RED HAT INC filed this 10-K on Apr 26, 2017
RED HAT INC - 10-K - 20170426 - FINANCIAL_STATEMENTS
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

INDEX TO CONSOLIDATED FINANCIAL STATEMENTS

 

     Page  

Report of Management on Internal Control Over Financial Reporting

     72  

Report of Independent Registered Public Accounting Firm

     73  

Financial Statements:

  

Consolidated Balance Sheets at February 28, 2017 and February 29, 2016

     74  

Consolidated Statements of Operations for the fiscal years ended February 28, 2017,  February 29, 2016 and February 28, 2015

     75  

Consolidated Statements of Comprehensive Income for the fiscal years ended February 28, 2017,  February 29, 2016 and February 28, 2015

     76  

Consolidated Statements of Stockholders’ Equity for the fiscal years ended February  28, 2017, February 29, 2016 and February 28, 2015

     77  

Consolidated Statements of Cash Flows for the fiscal years ended February 28, 2017,  February 29, 2016 and February 28, 2015

     78  

Notes to Consolidated Financial Statements

     79  

 

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REPORT OF MANAGEMENT ON INTERNAL CONTROL OVER FINANCIAL REPORTING

Our management is responsible for establishing and maintaining adequate internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) under the Securities Exchange Act). Internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with accounting principles generally accepted in the United States of America. The Company’s internal control over financial reporting includes those policies and procedures that: (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the Company; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with accounting principles generally accepted in the United States of America, and that receipts and expenditures of the Company are being made only in accordance with authorizations of management and directors of the Company; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the Company’s assets that could have a material effect on the financial statements.

Our management conducted an evaluation of the effectiveness of our internal control over financial reporting as of the end of the period covered by this report based on the framework in Internal Control—Integrated Framework (2013)  issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on this evaluation, management concluded that the Company’s internal control over financial reporting was effective as of the end of the period covered by this report.

Our independent registered public accounting firm, which has audited the financial statements included in Part II, Item 8 of this report, has also audited the effectiveness of the Company’s internal control over financial reporting as of February 28, 2017, as stated in their attestation report on our internal control over financial reporting, which is included below.

 

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REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

To the Board of Directors and Shareholders of Red Hat, Inc.:

In our opinion, the accompanying consolidated balance sheets and the related consolidated statements of operations, of comprehensive income, of stockholders’ equity and of cash flows present fairly, in all material respects, the financial position of Red Hat, Inc. and its subsidiaries at February 28, 2017 and February 29, 2016, and the results of their operations and their cash flows for each of the three years in the period ended February 28, 2017 in conformity with accounting principles generally accepted in the United States of America. Also in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of February 28, 2017, based on criteria established in Internal Control—Integrated Framework (2013)  issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Company’s management is responsible for these financial statements, for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in the Report of Management on Internal Control over Financial Reporting appearing in Item 8. Our responsibility is to express opinions on these financial statements and on the Company’s internal control over financial reporting based on our integrated audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement and whether effective internal control over financial reporting was maintained in all material respects. Our audits of the financial statements included examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions.

As discussed in Note 2 to the consolidated financial statements, the Company changed the manner in which it accounts for stock compensation during the fiscal year ended February 28, 2017.

A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

/s/ PricewaterhouseCoopers LLP

Raleigh, North Carolina

April 26, 2017

 

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RED HAT, INC.

CONSOLIDATED BALANCE SHEETS

(in thousands—except share and per share amounts)

 

     February 28,
2017
    February 29,
2016
 
ASSETS     

Current assets:

    

Cash and cash equivalents

   $ 1,090,808     $ 927,778  

Investments in debt securities, short-term

     369,983       281,142  

Accounts receivable, net of allowances for doubtful accounts of $2,791 and $2,798, respectively

     634,821       509,715  

Prepaid expenses

     200,609       150,877  

Other current assets

     19,481       2,921  
  

 

 

   

 

 

 

Total current assets

     2,315,702       1,872,433  

Property and equipment, net of accumulated depreciation and amortization of $231,533 and $194,819, respectively

     189,629       166,886  

Goodwill

     1,040,709       1,027,277  

Identifiable intangibles, net

     137,767       146,071  

Investments in debt securities, long-term

     672,440       786,470  

Deferred tax assets, net

     104,833       111,456  

Other assets, net

     74,105       44,506  
  

 

 

   

 

 

 

Total assets

   $ 4,535,185     $ 4,155,099  
  

 

 

   

 

 

 
LIABILITIES AND STOCKHOLDERS’ EQUITY     

Current liabilities:

    

Accounts payable and accrued expenses

   $ 376,957     $ 284,802  

Deferred revenue, short-term

     1,512,762       1,272,908  

Other current obligations

     1,354       1,467  
  

 

 

   

 

 

 

Total current liabilities

     1,891,073       1,559,177  

Deferred revenue, long-term

     557,194       449,636  

Convertible notes

     745,633       723,942  

Other long-term obligations

     93,965       87,912  

Commitments and contingencies (NOTES 14 and 15)

    

Stockholders’ equity:

    

Preferred stock, $0.0001 per share par value, 5,000,000 shares authorized, none outstanding

     —         —    

Common stock, $0.0001 per share par value, 300,000,000 shares authorized, 236,804,594 and 234,896,137 shares issued, 176,901,936 and 181,185,861 shares outstanding at February 28, 2017 and February 29, 2016, respectively

     24       23  

Additional paid-in capital

     2,294,462       2,162,264  

Retained earnings

     1,352,991       1,099,738  

Treasury stock at cost, 59,902,658 and 53,710,276 shares at February 28, 2017 and February 29, 2016, respectively

     (2,311,805     (1,853,144

Accumulated other comprehensive loss

     (88,352     (74,449
  

 

 

   

 

 

 

Total stockholders’ equity

   $ 1,247,320     $ 1,334,432  
  

 

 

   

 

 

 

Total liabilities and stockholders’ equity

   $ 4,535,185     $ 4,155,099  
  

 

 

   

 

 

 

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

 

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RED HAT, INC.

CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands—except per share amounts)

 

     Fiscal Years Ended  
     February 28,
2017
    February 29,
2016
    February 28,
2015
 

Revenue:

      

Subscriptions

   $ 2,135,780     $ 1,803,449     $ 1,561,234  

Training and services

     276,023       248,781       228,255  
  

 

 

   

 

 

   

 

 

 

Total subscription and training and services revenue

     2,411,803       2,052,230       1,789,489  
  

 

 

   

 

 

   

 

 

 

Cost of subscription and training and services revenue:

      

Cost of subscriptions

     158,977       126,663       112,856  

Cost of training and services

     195,401       182,966       160,343  
  

 

 

   

 

 

   

 

 

 

Total cost of subscription and training and services revenue

     354,378       309,629       273,199  
  

 

 

   

 

 

   

 

 

 

Gross profit

     2,057,425       1,742,601       1,516,290  

Operating expense:

      

Sales and marketing

     1,036,021       848,950       728,387  

Research and development

     480,668       413,322       367,856  

General and administrative

     208,491       192,281       170,053  
  

 

 

   

 

 

   

 

 

 

Total operating expense

     1,725,180       1,454,553       1,266,296  
  

 

 

   

 

 

   

 

 

 

Income from operations

     332,245       288,048       249,994  

Interest income

     13,921       11,673       8,336  

Interest expense

     23,822       23,121       9,394  

Other (expense) income, net

     (2,164     (1,735     6,562  
  

 

 

   

 

 

   

 

 

 

Income before provision for income taxes

     320,180       274,865       255,498  

Provision for income taxes

     66,477       75,500       75,297  
  

 

 

   

 

 

   

 

 

 

Net income

   $ 253,703     $ 199,365     $ 180,201  
  

 

 

   

 

 

   

 

 

 

Net income per share:

      

Basic

   $ 1.41     $ 1.09     $ 0.97  

Diluted

   $ 1.39     $ 1.07     $ 0.95  

Weighted average shares outstanding:

      

Basic

     179,642       182,817       186,529  

Diluted

     182,961       186,119       189,246  

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

 

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RED HAT, INC.

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

(in thousands)

 

    Fiscal Years Ended  
    February 28,
2017
    February 29,
2016
    February 28,
2015
 

Net income

  $ 253,703     $ 199,365     $ 180,201  

Other comprehensive income (loss):

     

Change in foreign currency translation adjustment

    (14,008     (12,790     (56,163

Available-for-sale securities:

     

Unrealized gain (loss) on available-for-sale securities during the period

    14       (1,593     (148

Reclassification for gain realized on available-for-sale securities, reported in Other income (expense), net

    (21     (4     (152

Tax benefit

    112       559       301  
 

 

 

   

 

 

   

 

 

 

Net change in available-for-sale securities (net of tax)

    105       (1,038     1  
 

 

 

   

 

 

   

 

 

 

Total other comprehensive loss

    (13,903     (13,828     (56,162
 

 

 

   

 

 

   

 

 

 

Comprehensive income

  $ 239,800     $ 185,537     $ 124,039  
 

 

 

   

 

 

   

 

 

 

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

 

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RED HAT, INC.

CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY

(in thousands)

 

     Common Stock      Additional
Paid-In
Capital
    Retained
Earnings
    Treasury
Stock
    Accumulated
Other
Comprehensive
Loss
    Total
Stockholders’
Equity
 
     Shares      Amount             

Balance at February 28, 2014

     230,916      $ 23      $ 1,891,848     $ 720,172     $ (1,056,419   $ (4,459   $ 1,551,165  

Net income

     —          —          —         180,201       —         —         180,201  

Other comprehensive loss, net of tax

     —          —          —         —         —         (56,162     (56,162

Vest and exercise of share-based awards

     2,146        —          2,434       —         —         —         2,434  

Common stock repurchase

     —          —          (75,000     —         (460,062     —         (535,062

Share-based compensation expense

     —          —          135,232       —         —         —         135,232  

Assumed employee share-based awards from acquisitions

     —          —          895       —         —         —         895  

Tax benefits related to share-based awards

     —          —          6,436       —         —         —         6,436  

Minimum tax withholdings paid by the Company on behalf of employees related to net settlement of employee share-based awards

     —          —          (43,462     —         —         —         (43,462

Equity component of convertible notes

     —          —          96,890       —         —         —         96,890  

Equity component of convertible notes issuance cost

     —          —          (1,833     —         —         —         (1,833

Purchase of convertible note hedges

     —          —          (148,040     —         —         —         (148,040

Proceeds from issuance of warrants

     —          —          79,776       —         —         —         79,776  

Deferred taxes related to convertible notes

     —          —          19,868       —         —         —         19,868  

Other

     —          —          (1,193     —         1,193       —         —    
  

 

 

    

 

 

    

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Balance at February 28, 2015

     233,062      $ 23      $ 1,963,851     $ 900,373     $ (1,515,288   $ (60,621   $ 1,288,338  
  

 

 

    

 

 

    

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net income

     —          —          —         199,365       —         —         199,365  

Other comprehensive loss, net of tax

     —          —          —         —         —         (13,828     (13,828

Vest and exercise of share-based awards

     1,834        —          3,596       —         —         —         3,596  

Common stock repurchase

     —          —          75,000       —         (337,643     —         (262,643

Share-based compensation expense

     —          —          166,234       —         —         —         166,234  

Assumed employee share-based awards from acquisitions

     —          —          505       —         —         —         505  

Tax benefits related to share-based awards

     —          —          19,772       —         —         —         19,772  

Minimum tax withholdings paid by the Company on behalf of employees related to net settlement of employee share-based awards

     —          —          (66,907     —         —         —         (66,907

Other

     —          —          213       —         (213     —         —    
  

 

 

    

 

 

    

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Balance at February 29, 2016

     234,896      $ 23      $ 2,162,264     $ 1,099,738     $ (1,853,144   $ (74,449   $ 1,334,432  
  

 

 

    

 

 

    

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net income

     —          —          —         253,703       —         —         253,703  

Other comprehensive loss, net of tax

     —          —          —         —         —         (13,903     (13,903

Vest and exercise of share-based awards

     1,909        1        3,828       —         —         —         3,829  

Common stock repurchase

     —          —          —         —         (458,661     —         (458,661

Share-based compensation expense

     —          —          192,530       —         —         —         192,530  

Minimum tax withholdings paid by the Company on behalf of employees related to net settlement of employee share-based awards

     —          —          (66,529     —         —         —         (66,529

Cumulative-effect adjustment from adoption of ASU 2016-09

     —          —          2,369       (450     —         —         1,919  
  

 

 

    

 

 

    

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Balance at February 28, 2017

     236,805      $ 24      $ 2,294,462     $ 1,352,991     $ (2,311,805   $ (88,352   $ 1,247,320  
  

 

 

    

 

 

    

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Note: No preferred stock was issued or outstanding during the three fiscal years ended February 28, 2017.

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

 

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RED HAT, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

 

    Fiscal Years Ended  
    February 28,
2017
    February 29,
2016
    February 28,
2015
 

Cash flows from operating activities:

     

Net income

  $ 253,703     $ 199,365     $ 180,201  

Adjustments to reconcile net income to net cash provided by operating activities:

     

Depreciation and amortization

    85,309       76,088       76,263  

Amortization of debt discount and transaction costs

    21,691       21,003       8,227  

Deferred income taxes

    12,327       (13,673     23,517  

Share-based compensation expense

    192,530       166,234       135,232  

Excess tax benefits from share-based payment arrangements (1)

    —         20,231       5,607  

Net amortization of bond premium on debt securities available for sale

    12,623       12,169       9,314  

Other

    946       4,418       (3,474

Changes in operating assets and liabilities net of effects of acquisitions:

     

Accounts receivable

    (119,102     (48,404     (121,536

Prepaid expenses

    (76,787     (24,486     (40,741

Accounts payable and accrued expenses

    71,026       62,438       71,040  

Deferred revenue

    348,534       260,495       282,693  

Other

    (19,083     445       2,059  
 

 

 

   

 

 

   

 

 

 

Net cash provided by operating activities

    783,717       736,323       628,402  
 

 

 

   

 

 

   

 

 

 

Cash flows from investing activities:

     

Purchase of investment in debt securities available for sale

    (500,849     (982,935     (568,551

Proceeds from maturities of investment in debt securities available for sale

    457,710       652,706       502,365  

Proceeds from sales of investment in debt securities available for sale

    43,273       2,916       77,793  

Acquisitions of businesses, net of cash acquired

    (28,667     (126,459     (296,121

Purchase of developed software and other intangible assets

    (11,774     (13,964     (6,123

Purchase of property and equipment

    (69,123     (41,553     (45,648

Other

    (703     (2,819     11,282  
 

 

 

   

 

 

   

 

 

 

Net cash used in investing activities

    (110,133     (512,108     (325,003
 

 

 

   

 

 

   

 

 

 

Cash flows from financing activities:

     

Proceeds from exercise of common stock options

    3,829       3,596       2,434  

Proceeds from employee stock purchase program

    18,852       —         —    

Purchase of treasury stock

    (458,661     (262,643     (535,062

Payments related to settlement of employee shared-based awards

    (66,529     (66,907     (43,462

Proceeds from issuance of convertible notes, net of issuance costs

    —         —         789,769  

Purchase of convertible note hedges

    —         —         (148,040

Proceeds from issuance of warrants

    —         —         79,776  

Payments on other borrowings

    (1,684     (1,843     (2,782
 

 

 

   

 

 

   

 

 

 

Net cash (used in) provided by financing activities

    (504,193     (327,797     142,633  
 

 

 

   

 

 

   

 

 

 

Effect of foreign currency exchange rates on cash and cash equivalents

    (6,361     (16,113     (45,301
 

 

 

   

 

 

   

 

 

 

Net increase (decrease) in cash and cash equivalents

    163,030       (119,695     400,731  

Cash and cash equivalents at beginning of year

    927,778       1,047,473       646,742  
 

 

 

   

 

 

   

 

 

 

Cash and cash equivalents at end of year

  $ 1,090,808     $ 927,778     $ 1,047,473  
 

 

 

   

 

 

   

 

 

 

Supplemental cash flow information:

     

Cash paid for interest

  $ 2,080     $ 2,039     $ 52  

Cash paid for income taxes

  $ 56,655     $ 63,400     $ 33,701  

Non-cash investing and financing activities:

     

Fixed assets acquired under capital leases

  $ 1,652     $ 1,892     $ 1,818  

 

(1) Effective March 1, 2016, the Company adopted ASU 2016-09 which, among other items, updates the cash flow presentation of excess tax benefits related to share-based compensation. The Company elected to adopt the ASC 2016-09 updates related to cash flows on a retrospective basis. As a result, net cash provided by operating activities and net cash used in financing activities each increased by $20.2 million for the fiscal year ended February 29, 2016 and $5.6 million for the fiscal year ended February 28, 2015. For the fiscal year ended February 28, 2017, excess tax benefits from share-based payment arrangements totaled $16.0 million and are included in net income. See NOTE 2—Summary of Significant Accounting Policies for detailed information on adoption of ASU 2016-09.

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

 

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RED HAT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

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.

NOTE 2—Summary of Significant Accounting Policies

Basis of presentation

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

The Consolidated Statements of Cash Flows as of February 29, 2016 and February 28, 2015 include the effect of retrospective application of Accounting Standards Update 2016-09, Compensation—Stock Compensation (Topic 718): Improvements to Employee Share-Based Payment Accounting (“ASU 2016-09”). 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 the Company’s permitted election to retrospectively apply this classification amendment, $20.2 million and $5.6 million, respectively, of windfall tax benefits previously reported as cash inflows from financing activities on the Company’s Consolidated Statements of Cash Flows for the fiscal years ended February 29, 2016 and February 28, 2015 have been reclassified as cash inflows from operating activities.

For additional discussion related to recent accounting pronouncements the Company has either recently adopted or is currently evaluating the impact from future adoption, see “Recent accounting pronouncements” in this note.

In addition to the reclassifications resulting from application of ASU 2016-09, certain other amounts for the fiscal years ended February 29, 2016 and February 28, 2015 have been reclassified to conform to the current year presentation.

 

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Use of estimates

The preparation of financial statements in conformity with accounting principles generally accepted in the U.S. (“U.S. GAAP”) requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the balance sheet dates and the reported amounts of revenue and expenses during the reporting periods. Actual results could differ from such estimates.

Revenue recognition

The Company establishes persuasive evidence of a sales arrangement for each type of revenue transaction based on either a signed contract with the end customer, a click-through contract on the Company’s website whereby the customer agrees to the Company’s standard subscription terms, signed or click-through distribution contracts with original equipment manufacturers (“OEMs”) and other resellers, or, in the case of individual training seats, through receipt of payment which indicates acceptance of the Company’s training agreement terms.

Subscription revenue

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

Subscription arrangements with large enterprise customers often have contracts with multiple elements (e.g., software technology, support, training, consulting and other services). The Company allocates revenue to each element of the arrangement based on vendor-specific objective evidence (“VSOE”) of each element’s fair value when the Company can demonstrate sufficient evidence of the fair value of at least those elements that are undelivered. The fair value of each element in multiple element arrangements is created by either (i) providing the customer with the ability during the term of the arrangement to renew that element at the same rate paid for the element included in the initial term of the agreement or (ii) selling the element on a stand-alone basis.

The Company derives a portion of its revenue from CCSPs that provide public clouds with, and allow users to consume, computing resources as a service. The Company earns revenue based on subscription units consumed by the CCSP or its end users.

For periods prior to March 1, 2015, the Company recognized cloud-usage revenue upon receipt of usage reports from the CCSPs, which typically report fees owed to the Company one month or more after the fees have been earned. Effective March 1, 2015, the Company believed that it had sufficient historical data and experience

 

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to estimate this cloud-usage revenue and has begun estimating the amount of and recognizing such revenue in the period earned. The estimates are based on the historical cloud-usage data available.

Training and services revenue

Training and services revenue is comprised of revenue for consulting, engineering and customer training and education services. Consulting services consist of time-based arrangements, and revenue is recognized as these services are performed. Engineering services represent revenue earned under fixed fee arrangements with the Company’s OEM partners and other customers to provide for significant modification and customization of Red Hat technologies. The Company recognizes revenue for these fixed fee engineering services using the percentage of completion basis of accounting, provided the Company has the ability to make reliable estimates of progress towards completion, the fee for such services is fixed or determinable and collection of the resulting receivable is probable. Under the percentage of completion method, earnings under the contract are recognized based on the progress toward completion as estimated using the ratio of labor hours incurred to total expected project hours. Changes in estimates are recognized in the period in which they are known. Revenue for customer training and education services is recognized on the dates the services are complete.

Deferred selling costs

Deferred commissions are the incremental costs that are directly associated with non-cancellable subscription contracts with customers and consist of sales commissions paid to the Company’s sales force. The commissions are deferred and amortized over a period that approximates the subscription period. The commission payments are paid in full subsequent to the month in which the customer’s service commences. The deferred commission amounts are recoverable through the future revenue streams under the non-cancellable customer contracts. In addition, the Company has the ability and intent under the commission plans with its sales force to recover commissions previously paid to its sales force in the event that customers breach the terms of their subscription agreements and do not fully pay for their subscription agreements. Deferred commissions are included in Prepaid expenses and Other assets, net on the accompanying Consolidated Balance Sheets. Amortization of deferred commissions is included in sales and marketing expense in the accompanying Consolidated Statements of Operations.

Goodwill and other long-lived assets

Goodwill

The Company evaluates goodwill for impairment during the fourth quarter of its fiscal year or more frequently if events or changes in circumstances indicate that an impairment to goodwill may have occurred. For fiscal years ended February 28, 2017 and February 28, 2015, the Company applied its test for goodwill impairment as permitted by Accounting Standards Update 2011-08,  Intangibles—Goodwill and Other (Topic 350): Testing Goodwill for Impairment (“ASU 2011-08”), which allows the Company to first assess qualitative factors to determine whether it is “more likely than not” that the fair value of a reporting unit is less than its carrying value. The outcome of these qualitative tests determines whether it is necessary for a company to perform the two-step goodwill impairment test as required in years prior to the adoption of ASU 2011-08.

After considering such qualitative factors as macroeconomic conditions, actual or anticipated changes to cost factors (for example, selling and delivery), overall financial performance and other Company-specific factors, such as potential changes in strategy, the Company determined that it was not more likely than not that any impairment to goodwill had occurred during the fiscal years ended February 28, 2017 and February 28, 2015. Consequently, the Company was not required to perform the remaining two-step quantitative goodwill impairment test.

 

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For the fiscal year ended February 29, 2016, the Company elected to perform a quantitative assessment of goodwill for all of its reporting units. In doing so, the Company compared the estimated fair value of each of the reporting units to its respective book value, including allocated goodwill. The Company concluded that there were no impairments of goodwill.

Other long-lived assets

The Company evaluates the recoverability of its property and equipment and other long-lived assets whenever events or changes in circumstances indicate that an impairment may have occurred. An impairment loss is recognized when the net book value of such assets exceeds the estimated future undiscounted cash flows attributable to the assets or the business to which the assets relate. Impairment losses, if any, are measured as the amount by which the carrying value exceeds the fair value of the assets.

Cash and cash equivalents

The Company considers highly liquid investments purchased with a maturity period of three months or less at the date of purchase to be cash equivalents.

Accounts receivable and allowance for doubtful accounts

Trade accounts receivable are recorded at the invoiced amount and do not bear interest. The allowance for doubtful accounts is the Company’s estimate of the amount of probable credit losses in the Company’s existing accounts receivable. The Company determines the allowance based on historical write-off experience. The Company reviews its allowance for doubtful accounts monthly. Past due balances over 90 days and over a specified amount are reviewed individually for collectability. All other balances are reviewed on a pooled basis by type of receivable. Account balances are charged off against the allowance when the Company determines it is probable the receivable will not be recovered. The Company does not have off-balance sheet credit exposure related to its customers. See NOTE 4—Accounts Receivable for further discussion on accounts receivable balances.

Fair value measurements

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.

 

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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. Realized gains and losses are recorded using the specific identification method and 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 Company’s 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. See NOTE 17—Assets and Liabilities Measured at Fair Value on a Recurring Basis for further discussion on fair value measurements.

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.

Internal use software

The Company capitalizes costs related to the development of internal use software for its website, enterprise resource planning system and systems management applications. The Company amortizes the costs of computer software developed for internal use on a straight-line basis over an estimated useful life of five years. The carrying value of internal use software is included in property and equipment on the Company’s Consolidated Balance Sheets.

Capitalized software costs

Capitalization of software development costs for products to be sold to third parties begins upon the establishment of technological feasibility and ceases when the product is available for general release. As a result of the Company’s practice of frequently releasing source code that it has developed on an on-going basis for unrestricted download on the Internet, there is generally no passage of time between achievement of technological feasibility and the availability of the Company’s product for general release. Therefore, at February 28, 2017 and February 29, 2016, the Company had no internally developed capitalized software costs for products to be sold to third parties.

 

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Property and equipment

Property and equipment is primarily comprised of furniture, computer and other equipment, computer software and leasehold improvements, which are recorded at cost and depreciated or amortized using the straight-line method. Expenditures for maintenance and repairs are charged to operations as incurred; major expenditures for renewals and betterments are capitalized and depreciated. Property and equipment acquired under capital leases are depreciated over the lesser of the estimated remaining useful life of the asset or the remaining term of the lease.

Share-based compensation

The Company measures share-based compensation cost as of 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 (“PSUs”) are measured at their underlying closing share price on the date of grant. The Company’s share-based compensation is described further in NOTE 13—Share-based Awards.

Sales and marketing expenses

Sales and marketing expenses consist of costs, including salaries, sales commissions and related expenses, such as travel, of all personnel involved in the sales and marketing process. Sales and marketing expenses also include costs of advertising, sales lead generation programs, cooperative marketing arrangements and trade shows. Payments made to resellers or other customers are recognized as a reduction of revenue unless the Company (i) receives an identifiable benefit (goods or services) in exchange for such payments that is sufficiently separable from the purchase of the Company’s products and (ii) the Company can reasonably estimate the fair value of the benefit identified. Advertising costs are expensed as incurred.

Advertising expense totaled $95.7 million, $88.9 million and $62.6 million for the fiscal years ended February 28, 2017, February 29, 2016 and February 28, 2015, respectively.

Research and development expenses

Research and development expenses include all direct costs, primarily salaries for Company personnel and outside consultants, related to the development of new software products, significant enhancements to existing software products, and the portion of costs of development of internal use software required to be expensed. Research and development costs are charged to operations as incurred.

Income taxes

The Company accounts for income taxes using the asset and liability method. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and tax credit carryforwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled.

The Company continues to assess the realizability of its deferred tax assets, which primarily consist of share-based compensation expense deductions, tax credit carryforwards and deferred revenue. In assessing the realizability of these deferred tax assets, management considers whether it is more likely than not that some

 

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portion or all of the deferred tax assets will be realized. The Company continues to maintain a valuation allowance against its deferred tax assets with respect to certain foreign net operating loss (“NOL”) carryforwards.

With respect to foreign earnings, it is the Company’s policy to invest the earnings of foreign subsidiaries indefinitely outside the U.S. From time to time, however, the Company may remit a portion of these earnings to the extent it incurs no additional U.S. tax and it is otherwise feasible.

Because tax laws are complex and subject to different interpretations, significant judgment is required. As a result, the Company makes certain estimates and assumptions in (i) calculating its income tax expense, deferred tax assets and deferred tax liabilities, (ii) determining any valuation allowance recorded against deferred tax assets and (iii) evaluating the amount of unrecognized tax benefits, as well as the interest and penalties related to such uncertain tax positions. The Company’s estimates and assumptions may differ significantly from tax benefits ultimately realized. The Company’s income tax expense and deferred taxes are described further in NOTE 11—Income Taxes.

Foreign currency translation

The Euro has been determined to be the primary functional currency for the Company’s European operations, and local currencies have been determined to be the functional currencies for the Company’s Asia Pacific and Latin American operations. Foreign exchange gains and losses, which result from the process of remeasuring foreign currency transactions into the appropriate functional currency, are included in Other income (expense), net in the Company’s Consolidated Statements of Operations.

The impact of changes in foreign currency exchange rates resulting from the translation of foreign currency financial statements into U.S. dollars for financial reporting purposes is included in other comprehensive income, which is a separate component of stockholders’ equity. Assets and liabilities are translated into U.S. dollars at exchange rates in effect at the balance sheet date. Income and expense items are translated at average rates for the period.

Customers and credit risk

Financial instruments, which potentially subject the Company to concentrations of credit risk, consist principally of cash, cash equivalents, investments and trade receivables. The Company primarily places its cash, cash equivalents and investments with high-credit quality financial institutions which invest predominantly in U.S. government instruments, investment grade corporate bonds and certificates of deposit guaranteed by banks that are members of the Federal Deposit Insurance Corporation. Cash deposits are primarily in financial institutions in the U.S. and the United Kingdom. However, cash for monthly operating costs of international operations are deposited in banks outside the U.S.

The Company performs credit evaluations to reduce credit risk and generally requires no collateral from its customers. Management estimates the allowance for uncollectible accounts based on its historical experience and credit evaluation. The Company’s standard credit terms are net 30 days in North America, net 30 to net 45 days in EMEA (Europe, Middle East and Africa) and Latin America, and range from net 30 to net 60 days in Asia Pacific (principally Australia, China, India, Japan, Singapore and South Korea).

Net income per common 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

 

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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.

With respect to the Company’s 0.25% convertible senior notes due 2019 (the “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 notes are considered in diluted earnings per share under the treasury stock method. See NOTE 21—Convertible Notes for detailed information on the convertible notes.

Segment reporting

The Company is organized primarily on the basis of three geographic business units: the Americas (U.S., Latin America and Canada), EMEA and Asia Pacific. These business units are aggregated into one reportable segment due to the similarity in nature of products and services provided, financial performance economic characteristics (e.g., revenue growth and gross margin), methods of production and distribution and customer classes (e.g., cloud service providers, distributors, resellers and enterprise).

The Company has offices in more than 90 locations around the world. The Company manages its international business on an Americas-wide, EMEA-wide and Asia Pacific-wide basis. See NOTE 19—Segment Reporting for further discussion.

Recent accounting pronouncements

Accounting pronouncements adopted

In March 2016, the Financial Accounting Standards Board (“FASB”) issued 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 fiscal year ended February 28, 2017, the Company recognized a discrete tax benefit of $15.8 million 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 Statements of Operations for the fiscal years ended February 29, 2016 and February 28, 2015 related to the $19.8 million and $6.4 million, respectively, of net windfall tax benefits the Company recognized as additional paid-in capital during the fiscal years ended February 29, 2016 and February 28, 2015. Net windfall tax benefits of $19.8 million recognized as additional paid-in capital during the fiscal year ended February 29, 2016 includes gross windfall tax benefits of $20.2 million net of $0.5 million shortfall tax expense. Net windfall tax benefits of $5.4 million recognized

 

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within additional paid-in capital during the fiscal year ended February 28, 2015 includes gross windfall tax benefits of $5.6 million net of $0.3 million shortfall tax expense.

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 this classification amendment retrospectively. As a result, $20.2 million and $5.6 million, respectively, of windfall tax benefits previously reported as cash flows from financing activities on the Company’s Consolidated Statements of Cash Flows for the fiscal years ended February 29, 2016 and February 28, 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 fiscal year ended February 28, 2017, 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  

In August 2014, the FASB issued Accounting Standards Update 2014-15, Presentation of Financial Statements—Going Concern (Subtopic 205-40), Disclosure of Uncertainties about an Entity’s Ability to Continue as a Going Concern (“ASU 2014-15”). This standard sets forth management’s responsibility to evaluate, each reporting period, whether there is substantial doubt about the Company’s ability to continue as a going concern, and if so, to provide related footnote disclosures. This guidance is effective for the Company as of February 28, 2017. The Company early adopted ASU 2014-15 and performed its evaluation during the fourth quarter of its fiscal year ended February 28, 2017. As a result of this evaluation, the Company does not have substantial doubt about its ability to continue as a going concern.

 

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Accounting pronouncements being evaluated

In January 2017, the FASB issued Accounting Standards Update 2017-04, Intangibles—Goodwill and Other (Topic 350): Simplifying the Test for Goodwill Impairment (“ASU 2017-04”) . The FASB issued ASU 2017-04 to simplify the subsequent measurement of goodwill by eliminating Step 2 from the goodwill impairment test. Under this updated standard, an entity should recognize an impairment charge for the amount by which the carrying amount exceeds the reporting unit’s fair value, but the loss recognized should not exceed the total amount of goodwill allocated to that reporting unit. An entity also should consider income tax effects from any tax-deductible goodwill on the carrying amount of the reporting unit when measuring the goodwill impairment loss, if any. The FASB also eliminated the requirement for reporting units with a zero or negative carrying amount to first perform a qualitative assessment. This guidance is effective for the Company as of the first quarter of its fiscal year ending February 29, 2020. The Company is currently evaluating the impact that this updated standard, but does not believe this update will have a significant impact on its consolidated financial statements.

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.

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 , now referred to as Accounting Standards Codification Topic 606 (“ASC 606”). The FASB issued ASC 606 to clarify the principles for recognizing revenue and to develop a common revenue standard for U.S. 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

 

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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 substantially completed its preliminary assessment of the potential impact that the implementation of this updated standard will have on its consolidated financial statements. With respect to the Company’s software subscription offerings, which accounted for 89%, 88%, and 87% of the Company’s total revenue for the fiscal years ended February 28, 2017, February 29, 2016 and February 28, 2015, respectively, the Company provides value to its customers through continuous aggregation, integration, testing, certification, maintenance, enhancement and support of the open source technologies that it distributes. The Company currently recognizes subscription revenue ratably over the subscription period. Under the updated standard, these subscription attributes represent a series of performance obligations that are delivered over time, primarily on a stand-ready basis (for example, attributes such as updates, upgrades, and support are not forced upon subscribers but rather made available to subscribers). As a result, the Company believes that its subscription revenue meets the criteria for revenue recognition over time and will continue to be recognized ratably under the updated standard.

The Company also offers professional consulting and training services that are designed to help customers derive additional value from Red Hat technologies. Under the updated guidance, revenue from professional consulting and training services that were previously sold on a standalone basis will continue to be recognized over time as the Company satisfies its performance obligations by delivering and transferring such services to the customer.

With respect to customer contracts with multiple elements (such as software subscriptions and professional consulting and training services), under the current standard the Company allocates total contract revenue to each element’s relative fair value when the Company can demonstrate sufficient VSOE of the fair value of at least those elements that are undelivered. For multiple-element contracts in which one or more of the undelivered elements lacks VSOE, the Company defers recognition of any revenue until the elements lacking VSOE have been delivered. However, under the updated standard, the Company will be required to allocate total contract revenue to each element (referred to as a distinct performance obligation under the updated standard) based on either an established or estimated standalone selling price. The Company would then recognize the allocated revenue as each element (performance obligation) is delivered. Because the Company has historically established VSOE for most of its offerings and as a result has not been required to defer a significant amount of revenue due to insufficient VSOE, the Company does not anticipate the updated standard’s requirement to establish or estimate a standalone selling price, rather than defer revenues in the absence of VSOE, to have a significant impact on the Company’s financial statements.

The Company continues to assess the impact of the updated guidance, including for example, any potential changes to and investments in the Company’s policies, processes, systems and internal controls over financial reporting that may be required to comply with new guidance related to variable consideration, contract modifications, allocation of discounts and expanded disclosures. The Company has not yet finalized its decision with respect to transition method.

NOTE 3—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.

 

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RED HAT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

The consideration paid was $29.1 million in cash. Management has completed its assessment of the acquisition-date fair value of the assets acquired and liabilities assumed. The total consideration transferred of $29.1 million was allocated to the Company’s assets and liabilities as follows: $16.9 million to goodwill, $13.1 million to identifiable intangible assets and $0.9 million to working capital as a net current liability.

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 fiscal year ended February 28, 2017.

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 augments 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. Management has completed its 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 as follows: $102.3 million to goodwill, $25.1 million to identifiable intangible assets and $1.4 million to working capital as a net current liability.

The Company incurred approximately $3.9 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 fiscal year ended February 29, 2016.

Acquisition of FeedHenry Ltd.

On October 8, 2014, the Company completed its acquisition of all of the shares of FeedHenry Ltd. (“FeedHenry”). FeedHenry is a provider of cloud-based enterprise mobile application platforms. The acquisition expands the Company’s portfolio of application development, integration and platform-as-a-service solutions, enabling the Company to support mobile application development in public and private environments.

The consideration paid as of the closing date was $80.2 million and has been allocated to the Company’s assets and liabilities as follows: $68.5 million to goodwill, $9.0 million to identifiable intangible assets and the remaining $2.7 million to net working capital.

The Company incurred approximately $1.1 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 fiscal year ended February 28, 2015.

 

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Index to Financial Statements

RED HAT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

Acquisition of eNovance, SAS

On June 24, 2014, the Company completed its acquisition of all of the shares of eNovance, SAS (“eNovance”), a provider of open source cloud computing services. The acquisition assists in advancing the Company’s market position in OpenStack, and the addition of eNovance’s systems integration capabilities and engineering talent is expected to help meet growing demand for enterprise OpenStack consulting, design and deployment.

The consideration paid was $67.6 million and has been allocated to the Company’s assets and liabilities as follows: $60.8 million to goodwill, $5.3 million to identifiable intangible assets and the remaining $1.5 million to net working capital.

In addition to the cash consideration transferred, the Company issued a total of 529,057 restricted common shares to certain employee-shareholders. The vesting of these restricted shares is conditioned on continued employment with the Company. As a result of the employment condition, the transfer of these shares has been accounted for apart from the business combination.

The Company incurred approximately $0.9 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 fiscal year ended February 28, 2015.

Acquisition of Inktank Storage, Inc.

On April 30, 2014, the Company completed its acquisition of all of the shares of Inktank Storage, Inc. (“Inktank”), a provider of scale-out, open source storage systems, whose flagship technology, Inktank Ceph Enterprise, delivers object and block storage software to enterprises deploying public or private clouds. The acquisition complements the Company’s existing GlusterFS-based storage offering.

The consideration paid was $152.5 million and has been allocated to the Company’s assets and liabilities as follows: $131.4 million to goodwill, $10.8 million to identifiable intangible assets and the remaining $10.3 million to net working capital.

The Company incurred approximately $2.0 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 fiscal year ended February 28, 2015.

Pro forma consolidated financial information (unaudited)

The following unaudited pro forma consolidated financial information reflects the results of operations of the Company (in thousands, except per share amounts) as if the acquisition of 3scale, Ansible, FeedHenry, eNovance and Inktank had closed on March 1, 2014, 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 fiscal year ended February 28, 2017 has not been provided because the acquisition

 

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RED HAT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

of 3scale would not have had a significant impact on consolidated operating results if the acquisition had closed on March 1, 2016.

 

     Fiscal Years Ended  
     February 29,
2016
     February 28,
2015
 

Revenue

   $ 2,057,565      $ 1,797,959  

Net income

     188,825        158,467  

Basic net income per common share

   $ 1.03      $ 0.85  

Diluted net income per common share

   $ 1.01      $ 0.84  

Goodwill and other business combinations

The Company completed its annual goodwill impairment tests for the fiscal years ended February 28, 2017, February 29, 2016 and February 28, 2015. No goodwill impairment was deemed to have occurred for any of the fiscal years. The following is a summary of goodwill (in thousands):

 

     February 28,
2017
    February 29,
2016
    February 28,
2015
 

Balance at beginning of year

   $ 1,027,277     $ 927,060     $ 687,430  

Acquisitions

     16,923       102,260       260,786  

Impact of foreign currency fluctuations

     (3,636     (3,493     (21,156

Other adjustments

     145       1,450       —    
  

 

 

   

 

 

   

 

 

 

Balance at end of year

   $ 1,040,709     $ 1,027,277     $ 927,060  
  

 

 

   

 

 

   

 

 

 

The excess of purchase price paid for 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 4—Accounts Receivable

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

 

Fiscal year ended

   Balance at
beginning
of period
     Charged to
(recovery  of)

expense
    Adjustments (1)     Balance at
end of
period
 

February 28, 2015

   $ 1,986        469       (208   $ 2,247  

February 29, 2016

   $ 2,247        1,323       (772   $ 2,798  

February 28, 2017

   $ 2,798        (140     133     $ 2,791  

 

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

 

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RED HAT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

As of February 28, 2017 and February 29, 2016, no individual customer accounted for 10% or more of the Company’s accounts receivable.

NOTE 5—Prepaid Expenses

Prepaid expenses include sales commissions, which are the incremental costs that are directly associated with non-cancellable subscription contracts with customers and consist of sales commissions paid to the Company’s sales force. The commissions are deferred and amortized over a period to approximate the period of the subscription term. For further discussion on deferred commissions see NOTE 2—Summary of Significant Accounting Policies. Prepaid expenses, including sales commissions, were comprised of the following (in thousands):

 

     February 28,
2017
     February 29,
2016
 

Deferred commissions

   $ 147,695      $ 102,254  

Professional services

     24,135        21,160  

Taxes

     10,734        15,819  

Insurance

     2,166        2,160  

Other

     15,879        9,484  
  

 

 

    

 

 

 

Total prepaid expenses

   $ 200,609      $ 150,877  
  

 

 

    

 

 

 

NOTE 6—Property and Equipment

The Company’s property and equipment is recorded at cost and consists of the following (in thousands):

 

     Estimated
Useful Life
(Years)
     February 28,
2017
    February 29,
2016
 

Computer and other equipment

     3-5      $ 155,615     $ 135,342  

Software, including software developed for internal use

     5        93,727       85,517  

Furniture and fixtures

     7        32,260       28,800  

Leasehold improvements

     up to 15        124,060       104,045  

Property and equipment—in progress

            15,500       8,001  
     

 

 

   

 

 

 

Property and equipment

        421,162       361,705  

Less: accumulated depreciation

        (231,533     (194,819
     

 

 

   

 

 

 

Property and equipment, net

      $ 189,629     $ 166,886  
     

 

 

   

 

 

 

Property and equipment is depreciated or amortized using the straight-line method over the respective asset’s estimated useful life. Leasehold improvements are depreciated up to 15 years, over the lesser of the estimated remaining useful life of the asset or the remaining term of the lease. Depreciation expense recognized in the Company’s Consolidated Financial Statements is summarized as follows (in thousands):

 

     Fiscal Years Ended  
       February 28,
2017
     February 29,
2016
     February 28,
2015
 

Total depreciation expense

   $ 54,077      $ 48,909      $ 48,001  
  

 

 

    

 

 

    

 

 

 

 

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RED HAT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

NOTE 7—Identifiable Intangible Assets

Identifiable intangible assets consist primarily of trademarks, copyrights and patents, purchased technologies, customer and reseller relationships, and covenants not to compete, all of which are amortized over the estimated useful life, generally on a straight-line basis, with the exception of customer and reseller relationships, which are generally amortized over the greater of straight-line or the related asset’s pattern of economic benefit. Useful lives range from two to 10 years. As of February 28, 2017 and February 29, 2016, trademarks with an indefinite estimated useful life totaled $10.9 million and $11.1 million, respectively. The following is a summary of identifiable intangible assets (in thousands):

 

     February 28, 2017      February 29, 2016  
     Gross
Amount
     Accumulated
Amortization
    Net
Amount
     Gross
Amount
     Accumulated
Amortization
    Net
Amount
 

Trademarks, copyrights and patents

   $ 148,850      $ (59,440   $ 89,410      $ 138,106      $ (49,876   $ 88,230  

Purchased technologies

     107,078        (80,536     26,542        96,105        (70,940     25,165  

Customer and reseller relationships

     104,438        (88,046     16,392        104,593        (80,329     24,264  

Covenants not to compete

     14,081        (12,329     1,752        13,240        (9,875     3,365  

Other intangible assets

     8,833        (5,162     3,671        8,833        (3,786     5,047  
  

 

 

    

 

 

   

 

 

    

 

 

    

 

 

   

 

 

 

Total identifiable intangible assets

   $ 383,280      $ (245,513   $ 137,767      $ 360,877      $ (214,806   $ 146,071  
  

 

 

    

 

 

   

 

 

    

 

 

    

 

 

   

 

 

 

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

 

Balance at February 29, 2016

   $ 146,071  

Purchase of identifiable intangible assets from 3scale, primarily developed technologies

     13,130  

Purchase of developed software and other intangible assets

     11,038  

Amortization expense

     (31,232

Impact of foreign currency fluctuations and other adjustments

     (1,240
  

 

 

 

Balance at February 28, 2017

   $ 137,767  
  

 

 

 

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

 

     Fiscal Years Ended  
     February 28,
2017
     February 29,
2016
     February 28,
2015
 

Cost of revenue

   $ 16,938      $ 13,102      $ 12,049  

Sales and marketing

     7,078        8,075        7,838  

Research and development

     138        842        2,417  

General and administrative

     7,078        5,160        5,958  
  

 

 

    

 

 

    

 

 

 

Total amortization expense

   $ 31,232      $ 27,179      $ 28,262  
  

 

 

    

 

 

    

 

 

 

 

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RED HAT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

As of February 28, 2017, future amortization expense on existing intangibles is as follows (in thousands):

 

Fiscal Year

   Amortization
Expense of
Intangible Assets
 

2018

   $ 27,392  

2019

     22,170  

2020

     18,371  

2021

     11,867  

2022

     7,241  

Thereafter

     39,840  
  

 

 

 

Total amortization expense

   $ 126,881  
  

 

 

 

NOTE 8—Other Assets, Net

Other assets, net were comprised of the following (in thousands):

 

     February 28,
2017
     February 29,
2016
 

Deferred commissions, non-current

   $ 38,842      $ 8,722  

Cost-basis investments

     14,778        16,079  

Prepaid expenses, non-current

     12,209        12,553  

Security deposits and other

     8,276        7,152  
  

 

 

    

 

 

 

Other assets, net

   $ 74,105      $ 44,506  
  

 

 

    

 

 

 

The Company reviews its non-marketable cost-basis investments in equity securities for other than temporary declines in fair value based on prices recently paid for shares in that company, as well as changes in market conditions. The carrying values are not necessarily representative of the amounts that the Company could realize in a current transaction. The Company recognized losses of $2.0 million, $2.8 million and $4.6 million on certain investments during the fiscal years ended February 28, 2017, February 29, 2016 and February 28, 2015, respectively.

NOTE 9—Accounts Payable and Accrued Expenses

Accounts payable and accrued expenses were comprised of the following (in thousands):

 

     February 28,
2017
     February 29,
2016
 

Accounts payable

   $ 76,197      $ 63,268  

Accrued wages and other compensation-related expenses

     212,184        137,738  

Accrued other trade payables

     43,781        45,785  

Accrued income and other taxes payable

     44,032        37,069  

Accrued other

     763        942  
  

 

 

    

 

 

 

Total accounts payable and accrued expenses

   $ 376,957      $ 284,802  
  

 

 

    

 

 

 

 

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RED HAT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

NOTE 10—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 has elected not to prepare and maintain the documentation required to qualify for hedge accounting treatment and, therefore, changes in fair value are recorded in the Consolidated Statements of Operations. See NOTE 17—Assets and Liabilities Measured at Fair Value on a Recurring Basis for information regarding the fair value hierarchy of derivative instruments.

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

 

                   

Fiscal Year Ended February 28, 2017

 
     

As of February 28, 2017

   

Classification of Gain

(Loss) Recognized

in Income on

Derivatives

  Amount of  Gain
(Loss) Recognized
in Income on
Derivatives
 
     

Balance
Sheet Classification

  Fair
Value
    Notional
Value
     

Assets—foreign currency forward contracts not designated as
hedges

  Other current assets   $ 135     $ 15,151     Other income (expense), net   $ 3,663  

Liabilities—foreign currency
forward contracts not designated
as hedges

  Accounts payable and accrued expenses     (160     33,670     Other income (expense), net     (2,970
   

 

 

   

 

 

     

 

 

 

Total

    $ (25   $ 48,821       $ 693  
   

 

 

   

 

 

     

 

 

 

 

                   

Fiscal Year Ended February 29, 2016

 
     

As of February 29, 2016

   

Classification of Gain

(Loss) Recognized

in Income on

Derivatives

  Amount of  Gain
(Loss) Recognized
in Income on
Derivatives
 
     

Balance
Sheet Classification

  Fair
Value
    Notional
Value
     

Assets—foreign currency forward contracts not designated as hedges

  Other current assets   $ 566     $ 31,390     Other income (expense), net   $ 1,226  

Liabilities—foreign currency forward contracts not designated as hedges

  Accounts payable and accrued expenses     (452     41,214     Other income (expense), net     (1,195
   

 

 

   

 

 

     

 

 

 

Total

    $ 114     $ 72,604       $ 31  
   

 

 

   

 

 

     

 

 

 

 

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RED HAT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

NOTE 11—Income Taxes

Components of income tax expense

The U.S. and foreign components of the Company’s income before provision for income taxes consisted of the following (in thousands):

 

     Fiscal Years Ended  
     February 28,
2017
     February 29,
2016
     February 28,
2015
 

U.S.

   $ 187,316      $ 155,550      $ 167,388  

Foreign

     132,864        119,315        88,110  
  

 

 

    

 

 

    

 

 

 

Income before provision for income taxes

   $ 320,180      $ 274,865      $ 255,498  
  

 

 

    

 

 

    

 

 

 

The components of the Company’s provision for income taxes consisted of the following (in thousands):

 

     Fiscal Years Ended  
     February 28,
2017
    February 29,
2016
    February 28,
2015
 

Current:

      

Foreign

   $ 35,791     $ 39,168     $ 26,325  

Federal

     16,857       44,872       15,252  

State

     1,502       5,133       4,090  
  

 

 

   

 

 

   

 

 

 

Current tax expense

   $ 54,150     $ 89,173     $ 45,667  

Deferred:

      

Foreign

     (4,854     (5,170     (8,188

Federal

     17,712       (6,142     36,197  

State

     (531     (2,361     1,621  
  

 

 

   

 

 

   

 

 

 

Deferred tax expense (benefit)

   $ 12,327     $ (13,673   $ 29,630  
  

 

 

   

 

 

   

 

 

 

Net provision for income taxes

   $ 66,477     $ 75,500     $ 75,297  
  

 

 

   

 

 

   

 

 

 

 

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RED HAT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

Statutory Rate Reconciliation

Taxes computed at the statutory federal income tax rates are reconciled to the provision for income taxes as follows (in thousands):

 

     Fiscal Years Ended  
     February 28, 2017     February 29, 2016     February 28, 2015  

Provision at federal statutory rate

   $ 112,063        35.0   $ 96,203        35.0   $ 89,424        35.0

State tax, net of federal tax benefit

     520        0.2     601        0.2     4,042        1.6

Foreign rate differential (1)

     (11,795      (3.7 )%      (8,232      (3.0 )%      (13,983      (5.5 )% 

Foreign dividend

     —          —       —          —       8,720        3.4

Nondeductible items

     3,077        1.0     3,426        1.2     3,339        1.3

Share-based compensation (2)

     (12,749      (4.0 )%      149        0.1     105        —  

Research tax credit

     (9,532      (3.0 )%      (5,105      (1.9 )%      (5,329      (2.1 )% 

Foreign tax credit

     (8,930      (2.8 )%      (10,267      (3.7 )%      (11,755      (4.6 )% 

Domestic production activities deduction

     (4,601      (1.4 )%      (5,033      (1.8 )%      (4,433      (1.7 )% 

Other

     (1,576      (0.5 )%      3,758        1.4     5,167        2.1
  

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

 

 

 

Provision for income taxes

   $ 66,477        20.8   $ 75,500        27.5   $ 75,297        29.5
  

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

 

 

 

 

(1) Foreign rate differential includes a reduction of $1.5 million related to a tax holiday in Israel. The tax holiday provides for a reduced tax rate on income attributable to research and development activities and is scheduled to terminate as of the fiscal year ending February 29, 2020. The financial impact from the tax holiday for the fiscal year ended February 28, 2017 resulted in an increase to the Company’s diluted earnings per share of approximately $0.01.
(2) Share-based compensation in the fiscal year ended February 28, 2017 includes $15.8 million net windfall 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 additional discussion regarding the adoption of ASU 2016-09. This windfall is offset by certain stock-based compensation for which the Company receives no tax benefit.

Deferred taxes

Significant components of the Company’s deferred tax assets and liabilities consisted of the following (in thousands):

 

     February 28,
2017
    February 29,
2016
 

Deferred tax assets:

  

Foreign net operating loss carryforwards

   $ 4,218     $ 6,679  

Domestic net operating loss carryforwards

     5,696       13,202  

Domestic credit carryforwards

     9,864       7,849  

Share-based compensation

     51,016       44,276  

Deferred revenue

     97,258       83,901  

Foreign deferred royalty expenses

     2,505       9,896  

Convertible notes

     11,377       15,182  

Other

     17,077       12,313  
  

 

 

   

 

 

 

Total deferred tax assets

     199,011       193,298  

Valuation allowance for deferred tax assets

     (5,621     (3,291
  

 

 

   

 

 

 

Total deferred tax assets, net of valuation allowance

     193,390       190,007  
  

 

 

   

 

 

 

 

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RED HAT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

     February 28,
2017
     February 29,
2016
 

Deferred tax liabilities:

  

Goodwill

     10,757        9,450  

Property and equipment

     25,163        22,669  

Identifiable intangible assets

     21,101        21,416  

Compensation accruals

     30,128        21,415  

Other

     4,347        3,770  
  

 

 

    

 

 

 

Total deferred tax liabilities

     91,496        78,720  
  

 

 

    

 

 

 

Net deferred tax asset (1)

   $ 101,894      $ 111,287  
  

 

 

    

 

 

 

 

(1) Net deferred tax asset is reported on the Company’s Consolidated Balance Sheets as Deferred tax assets, net and included in Other long-term obligations.

The Company maintains a valuation allowance against its deferred tax assets with respect to certain foreign and state NOL and credit carryforwards that the Company does not believe will ultimately be realized. For the fiscal year ended February 28, 2017, the valuation allowance increased $2.3 million primarily as a result of foreign NOL and credit carryforwards acquired through recent acquisitions.

As of February 28, 2017, the Company had U.S. federal NOL carryforwards of $9.2 million, foreign NOL carryforwards of $22.9 million and U.S. state NOL carryforwards of $72.3 million. The NOL carryforwards expire in varying amounts beginning in the fiscal year ending February 28, 2018. As of February 28, 2017, the Company had U.S. federal research tax credit carryforwards of $0.8 million, state research tax credit carryforwards of $18.1 million and foreign research tax credit carryforwards of $1.2 million, which expire in varying amounts beginning in the fiscal year ending February 28, 2018.

As of February 28, 2017, cumulative undistributed earnings of non-U.S. subsidiaries totaled $677.4 million. Determination of the deferred tax liability on these earnings reinvested indefinitely outside the U.S. is not practicable because of available foreign tax credits, continually changing variables and other factors. It is the Company’s policy to invest the earnings of foreign subsidiaries indefinitely outside the U.S. From time to time, however, the Company may remit a portion of these earnings to the extent it is economically prudent. The Company has provided U.S. income taxes on the earnings of certain foreign subsidiaries that are not considered as permanently reinvested outside the U.S. The U.S. income tax on such earnings has been offset by U.S. foreign tax credits. The Company has also provided U.S. income taxes on the earnings of certain foreign subsidiaries that are permanently reinvested outside the U.S. but are deemed distributed for U.S. federal income tax purposes. The U.S. income tax on such earnings is reduced or offset by available U.S. foreign tax credits.

Unrecognized tax benefits

The following table reconciles unrecognized tax benefits (in thousands):

 

     February 28,
2017
    February 29,
2016
    February 28,
2015
 

Balance at beginning of year

   $ 74,886     $ 60,343     $ 57,054  

Additions based on tax positions related to prior years

     2,142       13,486       514  

Additions based on tax positions related to the current year

     4,893       3,494       3,374  

(Reductions) additions related to changes in facts and circumstances

     (2,271     256       (229

Reductions related to lapse of the statute of limitations

     (2,748     (1,581     (370

Reductions related to settlements with tax authorities

     —         (1,112     —    
  

 

 

   

 

 

   

 

 

 

Balance at end of year

   $ 76,902     $ 74,886     $ 60,343  
  

 

 

   

 

 

   

 

 

 

 

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RED HAT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

The Company’s unrecognized tax benefits as of February 28, 2017 and February 29, 2016, which, if recognized, would affect the Company’s effective tax rate were $69.1 million and $59.1 million, respectively.

It is the Company’s policy to recognize interest and penalties related to uncertain tax positions as income tax expense. Uncertain tax position interest and penalties recognized in the Consolidated Statements of Operations totaled $2.5 million, $1.5 million and $2.7 million for the fiscal years ended February 28, 2017, February 29, 2016 and February 28, 2015, respectively. Uncertain tax position accrued interest and accrued penalties recognized in the Consolidated Balance Sheets totaled $13.2 million and $10.7 million as of February 28, 2017 and February 29, 2016, respectively.

As of February 28, 2017, it is reasonably possible that total unrecognized tax benefits may be reduced by up to $7.6 million within the next 12 months as a result of statutes of limitations expirations in various tax jurisdictions, all of which would affect the Company’s effective tax rate.

The Company is subject to taxation in the U.S. and various other state and foreign jurisdictions. The material jurisdictions in which the Company is subject to potential examination include India, Ireland and the U.S., where the Company is no longer subject to examination prior to fiscal years ended February 28, 2006, February 29, 2012 and February 29, 2000, respectively. The Company is currently under examination in France, India and the United Kingdom. The Company believes it has adequately provided for any reasonably foreseeable outcomes related to tax audits.

NOTE 12—Stockholders’ Equity

Common stock

The Company has authorized 300,000,000 shares of common stock with a par value of $0.0001 per share. Holders of these shares have one vote per share. Upon the dissolution, liquidation or winding up of the Company, holders of common stock will be entitled to receive the assets of the Company after satisfaction of the preferential rights of any outstanding preferred stock or any other outstanding stock ranking on liquidation senior to or on parity with the common stock.

The Company repurchased 6,192,382 shares, 3,476,229 shares and 8,355,757 shares of its common stock during the fiscal years ended February 28, 2017, February 29, 2016 and February 28, 2015, respectively, at an aggregate cost of $458.7 million, $262.6 million and $535.1 million, respectively, in accordance with the share repurchase programs described below. These amounts are recorded in Treasury stock on the Company’s Consolidated Balance Sheets.

Preferred stock

At February 28, 2017, the Company has authorized 5,000,000 shares of preferred stock with a par value of $0.0001 per share. No shares of preferred stock were outstanding as of February 28, 2017 or February 29, 2016.

Share repurchase programs

On March 25, 2015, the Company announced that its Board of Directors had authorized the repurchase of up to $500.0 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 discontinuance 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 of Directors 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

 

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RED HAT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

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 $500.0 million repurchase program, which was discontinued by the Board effective June 30, 2016.

From its commencement on July 1, 2016 through February 28, 2017, the Company has repurchased 4,900,649 shares of its common stock for $364.3 million under this program. As of February 28, 2017, the amount available under the program for the repurchase of the Company’s common stock was $635.7 million.

Accelerated share repurchase

During the fiscal year ended February 28, 2015, the Company entered into an accelerated share repurchase program (the “ASR Agreement”). On October 7, 2014, under the ASR Agreement, the Company paid $375.0 million to the ASR Agreement counterparty and received 5,312,555 shares of its common stock from the ASR Agreement counterparty, which represented 80 percent of the shares deliverable to the Company under the ASR Agreement assuming an average share price of $56.47 (the Company’s closing share price at October 1, 2014). The ASR Agreement was completed on February 27, 2015. On March 4, 2015, the ASR Agreement counterparty delivered 720,101 additional shares of the Company’s common stock to the Company in settlement of the ASR Agreement.

The Company initially accounted for the ASR Agreement as two separate transactions: (i) the 5,312,555 shares of common stock initially delivered to the Company were accounted for as a treasury stock transaction with $300.0 million, or 80 percent, of the $375.0 million upfront payment being recorded in Treasury stock in the Company’s Consolidated Balance Sheet at February 28, 2015 and (ii) the unsettled portion of the ASR Agreement of $75.0 million was recorded in Additional paid-in capital on the Company’s Consolidated Balance Sheet as of February 28, 2015. The $75.0 million representing the unsettled portion of the ASR originally recorded in Additional paid-in capital was reclassified upon settlement to Treasury stock during the fiscal year ended February 29, 2016.

The total number of shares of common stock the Company repurchased under the ASR Agreement was 6,032,656 shares with a weighted average share price of $62.16.

Accumulated Other Comprehensive Loss

Accumulated other comprehensive loss was comprised of the following (in thousands):

 

     February 28,
2017
    February 29,
2016
 

Accumulated loss from foreign currency translation adjustment

   $ (87,784   $ (73,776

Accumulated unrealized loss, net of tax, on available-for-sale securities

     (568     (673
  

 

 

   

 

 

 

Accumulated other comprehensive loss

   $ (88,352   $ (74,449
  

 

 

   

 

 

 

NOTE 13—Share-based Awards

Overview

The Company’s 2004 Long-Term Incentive Plan, as amended and restated (the “LTIP”), provides for the granting of service- and performance-based share awards, among other awards. As of February 28, 2017, there were 10.0 million shares of common stock reserved for issuance under the LTIP for future share-based awards to

 

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RED HAT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

be granted to any employee, officer, director or consultant of the Company at terms and prices to be determined by the Board of Directors.

The following table summarizes granted share-based awards by type:

 

    Awards Granted in Fiscal Years Ended  
    February 28, 2017     February 29, 2016     February 28, 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
    Shares and
Shares
Underlying
Awards
    Weighted
Average
Per Share
Award
Fair Value
 

Service-based shares and share units (1)

    2,212,006     $ 75.62       2,108,639     $ 76.45       2,994,553     $ 53.23  

Performance-based share units—Maximum

    725,004     $ 76.68       628,596     $ 77.87       1,148,084     $ 52.17  

Stock options assumed as part of a business combination

    —       $ —         119,515     $ 58.22       219,169     $ 48.45  

Restricted shares issued as part of a business combination with continued-employment service conditions

    —       $ —         —       $ —         529,057     $ 54.75  
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total share-based awards

    2,937,010     $ 75.88       2,856,750     $ 76.00       4,890,863     $ 52.93  
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

 

(1) Service-based shares granted during the fiscal year ended February 28, 2017 include 140,182 restricted shares awarded to certain executives that were subject to both a four-year service condition and the achievement of a specified dollar amount of revenue for the fiscal year ended February 28, 2017 (the “RSA performance goal”). The RSA performance goal for the fiscal year ended February 28, 2017 was met. Therefore, as of February 28, 2017 only the service condition remained with 25% vesting on July 17, 2017, and the remainder vesting ratably on a quarterly basis over the course of the subsequent three-year period.

The following summarizes share-based compensation expense recognized in the Company’s Consolidated Financial Statements (in thousands):

 

     Fiscal Years Ended  
     February 28,
2017 (1)
     February 29,
2016
     February 28,
2015
 

Cost of revenue

   $ 16,553      $ 15,898      $ 14,027  

Sales and marketing

     93,378        69,089        55,203  

Research and development

     52,424        48,466        38,517  

General and administrative

     30,175        32,781        27,485  
  

 

 

    

 

 

    

 

 

 

Total share-based compensation expense

   $ 192,530      $ 166,234      $ 135,232  
  

 

 

    

 

 

    

 

 

 

 

(1) Total share-based compensation expense of $192.5 million includes $5.0 million of expense related to the Company’s employee stock purchase plan (“ESPP”). See NOTE 16—Employee Benefit Plans for information regarding the ESPP.

Share-based compensation expense qualifying for capitalization was insignificant for each of the Company’s fiscal years ended February 28, 2017, February 29, 2016 and February 28, 2015. Accordingly, no share-based compensation expense was capitalized during these years.

As discussed in NOTE 2—Summary of Significant Accounting Policies, as a result of adopting ASU 2016-09 during the fiscal year ended February 28, 2017, the Company recognizes share-based award

 

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RED HAT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

forfeitures only as they occur rather than estimating by applying a forfeiture rate. During the fiscal years ended February 29, 2016 and February 28, 2015, an estimated forfeiture rate of 10% per annum, which approximated the Company’s historical rate, was applied to options and service-based share awards. Awards were adjusted to actual forfeiture rates at vesting.

Stock options

The total share-based compensation expense related to stock options recognized in the Consolidated Financial Statements was as follows (in thousands):

 

    Fiscal Years Ended  
    February 28,
2017
    February 29,
2016
    February 28,
2015
 

Share-based compensation expense—stock options

  $ 4,813     $ 4,918     $ 5,085  
 

 

 

   

 

 

   

 

 

 

As of February 28, 2017, the Company had 208,505 stock options outstanding with a weighted average remaining contractual life of 4.5 years and a weighted average exercise price of $34.70. The number of stock options exercisable as of February 28, 2017 was 129,576 with a weighted average share price of $38.49.

The intrinsic value of stock options exercised was as follows (in thousands):

 

     Fiscal Years Ended  
     February 28,
2017
     February 29,
2016
     February 28,
2015
 

Total intrinsic value of stock options exercised

   $ 7,928      $ 9,103      $ 6,289  
  

 

 

    

 

 

    

 

 

 

As of February 28, 2017, compensation cost related to unvested stock options not yet recognized in the Company’s Consolidated Financial Statements totaled $3.2 million. The weighted average period over which these unvested stock options are expected to be recognized is approximately 1.6 years.

Service-based share awards

Service-based share awards include nonvested shares, nonvested share units and deferred share units granted under the LTIP. Nonvested shares vest, subject to continued service to the Company, 25% on the first trading day on or about July 16 of the year subsequent to the year in which the grant occurs and 6.25% on the last day of each subsequent three-month period. Nonvested share units generally vest, subject to continued service to the Company, 25% each year over a four-year period beginning on the date of grant. Nonvested shares and nonvested share units are generally amortized to expense on a straight-line basis over four years. Deferred share units are awarded to directors and generally vest within one year when issued in lieu of annual share awards or immediately when issued in lieu of cash.

The total share-based compensation expense related to service-based share awards recognized in the Company’s Consolidated Financial Statements was as follows (in thousands):

 

     Fiscal Years Ended  
     February 28,
2017
     February 29,
2016
     February 28,
2015
 

Share-based compensation expense—service-based awards

   $ 147,843      $ 124,904      $ 107,887  
  

 

 

    

 

 

    

 

 

 

 

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RED HAT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

The following table summarizes the activity for the Company’s service-based share awards:

 

     Nonvested
Shares and
Share Units
    Weighted Average
Per Share
Grant Date
Fair Value
 

Service-based share awards at February 28, 2014

     5,373,308     $ 48.34  

Granted

     2,994,553       53.23  

Vested

     (1,948,247     47.24  

Forfeited

     (569,952     48.50  

Restricted shares issued as part of a business combination with continued-employment service conditions (1)

     529,057       54.75  
  

 

 

   

 

 

 

Service-based share awards at February 28, 2015

     6,378,719     $ 51.49  

Granted

     2,108,639       76.45  

Vested

     (2,047,169     50.78  

Forfeited

     (265,315     56.21  
  

 

 

   

 

 

 

Service-based share awards at February 29, 2016

     6,174,874     $ 60.05  

Granted

     2,212,006       75.62  

Vested

     (2,409,518     57.42  

Forfeited

     (313,162     64.36  
  

 

 

   

 

 

 

Service-based share awards at February 28, 2017

     5,664,200     $ 67.01  
  

 

 

   

 

 

 

 

(1) As part of the Company’s acquisition of eNovance, a total of 529,057 restricted common shares were issued to certain shareholders of eNovance. These restricted shares are conditioned on continued employment with the Company.

The following summarizes the intrinsic value as of February 28, 2017 of the Company’s service-based awards outstanding:

 

       Number of
Shares and
Share Units
     Weighted Average
Remaining
Vesting Period
     Intrinsic Value at
February 28, 2017
(in thousands)
 

Outstanding

     5,664,200        2.6      $ 469,052  

The intrinsic value of service-based awards vesting was as follows (in thousands):

 

    Fiscal Years Ended  
    February 28,
2017
    February 29,
2016
    February 28,
2015
 

Total intrinsic value of service-based awards vesting

  $ 181,691     $ 157,864     $ 108,066  
 

 

 

   

 

 

   

 

 

 

As of February 28, 2017, compensation cost related to service-based share awards not yet recognized in the Company’s Consolidated Financial Statements totaled $279.9 million. The weighted average period over which these nonvested awards are expected to be recognized is approximately 2.6 years.

Performance-based share awards

Under the LTIP, certain executive officers and senior management were awarded a target number of PSUs. The PSU payouts are either based on (i) the Company’s financial performance (“performance condition”) or

 

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RED HAT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

(ii) the performance of the Company’s total stockholder return (“market condition”). Set forth below are general descriptions of the two types of performance-based awards granted to certain executive officers and members of senior management.

PSUs with performance conditions

Depending on the Company’s financial performance measured against the financial performance of specified peer companies during a three-year performance period, PSU grantees may earn up to 200% of the target number of PSUs (the “Maximum PSUs”). Payouts are earned over a performance period with two separate performance segments. Up to 50% of the Maximum PSUs may be earned in respect of the first performance segment; and up to 100% of the Maximum PSUs may be earned in respect of the second performance segment, less the amount earned in the first performance segment.

PSUs with market conditions

Depending on the performance of the Company’s total stockholder return measured against the performance of the total shareholder return of specified peer companies over a performance period of approximately three years, PSU grantees may earn up to 200% of the target number of PSUs. Each grantee will receive a number of shares of common stock equal to the number of PSUs earned in a single payout following the end of the performance period.

In addition to the PSUs with the market condition described above, certain executives were awarded a total of 242,352 PSUs that pay out only if the Company’s total shareholder return increases by at least 50% within a three-year performance period beginning on August 6, 2014 (“TSR Hurdle PSUs”). If the performance goal is achieved during the performance period and the grantee’s business relationship with the Company has not ceased, 50% of the TSR Hurdle PSUs vest upon achievement of the performance goal and the remaining 50% of the TSR Hurdle PSUs vest on the last day of the four-year service period beginning on August 6, 2014. The TSR Hurdle PSUs’ performance goal was met during the fourth quarter of the fiscal year ended February 29, 2016.

The total share-based compensation expense related to performance-based share awards recognized in the Company’s Consolidated Financial Statements was as follows (in thousands):

 

     Fiscal Years Ended  
       February 28,
2017
     February 29,
2016
     February 28,
2015
 

Share-based compensation expense—performance-based awards

   $ 34,865      $ 36,412      $ 22,260  
  

 

 

    

 

 

    

 

 

 

 

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RED HAT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

The following table summarizes the activity for the Company’s PSUs:

 

     Maximum (1)  

Activity

   Shares
Underlying
Performance
Share Units
    Weighted Average
Per Share
Grant Date
Fair Value
 

Outstanding at February 28, 2014

     1,675,225     $ 47.34  

Granted

     1,148,084       52.17  

Vested

     (374,921     45.42  

Forfeited

     (299,053     41.90  
  

 

 

   

 

 

 

Outstanding at February 28, 2015

     2,149,335     $ 51.01  

Granted

     628,596       77.87  

Vested

     (497,656     52.41  

Forfeited

     (230,764     52.29  
  

 

 

   

 

 

 

Outstanding at February 29, 2016

     2,049,511     $ 58.76  

Granted

     725,004       76.68  

Vested

     (492,518     48.94  

Forfeited

     (346,102     62.68  
  

 

 

   

 

 

 

Outstanding at February 28, 2017

     1,935,895     $ 67.27  
  

 

 

   

 

 

 

 

(1) Vested and forfeited amounts represent the actual number of shares vesting and forfeited during the year. Outstanding amounts represent the remaining maximum potential shares available to vest as of the period ended.

The total intrinsic value of performance-based share awards vesting was as follows (in thousands):

 

    Fiscal Years Ended  
    February 28,
2017
    February 29,
2016
    February 28,
2015
 

Total intrinsic value of performance-based awards vesting

  $ 36,768     $ 36,555     $ 18,733  
 

 

 

   

 

 

   

 

 

 

As of February 28, 2017, the number of shares subject to PSU awards expected to vest was 1.3 million shares. Compensation expense related to PSUs expected to vest but not yet recognized in the Consolidated Financial Statements totaled $31.1 million as of February 28, 2017. The weighted average period over which these awards are expected to be recognized is approximately 1.1 years.

 

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RED HAT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

NOTE 14—Commitments and Contingencies

Operating leases

As of February 28, 2017, the Company leased office space and certain equipment under various non-cancellable operating leases. Future minimum lease payments required under the operating leases at February 28, 2017 are as follows (in thousands):

 

Fiscal Year

   Operating
Leases
 

2018

   $ 56,068  

2019

     49,856  

2020

     42,851  

2021

     36,514  

2022

     31,640  

Thereafter

     72,873  
  

 

 

 

Total minimum lease payments

   $ 289,802  
  

 

 

 

Rent expense under operating leases is provided in the following table (in thousands):

 

    Fiscal Years Ended  
    February 28,
2017
    February 29,
2016
    February 28,
2015
 

Total operating lease expense

  $ 44,228     $ 38,152     $ 36,581  
 

 

 

   

 

 

   

 

 

 

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. Payments pursuant to these indemnification claims during the fiscal years ended February 28, 2017, February 29, 2016 and February 28, 2015 were in the aggregate immaterial.

NOTE 15—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.

 

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RED HAT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

NOTE 16—Employee Benefit Plans

Retirement plans

The Company provides retirement plans whereby participants may elect to contribute a portion of their annual compensation to the plans, after complying with certain limitations. The Company has the option to make contributions to the plans and contributed to the plans as follows (in thousands):

 

    Fiscal Years Ended  
    February 28,
2017
    February 29,
2016
    February 28,
2015
 

Total contributions to employee benefit plans

  $ 32,839     $ 25,731     $ 21,721  
 

 

 

   

 

 

   

 

 

 

Employee stock purchase plan

During the third quarter of the fiscal year ended February 28, 2017, the Company began offering an ESPP whereby eligible employees may elect to purchase common stock of the Company at the end of a six-month plan period (“Plan Period”). During each Plan Period, eligible employees who so elect may authorize payroll deductions in an amount no less than 1% nor greater than 15% of his or her eligible compensation during the Plan Period. At the end of each Plan Period, the accumulated deductions are used to purchase shares of common stock. Shares are purchased at a price equal to 85% of the closing price of the Company’s common stock, on either the first business day of the Plan Period or the last business day of the Plan Period, whichever is lower. No participant may purchase more than $25,000 worth of common stock per calendar year.

As of February 28, 2017, the Company has 5,000,000 common shares reserved for issuance under the ESPP. Share-based compensation expense recognized in the Company’s Consolidated Statements of Operations for the fiscal year ended February 28, 2017 related to the ESPP totaled $5.0 million.

NOTE 17—Assets and Liabilities Measured at Fair Value on a Recurring Basis

The following table summarizes the composition and fair value hierarchy of the Company’s financial assets and liabilities at February 28, 2017 (in thousands):

 

     As of
February 28,
2017
    Quoted Prices  In
Active Markets
for Identical
Assets (Level 1)
     Significant
Other
Observable
Inputs (Level 2)
    Significant
Unobservable
Inputs (Level 3)
 

Assets:

         

Money markets (1)

   $ 258,188     $ 258,188      $ —       $ —    

Available-for-sale securities (1):

         

U.S. agency securities

     327,430       —          327,430       —    

Corporate securities

     714,993       —          714,993       —    

Foreign currency derivatives (2)

     135       —          135       —    

Liabilities:

         

Foreign currency derivatives (3)

     (160     —          (160     —    
  

 

 

   

 

 

    

 

 

   

 

 

 

Total

   $ 1,300,586     $ 258,188      $ 1,042,398     $ —    
  

 

 

   

 

 

    

 

 

   

 

 

 

 

(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 28, 2017 in addition to $832.6 million of cash.

 

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Index to Financial Statements

RED HAT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

(2) Included in Other current assets in the Company’s Consolidated Balance Sheet at February 28, 2017.
(3) Included in Accounts payable and accrued expenses in the Company’s Consolidated Balance Sheet at February 28, 2017.

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:

         

Money markets (1)

   $ 221,970     $ 221,970      $ —       $ —    

Available-for-sale securities (1):

         

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.
(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 investments measured at fair value as of February 28, 2017 (in thousands):

 

                                Balance Sheet Classification  
     Amortized
Cost
     Gross Unrealized     Aggregate
Fair Value
     Cash
Equivalent
Marketable
Securities
     Investments
in debt
securities,
short-term
     Investments
in debt
securities,
long-term
 
        Gains      Losses(1)             

Money markets

   $ 258,188      $ —        $ —       $ 258,188      $ 258,188      $ —        $ —    

U.S. agency securities

     329,617        37        (2,224     327,430        —          27,593        299,837  

Corporate securities

     714,226        1,416        (649     714,993        —          342,390        372,603  
  

 

 

    

 

 

    

 

 

   

 

 

    

 

 

    

 

 

    

 

 

 

Total

   $ 1,302,031      $ 1,453      $ (2,873   $ 1,300,611      $ 258,188      $ 369,983      $ 672,440  
  

 

 

    

 

 

    

 

 

   

 

 

    

 

 

    

 

 

    

 

 

 

 

(1) As of February 28, 2017, there were $0.6 million of accumulated unrealized losses related to investments that have been in a continuous unrealized loss position for 12 months or longer. The aggregate related fair value of investments with unrealized losses was $605.9 million.

 

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Index to Financial Statements

RED HAT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

The following table summarizes the stated maturities of the Company’s investment in available-for-sale securities (in thousands):

 

     As of
February 28,
2017
    Less than
1 Year
    1-5 Years     More than
5 Years
 

Maturity of current and long-term available-for-sale securities

   $ 1,042,423     $ 369,984     $ 672,439     $ —    

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

 

                                Balance Sheet Classification  
     Amortized
Cost
     Gross Unrealized     Aggregate
Fair Value
     Cash
Equivalent
Marketable
Securities
     Investments
in debt
securities,
short-term
     Investments
in debt
securities,
long-term
 
        Gains      Losses(1)             

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. The aggregate related fair value of investments with unrealized losses was $608.8 million.

NOTE 18—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 (in thousands, except per share amounts):

 

     Fiscal Years Ended  
     February 28,
2017
     February 29,
2016
     February 28,
2015
 

Net income, basic and diluted

   $ 253,703      $ 199,365      $ 180,201  
  

 

 

    

 

 

    

 

 

 

Weighted average common shares outstanding

     179,642        182,817        186,529  

Incremental shares attributable to assumed vesting or exercise of outstanding equity award shares

     3,027        3,020        2,717  

Dilutive effect of convertible notes

     292        282        —    
  

 

 

    

 

 

    

 

 

 

Diluted shares

     182,961        186,119        189,246  
  

 

 

    

 

 

    

 

 

 

Net income per share - diluted

   $ 1.39      $ 1.07      $ 0.95  

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

 

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Index to Financial Statements

RED HAT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

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 are considered in diluted EPS under the treasury stock method. See NOTE 21—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 fiscal years ended February 28, 2017, February 29, 2016 and February 28, 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.

The following share awards are not included in the computation of diluted EPS 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):

 

     Fiscal Years Ended  
     February 28,
2017
     February 29,
2016
     February 28,
2015
 

Number of shares considered anti-dilutive for calculating diluted EPS

     77        21        121  
  

 

 

    

 

 

    

 

 

 

NOTE 19—Segment Reporting

The following summarizes revenue from unaffiliated customers; income (loss) from operations; total cash, cash equivalents and available-for-sale investment securities and total assets by geographic segment (in thousands):

 

     Americas      EMEA      Asia Pacific      Corporate(1)     Consolidated  
     Fiscal Year Ended February 28, 2017  

Revenue from unaffiliated customers

   $ 1,555,290      $ 515,642      $ 340,871      $ —       $ 2,411,803  

Income (loss) from operations

   $ 318,244      $ 106,769      $ 99,762      $ (192,530   $ 332,245  

Total cash, cash equivalents and available-for-sale investment securities

   $ 1,100,827      $ 706,028      $ 326,376      $ —       $ 2,133,231  

Total assets

   $ 2,974,734      $ 1,075,422      $ 485,029      $ —       $ 4,535,185  
     Fiscal Year Ended February 29, 2016  

Revenue from unaffiliated customers

   $ 1,354,345      $ 436,304      $ 261,581      $ —       $ 2,052,230  

Income (loss) from operations

   $ 297,462      $ 93,373      $ 63,447      $ (166,234   $ 288,048  

Total cash, cash equivalents and available-for-sale investment securities

   $ 1,222,470      $ 540,584      $ 232,336      $ —       $ 1,995,390  

Total assets

   $ 2,909,238      $ 871,475      $ 374,386      $ —       $ 4,155,099  
     Fiscal Year Ended February 28, 2015  

Revenue from unaffiliated customers

   $ 1,144,237      $ 410,299      $ 234,953      $ —       $ 1,789,489  

Income (loss) from operations

   $ 242,173      $ 89,364      $ 53,689      $ (135,232   $ 249,994  

Total cash, cash equivalents and available-for-sale investment securities

   $ 1,267,824      $ 405,114      $ 135,805      $ —       $ 1,808,743  

Total assets

   $ 2,755,923      $ 726,101      $ 302,545      $ —       $ 3,784,569  

 

(1) Amounts represent share-based compensation expense that was not allocated to geographic segments.

 

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Index to Financial Statements

RED HAT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

Supplemental information about geographic areas

The Company approximates its geographic sources of revenue based on the country of origin of its non-cancellable subscription and service agreements initiated during the year (commonly referred to as bookings). The following table lists revenue from unaffiliated customers in the United States, the Company’s country of domicile, and revenue from foreign countries (in thousands):

 

     Fiscal Years Ended  
     February 28,
2017
     February 29,
2016
     February 28,
2015
 

United States, the Company’s country of domicile

   $ 1,400,228      $ 1,213,493      $ 1,022,803  

Foreign

     1,011,575        838,737        766,686  
  

 

 

    

 

 

    

 

 

 

Total revenue from unaffiliated customers

   $ 2,411,803      $ 2,052,230      $ 1,789,489  
  

 

 

    

 

 

    

 

 

 

There were no individual foreign countries in which the Company earned 10% or more of its revenue from unaffiliated customers.

Total tangible long-lived assets located in the United States, the Company’s country of domicile, and similar tangible long-lived assets held outside the U.S. are summarized in the following table (in thousands):

 

     February 28,
2017
     February 29,
2016
     February 28,
2015
 

United States, the Company’s country of domicile

   $ 133,492      $ 126,937      $ 131,792  

Foreign

     56,137        39,949        40,359  
  

 

 

    

 

 

    

 

 

 

Total tangible long-lived assets

   $ 189,629      $ 166,886      $ 172,151  
  

 

 

    

 

 

    

 

 

 

Supplemental information about major customers

For the fiscal years ended February 28, 2017 and February 29, 2016, the U.S. government and its agencies represented in the aggregate approximately 10% of the Company’s total revenue. For the fiscal year ended February 28, 2015, there were no individual customers from which the Company generated 10% or greater revenue.

Supplemental information about products and services

The following table provides further detail, by type, of our 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 our Application Development-related and other emerging technology

 

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Index to Financial Statements

RED HAT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

offerings includes Red Hat JBoss Middleware, Red Hat Storage, Red Hat Mobile Application Platform and Red Hat cloud offerings such as Red Hat OpenStack Platform and Red Hat OpenShift (in thousands):

 

     Fiscal Years Ended  
     February 28,
2017
     February 29,
2016
     February 28,
2015
 

Subscription revenue:

  

Infrastructure-related offerings

   $ 1,696,443      $ 1,480,463      $ 1,324,693  

Application Development-related and other emerging technology offerings

     439,337        322,986        236,541  
  

 

 

    

 

 

    

 

 

 

Total subscription revenue

     2,135,780        1,803,449        1,561,234  
  

 

 

    

 

 

    

 

 

 

Training and services revenue:

  

Consulting services

     207,959        190,870        171,436  

Training

     68,064        57,911        56,819  
  

 

 

    

 

 

    

 

 

 

Total training and services revenue

     276,023        248,781        228,255  
  

 

 

    

 

 

    

 

 

 

Total revenue

   $ 2,411,803      $ 2,052,230      $ 1,789,489  
  

 

 

    

 

 

    

 

 

 

NOTE 20—Other Long-Term Obligations

Other long-term obligations were comprised of the following (in thousands):

 

     February 28,
2017
     February 29,
2016
 

Accrued income taxes

   $ 76,718      $ 73,403  

Deferred rent credits

     11,670        13,197  

Net deferred tax liability, non-current

     2,939        169  

Other

     2,638        1,143  
  

 

 

    

 

 

 

Total other long-term obligations

   $ 93,965      $ 87,912  
  

 

 

    

 

 

 

NOTE 21—Convertible Notes

Convertible note 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 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, as described in NOTE 12 Stockholders’ Equity.

 

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Index to Financial Statements

RED HAT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

The Company has and intends to continue 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 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, beginning on April 1, 2015. The convertible notes will mature on October 1, 2019, unless previously purchased or converted.

The convertible notes are convertible into shares of the Company’s common stock at an initial conversion rate of 13.6219 shares per $1,000 principal amount of 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 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.

 

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Index to Financial Statements

RED HAT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

The convertible notes consisted of the following (in thousands):

 

     February 28,
2017
     February 29,
2016
 

Liability component:

  

Principal

   $ 805,000      $ 805,000  

Less: debt issuance costs

     (7,442      (10,029

Less: debt discount

     (51,925      (71,029
  

 

 

    

 

 

 

Net carrying amount

   $ 745,633      $ 723,942  
  

 

 

    

 

 

 

Equity component (1)

   $ 96,890      $ 96,890  
  

 

 

    

 

 

 

 

(1) Recorded in the Consolidated Balance Sheets 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 February 28, 2017. Additionally, the Company recorded a deferred tax asset of $0.7 million related to the $1.8 million equity component of transactional costs, which are deductible for tax purposes.

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

 

     Fiscal Years Ended  
     February 28,
2017
     February 29,
2016
     February 28,
2015
 

Coupon rate 0.25% per year, payable semiannually

   $ 2,012      $ 2,012      $ 805  

Amortization of convertible note issuance costs—liability component

     2,587        2,433        935  

Accretion of debt discount

     19,104        18,570        7,292  
  

 

 

    

 

 

    

 

 

 

Total interest expense related to convertible notes

   $ 23,703      $ 23,015      $ 9,032  
  

 

 

    

 

 

    

 

 

 

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 convertible notes (the carrying value excludes the equity component of the convertible notes classified in equity) is as follows (in thousands):

 

     February 28, 2017  
     Fair Value      Carrying Value  

Convertible notes

   $ 745,865      $ 745,633  
  

 

 

    

 

 

 

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 (the “Option Counterparties”).

 

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Index to Financial Statements

RED HAT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

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.

NOTE 22—Unaudited Quarterly Results

Below are unaudited condensed quarterly results (in thousands, except per share data):

 

     Fiscal Year Ended February 28, 2017  
     (Unaudited)  
     4th
Quarter
    3rd
Quarter
    2nd
Quarter
     1st
Quarter
 

Revenue:

  

Subscriptions

   $ 559,588     $ 543,318     $ 531,209      <