we may not have enough available cash or be able to obtain financing at the time we are required to make repurchases of the convertible notes surrendered therefor or pay cash with respect to the convertible notes being converted or at their maturity.

In addition, our ability to repurchase or to pay cash upon conversions of the convertible notes may be limited by law, regulatory authority or agreements governing our future indebtedness and is dependent on our future performance, which is subject to economic, financial, competitive and other factors beyond our control. Our failure to repurchase the convertible notes at a time when the repurchase is required by the indenture or to pay any cash payable on future conversions of the convertible notes as required by the indenture would constitute a default under the indenture. A fundamental change under the indenture or a default under the indenture could also lead to a default under agreements governing our future indebtedness. If the repayment of the related indebtedness were to be accelerated after any applicable notice or grace periods, we may not have sufficient funds to repay the indebtedness and repurchase the convertible notes or make cash payments upon conversions thereof.

The conditional conversion feature of the convertible notes, if triggered, may adversely affect our financial condition and operating results.

In the event the conditional conversion feature of the convertible notes is triggered, holders of the convertible notes will be entitled to convert the convertible notes at any time during specified periods at their option. If one or more holders elect to convert their convertible notes, unless we elect to satisfy our conversion obligation by delivering solely shares of our common stock (other than paying cash in lieu of delivering any fractional share), we would be required to settle a portion or all of our conversion obligation through the payment of cash, which could adversely affect our liquidity. In addition, even if holders do not elect to convert their convertible notes, we could be required under applicable accounting rules to reclassify all or a portion of the outstanding principal of the convertible notes as a current rather than long-term liability, which would result in a material reduction of our net working capital.

The accounting method for convertible debt securities that may be settled in cash, such as the convertible notes, could have a material effect on our reported financial results.

Accounting Standards Codification Subtopic 470-20, Debt with Conversion and Other Options (“ASC 470-20”), requires an entity to separately account for the liability and equity components of convertible debt instruments (such as the convertible notes) that may be settled entirely or partially in cash upon conversion in a

manner that reflects the issuer’s non-convertible debt interest rate. Accordingly, the equity component of the convertible notes is required to be included in the additional paid-in capital section of stockholders’ equity on our consolidated balance sheet, and the value of the equity component is treated as original issue discount for purposes of accounting for the debt component of the convertible notes. As a result, we are required to recognize a greater amount of non-cash interest expense in our consolidated income statements in the current and future periods presented as a result of the amortization of the discounted carrying value of the convertible notes to their principal amount over the term of the convertible notes. We will report lower net income (or greater net losses) in our consolidated financial results because ASC 470-20 will require interest to include both the current period’s amortization of the original issue discount and the instrument’s non-convertible interest rate. This could adversely affect our reported or future consolidated financial results, the trading price of our common stock and the trading price of the convertible notes.

In addition, under certain circumstances, in calculating earnings per share, convertible debt instruments (such as the convertible notes) that may be settled entirely or partly in cash are currently accounted for utilizing the treasury stock method, the effect of which is that the shares of common stock issuable upon conversion of the convertible notes, if any, are not included in the calculation of diluted earnings per share except to the extent that the conversion value of the convertible notes exceeds their principal amount. Under the treasury stock method, diluted earnings per share is calculated as if the number of shares of common stock that would be necessary to settle such excess, if we elected to settle such excess in shares, were issued. We cannot be sure that the accounting standards in the future will continue to permit the use of the treasury stock method. If we are unable to use the treasury stock method in accounting for the shares issuable upon conversion of the convertible notes, if any, then our diluted consolidated earnings per share would be adversely affected.

The convertible note hedge and warrant transactions may affect the value of our common stock.

In connection with the sale of the convertible notes, we entered into convertible note hedge transactions with institutions that we refer to as the option counterparties. We also entered into warrant transactions with the option counterparties pursuant to which we sold warrants for the purchase of our common stock. The convertible note hedge transactions are expected to offset the potential dilution to our common stock upon any conversion of convertible notes and/or offset any cash payments we are required to make in excess of the principal amount upon conversion of any convertible notes. The warrant transactions could separately have a dilutive effect to the extent that the market price per share of our common stock exceeds the strike price of the relevant warrants, unless, subject to certain conditions, we elect to settle the warrants in cash.

The option counterparties or their respective affiliates may modify their hedge positions by entering into or unwinding various derivatives with respect to our common stock and/or purchasing or selling our common stock or other securities of ours in secondary market transactions prior to the maturity of the convertible notes (and are likely to do so during any observation period related to a conversion of convertible notes or following any repurchase of convertible notes by us in connection with any fundamental change repurchase date or otherwise). This activity could suppress or inflate the market price of our common stock.

We do not make any representation or prediction as to the direction or magnitude of any potential effect that the transactions described above may have on the price of the convertible notes or our common stock. In addition, we do not make any representation that the option counterparties or their respective affiliates will engage in these transactions or that these transactions, once commenced, will not be discontinued without notice.

We are subject to counterparty risk with respect to the convertible note hedge transactions.

The option counterparties are financial institutions or affiliates of financial institutions, and we will be subject to the risk that these option counterparties may default under the convertible note hedge transactions. Our exposure to the credit risk of the option counterparties will not be secured by any collateral. If one or more of the option counterparties to one or more of our convertible note hedge transactions becomes subject to insolvency proceedings, we will become an unsecured creditor in those proceedings with a claim equal to our exposure at the

time under those transactions. Our exposure will depend on many factors but, generally, the increase in our exposure will be correlated to the increase in the market price of our common stock and in the volatility of the market price of our common stock. In addition, upon a default by one of the option counterparties, we may suffer dilution with respect to our common stock as well as adverse financial consequences. We can provide no assurances as to the financial stability or viability of any of the option counterparties.

RISKS RELATED TO OWNERSHIP OF OUR COMMON STOCK

Our stock price has been volatile historically and may continue to be volatile.

The trading price of our common stock has been and may continue to be subject to wide fluctuations. Our stock price may fluctuate in response to a number of events and factors, such as quarterly variations in operating results, announcements of technological innovations or new offerings by us or our competitors, announcements relating to strategic decisions, announcements related to key personnel, customer purchase delays, service disruptions, changes in financial estimates and recommendations by securities analysts, the operating and stock price performance of other companies that investors may deem comparable to us, news reports relating to trends in our markets, the commencement or termination of any share repurchase program, general economic conditions and other risks listed herein.

The sale of our common stock by significant stockholders may cause the price of our common stock to decrease.

Several of our stockholders own significant portions of our common stock. If these stockholders were to sell all or a portion of their holdings of our common stock, then the market price of our common stock could be negatively impacted. The effect of such sales, or of significant portions of our stock being offered or made available for sale, could result in strong downward pressure on our stock price. Investors should be aware that they could experience significant short-term volatility in our stock if such stockholders decide to sell all or a portion of their holdings of our common stock at once or within a short period of time.

We may issue additional shares of our common stock or instruments convertible into shares of our common stock and thereby materially and adversely affect the market price of our common stock.

We are not restricted from issuing additional shares of our common stock or other instruments convertible into, or exchangeable or exercisable for, shares of our common stock. If we issue additional shares of our common stock or instruments convertible into shares of our common stock, it may materially and adversely affect the market price of our common stock.

In addition, a substantial number of shares of our common stock is reserved for instruments issued under our equity compensation plans, including for the issuance upon the exercise of stock options and the vesting of performance share units, restricted stock, restricted stock units and deferred stock units, upon conversion of the convertible notes, and in relation to the convertible note hedge and warrant transactions entered into in connection with the convertible notes. We may not be able to predict the size of future issuances or the effect, if any, that they may have on the market price for our common stock. The issuance and sale of substantial amounts of common stock, or the perception that such issuances and sales may occur, could adversely affect the market price of our common stock and impair our ability to raise capital through the sale of equity or equity-linked securities.

We do not currently expect to pay dividends on our common stock, so any returns may be limited to changes in the value of our common stock.

We have never declared or paid any cash dividends on our common stock. We currently anticipate that we will retain future earnings for the development, operation and expansion of our business and do not anticipate declaring or paying any cash dividends for the foreseeable future. In addition, our ability to pay cash dividends on our common stock may be prohibited or limited by the terms of any future debt financing arrangement. Any return to stockholders will therefore be limited to the increase, if any, of our stock price.

Conversion of the convertible notes may dilute the ownership interest of existing stockholders, including holders who had previously converted their convertible notes, or may otherwise depress the price of our common stock.

The conversion of the convertible notes into shares of our common stock, to the extent that we choose not to deliver all cash for the conversion value, will dilute the ownership interests of existing stockholders. Any sales in the public market of the common stock issuable upon conversion of the convertible notes could adversely affect prevailing market prices of our common stock. In addition, the existence of the convertible notes may encourage short selling by market participants due to this dilution or may facilitate trading strategies involving the convertible notes and our common stock.

Provisions of our certificate of incorporation, by-laws, Delaware law and the convertible notes may have anti-takeover effects that could prevent a change in control even if the change in control would be beneficial to our stockholders.

Provisions of our certificate of incorporation, by-laws and Delaware law could make it more difficult for a third party to acquire us, even if doing so would be beneficial to our stockholders. These provisions include:

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our Board of Directors has the right to elect directors to fill a vacancy created by the expansion of the Board of Directors or the resignation, death or removal of a director, which prevents stockholders from being able to fill vacancies on our Board of Directors;

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stockholders must provide advance notice to nominate individuals for election to the Board of Directors or to propose matters that can be acted upon at a stockholders’ meeting; such provisions may discourage or deter a potential acquirer from conducting a solicitation of proxies to elect the acquirer’s own slate of directors or otherwise attempting to obtain control of our company; and

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our Board of Directors may issue, without stockholder approval, shares of undesignated preferred stock; the ability to issue undesignated preferred stock makes it possible for our Board of Directors to issue preferred stock with voting or other rights or preferences that could impede the success of any attempt to acquire us.

Further, as a Delaware corporation, we are also subject to certain Delaware law anti-takeover provisions. Under Delaware law, a corporation may not engage in a business combination with any holder of 15% or more of its capital stock unless the holder has held the stock for three years or, among other things, the Board of Directors has approved the transaction. Our Board of Directors could rely on Delaware law to prevent or delay an acquisition of us. Additionally, certain provisions of the convertible notes could make it more difficult or more expensive for a third party to acquire us or could also have the effect of delaying or reducing the likelihood of a change in control of us even if such acquisition or change of control may be favorable to our stockholders.

ITEM 2.

UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

Issuer Purchases of Equity Securities

The table below sets forth information regarding the Company’s purchases of its common stock during its second fiscal quarter ended August 31, 2016:

Issuer Purchases of Equity Securities


Period	Total Number of Shares Purchased (1)		Weighted Average Price Paid per Share		Total Number of Shares Purchased as Part of Publicly Announced Plans or Programs (2)		Approximate Dollar Value of Shares that May Yet Be Purchased Under the Plans or Programs (2)
June 1, 2016—June 30, 2016		390,133	$	71.58		390,133	$	143.0 million
July 1, 2016—July 31, 2016		1,302,402	$	72.85		1,214,524	$	911.5 million
August 1, 2016—August 31, 2016		148,008	$	74.20		148,008	$	900.5 million

Total		1,840,543				1,752,665

(1)

During the three months ended August 31, 2016, the Company withheld an aggregate of 87,878 shares of its common stock (with a weighted average share price of $72.80) from employees to satisfy minimum tax withholding obligations relating to the vesting of share awards. These shares were not withheld pursuant to the program described in Note (2) below.

(2)

On March 25, 2015, the Company announced that its Board of Directors (the “Board) had authorized the repurchase of up to $500 million of Red Hat’s common stock from time to time on the open market or in privately negotiated transactions. Shares repurchased in June were made pursuant to such program, which was discontinued by the Board effective June 30, 2016.

On June 22, 2016, the Company announced that its Board authorized the repurchase of up to $1.0 billion of Red Hat’s common stock from time to time on the open market or in privately negotiated transactions. The program, which replaced a previous repurchase program, commenced on July 1, 2016, and will expire on the earlier of (i) June 30, 2018 or (ii) a determination by the Board, Chief Executive Officer or Chief Financial Officer to discontinue the program.

ITEM 6.

EXHIBITS

(a) List of Exhibits


Exhibit No.		Exhibit

10.1+*		Red Hat, Inc. 2016 Performance Compensation Plan (incorporated by reference to Exhibit 10.1 to the registrant’s Current Report on Form 8-K filed with the SEC on August 16, 2016 (File no. 001-33162))

10.2+*		Red Hat, Inc. 2016 Employee Stock Purchase Plan (incorporated by reference to Exhibit 10.2 to the registrant’s Current Report on Form 8-K filed with the SEC on August 16, 2016 (File no. 001-33162))

31.1		Certification of the registrant’s Chief Executive Officer pursuant to Rule 13a-14(a)/Rule 15d-14(a) under the Securities Exchange Act of 1934, as amended, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

31.2		Certification of the registrant’s Chief Financial Officer pursuant to Rule 13a-14(a)/Rule 15d-14(a) under the Securities Exchange Act of 1934, as amended, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

32.1		Certification of the registrant’s principal executive officer and principal financial officer pursuant to 18 U.S.C. Section 1350

101.INS		XBRL Instance Document

101.SCH		XBRL Taxonomy Extension Schema

101.CAL		XBRL Taxonomy Extension Calculation Linkbase

101.DEF		XBRL Taxonomy Extension Definition Linkbase

101.LAB		XBRL Taxonomy Extension Label Linkbase

101.PRE		XBRL Taxonomy Extension Presentation Linkbase

+	Previously filed.

*	Indicates a management contract or compensatory plan, contract or arrangement.

SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.


	RED HAT, INC.

Date: October 6, 2016	By:	/S/ JAMES M. WHITEHURST
		James M. Whitehurst President and Chief Executive Officer (Duly Authorized Officer on Behalf of the Registrant)

	RED HAT, INC.

Date: October 6, 2016	By:	/S/ FRANK A. CALDERONI
		Frank A. Calderoni Executive Vice President, Operations and Chief Financial Officer (Principal Financial Officer)

	RED HAT, INC.

Date: October 6, 2016	By:	/S/ ERIC R. SHANDER
		Eric R. Shander Vice President, Finance and Accounting (Principal Accounting Officer)