Document
Table of Contents

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
 
FORM 10-Q
 
(Mark One)
x
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended August 31, 2018
OR 
¨
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from                to                .
Commission File Number: 001-33162 
 
RED HAT, INC.
(Exact name of registrant as specified in its charter) 
 
Delaware
06-1364380
(State or other jurisdiction of
incorporation or organization)
(I.R.S. Employer
Identification No.)
100 East Davie Street, Raleigh, North Carolina 27601
(Address of principal executive offices, including zip code)
(919) 754-3700
(Registrant’s telephone number, including area code) 
 
Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  x    No  ¨
Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files).    Yes  x    No  ¨
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company” and “emerging growth company” in Rule 12b-2 of the Exchange Act.
 
Large accelerated filer
x
 
Accelerated filer
¨
 
 
Non-accelerated filer
¨
 
Smaller reporting company
¨
 
 
 
 
 
Emerging growth company
¨
 
If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ¨
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes  ¨    No  x
Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date:
As of October 5, 2018, there were 175,973,678 shares of common stock outstanding.

Table of Contents

RED HAT, INC.
 
 
 
Page
 
 
 
 
 
ITEM 1:
 
 
Consolidated Balance Sheets at August 31, 2018 (unaudited) and February 28, 2018 (derived from audited financial statements)
 
Consolidated Statements of Operations for the three and six months ended August 31, 2018 (unaudited) and 2017 (unaudited)
 
Consolidated Statements of Comprehensive Income for the three and six months ended August 31, 2018 (unaudited) and 2017 (unaudited)
 
Consolidated Statements of Cash Flows for the three and six months ended August 31, 2018 (unaudited) and 2017 (unaudited)
 
 
NOTE 1—Company
 
 
NOTE 2—Summary of Significant Accounting Policies
 
 
NOTE 3—Accounts Receivable
 
 
NOTE 4—Identifiable Intangible Assets
 
 
NOTE 5—Deferred Selling Costs
 
 
NOTE 6—Derivative Instruments
 
 
NOTE 7—Income Taxes
 
 
NOTE 8—Convertible Notes
 
 
NOTE 9—Commitments and Contingencies
 
 
NOTE 10—Legal Proceedings
 
 
NOTE 11—Stockholders’ Equity
 
 
NOTE 12—Deferred Revenue and Performance Obligations
 
 
NOTE 13—Earnings Per Share
 
 
NOTE 14—Share-based Awards
 
 
NOTE 15—Assets and Liabilities Measured at Fair Value on a Recurring Basis
 
 
NOTE 16—Segment Reporting
 
 
NOTE 17—Business Combinations
 
 
 
 
ITEM 2:
ITEM 3:
ITEM 4:
 
 
 
 
 
ITEM 1:
ITEM 1A:
ITEM 2:
ITEM 6:
 
 
 


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


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PART I

ITEM 1.
FINANCIAL STATEMENTS

RED HAT, INC.
CONSOLIDATED BALANCE SHEETS
(in thousands—except share and per share amounts)
 
August 31, 2018 (Unaudited)
 
February 28, 2018 (1)
ASSETS
 
 
 
Current assets:
 
 
 
Cash, cash equivalents and restricted cash
$
1,503,515

 
$
1,724,132

Investments in debt and equity securities, short-term
264,945

 
318,358

Accounts receivable, net of allowances for doubtful accounts of $2,777 and $2,167, respectively
516,008

 
806,744

Prepaid expenses
247,197

 
267,197

Other current assets
46,088

 
25,666

Total current assets
2,577,753

 
3,142,097

Property and equipment, net of accumulated depreciation and amortization of $294,252 and $269,429, respectively
195,230

 
206,105

Goodwill
1,278,478

 
1,288,830

Identifiable intangibles, net
213,260

 
224,953

Investments in debt securities, long-term
389,402

 
430,442

Deferred tax assets, net
83,761

 
92,606

Other assets, net
68,984

 
89,460

Total assets
$
4,806,868

 
$
5,474,493

LIABILITIES AND STOCKHOLDERS’ EQUITY
 
 
 
Current liabilities:
 
 
 
Accounts payable and accrued expenses
$
405,970

 
$
427,139

Deferred revenue, short-term
1,683,503

 
1,853,719

Other current obligations
544

 
843

Convertible notes
4,435

 
23,806

Total current liabilities
2,094,452

 
2,305,507

Deferred revenue, long-term
709,746

 
741,453

Convertible notes
512,095

 
744,194

Other long-term obligations
200,771

 
205,215

Commitments and contingencies (NOTES 9 and 10)

 

Stockholders’ equity:
 
 
 
Preferred stock, $0.0001 per share par value, 5,000,000 shares authorized, none outstanding
—

 
—

Common stock, $0.0001 per share par value, 300,000,000 shares authorized, 241,789,438 and 238,688,708 shares issued, and 175,859,770 and 177,073,904 shares outstanding, respectively
24

 
24

Additional paid-in capital
2,576,560

 
2,416,080

Retained earnings
1,820,124

 
1,619,688

Treasury stock, at cost, 65,929,668 and 61,614,804 shares, respectively
(3,055,268
)
 
(2,525,072
)
Accumulated other comprehensive loss
(51,636
)
 
(32,596
)
Total stockholders’ equity
1,289,804

 
1,478,124

Total liabilities and stockholders’ equity
$
4,806,868

 
$
5,474,493

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


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

4

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RED HAT, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands—except per share amounts)
(Unaudited) 
 
Three Months Ended
 
Six Months Ended
 
August 31,
2018
 
August 31,
2017 (1)
 
August 31,
2018
 
August 31,
2017 (1)
Revenue:
 
 
 
 
 
 
 
Subscriptions
$
722,699

 
$
637,562

 
$
1,434,220

 
$
1,234,070

Training and services
100,048

 
85,793

 
202,057

 
166,081

Total revenue
822,747

 
723,355

 
1,636,277

 
1,400,151

Cost of revenue:
 
 
 
 
 
 
 
Subscriptions
51,931

 
46,324

 
104,104

 
89,957

Training and services
66,999

 
60,393

 
137,525

 
117,456

Total cost of revenue
118,930

 
106,717

 
241,629

 
207,413

Gross profit
703,817

 
616,638

 
1,394,648

 
1,192,738

Operating expense:
 
 
 
 
 
 
 
Sales and marketing
334,380

 
278,317

 
683,195

 
572,640

Research and development
166,308

 
141,809

 
332,814

 
278,972

General and administrative
68,573

 
61,722

 
131,927

 
116,592

Total operating expense
569,261

 
481,848

 
1,147,936

 
968,204

Income from operations
134,556

 
134,790

 
246,712

 
224,534

Interest income
7,855

 
4,612

 
15,689

 
8,605

Interest expense
4,808

 
6,081

 
11,127

 
12,166

Other expense, net
(2,457
)
 
(1,260
)
 
(4,651
)
 
(1,846
)
Income before provision for income taxes
135,146

 
132,061

 
246,623

 
219,127

Provision for income taxes
48,292

 
34,973

 
46,579

 
46,725

Net income
$
86,854

 
$
97,088

 
$
200,044

 
$
172,402

Net income per share:
 
 
 
 
 
 
 
Basic
$
0.49

 
$
0.55

 
$
1.13

 
$
0.97

Diluted
$
0.46

 
$
0.53

 
$
1.06

 
$
0.94

Weighted average shares outstanding:
 
 
 
 
 
 
 
Basic
176,746

 
177,257

 
177,024

 
177,250

Diluted
186,936


183,021


188,061


182,460

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

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

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RED HAT, INC.
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(in thousands)
(Unaudited) 
 
Three Months Ended
 
Six Months Ended
 
August 31,
2018
 
August 31,
2017 (1)
 
August 31,
2018
 
August 31,
2017 (1)
Net income
$
86,854

 
$
97,088

 
$
200,044

 
$
172,402

Other comprehensive income (loss):
 
 
 
 
 
 
 
Change in foreign currency translation adjustment
(8,459
)
 
31,861

 
(19,290
)
 
54,531

Available-for-sale securities:
 
 
 
 
 
 
 
Unrealized gain on available-for-sale securities during the period
416

 
990

 
454

 
1,154

Reclassification for loss (gain) realized on available-for-sale securities, reported in Other expense, net
3

 
—

 
(125
)
 
—

Tax benefit (expense)
(95
)
 
(287
)
 
(79
)
 
(509
)
Net change in available-for-sale securities (net of tax)
324

 
703

 
250

 
645

Total other comprehensive (loss) income
(8,135
)
 
32,564

 
(19,040
)
 
55,176

Comprehensive income
$
78,719

 
$
129,652

 
$
181,004

 
$
227,578

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



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

6

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RED HAT, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
(Unaudited)
 
 
Three Months Ended
 
Six Months Ended
 
August 31, 2018
 
August 31,
2017 (1)
 
August 31, 2018
 
August 31,
2017 (1)
Cash flows from operating activities:
 
 
 
 
 
 
 
Net income
$
86,854

 
$
97,088

 
$
200,044

 
$
172,402

Adjustments to reconcile net income to net cash provided by operating activities:
 
 
 
 
 
 
 
Depreciation and amortization
26,666

 
24,136

 
53,720

 
45,953

Amortization of debt discount and transaction costs
4,570

 
5,570

 
10,408

 
11,110

Repayments of convertible notes attributable to debt discount
(32,563
)
 
—

 
(32,563
)
 
—

Deferred income taxes
(293
)
 
(359
)
 
(3,688
)
 
7,558

Share-based compensation expense
52,686

 
46,947

 
98,691

 
90,665

Net amortization of bond premium on debt securities available for sale
543

 
2,439

 
1,286

 
4,875

Other
2,553

 
571

 
3,650

 
1,532

Changes in operating assets and liabilities, net of effects of acquisitions:
 
 
 
 
 
 
 
Accounts receivable
(22,049
)
 
17,036

 
277,390

 
225,797

Other receivables
14,915

 
(949
)
 
(20,245
)
 
(20,346
)
Prepaid expenses
6,280

 
(11,793
)
 
31,662

 
231

Accounts payable and accrued expenses
26,937

 
2,010

 
(1,705
)
 
(53,316
)
Deferred revenue
(33,786
)
 
(40,575
)
 
(138,378
)
 
(86,292
)
Other
(521
)
 
775

 
(1,321
)
 
599

Net cash provided by operating activities
132,792

 
142,896

 
478,951

 
400,768

Cash flows from investing activities:
 
 
 
 
 
 
 
Purchase of investment in debt securities available for sale
(9,725
)
 
(109,669
)
 
(118,061
)
 
(259,193
)
Proceeds from maturities of investment in debt securities available for sale
106,050

 
105,303

 
193,054

 
217,344

Proceeds from sales of investment in debt securities available for sale
7,966

 
—

 
8,491

 
14,324

Proceeds from sales of strategic equity investments
—

 
—

 
1,300

 
—

Acquisition of businesses, net of cash acquired
—

 
(83,965
)
 
—

 
(83,965
)
Purchase of developed software and other intangible assets
(3,258
)
 
(7,671
)
 
(6,124
)
 
(9,445
)
Purchase of property and equipment
(13,653
)
 
(25,781
)
 
(26,616
)
 
(51,681
)
Other
—

 
(189
)
 
(986
)
 
(189
)
Net cash provided by (used in) investing activities
87,380

 
(121,972
)
 
51,058

 
(172,805
)
Cash flows from financing activities:
 
 
 
 
 
 
 
Proceeds from exercise of common stock options
189

 
862

 
1,064

 
3,830

Proceeds from employee stock purchase program
13,685

 
10,952

 
28,947

 
22,713

Payments related to net settlement of share-based compensation awards
(17,638
)
 
(7,413
)
 
(94,732
)
 
(48,423
)
Purchase of treasury stock
(250,035
)
 
(75,015
)
 
(400,054
)
 
(137,002
)
Payments on other borrowings
(250
)
 
(418
)
 
(549
)
 
(861
)
Repayments of convertible notes attributable to principal
(211,990
)
 
—

 
(237,943
)
 
—

Net cash used in financing activities
(466,039
)
 
(71,032
)
 
(703,267
)
 
(159,743
)
Effect of foreign currency exchange rates on cash, cash equivalents and restricted cash
(19,098
)
 
29,959

 
(47,359
)
 
51,280

Net (decrease) increase in cash, cash equivalents and restricted cash
(264,965
)
 
(20,149
)
 
(220,617
)
 
119,500

Cash, cash equivalents and restricted cash at beginning of the period
1,768,480

 
1,230,457

 
1,724,132

 
1,090,808

Cash, cash equivalents and restricted cash at end of the period
$
1,503,515

 
$
1,210,308

 
$
1,503,515

 
$
1,210,308

Restricted cash included in cash, cash equivalents and restricted cash
$
1,137

 
$
3,104

 
$
1,137

 
$
3,104

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

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

7


RED HAT, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)


NOTE 1—Company
Red Hat, Inc., incorporated in Delaware, together with its subsidiaries (“Red Hat” or the “Company”) is a leading global provider of open source software solutions, using a community-powered approach to develop and offer reliable and high-performing operating system, virtualization, management, middleware, cloud, mobile and storage technologies.
Open source software is an alternative to proprietary software and represents a different model for the development and licensing of commercial software code than that typically used for proprietary software. Because open source software code, generally, is freely shared, there are customarily no licensing fees for the use of open source software. Therefore, the Company does not recognize revenue from the licensing of the code itself. The Company provides value to its customers through the development, aggregation, integration, testing, certification, delivery, maintenance, enhancement and support of its Red Hat technologies, and by providing a level of performance, scalability, flexibility, reliability and security for the technologies the Company packages and distributes. Moreover, because communities of developers not employed by the Company assist with the creation of the Company’s open source offerings, opportunities for further innovation of the Company’s offerings are supplemented by these communities.
The Company derives its revenue and generates cash from customers primarily from two sources: (i) subscription revenue and (ii) training and services revenue. These arrangements typically involve subscriptions to Red Hat technologies. The arrangements with the Company’s customers that produce this revenue and cash are explained in further detail in NOTE 2—Summary of Significant Accounting Policies.
NOTE 2—Summary of Significant Accounting Policies
Basis of presentation
The unaudited interim consolidated financial statements as of and for the three and six months ended August 31, 2018 have been prepared by the Company pursuant to the rules and regulations of the Securities and Exchange Commission (the “SEC”) for interim financial reporting. These consolidated statements are unaudited and, in the opinion of management, include all adjustments (consisting of normal recurring adjustments and accruals) necessary for a fair statement of the consolidated balance sheets, consolidated operating results, consolidated other comprehensive income and consolidated cash flows for the periods presented in accordance with accounting principles generally accepted in the U.S. (“U.S. GAAP”). Operating results for the three and six months ended August 31, 2018 are not necessarily indicative of the results that may be expected for the fiscal year ending February 28, 2019. Certain information and footnote disclosures normally included in annual financial statements prepared in accordance with U.S. GAAP have been omitted in accordance with the SEC’s rules and regulations for interim reporting. These unaudited financial statements should be read in conjunction with the Company’s Consolidated Financial Statements, including notes thereto, included in the Company’s Annual Report on Form 10-K for the fiscal year ended February 28, 2018. Other than the accounting pronouncement adopted during the three months ended May 31, 2018 related to accounting for revenue from contracts with customers as described below, there have been no changes to the Company’s significant accounting policies from those described in NOTE 2—Summary of Significant Accounting Policies to the Consolidated Financial Statements contained in the Company’s Annual Report on Form 10-K for the fiscal year ended February 28, 2018.
The Company adopted Accounting Standards Update 2014-09, Revenue from Contracts with Customers, now commonly referred to as Accounting Standards Codification Topic 606 (“ASC 606”), effective March 1, 2018, using the full retrospective transition method. All amounts and disclosures set forth in this Form 10-Q have been updated to comply with the new standard and such information is designated “as adjusted.”
Certain amounts for the three and six months ended August 31, 2017 have been reclassified to conform to the current period presentation.
The Company’s fiscal year ends on the last day of February, and the Company identifies fiscal years by the calendar years in which they end. For example, the fiscal year ending February 28, 2019 is referred to as “fiscal 2019.”
Consolidation policy
The accompanying Consolidated Financial Statements include the accounts of the Company and all of its wholly owned subsidiaries. All significant inter-company accounts and transactions are eliminated in consolidation. There are no significant foreign exchange restrictions on the Company’s foreign subsidiaries.

8

RED HAT, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
(Unaudited)


Use of estimates
The preparation of financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the balance sheet dates and the reported amounts of revenue and expenses during the reporting periods. Actual results could differ from such estimates. Estimates are used for, but not limited to, revenue recognition, goodwill and other long-lived assets, share-based compensation, income taxes and loss contingencies.
Revenue recognition
The Company derives its revenues from subscription contracts and training and service contracts. Revenue is recognized when performance obligations, as stipulated in the contracts, are transferred to a customer for an amount that reflects the consideration the Company expects to receive in exchange for those subscription contracts and training and service contracts.
The Company applies the following five steps to recognize revenue:
1)    Identify the contract with a customer. The Company determines that it has a contract with a customer when the contract is approved, the party’s rights regarding the products and services to be transferred can be identified, the payment terms for the products and services are identified, the customer’s ability and intent to pay can be determined, and the contract has commercial substance. Judgment is used to assess the customer’s ability and intent to pay, which is based upon factors including the customer’s historical payment experience or credit and financial information pertaining to the customer.
2)    Identify the performance obligations in the contract. The Company’s performance obligations are identified based on the products and services that will be transferred to the customer that are both capable of being distinct and are distinct in the context of the contract and consist of (i) subscription offerings, including non-proprietary open-source software code delivered to the customer, software support subscriptions delivered to the customer, software support subscriptions embedded in partner products and learning subscriptions and (ii) training and services, including professional services sold at a fixed fee, professional services sold on a time-and-material-basis, training courses or units, and consulting units. In limited cases, the option to purchase additional subscription offerings or training and services may be offered at a price representing a material right. In such cases, the option to purchase is considered a distinct performance obligation.
3)     Determine the transaction price. The Company determines transaction price based on the consideration expected to be received in exchange for transferring certain performance obligations to the customer. In determining the transaction price, variable consideration, if any, would be considered if, in management’s judgment, it is probable that a significant future reversal of cumulative revenue under the contract will not occur.
The Company’s contracts do not contain significant financing components. Specifically, the Company does not typically extend customer payment terms beyond a standard 30- to 60-day term and as a result the Company has elected the one-year-or-less safe harbor expedient and does not impute any interest.
The Company has elected to exclude all taxes from the transaction price (e.g. sales, use, value-added, etc). Revenue is recognized net of such taxes.
4)     Allocate the transaction price to performance obligations in the contract. When a contract contains a single performance obligation, the entire transaction price is allocated to that one performance obligation. Contracts that contain multiple performance obligations require an allocation of the transaction price to each performance obligation based on a relative standalone selling price (“SSP”). The Company typically determines SSP based on the observable price when the Company sells the subscriptions or training and services separately, taking into consideration the geographical region of the customer, type of offering and sales channel. In instances where SSP is not directly observable, the Company determines SSP either from the renewal rate paid for the performance obligation to the extent it is the same rate as stipulated in the initial customer contract or by using the expected-cost-plus-margin approach.
5)     Recognize revenue when or as the performance obligation is satisfied. Revenue is recognized at the time the related performance obligation is satisfied by transferring the promised subscription offerings and training and services to a customer. For each performance obligation, a determination is made as to whether the control is transferred over time or at a point in time. For performance obligations satisfied over time, a method to measure progress toward complete satisfaction is selected, based upon the most faithful depiction of performance. The selected method for each performance obligation type is applied consistently to similar contracts.

9

RED HAT, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
(Unaudited)


Subscription revenue
Subscription revenue is comprised of direct and indirect sales of subscriptions relating to Red Hat technologies. Accounts receivable and deferred revenue are recorded at the time a customer enters into a binding and non-cancellable subscription agreement for the purchase of a subscription, subscription services are made available to the customer and the customer is billed. The deferred revenue amount is recognized as revenue ratably over the subscription period. Red Hat technologies are generally offered with base subscription periods of either one year or three years; the majority of the Company’s subscriptions have terms of one year. Under these subscription agreements, renewal rates are generally specified for renewal terms of one year or three years. Subscriptions generally entitle the end user to the technology itself and post-contract customer support, generally consisting of varying levels of support services as well as access to security updates, fixes, functionality enhancements, upgrades to the technologies, each on an if and when available basis, and compatibility with an ecosystem of certified hardware and software, during the term of the subscription. The Company sells its offerings through two principal channels: (1) direct, which includes sales by the Company’s sales force as well as web store sales, and (2) indirect, which includes certified cloud and service providers (“CCSPs”), distributors, original equipment manufacturers (“OEMs”), systems integrators and value added resellers.
The Company recognizes revenue from the sale of Red Hat technologies ratably over the period of the subscription beginning on the commencement date of the subscription agreement. The Company has determined that the delivery of software code underlying the subscription is a distinct performance obligation as it is both capable of being distinct and is distinct within the context of a customer contract. The Company uses a non-proprietary open-source development and licensing model to provide its software technologies to customers and therefore the amount of transaction price allocated to the underlying software code is negligible. The Company derives a portion of its revenue from CCSPs that provide public clouds with, and allow users to consume, computing resources as a service. The Company earns revenue based on subscription units consumed by the CCSP or its end users. The Company uses its historical cloud-usage data to estimate the amount of revenue earned and recognized each month and adjusts to actual amounts earned upon receipt of usage reports from the CCSPs in the following month. The differences between actual amounts earned and estimates made have generally been insignificant.
Training and services revenue
Training and services revenue is comprised of revenue for consulting, engineering and customer training courses or units and education services. Consulting services consist of time-based units or fixed-fee arrangements. For time-based arrangements, revenue is recognized over time as these services are performed and for fixed-fee arrangements, revenue is recognized based on the proportion of services performed. Engineering services represent revenue earned under fixed-fee arrangements with the Company’s OEM partners and other customers to provide for significant modification and customization of Red Hat technologies. The Company recognizes revenue for these fixed-fee engineering services based on a proportional performance basis using actual costs incurred to date over the estimated total projected costs, which includes a representative profit margin. A representative profit margin is determined based on analysis of a population of similar contracts by region. Revenue for customer training and education services is recognized on the dates the services are performed.
See NOTE 16—Segment Reporting for further information, including revenue by geographic area and significant product and service offerings.
Contract Balances
Timing of revenue recognition may differ from the timing of invoicing to customers. The Company records a receivable when revenue is recognized prior to invoicing, or deferred revenue when revenue is recognized subsequent to invoicing. For multi-year arrangements, the Company will generally invoice customers upfront or annually at the beginning of each annual coverage period. See below for the accounting policy related to receivables and see NOTE 12—Deferred Revenue and Performance Obligations for further information on deferred revenue balances.
Accounts receivable and allowance for doubtful accounts
Trade accounts receivable are recorded at the invoiced amount and do not bear interest. The allowance for doubtful accounts is the Company’s estimate of the amount of probable credit losses in the Company’s existing accounts receivable. The Company determines the allowance based on historical write-off experience and other qualitative factors. The Company reviews its allowance for doubtful accounts monthly. Past due balances over 90 days and over a specified amount are reviewed individually for collectability. All other balances are reviewed on a pooled basis by type of receivable. Account balances are charged off against the allowance when the Company determines it is probable the receivable will not be recovered. The Company does not have off-balance sheet credit exposure related to its customers. Unbilled receivables related to subscription and training and services contracts are included in accounts receivable. See NOTE 3—Accounts Receivable for further information on accounts receivable balances.
Deferred selling costs
Deferred commissions are the incremental costs that are directly associated with non-cancellable subscription contracts with customers and consist of sales commissions and certain related fringe benefits earned by the Company’s sales force. The commissions are deferred and amortized on a straight-line basis over a period that approximates the subscription period. In determining the period that approximates the subscription period, the Company utilizes a portfolio approach that allows for the analysis of customer contracts with similar characteristics. The Company has determined that the effects on the financial statements of the portfolio approach would not differ materially from an individual customer contract analysis approach. The commission payments are paid in full subsequent to the month in which the customer’s service commences. The deferred commission amounts are recoverable through the future revenue streams under the non-cancellable customer contracts. In addition, the Company has the ability and intent under the commission plans with its sales force to recover commissions previously paid to its sales force in the event that customers breach the terms of their subscription agreements and do not fully pay for their subscription agreements. See NOTE 5—Deferred Selling Costs for further information on deferred commissions and the related amortization of deferred commissions.
Recent accounting pronouncements
Accounting pronouncements adopted
In February 2018, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update 2018-02, Income Statement—Reporting Comprehensive Income (Topic 220): Reclassification of Certain Tax Effects from Accumulated Other Comprehensive Income (“ASU 2018-02”). The FASB issued ASU 2018-02 to give entities the option to reclassify tax effects stranded in accumulated other comprehensive income as a result of the enactment of the Tax Cuts and Jobs Act (the “Tax Act”) to retained earnings. The Company adopted ASU 2018-02 as of June 1, 2018. The Company opted not to reclassify tax effects stranded in accumulated other comprehensive income as a result of the enactment of the Tax Act to retained earnings.
In January 2016, the FASB issued Accounting Standards Update 2016-01, Financial Instruments—Overall (Subtopic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities (“ASU 2016-01”). The FASB issued ASU 2016-01 to require equity investments with readily determinable fair values to be measured at fair value with changes in fair value recognized in net income. Equity investments that do not have readily determinable fair values are allowed to be remeasured upon the occurrence of an observable price change or upon identification of an impairment. Along with ASU 2016-01, the Company evaluated the Accounting Standards Update 2018-03, Technical Corrections and Improvements to Financial Instruments Overall (Subtopic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities (“ASU 2018-03”), which was issued in February 2018, and Accounting Standards Update 2018-04, Investments—Debt Securities (Topic 320) and Regulated Operations (Topic 980): Amendments to SEC Paragraphs Pursuant to SEC Staff Accounting Bulletin No. 117 and SEC Release No. 33-9273 (“ASU 2018-04”), which was issued in March 2018. The Company adopted ASU 2016-01, ASU 2018-03 and ASU 2018-04 as of March 1, 2018. The adoption of these standards did not significantly impact the Company’s Consolidated Financial Statements.
In May 2014, the FASB issued ASC 606 to clarify the principles for recognizing revenue and to develop a common revenue standard for U.S. GAAP. The standard outlines a single comprehensive model for entities to use in accounting for revenue arising from contracts with customers and supersedes the most current revenue recognition guidance. ASC 606 requires the recognition of revenue when control of performance obligations as stipulated in the contracts, is transferred to a customer for an amount that reflects the consideration the entity expects to receive in exchange promised goods and services. The standard also includes Subtopic 340-40, Other Assets and Deferred Costs—Contracts with Customers, which requires the deferral of incremental costs of obtaining a contract with a customer. Collectively, ASC 606 and Subtopic 340-40 are referred to as “ASC 606.”

10

RED HAT, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
(Unaudited)


The Company adopted ASC 606 as of March 1, 2018, utilizing the full retrospective method of transition, which requires a restatement of each prior reporting period presented. In adopting ASC 606, the Company used the practical expedient where the transaction price allocated to the remaining performance obligations before the date of the initial application is not disclosed. The Company implemented new policies, processes and systems to enable both the preparation of financial information and internal controls over financial reporting in connection with its adoption of ASC 606. The impact of adopting ASC 606 on the Company’s fiscal 2018 and fiscal 2017 revenue was not material. The primary impact of adopting the standard related to the deferral of incremental commission and other costs of obtaining contracts with customers. Previously, the Company deferred direct and incremental commission costs to obtain a contract and amortized those costs on a straight-line basis over a period that approximated the subscription period, and under ASC 606, the Company now also defers related fringe benefit costs.
Select adjusted unaudited financial statement information, which reflects the Company’s adoption of ASC 606, is set forth below.
Consolidated balance sheets (in thousands):
 
February 28, 2018
 
As Reported
 
Adjustments
 
As Adjusted
Prepaid expenses
$
260,092

 
$
7,105

 
$
267,197

Deferred tax assets, net
$
93,300

 
$
(694
)
 
$
92,606

Other assets, net
$
87,924

 
$
1,536

 
$
89,460

Accounts payable and accrued expenses
$
427,086

 
$
53

 
$
427,139

Retained earnings
$
1,611,794

 
$
7,894

 
$
1,619,688

Consolidated statements of operations (in thousands, except per share amounts):
 
Three Months Ended August 31, 2017
 
Six Months Ended August 31, 2017
 
As Reported
 
Adjustments
 
As Adjusted
 
As Reported
 
Adjustments
 
As Adjusted
Operating expense:


 


 


 
 
 
 
 
 
Sales and marketing
$
278,548

 
$
(231
)
 
$
278,317

 
$
575,007

 
$
(2,367
)
 
$
572,640

Net income
$
96,859

 
$
229

 
$
97,088

 
$
170,049

 
$
2,353

 
$
172,402

Net income per share:


 


 


 
 
 
 
 
 
Basic
$
0.55

 
$
—

 
$
0.55

 
$
0.96

 
$
0.01

 
$
0.97

Diluted
$
0.53

 
$
—

 
$
0.53

 
$
0.93

 
$
0.01

 
$
0.94

The Company’s adoption of ASC 606 had no impact on net cash provided by or used in operating, investing or financing activities for any of the periods reported.
Accounting pronouncements being evaluated
In August 2018, the FASB issued Accounting Standards Update 2018-15, Intangibles—Goodwill and Other—Internal-Use Software: Customer’s Accounting for Implementation Costs Incurred in a Cloud Computing Arrangement That Is a Service Contract (a consensus of the FASB Emerging Issues Task Force) (“ASU 2018-15”). The FASB issued ASU 2018-15 to align the requirements for capitalizing implementation costs in a cloud computing arrangement service contract with the requirements for capitalizing implementation costs incurred for an internal-use software license. The guidance is effective for the Company as of the first quarter of its fiscal year ending February 28, 2020, with early adoption permitted. The Company is currently evaluating the impact that this updated standard will have on its consolidated financial statements.

11

RED HAT, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
(Unaudited)


In February 2016, the FASB issued Accounting Standards Update 2016-02, Leases (Topic 842) (“ASU 2016-02”). The FASB issued ASU 2016-02 to increase transparency and comparability among organizations with respect to accounting for leases. Under ASU 2016-02, lessees will recognize a right-of-use asset and a lease liability for virtually all of their leases (other than leases that meet the definition of a short-term lease). The liability will be equal to the present value of lease payments. The asset will be based on the liability, subject to adjustment, such as for initial direct costs. For income statement purposes, the FASB retained a dual model, requiring leases to be classified as either operating or finance. This guidance is effective for the Company as of the first quarter of its fiscal year ending February 28, 2020. Along with ASU 2016-02, the Company is also evaluating Accounting Standards Update 2018-10, Codification Improvements to Topic 842 Leases (“ASU 2018-10”) and Accounting Standards Update 2018-11, Targeted Improvements to Topic 842 Leases (“ASU 2018-11”). The Company expects to adopt the transition method, which will not require adjustments to comparative periods nor require modified disclosures in those comparative periods. Upon adoption, the Company expects to elect the transition package of practical expedients permitted within the new standard, which among other things, allows the carryforward of the historical lease classification. The Company continues to evaluate which other, if any, practical expedients will be elected.
The Company continues to assess the impact of ASU 2016-02, ASU 2018-10 and ASU 2018-11, now commonly referred to as Accounting Standards Codification Topic 842 (“ASC 842”), including for example, any potential changes to and investments in the Company’s policies, processes, systems and internal controls over financial reporting that may be required to comply with the new guidance related to identifying and measuring right-of-use assets and lease liabilities. While the Company continues to evaluate the effect of adopting this guidance on its consolidated financial statements and related disclosures, it is expected that the operating leases, as disclosed in NOTE 13—Commitments and Contingencies contained in the Company’s Annual Report on Form 10-K for the fiscal year ended February 28, 2018, will be reported in the consolidated balance sheets upon adoption.
NOTE 3—Accounts Receivable
Accounts receivable are presented net of an allowance for doubtful accounts. Activity in the Company’s allowance for doubtful accounts is presented in the following table (in thousands):
As of
 
Balance at
beginning
of period
 
Charged to (recovery of)
expense
 
Adjustments (1)
 
Balance at
end of
period
February 28, 2018
 
$
2,791

 
172

 
(796
)
 
$
2,167

August 31, 2018
 
$
2,167

 
1,398

 
(788
)
 
$
2,777

_______________ 
(1) 
Represents foreign currency translation adjustments and amounts written-off as uncollectible accounts receivable.
Included in accounts receivable, net of allowance for doubtful accounts, are unbilled receivables of $32.2 million and $25.8 million as of August 31, 2018 and February 28, 2018, respectively.
As of August 31, 2018, the Company had one customer whose accounts receivable balance individually represented 12% of total accounts receivable. As of February 28, 2018, no individual customer accounted for 10% or more of the Company’s total accounts receivable.

12

RED HAT, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
(Unaudited)


NOTE 4—Identifiable Intangible Assets
Identifiable intangible assets consist primarily of trademarks, copyrights and patents, purchased technologies, customer and reseller relationships and covenants not to compete, all of which are amortized over the estimated useful life, generally on a straight-line basis, with the exception of customer and reseller relationships, which are generally amortized over the greater of straight-line over the estimated useful life or the related asset’s pattern of economic benefit. Useful lives range from two years to 10 years. As of August 31, 2018 and February 28, 2018, trademarks with an indefinite estimated useful life totaled $11.6 million and $12.0 million, respectively. The following is a summary of identifiable intangible assets (in thousands):
 
August 31, 2018
 
February 28, 2018
 
Gross
Amount
 
Accumulated
Amortization
 
Net
Amount
 
Gross
Amount
 
Accumulated
Amortization
 
Net
Amount
Trademarks, copyrights and patents
$
171,850

 
$
(76,812
)
 
$
95,038

 
$
167,005

 
$
(70,749
)
 
$
96,256

Purchased technologies
210,710

 
(103,294
)
 
107,416

 
208,096

 
(93,748
)
 
114,348

Customer and reseller relationships
105,949

 
(98,202
)
 
7,747

 
106,076

 
(95,558
)
 
10,518

Covenants not to compete
15,939

 
(14,486
)
 
1,453

 
15,861

 
(14,324
)
 
1,537

Other intangible assets
8,833

 
(7,227
)
 
1,606

 
8,833

 
(6,539
)
 
2,294

Total identifiable intangible assets
$
513,281

 
$
(300,021
)
 
$
213,260

 
$
505,871

 
$
(280,918
)
 
$
224,953

Amortization expense associated with identifiable intangible assets recognized in the Company’s Consolidated Financial Statements is summarized as follows (in thousands):
 
Three Months Ended
 
Six Months Ended
 
August 31, 2018
 
August 31, 2017
 
August 31, 2018
 
August 31, 2017
Cost of revenue
$
6,219

 
$
4,670

 
$
12,704

 
$
8,850

Sales and marketing
1,400

 
1,583

 
2,762

 
3,042

Research and development
35

 
35

 
69

 
69

General and administrative
2,380

 
2,227

 
4,753

 
4,053

Total amortization expense
$
10,034

 
$
8,515

 
$
20,288

 
$
16,014


NOTE 5—Deferred Selling Costs
Deferred selling costs include commissions paid to the Company’s sales associates that are the incremental costs incurred to obtain contracts with customers. The commissions are deferred and amortized over a period to approximate the period of the subscription term. For further discussion on deferred commissions, see NOTE 2—Summary of Significant Accounting Policies. Current and non-current deferred commissions are included in Prepaid expenses and Other assets, respectively, in the Company’s Consolidated Balance Sheets and are as follows (in thousands):
 
August 31, 2018
 
February 28, 2018 (1)
Deferred commissions, current
$
175,272

 
$
188,944

Deferred commissions, non-current
32,457

 
48,653

Total deferred commissions
$
207,729

 
$
237,597

____________________ 
(1)
As adjusted to reflect the impact of the retrospective application of ASC 606. See NOTE 2—Summary of Significant Accounting Policies for detailed information on adoption of ASC 606.
Amortization of deferred commissions is included in Sales and marketing expense in the Company’s Consolidated Statements of Operations. Amortization expense related to deferred commissions totaled $56.9 million and $41.2 million for the three months ended August 31, 2018 and August 31, 2017, respectively. Amortization expense related to deferred commissions totaled $113.1 million and $85.3 million for the six months ended August 31, 2018 and August 31, 2017, respectively. There was no impairment loss in relation to the costs capitalized for the periods presented.

13

RED HAT, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
(Unaudited)


NOTE 6—Derivative Instruments
The Company transacts business in various foreign countries and is, therefore, subject to risk of foreign currency exchange rate fluctuations. From time to time, the Company enters into forward contracts to economically hedge transactional exposure associated with commitments arising from trade accounts receivable, trade accounts payable and fixed purchase obligations denominated in a currency other than the functional currency of the respective operating entity. All derivative instruments are recorded in the Consolidated Balance Sheets at their respective fair values. The Company has elected not to prepare and maintain the documentation required to qualify for hedge accounting treatment and, therefore, changes in fair value are recorded in the Consolidated Statements of Operations. See NOTE 15—Assets and Liabilities Measured at Fair Value on a Recurring Basis for information regarding the fair value hierarchy of derivative instruments.
The effects of derivative instruments on the Company’s Consolidated Financial Statements are as follows (in thousands):
 
August 31, 2018
 
Classification of 
Gain (Loss)
Recognized in Income on
Derivatives
 
Three Months Ended August 31, 2018
 
Six Months Ended August 31, 2018
 
Balance Sheet 
Classification
 
Fair
Value
 
Notional
Value
 
 
 
Assets—foreign currency forward contracts not designated as hedges
Other current assets
 
$
147

 
$
37,815

 
Other expense, net
 
$
282

 
$
571

Liabilities—foreign currency forward contracts not designated as hedges
Accounts payable and accrued expenses
 
(83
)
 
22,201

 
Other expense, net
 
(314
)
 
(1,450
)
Total
 
 
$
64

 
$
60,016

 
 
 
$
(32
)
 
$
(879
)
 
August 31, 2017
 
Classification of 
Gain (Loss)
Recognized in Income on
Derivatives
 
Three Months Ended August 31, 2017
 
Six Months Ended August 31, 2017
 
Balance Sheet 
Classification
 
Fair
Value
 
Notional
Value
 
 
 
Assets—foreign currency forward contracts not designated as hedges
Other current assets
 
$
203

 
$
24,166

 
Other expense, net
 
$
675

 
$
1,280

Liabilities—foreign currency forward contracts not designated as hedges
Accounts payable and accrued expenses
 
(57
)
 
12,748

 
Other expense, net
 
(263
)
 
(583
)
Total
 
 
$
146

 
$
36,914

 
 
 
$
412

 
$
697


NOTE 7—Income Taxes
On December 22, 2017, the Tax Cuts and Jobs Act (“Tax Act”) was enacted into law. This new law includes significant changes to the U.S. corporate income tax system, including a permanent reduction in the corporate income tax rate from 35% to 21%, limitations on the deductibility of interest expense and executive compensation, elimination of the domestic production activities deduction and the transition of U.S. international taxation from a worldwide tax system to a territorial tax system.
On August 21, 2018, the Internal Revenue Service issued Notice 2018–68 providing guidance regarding amendments to Section 162(m) of the Internal Revenue Code contained in the Tax Act (“IRS Guidance”), which limit tax deductions for compensation granted to certain executives. As a result of this guidance, our provision for income taxes for the three and six months ended August 31, 2018 includes the impact of this tax deduction limitation. For the three and six months ended August 31, 2018, the Company recorded a tax charge of approximately $18.0 million resulting primarily from the write-off of deferred tax assets associated with the non-deductibility of certain share-based compensation and the reversal of certain share-based compensation benefits previously recognized during the three months ended May 31, 2018.

14

RED HAT, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
(Unaudited)


In December 2017, the SEC staff issued Staff Accounting Bulletin 118 (“SAB 118”), which provides guidance on accounting for the tax effects of the Tax Act. SAB 118 provides a measurement period that should not extend beyond one year from the Tax Act enactment date for companies to complete the accounting under ASC Topic 740—Income Taxes (“ASC 740”). The Company has calculated as final its re-measurement of deferred taxes and uncertain tax positions. While the Company has substantially completed its provisional analysis of the income tax effects of the Tax Act and recorded a reasonable estimate of such effects, the Company regards as provisional the transition tax, withholding and other taxes on future repatriation of cash, and the accounting for compensation accruals. These provisional tax effects may differ during the measurement period, possibly materially, due to further refinement of the calculations, changes in interpretations and assumptions made, and additional guidance that may be issued by the Department of the U.S. Treasury, the Internal Revenue Service, and other regulatory and standard setting bodies. The Company will complete its analysis within fiscal 2019 consistent with the guidance provided in SAB 118, and any adjustments during this measurement period will be included in net earnings from continuing operations as an adjustment to income tax expense in the reporting period when such adjustments are determined. The $18.0 million additional tax expense resulting from the IRS Guidance discussed above is an adjustment during the SAB 118 measurement period.
The effective tax rate for the three and six months ended August 31, 2018 of 35.7% and 18.9%, respectively, differed from the U.S. federal statutory rate of 21% primarily due to impacts from share-based compensation, research tax credits and the impact from the Tax Act. Tax expense for the three and six months ended August 31, 2018 included net discrete tax expense of $15.7 million and net discrete excess tax benefits of $11.1 million, respectively, primarily related to the impact from share-based compensation, inclusive of the $18.0 million adjustment under SAB 118.
For the three and six months ended August 31, 2017, the Company’s then-effective tax rate of 26.5% (1) and 21.3% (1), respectively, differed from the U.S. federal statutory rate of 35% primarily due to excess tax benefits from share-based compensation, foreign income taxed at lower rates, research tax credits and the domestic-production-activities deduction. Tax expense for the three and six months ended August 31, 2017 included net discrete tax benefits of $1.4 million and $13.1 million, respectively, primarily related to net excess tax benefits from share-based compensation.
The Company files a consolidated U.S. federal income tax return, as well as separate and combined income tax returns in numerous state and international jurisdictions. The Company is currently subject to examination by various taxing jurisdictions. The Company regularly assesses the potential outcomes of both ongoing and future examinations for the current and prior years, and believes that its provision for income taxes is adequate. The outcome of any one examination is not expected to have a material impact on the Company’s consolidated financial statements. The Company believes that some of these audits and negotiations may conclude during the next 12 months.
As of August 31, 2018, it is reasonably possible that total unrecognized tax benefits may be reduced by up to $0.5 million within the next 12 months primarily as a result of statutes of limitations expirations in various tax jurisdictions, all of which would affect the Company’s effective tax rate.
____________________ 
(1)
As adjusted to reflect the impact of the retrospective application of ASC 606. See NOTE 2—Summary of Significant Accounting Policies for detailed information on adoption of ASC 606.
NOTE 8—Convertible Notes
Convertible note offering
On October 7, 2014, the Company completed its offering of $805.0 million aggregate principal amount of the convertible notes. The convertible notes were sold in a private placement under a purchase agreement, dated as of October 1, 2014, entered into by and among the Company and the initial purchasers, for resale to qualified institutional buyers pursuant to Rule 144A under the Securities Act of 1933, as amended. For additional information, see NOTE 11—Convertible Notes to the Consolidated Financial Statements contained in the Company’s Annual Report on Form 10-K for the fiscal year ended February 28, 2018.
Indenture
On October 7, 2014, the Company entered into an indenture (the “Indenture”) with respect to the convertible notes with U.S. Bank National Association, as trustee (the “Trustee”). Under the Indenture, the convertible notes are senior unsecured obligations of the Company and bear interest at a rate of 0.25% per year, payable semiannually in arrears on April 1 and October 1 of each year, beginning on April 1, 2015. The convertible notes will mature on October 1, 2019, unless previously purchased or converted.

15

RED HAT, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
(Unaudited)


The convertible notes are convertible into shares of the Company’s common stock at an initial conversion rate of 13.6219 shares per $1,000 principal amount of the convertible notes (which is equivalent to an initial conversion price of approximately $73.41 per share), subject to adjustment upon the occurrence of certain events. Upon conversion of the convertible notes, holders will receive cash or shares of the Company’s common stock or a combination thereof, at the Company’s election.
At their option, holders may convert their convertible notes prior to the close of business on the business day immediately preceding April 1, 2019, only upon the occurrence of certain circumstances. For example, during any fiscal quarter commencing after the fiscal quarter ended on November 30, 2014 (and only during such fiscal quarter), if the last reported sale price of the Company’s common stock for at least 20 trading days (whether or not consecutive) during the period of 30 consecutive trading days ending on the last trading day of the immediately preceding fiscal quarter is greater than or equal to 130% of the conversion price, the convertible notes become convertible at the holders’ option. The price of the Company’s common stock was greater than or equal to 130% of the conversion price, which is $95.43, for at least 20 trading days during the 30 consecutive trading days ending on the last trading day of each of the fiscal quarters ended August 31, 2017 through August 31, 2018. Therefore, as of August 31, 2018, the convertible notes remain convertible at the holders’ option until November 30, 2018.
On and after April 1, 2019, holders may convert their convertible notes at any time until the close of business on the second scheduled trading day immediately preceding the maturity date of the convertible notes.
During the second quarter of the fiscal year ending February 28, 2019, the Company settled notices of conversion with respect to $244.6 million aggregate principal amount of the convertible notes and elected to settle such conversions by paying cash for the principal amount and issuing 1,774,798 shares of common stock for the excess conversion value. During the three and six months ended August 31, 2018, the Company recognized a loss on settled conversions of $1.4 million and $1.7 million, respectively. Total settled conversions as of August 31, 2018 amounted to $270.5 million aggregate principal amount of the convertible notes. The Company expects to settle conversions of $4.6 million in principal amount of the convertible notes in the third quarter of the fiscal year ending February 28, 2019 by paying cash for the principal amount and issuing shares of common stock for the excess conversion value. The Company continues to receive conversion requests and as of October 5, 2018, such incremental requests totaled $11.4 million in principal amount of the convertible notes. The aggregate principal amount of the convertible notes remaining is expected to be $518.5 million after the expected conversion settlements as discussed above and the incremental conversion requests received as of October 5, 2018.
Based on the closing price of the Company’s common stock of $147.73 on the last trading day of the second quarter of the fiscal year ending February 28, 2019, the if-converted value of the convertible notes as of August 31, 2018 exceeded their principal amount by approximately $541.1 million.
The Company continues to classify the net carrying amount of the convertible notes as a long-term liability, except for $4.4 million, classified as current and expected to be cash-settled within the next fiscal quarter. The equity component of the convertible notes will continue to be classified as additional paid-in capital because the Company has the option to settle the principal amount in shares and the convertible notes’ maturity date is more than 12 months away. However, it is the Company’s intent to settle the principal amount of the convertible notes in cash.
The conversion rate is subject to customary anti-dilution adjustments. If certain corporate events described in the Indenture occur prior to the maturity date, the conversion rate will be increased for a holder who elects to convert its convertible notes in connection with such corporate event in certain circumstances.
The convertible notes are not redeemable prior to maturity, and no sinking fund is provided for the notes. If the Company undergoes a “fundamental change,” as defined in the Indenture, subject to certain conditions, holders may require the Company to purchase for cash all or any portion of their convertible notes. The fundamental change purchase price will be 100% of the principal amount of the convertible notes to be purchased plus any accrued and unpaid 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.

16

RED HAT, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
(Unaudited)


In accounting for the issuance of the convertible notes, the Company separated the convertible notes into liability and equity components. The Company allocated the total transaction costs incurred to the liability and equity components based on their relative fair values. Issuance costs attributable to the liability component are being amortized to interest expense over the term of the convertible notes. The excess of the face value of the convertible notes as a whole over the carrying amount of the liability component (the “debt discount”) is being amortized to interest expense over the term of the convertible notes. In addition, the debt discount is impacted by the derecognition of the original debt discount on early settlements of convertible notes. The convertible notes consisted of the following (in thousands):
 
August 31, 2018
 
February 28, 2018
Liability component:
 
 
 
Principal
$
534,454

 
$
804,966

Less: debt issuance costs
(3,163
)
 
(4,695
)
Less: debt discount
(14,761
)
 
(32,271
)
Net carrying amount
$
516,530

 
$
768,000

Equity component (1)
$
64,327

 
$
96,890

__________
 
 
 
(1)   Recognized in the Consolidated Balance Sheets in Additional paid-in capital.
The following table includes total interest expense recognized related to the convertible notes (in thousands):
 
Three Months Ended
 
Six Months Ended
 
August 31, 2018
 
August 31, 2017
 
August 31, 2018
 
August 31, 2017
Coupon rate 0.25% per year, payable semiannually
$
215

 
$
503

 
$
686

 
$
1,006

Amortization of convertible note issuance costs — liability component
701

 
680

 
1,532

 
1,353

Accretion of debt discount
3,869

 
4,890

 
8,876

 
9,757

Total interest expense related to convertible notes
$
4,785

 
$
6,073

 
$
11,094

 
$
12,116

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):
 
August 31, 2018
  
Fair Value
 
Carrying Value
Convertible notes
$
516,641

 
$
516,530

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. In connection with the conversions of the convertible notes that settled in the second quarter of the fiscal year ending February 28, 2019, the Company exercised a portion of the options that are part of the convertible note hedge transactions for 1,774,754 shares of the Company’s common stock.

17

RED HAT, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
(Unaudited)


The convertible note hedge transactions are expected to offset, to the extent the Company’s common stock per share price does not exceed $101.65, 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 number of shares originally 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. For the three and six months ended August 31, 2018, the warrants were included in the computation of diluted shares outstanding because the warrants’ exercise price was less than the average market price of the Company’s common stock during the related period. However, subject to certain conditions, the Company may elect to settle all of the warrants in cash.
NOTE 9—Commitments and Contingencies
Operating leases
As of August 31, 2018, the Company leased office space and certain equipment under various non-cancellable operating leases. Rent expense under operating leases for the three months ended August 31, 2018 and August 31, 2017 was $13.7 million and $12.8 million, respectively. Rent expense under operating leases for the six months ended August 31, 2018 and August 31, 2017 was $27.1 million and $25.3 million, respectively.
Product indemnification
The Company is a party to a variety of agreements pursuant to which it may be obligated to indemnify the other party from losses arising in connection with the Company’s services or products, or from losses arising in connection with certain events defined within a particular contract, which may include litigation or claims relating to intellectual property infringement, certain losses arising from damage to property or injury to persons or other matters. In each of these circumstances, payment by the Company is conditioned on the other party making a claim pursuant to the procedures specified in the particular contract, which procedures typically allow the Company to challenge the other party’s claims. Further, the Company’s obligations under these agreements may in certain cases be limited in terms of time and/or amount, and in some instances, the Company may have recourse against third parties for certain payments made by the Company.
It is not possible to predict the maximum potential amount of future payments under these or similar agreements due to the conditional nature of the Company’s obligations and the facts and circumstances involved in each particular agreement. The Company does not record a liability for claims related to indemnification unless the Company concludes that the likelihood of a material claim is probable and estimable. Payments pursuant to these indemnification claims during the three and six months ended August 31, 2018 and August 31, 2017 were, in the aggregate, immaterial.
NOTE 10—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.


18

RED HAT, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
(Unaudited)


NOTE 11—Stockholders’ Equity
The following table summarizes the changes in the Company’s stockholders’ equity during the three months ended August 31, 2018 (in thousands): 
 
Common Stock
 
Additional
Paid-In
Capital
 
Retained
Earnings
 
Treasury
Stock
 
Accumulated
Other
Comprehensive
Loss
 
Total
Stockholders’
Equity
 
Shares
 
Amount
 
 
 
 
 
Balance at May 31, 2018
239,779

 
$
24

 
$
2,399,925

 
$
1,733,270

 
$
(2,657,774
)
 
$
(43,501
)
 
$
1,431,944

Net income
—

 
—

 
—

 
86,854

 
—

 
—

 
86,854

Other comprehensive loss, net of tax
—

 
—

 
—

 
—

 
—

 
(8,135
)
 
(8,135
)
Vest and exercise of share-based awards
235

 
—

 
189

 
—

 
—

 
—

 
189

Common stock repurchase
—

 
—

 
17,175

 
—

 
(267,210
)
 
—

 
(250,035
)
Share-based compensation expense
—

 
—

 
52,686

 
—

 
—

 
—

 
52,686

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

 
—

 
(17,638
)
 
—

 
—

 
—

 
(17,638
)
Convertible note conversions
1,775

 
—

 
(6,075
)
 
—

 
—

 
—

 
(6,075
)
Exercises of convertible note hedges
—

 
—

 
130,298

 
—

 
(130,284
)
 
—

 
14

Balance at August 31, 2018
241,789

 
$
24

 
$
2,576,560

 
$
1,820,124

 
$
(3,055,268
)
 
$
(51,636
)
 
$
1,289,804

The following table summarizes the changes in the Company’s stockholders’ equity during the three months ended August 31, 2017 (in thousands):
 
Common Stock
 
Additional
Paid-In
Capital
 
Retained
Earnings
 
Treasury
Stock
 
Accumulated
Other
Comprehensive
Loss
 
Total
Stockholders’
Equity
 
Shares
 
Amount
 
 
 
 
 
Balance at May 31, 2017
237,789

 
$
24

 
$
2,295,123

 
$
1,433,151

 
$
(2,350,044
)
 
$
(65,740
)
 
$
1,312,514

Net income
—

 
—

 
—

 
97,088

 
—

 
—

 
97,088

Other comprehensive income, net of tax
—

 
—

 
—

 
—

 
—

 
32,564

 
32,564

Vest and exercise of share-based awards
189

 
—

 
862

 
—

 
—

 
—

 
862

Common stock repurchase
—

 
—

 
—

 
—

 
(75,015
)
 
—

 
(75,015
)
Share-based compensation expense
—

 
—

 
46,947

 
—

 
—

 
—

 
46,947

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

 
—

 
(7,413
)
 
—

 
—

 
—

 
(7,413
)
Other adjustments
—

 
—

 
(1
)
 
—

 
—

 
—

 
(1
)
Balance at August 31, 2017
237,978

 
$
24

 
$
2,335,518

 
$
1,530,239

 
$
(2,425,059
)
 
$
(33,176
)
 
$
1,407,546

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

19

RED HAT, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
(Unaudited)


The following table summarizes the changes in the Company’s stockholders’ equity during the six months ended August 31, 2018 (in thousands): 
 
Common Stock
 
Additional
Paid-In
Capital
 
Retained
Earnings (1)
 
Treasury
Stock
 
Accumulated
Other
Comprehensive
Loss
 
Total
Stockholders’
Equity
 
Shares
 
Amount
 
 
 
 
 
Balance at February 28, 2018
238,689

 
$
24

 
$
2,416,080

 
$
1,619,688

 
$
(2,525,072
)
 
$
(32,596
)
 
$
1,478,124

Net income
—

 
—

 
—

 
200,044

 
—

 
—

 
200,044

Other comprehensive loss, net of tax
—

 
—

 
—

 
—

 
—

 
(19,040
)
 
(19,040
)
Vest and exercise of share-based awards
1,140

 
—

 
1,064

 
—

 
—

 
—

 
1,064

Common stock repurchase
—

 
—

 
—

 
—

 
(400,054
)
 
—

 
(400,054
)
Share-based compensation expense
—

 
—

 
98,691

 
—

 
—

 
—

 
98,691

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

 
—

 
(94,732
)
 
—

 
—

 
—

 
(94,732
)
Re-issuance of treasury stock under employee stock purchase plan
—

 
—

 
18,471

 
—

 
13,740

 
—

 
32,211

Convertible note conversions
1,960

 
—

 
(6,910
)
 
—

 
—

 
—

 
(6,910
)
Exercises of convertible note hedges
—

 
—

 
143,896

 
—

 
(143,882
)
 
—

 
14

Cumulative-effect adjustment from adoption of ASU 2016-01
—

 
—

 
—

 
392

 
—

 
—

 
392

Balance at August 31, 2018
241,789

 
$
24

 
$
2,576,560

 
$
1,820,124

 
$
(3,055,268
)
 
$
(51,636
)
 
$
1,289,804

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


20

RED HAT, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
(Unaudited)


The following table summarizes the changes in the Company’s stockholders’ equity during the six months ended August 31, 2017 (in thousands):
 
Common Stock
 
Additional
Paid-In
Capital
 
Retained
Earnings (1)
 
Treasury
Stock
 
Accumulated
Other
Comprehensive
Loss
 
Total
Stockholders’
Equity
 
Shares
 
Amount
 
 
 
 
 
Balance at February 28, 2017
236,805

 
$
24

 
$
2,294,462

 
$
1,357,837

 
$
(2,311,805
)
 
$
(88,352
)
 
$
1,252,166

Net income
—

 
—

 
—

 
172,402

 
—

 
—

 
172,402

Other comprehensive income, net of tax
—

 
—

 
—

 
—

 
—

 
55,176

 
55,176

Vest and exercise of share-based awards
1,173

 
—

 
3,830

 
—

 
—

 
—

 
3,830

Common stock repurchase
—

 
—

 
—

 
—

 
(137,002
)
 
—

 
(137,002
)
Share-based compensation expense
—

 
—

 
90,665

 
—

 
—

 
—

 
90,665

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

 
—

 
(48,423
)
 
—

 
—

 
—

 
(48,423
)
Re-issuance of treasury stock under employee stock purchase plan
—

 
—

 
—

 
—

 
23,748

 
—

 
23,748

Other adjustments
—

 
—

 
(5,016
)
 
—

 
—

 
—

 
(5,016
)
Balance at August 31, 2017
237,978

 
$
24

 
$
2,335,518

 
$
1,530,239

 
$
(2,425,059
)
 
$
(33,176
)
 
$
1,407,546

____________________ 
(1)
As adjusted to reflect the impact of the retrospective application of ASC 606. See NOTE 2—Summary of Significant Accounting Policies for detailed information on adoption of ASC 606.
Share repurchase programs
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 transactions. The program commenced on July 1, 2016 and expired on June 30, 2018.
From July 1, 2016 through its expiration on June 30, 2018, the Company repurchased 8,167,871 shares of its common stock for $751.3 million under this repurchase program.
On June 21, 2018, the Company announced that its Board authorized the repurchase of up to $1.0 billion of Red Hat’s common stock from time to time on the open market or in privately negotiated transactions. The new program commenced on July 1, 2018, and will expire on the earlier of (i) June 30, 2020 or (ii) a determination by the Board, Chief Executive Officer or Chief Financial Officer to discontinue the program. The new program replaced the previous $1.0 billion repurchase program, which expired on June 30, 2018.
From its commencement on July 1, 2018 through August 31, 2018, the Company repurchased 1,744,034 shares of its common stock at an aggregate cost of $250.0 million under this repurchase program. These amounts are recognized in Treasury stock in the Company’s Consolidated Balance Sheets in addition to $17.2 million, representing 103,744 shares, reclassified from Additional paid-in capital to Treasury stock during the quarter ended August 31, 2018 for transactions related to the prior repurchase program.
As of August 31, 2018, the amount available under this program for the repurchase of the Company’s common stock was $750.0 million.


21

RED HAT, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
(Unaudited)


Accumulated other comprehensive loss
Accumulated other comprehensive loss was comprised of the following (in thousands):
 
 
August 31, 2018
 
February 28, 2018
Accumulated loss from foreign currency translation adjustment
 
$
(48,969
)
 
$
(29,679
)
Accumulated unrealized loss, net of tax, on available-for-sale securities
 
(2,667
)
 
(2,917
)
Accumulated other comprehensive loss
 
$
(51,636
)
 
$
(32,596
)
NOTE 12—Deferred Revenue and Performance Obligations
Activity in the Company’s deferred revenue accounts is presented in the following table (in thousands):
 
 
February 28, 2018
 
Revenue recognized from opening balance
 
Deferred revenue, net (1)
 
August 31, 2018
Deferred revenue, short-term
 
$
1,853,719

 
$
(619,067
)
 
$
448,851

 
$
1,683,503

Deferred revenue, long-term
 
741,453

 
—

 
(31,707
)
 
709,746

Total deferred revenue
 
$
2,595,172

 
$
(619,067
)
 
$
417,144

 
$
2,393,249

____________________ 
(1) 
Includes revenue recognized from current period customer contracts and the impact from foreign currency exchange rate fluctuations.
As of August 31, 2018, the value of customer contracts allocated to performance obligations not yet satisfied, including $2.39 billion of total deferred revenue, was approximately $3.21 billion, of which approximately 60% is expected to be recognized as revenue within the next 12 months and the remainder thereafter.
In addition to the approximately $3.21 billion of customer contract value allocated to performance obligations not yet satisfied, as of August 31, 2018, the Company has offered customers options to purchase additional services at an agreed-upon price per hour that total approximately $129.6 million.
The summation of the customer contract value allocated to performance obligations not yet satisfied and the options to purchase additional services equals approximately $3.34 billion, which the Company considers as its total backlog.
NOTE 13—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 available to common stockholders 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, vesting of share-based awards, settlement of convertible notes, or exercise of warrants.
The following table reconciles the numerators and denominators of the earnings per share (“EPS”) calculation (in thousands, except per share amounts):
 
Three Months Ended
 
Six Months Ended
 
August 31, 2018
 
August 31, 2017 (1)
 
August 31, 2018
 
August 31, 2017 (1)
Net income available to common stockholders
$
86,854

 
$
97,088

 
$
200,044

 
$
172,402

Weighted average common shares outstanding
176,746

 
177,257

 
177,024

 
177,250

Incremental shares attributable to assumed vesting or exercise of outstanding equity award shares
2,997

 
3,058

 
3,525

 
3,021

Dilutive effect of convertible notes
3,699

 
2,706

 
3,801

 
2,189

Dilutive effect of warrants
3,494

 
—

 
3,711

 
—

Diluted shares
186,936

 
183,021

 
188,061

 
182,460

Diluted net income per share
$
0.46

 
$
0.53

 
$
1.06

 
$
0.94

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

22

RED HAT, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
(Unaudited)


With respect to the Company’s convertible notes, the Company has the option to pay cash or deliver, as the case may be, either cash, shares of its common stock or a combination of cash and shares of its common stock for the aggregate amount due upon conversion of the convertible notes. The Company’s intent is to settle the principal amount of the convertible notes in cash upon conversion. As a result, upon conversion of the convertible notes, only the amounts payable in excess of the principal amounts of the convertible notes are considered in diluted EPS under the treasury stock method. See NOTE 8—Convertible Notes for detailed information on the convertible notes.
Warrants to purchase 10,965,630 shares of the Company’s common stock at $101.65 per share were outstanding during the three and six months ended August 31, 2018 and August 31, 2017. For the three and six months ended August 31, 2018, the warrants were included in the computation of diluted EPS because the warrants’ exercise price was less 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): 
 
Three Months Ended
 
Six Months Ended
 
August 31, 2018
 
August 31, 2017
 
August 31, 2018
 
August 31, 2017
Number of shares considered anti-dilutive for calculating diluted EPS
1,052

 
—

 
—

 
10

NOTE 14—Share-based Awards
The Company measures share-based compensation cost at the grant date, based on the estimated fair value of the award and recognizes the cost over the employee requisite service period, typically on a straight-line basis. The Company estimates the fair value of stock options using the Black-Scholes-Merton valuation model. The fair value of nonvested share awards, nonvested share units and performance share units are measured at their underlying closing share price on the day of grant.
The following summarizes share-based compensation expense recognized in the Company’s Consolidated Financial Statements (in thousands):
 
Three Months Ended
 
Six Months Ended
 
August 31, 2018
 
August 31, 2017
 
August 31, 2018
 
August 31, 2017
Cost of revenue
$
4,747

 
$
4,261

 
$
9,875

 
$
8,209

Sales and marketing
22,824

 
20,817

 
42,344

 
41,430

Research and development
16,306

 
14,220

 
31,088

 
27,666

General and administrative
8,809

 
7,649

 
15,384

 
13,360

Total share-based compensation expense (1)
$
52,686

 
$
46,947

 
$
98,691

 
$
90,665

__________ 
(1)
Total share-based compensation expense included $3.8 million and $3.0 million, respectively, of expense related to the Company’s employee stock purchase plan (“ESPP”) for the three months ended August 31, 2018 and August 31, 2017 and $7.7 million and $5.9 million, respectively, for the six months ended August 31, 2018 and August 31, 2017.
Share-based compensation expense qualifying for capitalization was insignificant for each of the three and six months ended August 31, 2018 and August 31, 2017. Accordingly, no share-based compensation expense was capitalized during these periods.

23

RED HAT, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
(Unaudited)


The following table summarizes the Company’s share-based awards granted, by type:
 
Three Months Ended
 
August 31, 2018
 
August 31, 2017
 
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
93,517

 
$
146.20

 
48,443

 
$
98.53

 
Six Months Ended
 
August 31, 2018
 
August 31, 2017
 
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
762,967

 
$
158.77

 
886,838

 
$
86.85

Performance share units—target
173,014

(1) 
$
163.56

 
261,760

 
$
87.99

Performance share awards
64,219

(2) 
$
163.56

 
104,362

 
$
87.99

Total share-based awards
1,000,200

 
$
159.91

 
1,252,960

 
$
87.18

__________ 
(1) 
Certain executives and senior management were awarded a target number of performance share units (“PSUs”). PSU grantees may earn up to 200% of the target number of PSUs. Half of the target number of PSUs can be earned by the grantees depending upon the Company’s financial performance measured against the financial performance of specified peer companies during a three-year performance period beginning on March 1, 2018. The remaining target number of PSUs can be earned by the grantees depending upon the Company’s total shareholder return performance measured against the total shareholder return performance of specified peer companies during a three-year period beginning on March 1, 2018.
(2) 
Certain executives were granted restricted stock awards. These shares were awarded subject to the achievement of a specified dollar amount of revenue for the fiscal year ending February 28, 2019 (the “RSA Performance Goal”). If the Company fails to achieve the RSA Performance Goal, then all such shares are forfeited. If the Company achieves the RSA Performance Goal, then 25% of the restricted stock vests on or about July 16, 2019, and the remainder vests ratably on a quarterly basis over the course of the subsequent three years, provided that the grantee’s business relationship with the Company has not ceased.

NOTE 15—Assets and Liabilities Measured at Fair Value on a Recurring Basis
Fair value is defined as the exchange price that would be received for the purchase of an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for such asset or liability in an orderly transaction between market participants on the measurement date. Valuation techniques used to measure fair value should maximize the use of observable inputs and minimize the use of unobservable inputs. To measure fair value, the Company uses the following fair value hierarchy based on three levels of inputs, of which the first two are considered observable and the last unobservable:
Level 1—Quoted prices in active markets for identical assets or liabilities.
Level 2—Inputs other than Level 1 that are observable, either directly or indirectly, such as quoted prices for similar assets or liabilities; quoted prices in markets that are not active; or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the assets or liabilities.
Level 3—Unobservable inputs that are supported by little or no market activity and are significant to the fair value of the assets or liabilities.

24

RED HAT, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
(Unaudited)


The Company’s investments are comprised primarily of debt securities that are classified as available for sale and recorded at their fair 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 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 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 fair value, including broker quotes or model valuations. Independent price verifications of all holdings are performed by pricing vendors that 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 value.
The Company minimizes its credit risk associated with investments by investing primarily in investment-grade, liquid securities. The Company’s policy is designed to limit exposures to any one issuer depending on credit quality. Periodic evaluations of the relative credit standing of those issuers are considered in the Company’s investment strategy.
The following table summarizes the composition and fair value hierarchy of the Company’s financial assets and liabilities at August 31, 2018 (in thousands):
 
August 31, 2018
 
Level 1
 
Level 2
 
Level 3
Assets:
 
 
 
 
 
 
 
Money markets (1)
$
310,203

 
$
310,203

 
$
—

 
$
—

Interest-bearing deposits (1)
58,323

 
—

 
58,323

 
—

Available-for-sale securities (1):
 
 
 
 
 
 
 
Commercial paper
285,497

 
—

 
285,497

 
—

U.S. agency securities
275,584

 
—

 
275,584

 
—

Corporate securities
315,463

 
—

 
315,463

 
—

Foreign currency derivatives (2)
147

 
—

 
147

 
—

Liabilities:
 
 
 
 
 
 
 
Foreign currency derivatives (3)
(83
)
 
—

 
(83
)
 
—

Total
$
1,245,134

 
$
310,203

 
$
934,931

 
$
—

__________ 
(1) 
Included in Cash, cash equivalents and restricted cash, Investments in debt and equity securities, short-term or Investments in debt securities, long-term in the Company’s Consolidated Balance Sheet at August 31, 2018, in addition to $912.8 million of cash.
(2) 
Included in Other current assets in the Company’s Consolidated Balance Sheet at August 31, 2018.
(3) 
Included in Accounts payable and accrued expenses in the Company’s Consolidated Balance Sheet at August 31, 2018.

25

RED HAT, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
(Unaudited)


The following table summarizes the composition and fair value hierarchy of the Company’s financial assets and liabilities at February 28, 2018 (in thousands):
 
February 28, 2018
 
Level 1
 
Level 2
 
Level 3
Assets:
 
 
 
 
 
 
 
Money markets (1)
$
334,665

 
$
334,665

 
$
—

 
$
—

Interest-bearing deposits (1)
61,125

 
—

 
61,125

 
—

Available-for-sale securities (1):