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Edited Transcript of RHT earnings conference call or presentation 19-Sep-18 9:00pm GMT

Q2 2019 Red Hat Inc Earnings Call

Raleigh Sep 29, 2018 (Thomson StreetEvents) -- Edited Transcript of Red Hat Inc earnings conference call or presentation Wednesday, September 19, 2018 at 9:00:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Eric R. Shander

Red Hat, Inc. - Executive VP & CFO

* James M. Whitehurst

Red Hat, Inc. - President, CEO & Director

* Tom McCallum

Red Hat, Inc. - VP of IR

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Conference Call Participants

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* Brian John White

Monness, Crespi, Hardt & Co., Inc., Research Division - Research Analyst

* Daniel Robert Bergstrom

RBC Capital Markets, LLC, Research Division - Analyst

* Heather Anne Bellini

Goldman Sachs Group Inc., Research Division - MD & Analyst

* John Stephen DiFucci

Jefferies LLC, Research Division - Equity Analyst

* Karl Emil Keirstead

Deutsche Bank AG, Research Division - Director and Senior Equity Research Analyst

* Kasthuri Gopalan Rangan

BofA Merrill Lynch, Research Division - MD and Head of Software

* Keith Frances Bachman

BMO Capital Markets Equity Research - MD & Senior Research Analyst

* Mark Ronald Murphy

JP Morgan Chase & Co, Research Division - MD

* Raimo Lenschow

Barclays Bank PLC, Research Division - MD & Analyst

* Robert S. Majek

Raymond James & Associates, Inc., Research Division - Senior Research Associate

* Sanjit Kumar Singh

Morgan Stanley, Research Division - VP

* Stewart Kirk Materne

Evercore ISI Institutional Equities, Research Division - Senior MD

* Taylor John Reiners

Piper Jaffray Companies, Research Division - Research Analyst

* Walter H Pritchard

Citigroup Inc, Research Division - MD and U.S. Software Analyst

* Zane Brandon Chrane

Sanford C. Bernstein & Co., LLC., Research Division - Senior Analyst

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Presentation

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Operator [1]

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Good day, everyone, and welcome to the Red Hat Second Quarter Fiscal Year '19 Earnings Call. (Operator Instructions) It is my pleasure to turn today's conference over to the Vice President of Investor Relations, Mr. Tom McCallum. Please go ahead, sir.

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Tom McCallum, Red Hat, Inc. - VP of IR [2]

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Thank you, David. Hello, everyone, and welcome to Red Hat's earnings call for the second quarter of fiscal 2019. Speakers for today's call will be Jim Whitehurst, President and CEO; and Eric Shander, Executive Vice President and CFO. Our earnings press release was issued today after the market closed and may be downloaded from redhat.com on the Investor Relations page. Also on this page, you'll be able to find a copy of today's prepared remarks, a schedule of currency rates and a slide deck with financial highlights and supplemental metrics that, along with our earnings release, include a reconciliation of GAAP to non-GAAP financial metrics.

During this call, we will make forward-looking statements about future financial performance and other future events or trends, including guidance for the third quarter and full fiscal year '19. These statements are only predictions that are based on what we believe today, and actual results may differ materially. These forward-looking statements are subject to the risks, uncertainties, assumptions and other factors that could affect our financial results and performance of our business, which we detailed -- which we discussed in detail in our filings with the SEC, including today's press release and the risk factors and other information contained in our most recent filing of 10-K and Form 10-Q. Red Hat assumes no obligation to update forward-looking statements that we make beyond today's call.

And with that, let me turn the call over to Jim.

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James M. Whitehurst, Red Hat, Inc. - President, CEO & Director [3]

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Thank you, Tom, and let me add my welcome to all of you joining us on today's call. In the second quarter, we continued to see demand from our customers around the globe as they focus on their digital transformation and hybrid cloud initiatives. We enable our customers to succeed on these initiatives with our innovative solutions, award-winning support and global services. Our focus on customers helped us drive strong results in the second quarter where we delivered double-digit growth in a number of our key financial metrics. Let me highlight a few of those for the quarter.

Our total backlog, driven by strong bookings, grew 20% year-over-year. Our major geographic regions each grew bookings at double-digit rates year-over-year. Our Application Development-related and other emerging technologies subscription revenues grew more than 30% year-over-year. And our services revenue, led by demand for OpenShift and Ansible consulting and training, grew 19% year-over-year in constant currency.

Now let me give you some business metrics and highlights that demonstrate our continued traction with our customers and partners. Looking at our deals over $1 million this quarter, we closed a total of 73 deals over $1 million, up approximately 11% year-over-year. Within these deals, 11 were greater than $5 million, which is a record in a Q2 for us, and 1 deal was greater than $10 million. Cross-selling was strong in this cohort, over 76% of the top deals greater than $1 million including 1 or more components of our Application Development-related and emerging technologies offerings. One of the deals over $5 million was the largest services deal we have ever closed in a quarter. This deal is with a global bank that is digitally transforming their payments business based on our integration middleware. Other top industry verticals within the deals greater than $1 million were financial services and the government sector.

Looking at our top deals. 24 out of our top 25 deals that were up for renewal did so at an aggregate value of more than 100% of their previous value. The one deal that did not renew is a rare competitive loss to a legacy on-premise provider based on pricing. We're actively pursuing future business with this customer as they evaluate additional technologies such as adopting OpenShift as a multi-cloud platform for the digital transformation of their business. Removing the one lost deal and using the next largest deal that did renew, the adjusted top 25 deals for the quarter would have renewed at an aggregate value of approximately 115% of their previous value.

Looking more broadly across our customer base at 2 of our fastest growing technologies, OpenShift and Ansible, let me provide you with some recent achievements that demonstrate the momentum we're seeing with our customers and partners. Last week, we announced a multi-partner relationship with Hortonworks and IBM Cloud Private to bring their big data and analytics products onto OpenShift. This is designed to enable customers to develop and run data-intensive applications on OpenShift, bringing them the power of hybrid cloud. Our Ansible technology reached approximately 2 million managed nodes at the end of Q2, essentially doubling the number of managed nodes since Q4 of last year. Overall, both of these technologies added nearly 100 new customers each since Q1, and we continue to grow the median revenue per customer.

In summary, we continue to drive significant adoption of our hybrid cloud technologies even as we worked through the headwinds in middleware and our renewal base that we view and have previously disclosed -- or discussed. We remain confident in our long-term competitive position and our proven ability to become increasingly strategic with our customers as evidenced by our growth over the past several quarters with large customer engagements and momentum with our partners.

I want to thank Red Hat associates for their tireless efforts in serving our customers. From building innovative solutions to delivering and supporting these technologies, we continue to stay focused on the success of our customers and delivering value every day.

With that, let me turn the call over to Eric.

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Eric R. Shander, Red Hat, Inc. - Executive VP & CFO [4]

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Thank you, Jim. Let me also recognize and thank our global associates for their continued commitment to helping our customers succeed. Red Hat's ability to deliver business value has been a key driver to building a multi-billion-dollar business, and the strength of our strategic customer relationships is one of the reasons we believe we are well positioned for the long term. Our performance this quarter was driven by the demand for our hybrid cloud technologies, which enabled us to deliver results that were in line with our guidance.

As a result of our performance to date and the outlook for the remainder of the year, we are reaffirming our full year revenue growth in constant currency at 16% to 17%, along with our full year non-GAAP operating margin and cash flow. However, in U.S. dollars, we are lowering the full year revenue range by approximately $15 million to account solely for the change in FX rates, as the trend of weaker rates against the dollar for many of the major foreign currencies has continued to decline in recent months.

For instance, Q2 total revenue would have been nearly $3 million higher using the FX rates from my June guidance. As such, for this call, I will discuss our results in both USD and constant currency to provide a full view of the impacts of foreign currency on our results. A more detailed view of our results and reconciliations of our -- for our non-GAAP measures to GAAP is included in our earnings press release.

I will now review our Q2 performance and business metrics before finishing with our outlook for Q3 and the rest of FY '19. In the second quarter, we delivered $823 million of total revenue, which was in line with guidance and represented growth of 14% in both USD and constant currency. As I mentioned earlier, this result of USD included a foreign exchange headwind of approximately $3 million from the rates used for guidance in June.

Subscription revenue, which is mainly renewable, made up 88% of total revenue in Q2 and grew 13% in USD or 14% in constant currency. Subscription revenue for our infrastructure-related offerings was $527 million, an increase of 8% year-over-year in both USD and constant currency. This result was impacted by the lower available renewal base, which is largely RHEL and the lower renewal value that Jim discussed in our top 25 renewals metric. Year-to-date, our infrastructure-related offerings are up 11% in USD and 10% in constant currency.

Subscription revenue for our Application Development-related and other emerging technology offerings was $196 million, an increase of 31% year-over-year in both USD and constant currency. Within this portfolio, we continue to drive rapid growth in our emerging technologies, particularly in Ansible and OpenShift. As we discussed in the past, this growth has become somewhat offset by the moderation we are experiencing in our middleware offerings. We continue to believe that as customers shift their workloads to container environments, our middleware results and subscription revenue will benefit in the long run. Overall, Application Development-related and emerging technologies revenue represented approximately 24% of total revenue, up 300 basis points from the year-ago quarter.

Lastly, our services revenue of $100 million grew 17% year-over-year in USD or 19% in constant currency. The strong growth of our services business was driven by demand for training and consulting projects for our Ansible and OpenShift offerings. As I have mentioned before, our services business is both a leading and lagging indicator for the demand around our emerging products. We have seen that customers who buy both services and subscriptions tend to have higher retention, which can lead to future opportunities and additional technology sales.

Before we move to our non-GAAP operating income results, as a reminder, our non-GAAP operating income adjusts for noncash share-based compensation expenses, amortization of intangible assets and transaction costs related to business combinations. Non-GAAP EPS adjusts for all these items as well as noncash interest expense related to the debt discount.

On a non-GAAP basis, our Q2 operating income of $197 million grew 3% year-over-year with a non-GAAP operating margin of 23.9%. This quarterly result was 90 basis points higher than my June guidance and reflects some repositioning of hiring and marketing programs to the second half of the fiscal year. Net other income was $4 million and in line with guidance.

Shifting to taxes and EPS, our non-GAAP effective tax rate was 22.3% for the quarter, which includes discrete tax benefits and the impact from certain nondeductible share-based compensation expense. This resulted in non-GAAP EPS of $0.85, up 10% year-over-year and above my guidance as a result of the higher non-GAAP operating margin.

Turning to the balance sheet. Our total deferred revenue at quarter end was $2.4 billion, an increase of $341 million, representing growth of 17% in USD or 19% in constant currency over the same quarter a year ago. Our cash and investments at the end of the quarter was approximately $2.2 billion after repurchasing approximately $250 million or 1.7 million shares under our new share repurchase authorization, which has a remaining balance of approximately $750 million. In addition, we had approximately $245 million of total cash outflows related to repayment of convertible notes.

Moving to operating cash flow. With the adoption of accounting standard ASU 2016-15: Statement of Cash Flows, which requires us to classify the portion of the repayment of convertible notes attributable to debt discount as an operating cash flow as opposed to financing cash outflow. In an effort to appropriately reflect the cash generated from the operations of the business and for comparability of prior periods, we will provide both a GAAP and non-GAAP operating cash flow metric.

Our GAAP operating cash flow, inclusive of the $32 million of repayments for the convertible notes attributable to the debt discount, was $133 million, down 7% year-over-year. The non-GAAP operating cash flow was $165 million, an increase of 16% year-over-year.

Our FX-adjusted DSO was 61 days, up 5 days from Q2 of last year, driven by business linearity. The rolling 4 quarters billings proxy was $884 million, up 19% year-over-year. As a reminder, the rolling 4 quarters billings proxy is calculated by adding revenue plus the change in deferred revenue on the cash flow statement for the last 4 quarters.

Now I will discuss our total backlog for Q2, which includes billed contracts from the balance sheet, the new ASC 606 performance obligation disclosures, and our backlog for time and materials service bookings. Total backlog was up 20% year-over-year in Q2 for an estimated balance of $3.3 billion in USD. Our backlog in the quarter was the result of our bookings performance with all of our regions at double-digit growth year-over-year. As for the regional mix in the second quarter, 54% of our bookings came from the Americas, 26% from EMEA and 20% from Asia Pacific. The second quarter route-to-market mix was 77% from the channel and 23% from our direct sales force compared to second quarter prior year's split of 79% and 21%.

Our proxy for bookings duration was approximately 22 months, up nearly 1 month from Q2 last year. We attribute this to some customers choosing to extend their commitment to Red Hat with a longer-term strategic partnership.

Now I'd like to turn to guidance. Our outlook assumes current business conditions and foreign exchange rates, which have generally continued to weaken against the dollar year-over-year.

I will begin with our full year guidance, which assumes an incremental FX headwind to revenue of $15 million as compared to our prior guidance. As a result, we are adjusting our total revenue guidance in USD to $3.360 billion to $3.395 billion or a year-over-year growth range of 15% to 16% in U.S. dollars. In constant currency, we are reaffirming the year-over-year growth range of 16% to 17%.

From a profitability perspective, we are reconfirming our full year non-GAAP operating margin of 23.9%, which includes the necessary investments to drive future growth. We are planning an annual non-GAAP effective tax rate of 22.5% for FY '19 prior to discrete items and our full year non-GAAP earnings per share to be approximately $3.45 to $3.49 per share. This assumes approximately $4 million per quarter for net other income and approximately 184 million diluted shares, which is lower due to share repurchases.

Due to the difficulty of predicting the timing and amount of any future convertible note settlements, our guidance will now be on the non-GAAP operating cash flow for FY '19. Excluding the repayments of convertible notes that are attributable to the debt discount, our outlook remains unchanged for the full year. Non-GAAP operating cash flow is expected to be in a range of approximately $1.035 billion to $1.045 billion, which includes an incremental $10 million in tax payments.

For Q3, we offer the following outlook. We expect revenue to be in the range of $848 million to $856 million, which is up approximately 13% to 14% in USD and 15% to 16% in constant currency. We expect non-GAAP operating margin of approximately 24%.

We expect non-GAAP earnings per share of $0.87 with a 22.5% tax rate prior to discrete items. This assumes approximately $4 million in Q3 for net other income and 184 million diluted shares. We will continue our practice of not providing quarterly cash flow guidance, but please note that it can be variable depending upon individual payments or collections.

Looking forward, we remain excited that Red Hat is increasingly viewed as a top strategic IT partner to the world's leading companies as they execute on their digital transformation and hybrid cloud initiatives, and we remain committed to our customers' success. David, at this point, please open up the call for questions.

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Questions and Answers

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Operator [1]

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(Operator Instructions) We will take our first question from Walter Pritchard with Citi.

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Walter H Pritchard, Citigroup Inc, Research Division - MD and U.S. Software Analyst [2]

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A question for Eric, maybe a two-parter. But just on the RHEL growth or the infrastructure growth at 8%, you talked about renewals driving that softness in revenue. I guess, we haven't seen in the past the renewal business drive such deceleration in RHEL. Could you help us understand what's going on this year versus when you've had that dynamic in the past? And then should we expect that business -- it sounds like if it's a renewal thing, as you get through the renewals, that would reaccelerate. Can you help us understand the timing of that reacceleration?

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Eric R. Shander, Red Hat, Inc. - Executive VP & CFO [3]

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Yes. Sure, Walter. So there's actually a couple of components that are impacting the RHEL revenue growth. So certainly, the lower renewal base is -- has impacted that because majority of our renewals are RHEL -- have a significant amount of RHEL content. The other thing is, as Jim had mentioned, we did have this larger competitive loss within the quarter, which impacted -- which did have an impact, as well as we also had a project descope from the army that impacted the growth in RHEL as well. So we had a couple of components other than just the lower renewal base. In terms of right now the way that we are looking at the bookings and the momentum we've seen in the field and the pipeline, we do believe that we've bottomed out in terms of the RHEL growth slowing down. And it's our expectation from here through the second half of the year and into next year that we will see a reacceleration of the growth rate.

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Operator [4]

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We'll take our next question from Karl Keirstead with Deutsche Bank.

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Karl Emil Keirstead, Deutsche Bank AG, Research Division - Director and Senior Equity Research Analyst [5]

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Maybe this question is for Eric. Eric, even though you don't disclose your middleware business, you've spoken in the past about this piece of the Red Hat revenue mix growing in the 9% to 10% ZIP code in fiscal '19. Given the quarter you just put up, is that still your expectation for the middleware growth rate this year?

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Eric R. Shander, Red Hat, Inc. - Executive VP & CFO [6]

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Sure. Sure, Karl. Yes. So we did -- what we've been saying is that we expect the middleware growth to moderate close to where the industry is, anywhere from the 8% to 10% range. We did see that this quarter, and we certainly expect that as we go into the second half of the year. So we -- nothing has changed in terms of the growth rate from a middleware perspective.

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Operator [7]

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We'll take our next question from Zane Chrane with Bernstein Research.

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Zane Brandon Chrane, Sanford C. Bernstein & Co., LLC., Research Division - Senior Analyst [8]

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It's a question for Eric or, I guess, Jim, either one. When we look at the growth in RHEL, how much of the growth is driven by new customer adoption versus expansion inside your existing base? And then when it is new customers, where are they choosing to deploy that in terms of on-premise versus public cloud deployments?

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Eric R. Shander, Red Hat, Inc. - Executive VP & CFO [9]

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Yes. So I mean, Zane, I'll start that and then certainly have Jane -- or have Jim add a little bit more color to it. So certainly for new customers, we are seeing both on-premise and in the cloud. Most of those typically start on-premise. For existing customers, we're still seeing expansion as our customers' IT footprints are continuing to expand. And I've shown several of these examples during our previous Analyst Days of not only do we see customers embracing in and adopting the emerging technologies, but a lot of that also has a pull-through effect in terms of the RHEL requirements as well. So...

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James M. Whitehurst, Red Hat, Inc. - President, CEO & Director [10]

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Yes. I mean, just to add to that. So yes, we haven't actually looked at it quite like a number that way. The only reason I say that is because the cloud revenue was immediate revenue, and obviously, our normal subscription business is lumpier when we do either 1- or 3-year deals. I think a lot of our new, smaller customers are coming in via cloud. We have some really nice growth there. It's still growing at more than twice the growth rate of the company. So yes -- and a lot of that, we believe, is new business. The core business, customers are continuing to renew, we give you those numbers. The odd part, again, just to remind everyone, we started about 2.5 years ago focusing on trying to do multi-year deals to try to basically kind of get our customers kind of into multi-year engagements, so our sales force could focus on net new. Well, obviously, 3 years -- 2.5 years into that, yes, we've done our best to get people in 3-year deals. So our renewal base is quite small relative to where it's been in the past. And it's at renewal when we typically take up the size of those relationships. So fewer renewals means less takeup in these last couple of quarters. But again, I mean we're seeing it from both. We still see a lot of growth with our existing customers. And as we talked about in the past, customers who are adopting cloud tend to grow their RHEL footprints faster than those who aren't.

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Zane Brandon Chrane, Sanford C. Bernstein & Co., LLC., Research Division - Senior Analyst [11]

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Got it. Actually, a quick follow-up. How should...

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Operator [12]

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We will take our next question from Kirk Materne with Evercore ISI.

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Stewart Kirk Materne, Evercore ISI Institutional Equities, Research Division - Senior MD [13]

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I guess, Jim, can you just talk about -- this year, obviously, you knew coming in the year that you're going to have sort of smaller renewal portfolio to build off of. So can you just talk about the net new business growth that you've seen? Because the billings this quarter obviously looked pretty good. And specifically within the emerging products segment, given the drag on JBoss, one can infer that things with -- that OpenShift, Ansible might actually be going better than you might have expected at the beginning of the year. So I'm just curious if you kind of come on net new business momentum and then some of the smaller products like OpenShift, Ansible relative to your expectations.

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James M. Whitehurst, Red Hat, Inc. - President, CEO & Director [14]

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Yes. I mean, you've hit on a good point there. I mean, if you look overall, given the overall backlog growth and the fact that we didn't have as great a renewal is that we're seeing some really good traction with new products to deliver what we delivered. And a lot of that is the new products, like we're seeing -- really, really pleased with OpenShift and with Ansible. We talked about adding -- we don't break those numbers out, but adding over 100 customers each in the quarter is pretty significant and shows the size of that momentum. We didn't give a lot of stats on OpenStack, but it continued to grow nicely as well. So across all 3 of those, we're seeing some really nice growth and really, really good traction. Yes. I had a plan where we're expecting to be, yes.

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Eric R. Shander, Red Hat, Inc. - Executive VP & CFO [15]

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Yes. And Kirk, it's Eric, just some additional color around the size of the deals and the traction. So in Q1, we articulated just the deals between $250,000 and $1 million that was growing over 130%. This quarter, the number of deals between $250,000 and $1 million grew at over 120%. So as you can see, we're still seeing a lot of momentum in the mid-section of the deals and the size of those deals. So we do expect, as we've been saying, that a lot of these deals will start smaller, and it will certainly take a couple of years to cultivate them into larger, strategic enterprise customers. But that absolutely is the strategy that we're on.

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Operator [16]

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Next question is from Michael Turits with Raymond James.

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Robert S. Majek, Raymond James & Associates, Inc., Research Division - Senior Research Associate [17]

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This is actually Robert Majek on for Michael. Jim, can you just talk about any changes that you're seeing in the competitive environment when it comes to RHEL cloud deployments, especially against competitors like Amazon Linux?

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James M. Whitehurst, Red Hat, Inc. - President, CEO & Director [18]

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I don't think we've seen anything new there. I think we're -- the cloud business is growing very nicely, and if you look kind of cloud by cloud, our growth rate's pretty consistent with the growth rates of the cloud. And so that, to me, says that we are maintaining share or in some of them, we're growing faster. So we're either maintaining or growing share across the major clouds. So to me, that's a good sign, and that's on the CCSP piece. And one of the other pieces that we've seen as well is we've had some very large CCSP customers, who have rolled out of CCSP and done subscription agreements with Red Hat because they want to have a direct relationship. So that's the direction we like to see things move. So we feel really good overall and we watch that carefully. But I don't see -- again, if I look at our growth rates cloud by cloud versus the clouds' growth rates, we feel pretty good that we're certainly maintaining or growing share.

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Operator [19]

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Our next question comes from Raimo Lenschow with Barclays.

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Raimo Lenschow, Barclays Bank PLC, Research Division - MD & Analyst [20]

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Eric, quick question for me. Like, if you look at the slightly better leverage this quarter, you talked about hiring some initiatives getting pushed out in the second half. Could you double click on that a little bit? Was that kind of you managing the business as you know, -- as you knew what your revenue was during this quarter? Or what were the drivers there?

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Eric R. Shander, Red Hat, Inc. - Executive VP & CFO [21]

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Yes. Thanks, Raimo. So there was a bit of -- certainly, as you go through the quarter and as we talked about this one competitive loss, it was not lost until the very end of the quarter. So we were certainly fighting to keep this until the end of the quarter. However, having said that, as you can imagine, as we look at some of the other trends in the business, we did a slight pullback in certain areas, certainly not in our sales area because that's a key area of investment and continued investment. So there was a little bit of cost management as we went through the quarter. Essentially, as you think about the guide for the rest of the year, I expect the margin essentially to be flat as we go into Q3. And then it will pop up into Q4 because some of the marketing spend that we have will be actually done in Q3 versus Q4. So we're going to continue to actively manage the cost side. But at the same time too, I just want to emphasize that we are continuing to be very, very mindful about making the appropriate investments into our more strategic areas. So a lot of those investments come, as we get efficiencies and productivities, in other spaces and -- within the company. So we absolutely will continue to invest in the strategic areas as we go through this year and certainly into next year. But we are taking a very active position, I am certainly, in terms of how we're managing the cost.

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Operator [22]

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Our next question is from Kash Rangan with Bank of America.

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Kasthuri Gopalan Rangan, BofA Merrill Lynch, Research Division - MD and Head of Software [23]

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I'm just curious to get your -- get a little bit more perspective on the renewal base you talked about with respect to the deceleration of the RHEL business. I know you're certainly pointing to that business reaccelerating. Typically, when we look at Q1 to Q2, there's been a nice sequential growth in the RHEL business. This time, it seemed -- the magnitude of that slowdown seemed to be a little surprising. So if you can just drill into that a little bit and also help us understand what is happening on the really emerging technology side of the middleware component, the PaaS side. A little bit more color there, that would be useful.

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Eric R. Shander, Red Hat, Inc. - Executive VP & CFO [24]

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Yes. So thanks, Kash. I'll start, and then Jim can give a little more color on the business side of it. But just as a reminder, Q1, our billings, we were at 9%. So what you're really seeing from a revenue perspective, that really flowed through, so that did have an impact to RHEL. So -- and then obviously, this quarter, as we looked at the bookings and the billings, the renewal base continued to be a bit of a headwind as well as just reemphasizing both this project descope that was out of our control that was specific to the army as well as this one loss -- this one competitive loss. They did also both have a fair amount of content of RHEL. So all of these impacted us in the current quarter, which, again, gives us confidence that, as we look at the pipeline, as we look at -- we go into second half, we do see a reacceleration of the growth.

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James M. Whitehurst, Red Hat, Inc. - President, CEO & Director [25]

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Yes. I mean, Kash, just a little bit on PaaS, and what I would also say, I mean, obviously, the vast majority of our revenue is baked when we come into a quarter. So coming out of Q1, where we were light on where we wanted to be on billings and backlog, kind of rolled through this -- obviously, we had a lot stronger quarter this quarter in growth there. And so we have some better visibility looking forward into RHEL. And so we do think this is kind of the bottom there. Related to PaaS, we're seeing great traction. I mean, we have over 100 new customers for OpenShift. Not only is it customers. It's also partners. And so unlike some other software companies that will pay tens of millions of dollars to enable SIs, we focus on bottom-up demand generation. And so we've gotten really good bottom-up support for OpenShift. And now the large global system integrators are all building practices around OpenShift, and I think that also leads to incremental traction. I think the Microsoft deal, which we announced -- the relationship that we announced back at Summit, is -- has raised awareness and has helped as well. So I was in Europe last week, and I think out of the maybe 30 or so customer meetings I had, 20 something of them were about OpenShift in particular. It really is a topic that people want to understand and figure out how to do in containers. I will say just editorial comment. I also think one of the things that has slowed RHEL growth a bit is customers want to talk about containers, and we need to continue to talk about RHEL is part of that portfolio. And I do think shiny object syndrome gets us all, me included, where we're talking about OpenShift and Ansible because there is so much traction around them. But overall, I've -- hard to find a customer that's not looking at or starting to use OpenShift in some way, which is great to see.

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Operator [26]

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Our next question is from Matt Hedberg with RBC Capital Markets.

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Daniel Robert Bergstrom, RBC Capital Markets, LLC, Research Division - Analyst [27]

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It's Dan Bergstrom for Matt Hedberg. Jim, maybe could you update us on overall spending environment? Any changes in customer buying behavior into the back half?

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James M. Whitehurst, Red Hat, Inc. - President, CEO & Director [28]

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No. I mean, customers seem to still feel good about the economy and where it's going. I think the concern about a trade war with China is spooking some people. But at this point, I wouldn't say I've seen that ripple all the way through into spending. So still feels pretty good. Our Q2, because it ends in August and there are a lot of vacations, et cetera, I would say I have typically less senior-level discussions in a Q2 than I would have in a Q1 or Q3. So I don't want to overstate my confidence in saying that in the sense that, again, having talked to as many CEOs about their overall thoughts there. So again, it still feels robust. But again, a little bit of that's -- I don't want to overstate kind of given that's a Q2 and ending in August and kind of less time directly out there with customers that I typically have.

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Operator [29]

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Our next question is from Heather Bellini with Goldman Sachs.

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Heather Anne Bellini, Goldman Sachs Group Inc., Research Division - MD & Analyst [30]

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I had a question about your comments about RHEL growth rate. So it went from 11% constant currency last quarter to 8% this quarter. You're talking about a reacceleration. But I think the big question is, is -- does that -- is that reacceleration you're expecting, that's a 10% as we normalize the renewal base that you're talking about? Or is this going to go back to what you used to say, which was low -- kind of the low teens growth rate? Because I'm just trying to get a sense for when you're talking about reacceleration off of what is a very low base.

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James M. Whitehurst, Red Hat, Inc. - President, CEO & Director [31]

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Yes. Heather, I'll start on that. I think we'll see, as we get into next year, bluntly, the -- yes. I do think we'll see it reaccelerate through this year. Exactly where that ends up, hard to exactly say. As we get into next year, we have a much larger renewal base. And since OpenShift's continuing its momentum, which I hope it does, I would say it can easily accelerate quite a bit. But we are running into a little bit of a sales capacity issue. And so the better OpenShift does and the more time we're spending on that, the less time we're selling RHEL. So the demand's clearly there. The market's clearly there. And so given the size of the renewal base, I think it'll expand more than that, but I want to be a little bit guarded just as people are -- there's just so much momentum around OpenShift right now that it does kind of eat into selling time on RHEL. So clearly, the -- if you look at the overall trends on the move of workloads from Windows to Linux and the overall growth of workloads, certainly feel like it should reaccelerate above well above 10% and back into the teens. But again, our other products can, at times, kind of start to push that out a little bit, which is I think part of the dynamic that we've seen with the strength at OpenShift affecting RHEL a bit. Now that's a long answer, but we feel really good about the macro trends around Linux. And it's just about ability of us to have the bandwidth to pick it all up.

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Eric R. Shander, Red Hat, Inc. - Executive VP & CFO [32]

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Yes. And just as a reminder, and we continue to always say this, but Linux is containers. So even as Jim is articulating the fact that customers are starting to purchase OpenShift, right, Linux -- RHEL is embedded into that. We certainly don't break it out, but we don't necessarily view it as a bad thing as OpenShift is continuing to gain momentum and gain traction because by default, they are using RHEL in that product. So just -- we'll just reiterate what we've been saying. That's a good thing.

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James M. Whitehurst, Red Hat, Inc. - President, CEO & Director [33]

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Right. It is a different way to deliver the operating system. It's not like OpenShift runs on top of RHEL. OpenShift is RHEL.

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Eric R. Shander, Red Hat, Inc. - Executive VP & CFO [34]

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Correct.

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James M. Whitehurst, Red Hat, Inc. - President, CEO & Director [35]

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And so that growth is also a good thing. And so how that mix works depends on the relative adoption rate of containers.

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Operator [36]

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Our next question comes from Keith Weiss with Morgan Stanley.

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Sanjit Kumar Singh, Morgan Stanley, Research Division - VP [37]

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This is Sanjit Singh for Keith. I had 2 small ones if I might. First on the 5G cycle, can you give us an update on how you feel the OpenStack portfolio is positioned for the coming 5G cycle? And any sense on timing on where you might start to see large deals come through? That would be helpful. And then secondly on JBoss and the middleware portfolio, there's a lot of elements within the middleware portfolio. Is the weakness that you're seeing particularly on the application server side? And would you expect the integration of pieces like Fuse to actually see potentially more demand as we -- as customers move to things like OpenShift and next-generation application architectures?

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James M. Whitehurst, Red Hat, Inc. - President, CEO & Director [38]

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Yes. So a couple of things there. In terms of the 5G cycle, I'm not an expert in telco, so I don't want to kind of overstate that. We have a lot of work going on with the major telcos around it. So I think OpenStack is very well positioned there. I've also been -- amazed is probably the wrong word but really surprised at the amount of traction we're having around containers with those telcos as well. So it's not just a matter of the infrastructure. It is the application platform at the edge. If you have a 5G network, you kind of need applications at the edge. That's the differentiator that telcos have. So we have a significant amount of engineering effort working with the telcos on OpenShift as well. The timing of that, again, those deals continue to grow. We had 14 deals with OpenStack over $1 million, which is up nicely from last year. Not all of those are in telco, though we did have some sizable telco wins. And we have, I think, 4 significant NFV wins with telcos in the quarter. I -- again, how fast those things scale, I'll leave that up to the experts to talk about, but we feel really good about where that is. Is there a second part?

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Tom McCallum, Red Hat, Inc. - VP of IR [39]

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Yes. There was a JBoss question, how...

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James M. Whitehurst, Red Hat, Inc. - President, CEO & Director [40]

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Oh, yes. JBoss, I mean, yes, absolutely. This is primarily an EAP-related thing. The other products sit nicely on top of OpenShift. And so as OpenShift grows, that increases the market for those. Just -- we mentioned the over $5 million services deal that is a ramp for a bank around our integration products. That includes very little of the integration products until -- that's up and running. But that's a good example of a bank that's also a big OpenShift user now looking to do some significant work with this on the integration side. So yes, this is primarily around EAP that we're seeing the moderation affecting the overall app dev and emerging growth.

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Operator [41]

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Our next question is from Mark Murphy with JPMorgan.

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Mark Ronald Murphy, JP Morgan Chase & Co, Research Division - MD [42]

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I'm curious at what point do you think the tide would begin to turn on the renewal cycle. I know you mentioned next year it's in better shape. But if we were to try to circle a quarter in our models where the renewal cycle would begin to switch from a headwind to a tailwind, I guess, I'm wondering next May, next August, if you can help us with that. And then also the -- I think you said the competitive loss did not happen until quarter end, but I believe you said it impacted the RHEL growth of 8%. And I guess, I don't understand, if there was daily ratable rev rec and it continued there until quarter end, I guess, I'm not understanding then how that impacted the revenue growth. If you could just clarify that.

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James M. Whitehurst, Red Hat, Inc. - President, CEO & Director [43]

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Yes. I'll start with the second one. So typically, in these large deals, there's been some degree of over deployment, so there's always some true-up revenue that's in there. And so they're -- and those can actually be more material than you realize. And so I -- because we lost it, I didn't get into the detailed details of the flows around that, but there was a -- across the portfolio, a couple million dollar -- several million-dollar impact across that. So it was fairly significant in terms of overall revenue. How much of that was around true up versus the last day was at -- at the end of the quarter. Eric, you may have those details.

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Eric R. Shander, Red Hat, Inc. - Executive VP & CFO [44]

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Yes. I mean, it was -- yes. There was -- I mean, Mark, a lot of it really had to do with the revenue true up. So during this period, the customer was in the process of phasing out their activities, and they were in the process of making some decisions. So had they made the decision to stay with us, there would have certainly been a retroactive adjustment in terms of the revenue and us trueing that up. But that was not the case in this situation. So unfortunately, it was this competitive loss to a legacy on-prem provider and certainly was unfortunate. But as Jim said, we're already working some new leads with this customer. But it really had to do with just the way the revenue would have been trued up.

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Tom McCallum, Red Hat, Inc. - VP of IR [45]

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The second part was on the -- when the tide would turn on the number of renewals next year -- quarter.

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Eric R. Shander, Red Hat, Inc. - Executive VP & CFO [46]

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Yes. So Mark, as we're looking at it, I would tell you the latter part of the first quarter, certainly as we get into the second quarter, you'll start to see the renewals pick up. Now I say that, and as I've mentioned previously, one of the things that makes the renewals analysis challenging for all of us is that assumes that customers don't come to us and decide that they want to co-term something early. So certainly, if we have a customer that comes in the second half of this year where they have something that's going to renew next year, but if they come to us and say, gee, we'd like to do a bigger engagement and we like to infuse some OpenShift or OpenStack, et cetera, we absolutely will do that deal. And that will throw some of this off, and there's a fair amount of that as it happens. Certainly, the one thing we're not going to do is pull in deals ourselves. But if a customer has a business need and they want to expand their scope with us, we absolutely will entertain those. So barring any big co-terms happening in the second half of this year, I would say, in your models, I would assume the latter part of Q1 and then really as you get into Q2 onwards is when you'll see it pick back up.

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Operator [47]

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The next question's from Alex Zukin with Piper Jaffray.

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Taylor John Reiners, Piper Jaffray Companies, Research Division - Research Analyst [48]

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This is Taylor Reiners on for Alex. Just wondering, when we think about the renewal base in the back half, I was wondering on what are your thoughts around the cross-selling opportunities that are being impacted. And as your renewal base starts to normalize, how are you handicapping the opportunity for maybe reacceleration around your emerging offerings just given the larger renewal base to sell into?

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James M. Whitehurst, Red Hat, Inc. - President, CEO & Director [49]

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It's a mixed bag. The reason I -- I mean, it's -- we really like the renewal because that's the time to cross sell and upsell, which is really, really nice. But some of the time on that deal is spent on the renewal of the components around it, where the reason we originally started 2.5 years ago trying to get people in these 3-year deals is it frees up more time to go sell net new. Now the net new may not be as efficient to sell and it may be shorter like 1-year deals, but it does -- it kind of creates more kind of clarity and focus in our go-to-market organization. So hard to say which of those actually kind of weighs out in terms of the emerging. I would say on [balance perhaps] the team, they're going to say attach and growing cross-sell, upsell around the renewal is the more efficient way to see that grow. But again, it is more sales time spent on that renewal as well than on the new business. So there might be a little bit of an impact there in terms of accelerating the other associated with it. But the big impact is those renewals just typically grow and we've given you the data on that. So bigger renewal base does a lot to especially help RHEL growth.

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Eric R. Shander, Red Hat, Inc. - Executive VP & CFO [50]

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Yes. I mean, we did have -- and it was certainly in our prepared remarks. Q2 was over 76% cross-selling, which certainly demonstrates that. But just as a reminder, as we've said, as we're going into this next tranche of smaller customers, and they're not necessarily small customers but customers that are spending smaller amounts with us, those will typically start out as a RHEL customer. And then as we continue to work with them, start expanding beyond that. So beyond the existing renewal base that we have, part of what we're doing very intentionality is going to that next tier of customers to be able to get certainly and grow an additional set of enterprise customers as we go forward. So some of this is going to be layering it on. But I think, as Jim said, I mean, I think there is nice cross-selling opportunities across the board with the existing renewal base that we have.

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Operator [51]

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We'll take our next question from Keith Bachman with BMO.

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Keith Frances Bachman, BMO Capital Markets Equity Research - MD & Senior Research Analyst [52]

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I wanted to dig down a little bit more on JBoss. You've mentioned that you see improved renewal cycle for RHEL. And I'm just wondering your thoughts on JBoss as we look out into '19. And part of the context of the question is you mentioned last quarter that some of your competitors were very aggressive on pricing. So do you think JBoss flattens out next year, improves? Or could there be more competitive pressure? And then the follow-up question on RHEL, you mentioned you had a loss. And implicit in your discussion tonight is that you feel really good about RHEL's opportunities, but the loss was based on, I think, an on-premise deal to pricing. What makes you convinced that there won't be some more very aggressive pricing by some of your competitors who try to maintain their legacy base? That's it for me.

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James M. Whitehurst, Red Hat, Inc. - President, CEO & Director [53]

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Yes. Well, I'll start with the second, and then I'll go to the first. Look, over the last 3 years, we talked about the top 25 renewals of the -- each quarter, and that's 300 deals. We've only now lost 2. And the one that we lost, we did an even bigger middleware deal with after. When we've lost people in the past, we have typically won them back. It sounds logical to say, "Oh, I can get a cheaper price for my Linux." But what production customers find is they don't get that quality of software and certainly not support that they get from us. And so honestly, I don't mind losing one every now and then. If we win them all, then we're probably underpricing. And we have a really good track record of winning them back after they've had a chance to experience the other. And so given that and how rare the losses are and how often the losses have come back and even become reference customers for us, we always want to take competitors seriously. But in terms of over looking at this one deal, I wouldn't kind of overly focus on that relative to our long-term history of competing with others. In terms of middleware, I think you hit on a good point. In the same way that we did multi-year deals on RHEL, a lot of those deals and stand-alone JBoss deals were multi-year deals 3 years ago as well. And so there's a lot of renewal on JBoss coming up next year as well. And so again, that's -- that'll be a good opportunity for us to continue to expand those.

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Operator [54]

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Our next question is from John DiFucci with Jefferies.

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John Stephen DiFucci, Jefferies LLC, Research Division - Equity Analyst [55]

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My question's for Jim. Jim, Red Hat's done a really impressive job over the years, and I've questioned you a lot. But you've really done it, and you dominate the paid Linux market. And more recently, you moved aggressively into new growth markets, and you've currently become very relative in those markets. You've been leading them. But -- and this is to ask in a respectful manner. It's really usually not a good sign when a growth business starts to talk about the effects of renewal cycles, the reasons of moderating growth. And I'm just -- I think a lot of us are just wondering, is there something else happening here in the Linux business? And I don't know. I don't know what it could be. Like there's -- people have feared at times that people are going to start in the public cloud, start to use sort of the "free" versions or unpaid Linux and -- is there a saturation on-premise? Is there anything else happening here? Or is it really -- or is it just sort of a renewal cycle?

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James M. Whitehurst, Red Hat, Inc. - President, CEO & Director [56]

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Yes. John, well, first off, thanks for the compliments. I was beginning to think that somebody was impersonating you. I appreciate that. But no, seriously, on the renewal cycle, the reason you're hearing us talk about it is we have always talked about how we get into a customer, and our business grows with them. And that almost always that growth happens when we step up at renewal time. And for a long time, we were more focused on doing 1-year deals than doing multi-year deals. And so every year, each of those deals would ratchet up. Well -- and I still think it's the right decision, 2.5 years ago, we decided to focus more on doing multi-year deals, so we could get the customers locked into a set of technologies on which we could then go work to upsell, which we do. But the problem with that is after you've been doing that for 2.5 years, you've drained a lot of the swamp of potential renewal, which means a deal we did making it up last year that had 20% growth, well, that growth rolling through revenue this year is 0. And the deal we did 2 years ago that had 20-something percent growth in it is rolling through revenue flat this year. And we just don't have as many renewals because these are the people we couldn't get in 3-year deals in the last 2 years that are up now. And so yes, we see good growth, and we talked about, since that one competitive loss, we still see solid upsell and cross-sell in our renewals when they come up. But the renewal is typically the precipitating event to do the upsell and cross-sell. And while certainly that's not always the case, we have people in multi-year deals. We have multiple other deals with them. But the renewal is that precipitating event, and we just -- it's a lot lower, which if you actually ask our sales teams the amount of net new growth that they have to get this year, they're seeing growth numbers 30%, 40%, 50% depending on the region, which given -- I don't want to say renewals are automatic. Obviously, we have a very high renewal rate. That amount of new business that they're seeing is like dramatically higher in terms of the new business that they have to go get and are going and getting than you're seeing in our revenue or even our bookings numbers because of just the kind of the relatively lower renewal rate. So that's why you hear us talking about. It's not that we're "milking" the renewal. It's just we don't have the precipitating events as often as we typically do. And again, that starts to come back next year because we get into the steady state of the -- from 3 years ago, those renewals coming back around. I don't think there's a change in focus on what we're doing. It's just the sheer math of how much business we have that we can cross sell and upsell on.

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Eric R. Shander, Red Hat, Inc. - Executive VP & CFO [57]

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Yes. I mean, John, it's Eric. I think just in addition to what Jim said, I mean, if you think about it, when we're out with customers, it's a natural progression, if they're already using RHEL, to then start to talk about using OpenShift, using OpenStack, et cetera, because that technology shift makes it a whole lot easier. So as Jim said, we're not giving -- we don't want to give the impression that we have a certain set of customers that we're just relying on those renewals. We've got thousands of customers, right? And if you think about most of the customer engagements that we have, even looking at the CCSP program, our online program, we're harvesting those opportunities for future growth opportunities. So it starts with when a customer's already using RHEL, from a technology perspective, it's a whole lot easier for conversations since they're already using our OS to then start using OpenShift, especially if they're going to start containerizing their applications. So it really is more of a technology discussion and why it makes sense. So it's not just the fact that we're going back to the same customers, but it really is, as Jim said, a business event that makes it much easier for them to leverage the newer technology.

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James M. Whitehurst, Red Hat, Inc. - President, CEO & Director [58]

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Well, it's also when they want to buy. I mean, the idea of going and saying I'm going to buy $500,000 of OpenShift, what kind of discount am I going to get versus I'm doing an $8 million renewal and I'm throwing this in, what kind of discount do I get. It's a natural way that customers buy as well.

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Operator [59]

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We'll take our last question from Brian White with Monness, Crespi.

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Brian John White, Monness, Crespi, Hardt & Co., Inc., Research Division - Research Analyst [60]

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Jim, so it sounds like RHEL has definitely been slowing. Would you say that you've lost market share in the server operating system markets? That's one of my questions. And also maybe give us an update on CoreOS. Ansible's been a phenomenal acquisition. Maybe give us an update on CoreOS.

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James M. Whitehurst, Red Hat, Inc. - President, CEO & Director [61]

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Yes. Yes. Sure. So no, I certainly don't think that we're losing share. If anything, we continue to gain share from our on-premise competitors. And again, just looking cloud for cloud and our relative RHEL growth rates in those clouds versus their overall growth rates, I don't think we're losing share to whether it's Amazon Linux or any of the other Linuxes out there. So I don't see a place where we are losing share. Again, a lot of this, you're getting the math of the fact that many of our customers are in 3-year engagements that aren't growing. So you're getting this weighted average thing, and we're in the year before the renewals restart. So I don't know. I don't see us losing share at all. If anything, I see us gaining share. And again, maintaining share on public cloud as public cloud grows is also taking share because that's vast majority Linux and -- versus on-premise where nearly half the workloads are Windows. So overall, I feel very, very good about where we stand with Linux and how we're growing. What's the second part of that?

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Tom McCallum, Red Hat, Inc. - VP of IR [62]

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CoreOS.

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Unidentified Company Representative, [63]

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CoreOS.

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James M. Whitehurst, Red Hat, Inc. - President, CEO & Director [64]

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Oh, CoreOS. Yes. Yes. The CoreOS, we're really excited about. To be clear, CoreOS is different than Ansible in the sense that Ansible was an additional product that has done extremely well for us. CoreOS is a set of features in a container platform that we are integrating into OpenShift. The CoreOS team focused on ease of use from the user's perspective. We bring incredible content associated with RHEL in the RHEL ecosystem and how we life cycle. Those, together, it's a phenomenal marriage. We've started to bring some of those technologies in into OpenShift in the various dot releases. And certainly, as we get into Openshift 4, you'll see kind of, let's say, basically the entirety of their core feature set integrated in. And we're really excited about it. I think that's one of the reasons that we're seeing so much traction with OpenShift today.

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Tom McCallum, Red Hat, Inc. - VP of IR [65]

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Great. Thanks, Jim, and thank you, everybody, for joining us on the call today. We look forward to speaking to you during the quarter. Thank you. Thanks, operator.

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Operator [66]

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This does conclude today's program. Thank you for your participation, and you may disconnect at any time.