News Column

RED HAT INC - 10-Q - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

July 9, 2014

OVERVIEW

We are a leading global provider of open source software solutions, using a community-powered approach to develop and offer reliable and high-performing operating system, virtualization, middleware, storage and cloud technologies.

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



We primarily offer our enterprise technologies in the form of annual or multi-year subscriptions, and we recognize revenue over the period of the subscription agreements with our customers. We market our offerings primarily to enterprise customers.

We have focused on introducing and gaining acceptance for Red Hat enterprise technologies that comprise our open source architecture. Red Hat Enterprise Linux ("RHEL") and Red Hat JBoss Middleware offerings have gained widespread independent software vendor ("ISV") and independent hardware vendor ("IHV") support. We have continued to build our open source architecture by expanding our enterprise operating system and middleware offerings and introducing virtualization, storage, cloud and other offerings. We derive our revenue and generate cash from customers primarily from two sources: (i) subscription revenue and (ii) training and services revenue. These arrangements typically involve subscriptions to Red Hat enterprise technologies. Our revenue is affected by, among other factors, corporate, government and consumer spending levels. In evaluating the performance of our business, we consider a number of factors, including total revenue, deferred revenue, operating income, operating margin and cash flows from operations.



The arrangements with our customers that produce this revenue and cash are explained in further detail in Part II, Item 7 under "Critical Accounting Estimates" and in NOTE 2-Summary of Significant Accounting Policies to the Consolidated Financial Statements of our Annual Report on Form 10-K for the fiscal year ended February 28, 2014.

In our fiscal year ended February 28, 2014, we focused on and expect in our fiscal year ending February 28, 2015 to continue to focus on, among other things, (i) promoting the widespread adoption of Red Hat enterprise offerings by enterprise customers globally, (ii) expanding our virtualization, storage, cloud and other enterprise offerings, (iii) investing in the development of open source technologies, (iv) increasing revenue from our existing customer base, (v) increasing revenue by promoting a range of services to help our customers derive additional value, (vi) expanding routes to market, (vii) growing our presence in international markets, and (viii) pursuing strategic acquisitions and alliances. Revenue



For the three months ended May 31, 2014, total revenue increased 16.7%, or $60.5 million, to $423.8 million from $363.3 million for the three months ended May 31, 2013. Subscription revenue increased 17.8%, or $56.2

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million, driven primarily by additional subscriptions related to our principal Red Hat Enterprise Linux and Red Hat JBoss Middleware offerings, which continue to gain broader market acceptance in mission-critical areas of computing, and our expansion of sales channels and our geographic footprint. The increase is, in part, a result of the continued migration of enterprises in industries such as financial services, government, technology and telecommunications to our open source solutions from proprietary technologies. Training and services revenue increased 9.2%, or $4.3 million, for the three months ended May 31, 2014 as compared to the three months ended May 31, 2013. The increase is driven primarily by customer interest in new products and increased demand for our open source solutions.



We believe our success is influenced by:

the extent to which we can expand the breadth and depth of our enterprise

offerings; our ability to enhance the value of Red Hat enterprise offerings through



frequent and continuing innovation while maintaining stable platforms over

multi-year periods; our ability to generate increasing revenue from channel partner and other



strategic relationships, including cloud computing providers,

distributors, IHVs, ISVs, hardware original equipment manufacturers,

systems integrators and value added resellers;



our ability to generate new and recurring revenue for Red Hat enterprise

offerings;



the widespread and increasing deployment of open source technologies by

enterprises and similar institutions, such as government agencies and universities; and



our ability to provide customers with consulting and training services

that generate additional revenue.

Deferred revenue and billings proxy

Our deferred revenue, current and long-term, balance at May 31, 2014 was $1.27 billion. Because of our subscription model and revenue recognition policies, deferred revenue improves predictability of future revenue. For example, current deferred revenue provides a baseline for revenue to be recognized over the next twelve months. Similarly, long-term deferred revenue provides a baseline for revenue to be recognized beyond twelve months. Total deferred revenue at May 31, 2014 decreased $16.6 million, or 1.3%, as compared to the balance at February 28, 2014 of $1.29 billion. The decrease in deferred revenue reported on our Consolidated Balance Sheets of $16.6 million differs from the decrease we reported on our Consolidated Statement of Cash Flows for the three months ended May 31, 2014 of $19.7 million as the amount reported on our Consolidated Statement of Cash Flows for the three months ended May 31, 2014 excludes (i) the impact of changes in foreign currency exchange rates used to translate deferred revenue balances from our foreign subsidiaries' functional currencies into U.S. dollars and (ii) deferred revenue acquired as part of a business combination.



Billings proxy

We approximate our quarterly billings by adding revenue recognized on our Consolidated Statements of Operations to the change in total deferred revenue reported on our Consolidated Statements of Cash Flows. We use the change in deferred revenue as reported on our Consolidated Statements of Cash Flows because the amount has been adjusted for the impact of changes in foreign currency exchange rates used to translate deferred revenue balances from our foreign subsidiaries' functional currencies into U.S. dollars. Our billings proxy increased by $57.6 million, or 16.6%, to $404.0 million for the three months ended May 31, 2014 from $346.4 million for the three months ended May 31, 2013. For the four-fiscal-quarter period ended May 31, 2014 our rolling average billings proxy increased $67.4 million, or 17.6%, to $449.4 million from $382.0 million for the four-fiscal-quarter period ended May 31, 2013. For information regarding seasonality, see Part II, Item 7 under "Overview" of our Annual Report on Form 10-K for the fiscal year ended February 28, 2014. Subscription revenue Our enterprise technologies are sold primarily under subscription agreements. These agreements typically have a one- or three-year subscription period. A subscription generally entitles a customer to, among other things, a specified level of support, as well as new versions of the software, security updates, fixes, functionality 25



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enhancements and upgrades to the technology, if and when available, and compatibility with an ecosystem of certified hardware and software applications. Subscription revenue increased sequentially for the first quarter of fiscal 2015 and for each quarter of fiscal 2014 and fiscal 2013 and is being driven primarily by the increased use of our offerings by the enterprise and our expansion of sales channels and geographic footprint during these periods.



Revenue by geography

For the three months ended May 31, 2014, approximately $189.4 million, or 44.7%, of our revenue was generated outside the United States compared to approximately $158.3 million, or 43.6%, for the three months ended May 31, 2013. Our international operations are expected to grow as our international sales force and channels become more mature and as we enter new locations or expand our presence in existing locations. As of May 31, 2014, we had offices in more than 80 locations throughout the world. We operate our business in three geographic regions: the Americas (U.S., Latin America and Canada); EMEA (Europe, Middle East and Africa); and Asia Pacific (principally Australia, China, India, Japan, Singapore and South Korea). Revenue generated by the Americas, EMEA and Asia Pacific for the three months ended May 31, 2014 and the three months ended May 31, 2013 was as follows (in thousands): Americas EMEA Asia Pacific Consolidated Three Months Ended May 31, 2014 $ 266,093$ 100,774$ 56,887$ 423,754 Three Months Ended May 31, 2013 $ 233,426$ 80,050 $



49,783 $ 363,259

Year-over-year revenue growth rates in U.S. dollars for our three geographical regions were as follows for the three months ended May 31, 2014 and three months ended May 31, 2013: Americas EMEA Asia Pacific Consolidated Three Months Ended May 31, 2014 14.0 % 25.9 % 14.3 % 16.7 % Three Months Ended May 31, 2013 14.4 % 20.2 % 12.8 % 15.4 % Excluding the impact of foreign currency exchange rates, Americas, EMEA and APAC revenue grew 15.2%, 18.6% and 19.4%, respectively for the three months ended May 31, 2014 as compared to the three months ended May 31, 2013. As a result of our subscription-based revenue recognition model, revenue from the Americas continued to be affected by prior quarters' U.S. federal government spending while Japan, which is the largest revenue-producing country in our APAC region, performed well despite a weakened yen. As we expand further within each region, we anticipate revenue growth rates in local currencies to be similar among our geographic regions due to the similarity of products and services offered and the similarity in customer types or classes. Gross profit Gross profit margin increased to 84.8% for the three months ended May 31, 2014 from 84.6% for the three months ended May 31, 2013 due to a favorable mix shift, which increased subscription revenue relative to total revenue. The favorable mix shift was partially offset by increased staffing cost to support our emerging cloud offerings, such as OpenStack and OpenShift.



Gross profit margin by geography

Gross profit margins by our geographic regions for the three months ended May 31, 2014 and May 31, 2013 were as follows:

Americas EMEA Asia Pacific Consolidated Three Months Ended May 31, 2014 84.7 % 88.1 % 84.7 % 84.8 % Three Months Ended May 31, 2013 84.6 % 89.2 % 82.5 % 84.6 % 26



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

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



Income from operations

Operating income was 12.0% and 15.6% of total revenue for the three months ended May 31, 2014 and May 31, 2013, respectively. The decrease in operating income as a percentage of revenue was due primarily to continued investment in new and emerging cloud management technologies, the timing of our technology conferences which were held in the first quarter of fiscal 2015 versus the second quarter of fiscal 2014 and incremental transaction costs related to business combinations. These investments are described further in our analysis of results of operations below.



Income from operations by geography

Operating income as a percentage of revenue generated by our geographic regions for the three months ended May 31, 2014 and the three months ended May 31, 2013 was as follows: Americas EMEA Asia Pacific Consolidated (1) Three Months Ended May 31, 2014 15.6 % 24.0 % 24.8 % 12.0 % Three Months Ended May 31, 2013 20.1 % 25.6 % 24.6 % 15.6 %



(1) Consolidated operating income as a percentage of revenue includes corporate

(non-allocated) share-based compensation expense for the three months ended

May 31, 2014 and May 31, 2013 of $28.7 million and $23.1 million, respectively. For additional information, see NOTE 11-Segment Reporting to our Consolidated Financial Statements. Operating margin for the Americas decreased for the three months ended May 31, 2014 as compared to the three months ended May 31, 2013 primarily as a result of increased investments in research and development to support new technologies such as cloud management and the timing of our technology conferences which were held in the first quarter of fiscal 2015 versus the second quarter of fiscal 2014.



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

Cash, cash equivalents, available-for-sale investments in debt securities and cash flow from operations

Cash, cash equivalents and short-term and long-term available-for-sale investments in debt securities balances at May 31, 2014 totaled $1.40 billion. Cash generated from operating activities for the three months ended May 31, 2014 totaled $164.7 million which represents an increase of 16.1% in operating cash flow as compared to the three months ended May 31, 2013. This increase is due to increases in subscription and services revenues, billings and collections during the same periods. Our significant cash and investment balances give us a measure of flexibility to take advantage of opportunities such as acquisitions, increasing investment in international areas and repurchasing our common stock. 27



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Foreign currency exchange rates' impact on results of operations

Approximately 44.7% of our revenue for the three months ended May 31, 2014 was produced by sales outside the United States. We are exposed to significant risks of foreign currency fluctuation primarily from receivables denominated in foreign currency and are subject to transaction gains and losses, which are recorded as a component of net income. The income statements of our non-U.S. operations are translated into U.S. dollars at the average exchange rates for each applicable month in a period. To the extent the U.S. dollar weakens against foreign currencies, the translation of these foreign-currency-denominated transactions results in increased revenue and operating expenses from operations for our non-U.S. operations. Similarly, our revenue and operating expenses will decrease for our non-U.S. operations if the U.S. dollar strengthens against foreign currencies.



Three Months Ended May 31, 2014

Using the average foreign currency exchange rates from the first quarter of our prior fiscal year ended February 28, 2014, our revenue and operating expenses from non-U.S. operations for the three months ended May 31, 2014 would have been lower than we reported by approximately $0.6 million and higher than we reported by approximately $1.3 million, respectively, which would have resulted in income from operations being lower by $1.9 million.



Business combinations

On April 30, 2014, we completed our acquisition of Inktank, a provider of scale-out, open source storage systems, whose flagship technology, Inktank Ceph Enterprise, delivers object and block storage software to enterprises deploying public or private clouds. The acquisition is intended to complement our existing GlusterFS-based storage offering. Under the terms of the purchase agreement, the consideration transferred totaled $152.5 million. Additionally, we incurred approximately $2.0 million in acquisition-related expenses, including legal and accounting fees. These costs have been expensed as incurred and are included in general and administrative expense on our Consolidated Statement of Operations for the three months ended May 31, 2014. As a result of the acquisition of Inktank, operating expenses, other than acquisition-related expenses described above, increased by approximately $1.8 million for the three months ended May 31, 2014 as compared to the three months ended May 31, 2013. For further discussion, see NOTE 14-Business Combinations to our Consolidated Financial Statements. On June 18, 2014 we announced the signing of a definitive agreement to acquire eNovance, a privately held company, for approximately 50 million Euros in cash and 20 million Euros of value in shares of our common stock. eNovance is a provider of open source cloud computing services. The acquisition is intended to advance our existing leadership in OpenStack, and the addition of eNovance's systems integration capabilities and engineering talent is expected to help meet growing demand for enterprise OpenStack consulting, design and deployment. The acquisition was completed on June 24, 2014. 28



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RESULTS OF OPERATIONS



Three months ended May 31, 2014 and May 31, 2013

The following table is a summary of our results of operations for the three months ended May 31, 2014 and May 31, 2013 (in thousands):

Three Months Ended (Unaudited) May 31, May 31, $ % 2014 2013 Change Change Revenue: Subscriptions $ 371,968$ 315,817$ 56,151 17.8 % Training and services 51,786 47,442 4,344 9.2 Total subscription and training and services revenue 423,754 363,259



60,495 16.7

Cost of subscription and training and services revenue: Cost of subscriptions 27,760 23,375 4,385 18.8 As a % of subscription revenue 7.5 % 7.4 % Cost of training and services 36,683 32,682 4,001 12.2 As a % of training and services revenue 70.8 % 68.9 % Total cost of subscription and training and services revenue 64,443 56,057 8,386 15.0 As a % of total revenue 15.2 % 15.4 % Total gross profit 359,311 307,202 52,109 17.0 Operating expense: Sales and marketing 176,838 142,444 34,394 24.1 Research and development 89,939 73,802 16,137 21.9 General and administrative 41,571 34,333 7,238 21.1 Total operating expense 308,348 250,579 57,769 23.1 Income from operations 50,963 56,623 (5,660 ) (10.0 ) Interest income 1,842 1,502 340 22.6 Other income (expense), net 357 (424 ) 781 184.2



Income before provision for income taxes 53,162 57,701

(4,539 ) (7.9 ) Provision for income taxes 15,417 17,310 (1,893 ) (10.9 ) Net income $ 37,745$ 40,391$ (2,646 ) (6.6 )% Gross profit margin-subscriptions 92.5 % 92.6 % Gross profit margin-training and services 29.2 % 31.1 % Gross profit margin 84.8 % 84.6 % As a % of total revenue: Subscription revenue 87.8 % 86.9 % Training and services revenue 12.2 % 13.1 % Sales and marketing expense 41.7 % 39.2 % Research and development expense 21.2 % 20.3 % General and administrative expense 9.8 % 9.5 % Total operating expenses 72.8 % 69.0 % Income from operations 12.0 % 15.6 %



Income before provision for income taxes 12.5 % 15.9 % Net income

8.9 % 11.1 % Estimated annual effective income tax rate 29.0 % 30.0 % 29



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Table of Contents Revenue Subscription revenue Subscription revenue, which is primarily comprised of direct and indirect sales of Red Hat enterprise offerings, increased by 17.8%, or $56.2 million, to $372.0 million for the three months ended May 31, 2014 from $315.8 million for the three months ended May 31, 2013. Revenue derived from the sale of subscriptions supporting our Infrastructure-related offerings increased by 14.2%, or $39.8 million, to $319.1 million for the three months ended May 31, 2014 from $279.3 million for the three months ended May 31, 2013 and is primarily due to increases in volumes sold, including additional subscriptions attributable to geographic expansion and the continued migration of enterprises to our open source Linux platform from proprietary operating systems. Revenue derived from the sale of subscriptions supporting our Application Development-related and other emerging technology offerings increased by 44.8%, or $16.4 million, to $52.9 million for the three months ended May 31, 2014 from $36.5 million for the three months ended May 31, 2013. The increase is primarily due to additional subscriptions for Red Hat JBoss Middleware offerings. We expect the growth rate of revenue derived from our Application Development-related and other emerging technology offerings to exceed the growth rate of revenue derived from our Infrastructure-related offerings as our Application Development-related and other emerging technology offerings continue to gain broader market acceptance in the enterprise IT environment.



Training and services revenue

Training revenue includes fees paid by our customers for delivery of educational materials and instruction. Services revenue includes fees received from customers for consulting services regarding our offerings, deployment of Red Hat enterprise technologies and for delivery of added functionality to Red Hat enterprise technologies for our major customers and OEM partners. Total training and services revenue increased by 9.2%, or $4.3 million, to $51.8 million for the three months ended May 31, 2014 from $47.4 million for the three months ended May 31, 2013. The increase is due to services revenue which increased by 13.6%, or $4.7 million, as a result of an increase in consulting engagements driven by increased demand for our open source solutions. Combined training and services revenue decreased as a percentage of total revenue to 12.2% for the three months ended May 31, 2014 from 13.1% for the three months ended May 31, 2013. Cost of revenue Cost of subscription revenue The cost of subscription revenue primarily consists of expenses we incur to support, distribute and package Red Hat enterprise offerings. These costs include labor-related cost to provide technical support, security updates and fixes, as well as costs for fulfillment, physical media, literature, packaging and shipping. Cost of subscription revenue increased by 18.8%, or $4.4 million, to $27.8 million for the three months ended May 31, 2014 from $23.4 million for the three months ended May 31, 2013. The increase is primarily due to the expansion of our technical staff in order to meet the demands of our growing subscriber base for support, security updates and fixes, and includes additional compensation of $3.3 million. The remaining increase is driven primarily by incremental facilities costs and amortization expense related to technology acquisitions. Gross profit margin on subscriptions decreased slightly to 92.5% for the three months ended May 31, 2014 from 92.6% for the three months ended May 31, 2013. As the number of open source technology subscriptions continues to increase, we expect associated support cost will continue to increase, although we anticipate this will occur at a rate slower than that of subscription revenue growth due to economies of scale.



Cost of training and services revenue

Cost of training and services revenue is mainly comprised of personnel and third-party consulting costs for the design, development and delivery of custom engineering, training courses and professional services provided

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to various types of customers. Cost of training and services revenue increased by 12.2%, or $4.0 million, to $36.7 million for the three months ended May 31, 2014 from $32.7 million for the three months ended May 31, 2013. Costs to deliver our services revenue increased by 15.7%, or $4.0 million, and relate to additional employee compensation and travel associated with additions to our emerging technologies staff. Total costs to deliver training and services as a percentage of training and services revenue was 70.8% and 68.9% for each of the three month periods ended May 31, 2014 and May 31, 2013, respectively.



Gross profit

Gross profit margin increased to 84.8% for the three months ended May 31, 2014 from 84.6% for the three months ended May 31, 2013 due to a favorable mix shift, which increased subscription sales relative to total sales. The favorable mix shift was partially offset by an increase in staffing costs to support our emerging cloud offerings, such as OpenStack and OpenShift.



Operating expenses

Sales and marketing

Sales and marketing expense consists primarily of salaries and other related costs for sales and marketing personnel, sales commissions, travel, public relations and marketing materials and trade shows. Sales and marketing expense increased by 24.1%, or $34.4 million, to $176.8 million for the three months ended May 31, 2014 from $142.4 million for the three months ended May 31, 2013. This increase was primarily due to a $23.8 million increase in selling costs, which includes $17.2 million of additional employee compensation expense attributable to the expansion of our sales force from the prior year and $2.8 million related to travel. The remaining increase relates to marketing costs, which grew 32.3%, or $10.5 million, for the three months ended May 31, 2014 as compared to the three months ended May 31, 2013. The increase in marketing costs includes $7.1 million related to increased advertising expense primarily resulting from trade-show costs, as we held our technology conferences in the first quarter of fiscal 2015 versus the second quarter of fiscal 2014. As a result of expanded sales staffing and the timing of our technology conferences, sales and marketing expense increased as a percentage of revenue to 41.7% for the three months ended May 31, 2014 from 39.2% for the three months ended May 31, 2013.



Research and development

Research and development expense consists primarily of personnel and related costs for development of software technologies and systems management offerings. Research and development expense increased by 21.9%, or $16.1 million, to $89.9 million for the three months ended May 31, 2014 from $73.8 million for the three months ended May 31, 2013. The increase in research and development costs primarily resulted from the expansion of our engineering group as a result of both direct hires and business combinations as we continue investing in cloud management and our other emerging technologies. Employee compensation increased by $11.7 million. The remaining increase in research and development costs relates primarily to process and technology infrastructure enhancements, which increased $2.7 million. Research and development expense was 21.2% and 20.3% of total revenue for the three months ended May 31, 2014 and May 31, 2013, respectively.



General and administrative

General and administrative expense consists primarily of personnel and related costs for general corporate functions, including information systems, finance, accounting, legal, human resources and facilities expense. General and administrative expense increased by 21.1%, or $7.2 million, to $41.6 million for the three months ended May 31, 2014 from $34.3 million for the three months ended May 31, 2013. The increase in general and administrative expenses results from increased compensation-related expense of $3.3 million. The remaining increase includes $2.0 million of transaction costs related to business combinations. Primarily as a result of the incremental costs related to business combinations, general and administrative expense increased as a percentage 31



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of revenue to 9.8% for the three months ended May 31, 2014 from 9.5% for the three months ended May 31, 2013. We expect general and administrative costs to decrease as a percentage of total revenue as we continue to realize and leverage benefits from investments made during the prior fiscal year in process and technology infrastructure enhancements to support our corporate functions.



Interest income

Interest income increased by 22.6%, or $0.3 million, for the three months ended May 31, 2014 as compared to the three months ended May 31, 2013. The increase in interest income for the three months ended May 31, 2014 is attributable to prevailing yields earned on larger cash and investment balances.



Other income (expense), net

Other income (expense), net increased by 184.2%, or $0.8 million, for the three months ended May 31, 2014 as compared to the three months ended May 31, 2013. The increase is primarily due to net gains realized on the sale of investments during the three months ended May 31, 2014.



Income taxes

During the three months ended May 31, 2014, we recorded $15.4 million of income tax expense, which is based on an estimated annual effective tax rate of 29%. Our estimated annual effective tax rate of 29% is less than the U.S. federal statutory rate of 35% primarily due to foreign income taxed at lower rates. During the three months ended May 31, 2013, we recorded $17.3 million of income tax expense, which was based on a then estimated annual effective tax rate of 30%. Our estimated annual effective tax rate of 30% was less than the U.S. federal statutory rate of 35% primarily due to foreign income taxed at lower rates and the U.S. federal research tax credit. LIQUIDITY AND CAPITAL RESOURCES We derive our liquidity and operating capital primarily from cash flows from operations. Historically, we also received cash from the sale of equity securities, including private sales of preferred stock and the sale of common stock in our initial and follow-on public offerings, and the issuance of convertible debentures. At May 31, 2014, we had total cash and investments of $1.40 billion, which was comprised of $564.1 million in cash and cash equivalents, $179.8 million of short-term, available-for-sale, fixed-income investments, $59.3 million in interest-bearing deposit accounts with maturity dates greater than 30 days and $596.9 million of long-term, available-for-sale fixed-income investments. This compares to total cash and investments of $1.49 billion at February 28, 2014. With $564.1 million in cash and cash equivalents on hand, we believe our cash and cash equivalent balances, together with our ability to generate additional cash from operations, should be sufficient to satisfy our cash requirements for the next twelve months and for the foreseeable future. However, we may take advantage of favorable capital market conditions that may arise from time to time to raise additional capital. We presently do not intend to liquidate our short- and long-term investments in debt securities prior to their scheduled maturity dates. However, in the event that we liquidate these investments prior to their scheduled maturities and there are adverse changes in market interest rates or the overall economic environment, we could be required to recognize a realized loss on those investments when we liquidate those investments. At May 31, 2014, net accumulated unrealized gains on our available-for-sale debt securities totaled $0.4 million. At February 28, 2014, net accumulated unrealized gains on our available-for-sale debt securities totaled $0.5 million. 32



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Three months ended May 31, 2014

Cash flows-overview

At May 31, 2014, cash and cash equivalents totaled $564.1 million, a decrease of $82.6 million as compared to February 28, 2014. The decrease in cash and cash equivalents for the three months ended May 31, 2014 is primarily the result of the acquisition of Inktank, which included net cash consideration of $151.6 million, and the repurchase of 1,597,696 shares of our common stock for $80.0 million. Partially offsetting cash used in investing and financing activities was cash provided by operations which generated $164.7 million for the three months ended May 31, 2014. Net cash generated by operating activities and used for investing and financing activities is further described below.



Cash flows from operations

Cash provided by operations of $164.7 million during the three months ended May 31, 2014 includes net income of $37.7 million, adjustments to exclude the impact of non-cash revenues and expenses, which totaled a $51.7 million net source of cash, and changes in operating assets and liabilities, which totaled a $75.3 million net source of cash. Cash provided by changes in operating assets and liabilities for the three months ended May 31, 2014 was primarily the result of collections on our prior quarter's significant billings which generated operating cash flow of $96.6 million. These collections were partially offset by a reduction in deferred revenue of $19.7 million for the three months ended May 31, 2014 which corresponds to our typical, seasonal first quarter reduction in billings. Cash flows from investing Cash used in investing activities of $156.4 million for the three months ended May 31, 2014 includes net cash of $151.6 million used to acquire Inktank and investments in property and equipment of $8.6 million, primarily related to leasehold improvements.



Cash flows from financing

Cash used in financing activities of $93.1 million for the three months ended May 31, 2014 includes $80.0 million used to repurchase 1,597,696 shares of our common stock. See NOTE 10-Share Repurchase Program to our Consolidated Financial Statements for further discussion of our share repurchase program. Payments made in return for common shares received from employees to satisfy employees' minimum tax withholding obligations related to restricted share awards vesting during the three months ended May 31, 2014 totaled $13.7 million. Partially offsetting financing activities using cash were proceeds from excess tax benefits related to share-based employee compensation which totaled $1.0 million.



Investments in debt securities

Our investments are comprised primarily of debt securities that are classified as available for sale and recorded at their fair market values. At May 31, 2014 and February 28, 2014, the vast majority of our investments were priced with the assistance of pricing vendors. These pricing vendors use the most recent observable market information in pricing these securities or, if specific prices are not available for these securities, use other observable inputs. In the event observable inputs are not available, we assess other factors to determine the securities' market value, including broker quotes or model valuations. Independent price verifications of all of our holdings are performed by the pricing vendors, which we review. In the event a price fails a pre-established tolerance check, it is researched so that we can assess the cause of the variance to determine what we believe is the appropriate fair market value.



Capital requirements

We have experienced a substantial increase in our operating expenses since our inception in connection with the growth of our operations, the development of our enterprise technologies, the expansion of our services 33



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operations and our acquisition activity. Our capital requirements during the fiscal year ending February 28, 2015 will depend on numerous factors, including the amount of resources we devote to: funding the continued development of our enterprise offerings; improving and extending our services and the technologies used to market



and deliver these services to our customers and support our business;

pursuing strategic acquisitions and alliances; investing in or acquiring businesses, products and technologies; and



investing in enhancements to the systems we use to run our business and

the expansion of our office facilities.

We have utilized, and will continue from time to time to utilize, cash and investments to fund, among other potential uses, purchases of our common stock, purchases of fixed assets, purchases of intangible assets (primarily patents) and mergers and acquisitions. Given our historically strong operating cash flow and the $1.40 billion of cash and investments held at May 31, 2014, we do not presently anticipate the need to raise cash to fund our operations, either through the sale of additional equity or through the issuance of debt, in the foreseeable future. However, we may take advantage of favorable capital market conditions that may arise from time to time to raise additional capital. We believe that cash flows from operations will continue to improve; however, there can be no assurances that we will improve our cash flows from operations from the current rate or that such cash flows will be adequate to fund other investments or acquisitions that we may choose to make or that cash may be located in or generated in the appropriate geography where we can effectively use such cash. We may choose to accelerate the expansion of our business from our current plans, which may require us to raise additional funds through the sale of equity or debt securities or through other financing means. There can be no assurances that any such financing would occur in amounts or on terms favorable to us, if at all. As of May 31, 2014, our cash, cash equivalents and available-for-sale investment securities totaled $1.40 billion, of which $791.7 million was held outside the U.S. Our intent is to reinvest the earnings of foreign subsidiaries indefinitely outside the U.S. to fund both organic growth and acquisitions. For further discussion related to geographic segments, see NOTE 11-Segment Reporting to our Consolidated Financial Statements. With $608.4 million or 43.5% of our available cash, cash equivalents and available-for-sale investments, as of May 31, 2014, held within the U.S., we do not anticipate a need to repatriate any foreign earnings for the foreseeable future. However, if cash held outside the U.S. were needed to fund our U.S. operations, under current tax law we would be subject to additional taxes on the portion related to repatriated earnings of our foreign subsidiaries. As of February 28, 2014, cumulative undistributed foreign earnings totaled $296.4 million. For further discussion, see NOTE 11-Income Taxes to our Consolidated Financial Statements contained in our Annual Report on Form 10-K for the year ended February 28, 2014.



Off-balance sheet arrangements

As of May 31, 2014 and February 28, 2014, we have no off-balance sheet financing arrangements and do not utilize any "structured debt", "special purpose" or similar unconsolidated entities for liquidity or financing purposes.

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