10-Q 1 d10q.txt FORM 10-Q UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-Q (Mark One) X QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarter ended May 31, 2001 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: 0-26281 RED HAT, INC. (Exact name of registrant as specified in its charter) Delaware (State of Incorporation) 06-1364380 (I.R.S. Employer Identification No.) 2600 Meridian Parkway, Durham, North Carolina 27713 (Address of principal executive offices, including Zip Code) (919) 547-0012 (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 the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date: As of May 31, 2001, there were 169,816,384 shares of common stock outstanding. RED HAT, INC. TABLE OF CONTENTS
Page ---- PART I - FINANCIAL INFORMATION: ITEM 1: FINANCIAL STATEMENTS Consolidated Balance Sheets at May 31, 2001 (unaudited) and February 28, 2001 3 Consolidated Statements of Operations for the three months ended May 31, 2001 and 2000 (unaudited) 4 Consolidated Statements of Cash Flows for the three months ended May 31, 2001 and 2000 (unaudited) 5 Notes to Consolidated Financial Statements (unaudited) 6 ITEM 2: MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS 11 ITEM 3: QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK 26 PART II - OTHER INFORMATION: ITEM 2: CHANGES IN SECURITIES AND USE OF PROCEEDS 27 ITEM 6: EXHIBITS AND REPORTS ON FORM 8-K 27
SIGNATURES EXHIBIT INDEX PART 1 - FINANCIAL INFORMATION ITEM 1: FINANCIAL STATEMENTS RED HAT, INC. CONSOLIDATED BALANCE SHEETS
ASSETS May 31, February 28, 2001 2001 (unaudited) ------------- ------------- Current assets: Cash and cash equivalents $ 72,459,166 $ 85,212,830 Investments in debt and equity securities 47,076,615 62,911,634 Accounts receivable, net 20,800,035 25,203,635 Subcontractor receivable 74,408 3,441,394 Inventory 1,357,792 739,960 Prepaid expenses and other current assets 2,287,071 2,171,721 ------------- ------------- Total current assets 144,055,087 179,681,174 Property and equipment, net 15,776,131 14,591,510 Goodwill and intangibles, net 130,871,143 147,396,649 Investments in debt and equity securities 175,051,633 154,556,684 Other assets, net 5,364,746 9,025,138 ------------- ------------- Total assets $ 471,118,740 $ 505,251,155 ============= ============= LIABILITIES AND STOCKHOLDERS' EQUITY Current liabilities: Accounts payable $ 3,909,384 $ 9,681,174 Accrued expenses 13,303,677 15,915,682 Deferred revenue 12,638,837 12,150,549 Short term payable - 2,750,000 Current portion of capital lease obligations 265,388 193,895 ------------- ------------- Total current liabilities 30,117,286 40,691,300 Capital lease obligations 227,488 277,338 Commitments and contingencies - - Stockholders' equity: Noncontrolling interest in subsidiary 37,810 - Preferred stock, 5,000,000 shares authorized, none outstanding - - Common stock, $0.0001 par value, 225,000,000 shares authorized, 169,816,384 and 168,485,899 shares issued and outstanding at May 31, 2001 and February 28, 2001, respectively 16,983 16,849 Additional paid-in capital 627,414,567 643,712,385 Deferred compensation (15,438,815) (36,051,412) Accumulated deficit (171,148,542) (143,588,767) Accumulated other comprehensive income (loss) (108,037) 193,462 ------------- ------------- Total stockholders' equity 440,773,966 464,282,517 ------------- ------------- Total liabilities and stockholders' equity $ 471,118,740 $ 505,251,155 ============= =============
The accompanying notes are an integral part of these consolidated financial statements. RED HAT, INC. CONSOLIDATED STATEMENTS OF OPERATIONS
Three Months Ended ------------------------------------------------ May 31, May 31, 2001 2000 (unaudited) (unaudited) ------------------ ------------------ Subscription and services revenue: Subscription $ 11,353,991 $ 9,768,364 Services: Network consulting 5,196,304 5,680,738 Embedded development services 4,697,325 4,241,916 Open source services 4,355,933 2,018,418 ------------- ------------- Total subscription and services revenue 25,603,553 21,709,436 ------------- ------------- Cost of subscription and services revenue: Subscription 3,125,563 3,749,793 Services 8,005,907 7,092,774 Stock-based services (income) expense (31,771) 16,545 ------------- ------------- Total cost of subscription and services revenue 11,099,699 10,859,112 ------------- ------------- Gross profit on subscription and services revenue 14,503,854 10,850,324 ------------- ------------- Hardware resale revenue - 449,178 Cost of hardware resale revenue - 360,955 ------------- ------------- Gross profit on hardware resale revenue - 88,223 ------------- ------------- Operating expense: Sales and marketing 10,683,600 12,162,715 Research and development 4,296,781 3,271,184 General and administrative 7,088,747 8,025,453 Stock-based sales and marketing expense 1,090,517 1,396,082 Stock-based research and development expense 1,549,438 285,454 Stock-based general and administrative expense 1,067,670 1,927,727 Write-down of investments 4,250,005 - Amortization of goodwill and intangibles 16,516,609 6,709,392 ------------- ------------- Total operating expense 46,543,367 33,778,007 ------------- ------------- Loss from operations (32,039,513) (22,839,460) ------------- ------------- Other income (expense), net 4,480,183 5,481,691 ------------- ------------- Loss before income taxes (27,559,330) (17,357,769) Provision for income taxes 445 64,414 ------------- ------------- Net loss $ (27,559,775) $ (17,422,183) ============= ============= Net loss per common share: Basic ($0.16) ($0.11) Diluted ($0.16) ($0.11) Weighted average shares outstanding: Basic 169,002,929 159,463,590 Diluted 169,002,929 159,463,590
The accompanying notes are an integral part of these consolidated financial statements. RED HAT, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS
Three Months Ended -------------------------------------------- May 31, May 31, 2001 2000 (unaudited) (unaudited) ---------------- -------------- Cash flows from operating activities: Net loss $ (27,559,775) $ (17,422,183) Adjustments to reconcile net loss to net cash used in operating activities: Depreciation and amortization 18,008,150 7,674,152 Write-down of investments 4,250,005 - Stock-based compensation expense 3,513,561 3,063,274 Noncontrolling interest in subsidiary 37,810 - Provision for doubtful accounts 225,520 1,122,464 Provision for inventory obsolescence - 165,520 Loss on sale of property and equipment - 40,968 Changes in operating assets and liabilities: Accounts receivable 7,545,066 (8,436,855) Inventory (617,832) (1,020,359) Prepaid expenses (115,350) (56,491) Intangibles and other assets (592,467) (2,921,984) Accounts payable (5,771,790) (5,829,257) Accrued expenses (1,657,005) 5,089,301 Deferred revenue 488,288 2,217,104 --------------- ------------- Net cash used in operating activities (2,245,819) (16,314,346) --------------- ------------- Cash flows from investing activities: Purchase of investment securities (87,048,488) (226,794,764) Proceeds from sales and maturities of investment securities 82,565,525 101,113,082 Acquisitions of businesses, net of cash acquired (993,900) 5,463,761 Purchase of property and equipment (2,625,511) (2,382,994) --------------- ------------- Net cash (used in) provided by investing activities (8,102,374) (122,600,915) --------------- ------------- Cash flows from financing activities: Decrease in stockholders' notes receivable - 66,899 Repayments of notes payable (2,750,000) - Proceeds from issuance of common stock by PTI - 1,264,488 Proceeds from issuance of common stock under Employee Stock Purchase Plan - 96,674 Proceeds from exercise of common stock options and warrants 801,352 2,838,535 Payment of dividends to PTI shareholders - (3,850,000) Payments on capital lease obligations 21,643 (39,780) --------------- ------------- Net cash provided by financing activities (1,927,005) 376,816 --------------- ------------- Effect of foreign currency exchange rates on cash and cash equivalents (478,466) 98,224 Net (decrease) increase in cash and cash equivalents (12,753,664) (138,440,221) Cash and cash equivalents at beginning of the period 85,212,830 248,429,962 --------------- ------------- Cash and cash equivalents at end of period $ 72,459,166 $ 109,989,741 =============== =============
The accompanying notes are an integral part of these consolidated financial statements. NOTE 1-Organization Red Hat, Inc. and its subsidiaries ("Red Hat" or the "Company") offer users one single, trusted point of contact and a common platform for developing, deploying and managing open source software across Internet infrastructure and devices that connect to the Internet, ranging from small embedded devices to high availability clusters and integrated web server/e-commerce operating systems. The Red Hat Network, Red Hat's unique web based system management technology, helps companies worldwide easily manage all of their Red Hat Linux servers and appliances by delivering open source products, service, support and information on-line in real-time. Red Hat was incorporated in Connecticut in March 1993 as ACC Corp., Inc. In September 1995, the Company changed its name to Red Hat Software, Inc. In September 1998, the Company reincorporated in Delaware. In June 1999, the Company changed its name to Red Hat, Inc. NOTE 2-Summary of Significant Accounting Policies Unaudited Interim Financial Information The interim consolidated financial statements as of May 31, 2001 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 to present fairly the consolidated balance sheets, consolidated operating results, and consolidated cash flows for the periods presented in accordance with generally accepted accounting principles. The consolidated balance sheet at February 28, 2001 has been derived from the audited consolidated financial statements at that date. Operating results for the three month period ended May 31, 2001 are not necessarily indicative of the results that may be expected for the year ending February 28, 2002. Certain information and footnote disclosures normally included in financial statements prepared in accordance with generally accepted accounting principles have been omitted in accordance with the rules and regulations of the SEC. These interim consolidated financial statements should be read in conjunction with the consolidated financial statements and notes thereto for the year ended February 28, 2001. Principles of Consolidation The accompanying consolidated financial statements include the accounts of the Company and all of its wholly-owned subsidiaries. All significant intercompany accounts and transactions are eliminated in consolidation. Use of Estimates The preparation of financial statements in conformity with accounting principles generally accepted in the United States 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 date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Revenue Recognition Revenue from the sale of software products for which no technical support is provided is generally recognized upon shipment of the products, net of a reserve for estimated returns. A reserve for sales returns is recognized for sales of software products to distributors, who have a right of return, based on the Company's historical experience of sell-through to the end user by the distributor. The Company recognizes revenue from the sale of software products to new distributors of its software products based upon sell-through to the end user until the Company has sufficient historical experience with the distributor to allow the accurate estimation of sales returns. The Company provides certain support and subscription services with Red Hat Linux for a period of time, not exceeding six months, from the date of registration of the software products for no additional fee. In accordance with the provisions of Statement of Position No. 97-2, "Software Revenue Recognition" ("SOP 97-2") as amended by SOP 98-4 and SOP 98-9, the Company is recognizing all of the revenue from the sale of Red Hat Linux ratably over the period that the support and subscription services are provided. Service revenue consists of revenue for technical support and maintenance services, other than installation support, and customer training and education, revenue for software compiling, debugging and optimization contracts ("Development Contracts") and royalty revenue. Revenue for technical support and maintenance services, other than installation support, is deferred and recognized ratably over the term of the agreement, which is typically twelve months. Revenue for Development Contracts is recognized on the percentage-of- completion method, provided that the fee for such engineering services is fixed or determinable and the collection of the resulting receivable is probable. Revenue from customer training and education and other services is recognized at the date the services are performed. Professional consulting revenue, which is also included in services revenue, is recognized as the consultants provide services. Provisions for estimated losses on uncompleted contracts are made in the period in which such losses are determined. Web advertising revenue, which is included in subscription revenue, is recognized ratably in the period in which the advertisement is displayed, provided that the Company has no significant remaining obligations, at the lesser of the ratio of connections to the advertiser's website delivered over total guaranteed connections to the advertiser's website or the straight line basis over the term of the contract. If minimum guaranteed connections are not met, the Company defers recognition of the corresponding revenue until the guaranteed connections are achieved. Hardware resale revenue is recognized based on the shipping terms of the product. Effective January 1, 2000, the Company began migrating from a value added reseller to a pure professional services company. Therefore, an immaterial amount of hardware resale revenue was generated in the first quarter of fiscal 2001. Net Loss Per Common Share The Company computes net loss per common share in accordance with Statement of Financial Accounting Standards No. 128, "Earnings Per Share," ("SFAS 128") and SEC Staff Accounting Bulletin No. 98 ("SAB 98"). Under the provisions of SFAS 128 and SAB 98, basic net loss per common share ("Basic EPS") is computed by dividing net loss available to common stockholders by the weighted average number of common shares outstanding. Diluted net loss available to common stockholders per common share ("Diluted EPS") is computed by dividing net loss by the weighted average number of common shares outstanding and dilutive potential common share equivalents. Potential common shares consist of shares issuable upon the exercise of stock options and warrants and shares issuable upon conversion of outstanding mandatorily redeemable preferred stock. The calculation of net loss per share available to common stockholders does not include 8,404,660 and 14,564,355 potential shares of common stock equivalents for the three month periods ended May 31, 2001 and 2000, respectively, as their impact would be antidilutive. Segment Reporting Management identifies its operating segments primarily based on differences in the nature of its products and services and on geographical location. The Company's operating segments are subscription, network consulting, embedded development services, and open source services. Performance of these segments is evaluated based on their respective gross margins. The following table presents the revenues, costs and gross margins of network consulting, embedded development services, and open source services for the three months ended May 31, 2001 and 2000, respectively.
May 31, 2001 May 31, 2000 ------------ ------------ Network consulting revenue............................ $5,196,304 $5,680,738 Cost of network consulting revenue.................... 3,112,137 3,480,086 ------------ ------------ Gross margin.......................................... $2,084,167 $2,200,652 Embedded development services revenue................. $4,697,325 $4,241,916 Cost of embedded development services revenue......... 2,417,418 2,415,467 ------------ ------------ Gross margin.......................................... $2,279,907 $1,826,449 Open source services.................................. $4,355,933 $2,018,418 Cost of open source services revenue.................. 2,476,352 1,197,221 ------------ ------------ Gross margin.......................................... $1,879,581 $ 821,197
Information on the subscription segment is presented on the Consolidated Statement of Operations. Management evaluates the Company's assets on a consolidated basis only. Accordingly, no information has been provided and no allocations have been made related to segment assets. There were no transactions entered into between the Company's operating segments. The Company has international sales offices in the United Kingdom, Ireland, Germany, Hong Kong, Australia, and Japan. The following disclosure aggregates individually immaterial international operations and separately discloses the significant international operations at and for the three months ended May 31, 2001 and 2000.
North Asia Pacific America Europe and Japan Total ------- ------ --------- ----- Three Months Ended May 31, 2001 ------------------------------- Revenues from unaffiliated customers....... $ 19,949,941 $3,106,342 $ 2,547,270 $ 25,603,553 Net loss available to common stockholders.... $(26,846,225) $ (803,454) $ 89,904 $(27,559,775) Total assets..... $460,092,724 $7,238,218 $ 3,787,798 $471,118,740 Three Months Ended May 31, 2000 ------------------------------- Revenues from unaffiliated customers................... $ 19,081,563 $ 2,072,556 $ 1,004,495 $ 22,158,614 Net loss available to common stockholders................ $(15,378,626) $(1,001,157) $(1,042,400) $(17,422,183) Total assets................. $471,592,872 $10,766,071 $ 2,632,317 $484,991,260
Comprehensive Income The Company's items of accumulated other comprehensive income (loss) during the three months ended May 31, 2001 totaled ($108,037) and are comprised of an unrealized gain on investments in marketable securities of $1,454,641 and a foreign currency translation adjustment of ($1,562,678). The Company's items of other comprehensive income (loss) during the three months ended May 31, 2000 totaled ($1,338,988) and are comprised of an unrealized loss on investments in marketable securities of ($1,496,991) and a foreign currency translation adjustment of $158,003. Recent Accounting Pronouncements The FASB recently issued Statement of Financial Accounting Standards No. 137, "Accounting for Derivative Instruments and Hedging Activities - Deferral of Effective Date of FASB Statement No. 133" ("SFAS137"). The Statement defers for one year the effective date of FASB Statement No. 133, "Accounting for Derivative Instruments and Hedging Activities". The rule applies to all fiscal quarters of all fiscal years beginning after June 15, 2000. The adoption of SFAS 137 and SFAS 133 in the three months ended May 31, 2001 did not have a material impact on the consolidated financial position or results of operations. Legal Contingency Subsequent to the end of fiscal 2001, the Company and certain of its officers and directors were named as defendants in a class action suit. The plaintiff contends that the defendants violated federal securities laws by issuing a Registration Statement and Prospectus that contained materially false and misleading information and failed to disclose material information. The Prospectus was issued in connection with the Company's initial public offering in August 1999. The Company is reviewing the suit and believes that the complaints are without merit and intends to vigorously defend itself and its officers and directors. ITEM 2 - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Management's Discussion and Analysis of Financial Condition and Results of Operations contains forward-looking statements that involve known and unknown risks and uncertainties, including statements regarding Red Hat's strategy, financial performance, and revenue sources. These risks and uncertainties may cause Red Hat's actual results to differ materially from any forward-looking statements. These risks and uncertainties include, without limitation, the risks detailed below and in Red Hat's other filings with the Securities and Exchange Commission (the "SEC"), copies of which may be accessed through the SEC's web site at http://www.sec.gov. ------------------ Results of Operations The following table sets forth the results of operations for Red Hat expressed as a percentage of total revenue.
Three Months Ended May 31, 2001 2000 ---------------------------- (Unaudited) Subscription and services revenue: Subscription 44.3% 44.1% Services: Network consulting 20.3% 25.6% Embedded development services 18.4% 19.2% Open source services 17.0% 9.1% ---------------------------- Total subscription and services revenue 100.0% 98.0% Cost of subscription and services revenue: Subscription 12.2% 16.9% Services 31.3% 32.0% Stock-based services (income) expense -0.1% 0.1% ---------------------------- Total cost of subscription and services revenue 43.4% 49.0% ---------------------------- Gross profit on subscription and services revenue 56.6% 49.0% ---------------------------- Hardware resale revenue 0.0% 2.0% Cost of hardware resale revenue 0.0% 1.6% ---------------------------- Gross profit on hardware resale revenue 0.0% 0.4% ---------------------------- Operating expense: Sales and marketing 41.7% 54.9% Research and development 16.8% 14.8% General and administrative 27.7% 36.2% Stock-based sales and marketing expense 4.3% 6.3% Stock-based research and development expense 6.0% 1.3% Stock-based general and administrative expense 4.1% 8.7% Write-down of investments 16.6% 0.0% Amortization of goodwill and intangibles 64.5% 30.2% ---------------------------- Total operating expense 181.7% 152.4% ---------------------------- Loss from operations -125.1% -103.0% ---------------------------- Other income (expense), net 17.5% 24.7% ---------------------------- Loss before income taxes -107.6% -78.3% Provision for income taxes 0.0% 0.3% ---------------------------- Net loss -107.6% -78.6% ============================
Three Months Ended May 31, 2001 and May 31, 2000 Total revenue Total revenue increased 15.5% to $25.6 million in the three months ended May 31, 2001 from $22.2 million in the three months ended May 31, 2000. Revenue from international operations totaled $5.7 million during the three months ended May 31, 2001. Subscription revenue Subscription revenue is comprised primarily of revenue from sales of Red Hat Linux and related software products, sales of software development tools, technical support and maintenance fees, and web advertising revenue. Subscription revenue increased 16.2% to $11.4 million in the three months ended May 31, 2001 from $9.8 million in the three months ended May 31, 2000. This increase was primarily due to the release of Version 7.1 of Red Hat Linux in April 2001, rapid growth of our international operations, introduction of new open source offerings during the three months ended May 31, 2001, and an increase in technical support and maintenance revenue as a result of our increased focus on providing these services in the three months ended May 31, 2001 as compared to May 31, 2000. As a percentage of total revenue, subscription revenue increased to 44.3% in the three months ended May 31, 2001 from 44.1% in the three months ended May 31, 2000. The increase in subscription revenue as a percentage of total revenue is primarily a result of the timing of our product releases and the growth in our support revenues. Services revenue Services revenue is primarily comprised of embedded development fees, network consulting and engineering fees, training and education fees, and short-term open-source consulting contracts. Services revenue increased 19.3% to $14.2 million in the three months ended May 31, 2001 from $11.9 million in the three months ended May 31, 2000. As a percentage of total revenue, services revenue increased to 55.7% in the three months ended May 31, 2001 from 53.9% in the three months ended May 31, 2000. The increase in services revenue in total and as a percentage of total revenue resulted primarily from an increase in embedded development revenue due to an increase in the number, size and scope of embedded development contracts and an increase in training and education revenue due to the expansion of our course offerings. The increase in services revenue as a percentage of total revenue is primarily a result of the high rate of growth of our learning services business and the initiation of our Open Source Consulting practice as open source solutions, specifically Red Hat Linux, continue to be adopted by the enterprise. Cost of revenue Cost of subscription revenue Cost of subscription revenue consists of expenses we incur to manufacture, package and distribute our products and related documentation. These costs include expenses for physical media, literature and packaging, fulfillment and shipping, and labor related costs to provide technical support and maintenance. Also included are the cost of developing advertising on our web site and royalties we pay for licensing third-party applications included in our software products. Cost of subscription revenue decreased 16.6% to $3.1 million in the three months ended May 31, 2001 from $3.7 million in the three months ended May 31, 2000. As a percentage of subscription revenue, cost of subscription revenue decreased to 27.5% in the three months ended May 31, 2001 from 38.3% in the three months ended May 31, 2000. These decreases were directly related to a reduction in expenses incurred for physical media, literature, packaging and fulfillment, as well as efficiencies gained in providing technical support and maintenance of our products through consolidation and reorganization of our support and maintenance resources. Cost of services revenue Cost of services revenue is primarily comprised of salaries and related costs-- including non-cash, stock-based compensation charges--incurred for our personnel to deliver embedded development, network consulting and engineering, and open source services. We incur no direct costs related to royalties received from the licensing of our trademarks to third parties. Cost of services revenue increased 12.2% to $8.0 million in the three months ended May 31, 2001 from $7.1 million in the three months ended May 31, 2000. This increase was primarily due to the addition of personnel to provide embedded development, network consulting and engineering, and the development of our open source services organization. As a percentage of services revenue, cost of services revenue decreased to 56.0% in the three months ended May 31, 2001 from 59.5% in the three months ended May 31, 2000. This decrease was primarily due to an increase in the utilization rate of our network consulting and engineering personnel. We expect cost of services to increase as we further expand our service offerings. Cost of services as a percentage of services revenue is expected to vary significantly from period to period depending upon: . the mix of services we provide; . the number and scope of embedded development contracts; . whether our services are provided by our employees or third-party partners and contractors; and . the overall utilization rate of our services staff. Gross Profit Gross profit increased 32.6% to $14.5 million in the three months ended May 31, 2001 from $10.9 million in the three months ended May 31, 2000. As a percentage of total revenue, gross profit increased to 56.6% in the three months ended May 31, 2001 from 49.4% in the three months ended May 31, 2000. These increases were primarily the result of the increases in sales of software products, due to the release of Version 7.1 of Red Hat Linux in April 2001, the release of Version 7 of Red Hat Linux in September 2000, and an associated reduction in expenses incurred for packaging and fulfillment, as well as efficiencies gained in providing technical support and maintenance of our products. The increase in gross profit as a percentage of total revenue is also due to the decreasing reliance upon hardware resale revenue, as these revenues generate significantly lower margins than do the Company's other sources of revenue. Operating expense Sales and marketing Sales and marketing expense consists primarily of salaries and other related costs--including non-cash, stock-based compensation charges--for sales and marketing personnel, sales commissions, travel, public relations and marketing materials and tradeshows. Sales and marketing expense decreased 13.2% to $11.8 million in the three months ended May 31, 2001 from $13.6 million in the three months ended May 31, 2000. As a percentage of total revenue, sales and marketing expense decreased to 46.0% in the three months ended May 31, 2001 from 61.2% in the three months ended May 31, 2000. These decreases in sales and marketing expense were primarily due to a reduction in redundant marketing personnel subsequent to May 31, 2000. These personnel came from acquisitions completed in fiscal 2001. Research and development Research and development expense consists primarily of personnel and related costs--including non-cash, stock-based compensation charges--for development of our software products and web site. Research and development expense increased 64.4% to $5.8 million in the three months ended May 31, 2001 from $3.6 million in the three months ended May 31, 2000. As a percentage of total revenue, research and development expense increased to 22.8% in the three months ended May 31, 2001 from 16.1% in the three months ended May 31, 2000. The increase in research and development expense resulted from increased spending related to the development of our e-commerce and database solutions, costs incurred to complete the development of Version 7.1 of Red Hat Linux, and an increase in stock-based compensation expense. General and administrative General and administrative expense consists primarily of personnel and related costs--including non-cash, stock-based compensation charges--for general corporate functions, including finance, accounting, legal, human resources, facilities and information systems expenses and merger and acquisition costs. General and administrative expense decreased 18.1% to $8.2 million in the three months ended May 31, 2001 from $10.0 million in the three months ended May 31, 2000. This decrease resulted from: . a decrease in payroll related information systems expenses; and . a reduction in redundant general and administrative personnel subsequent to May 31, 2000 resulting from acquisitions completed in fiscal 2001; and . a decrease in stock-based compensation expense. As a percentage of total revenue, general and administrative expense decreased to 31.9% in the three months ended May 31, 2001 from 44.9% in the three months ended May 31, 2000. We expect general and administrative expense, excluding merger and acquisition costs, to decrease as a percentage of revenue as our revenues continue to increase. Write-down of investments Write-down of investments consists of the non-cash write-down of non-marketable equity securities. Fair value for non-marketable equity securities is estimated based on prices recently paid for shares in that company, as well as changes in market conditions. The estimated fair values are not necessarily representative of the amounts that the Company could realize in a current transaction. Write- down of investments increased to $4.3 million in the three months ended May 31, 2001 from zero in the three months ended May 31, 2000. As a percentage of total revenue, write-down of investments increased to 16.6% in the three months ended May 31, 2001 from zero in the three months ended May 31, 2000. Amortization of goodwill and intangibles Amortization of goodwill and intangibles consists of the amortization of goodwill and other intangible assets. Goodwill, which represents the excess of acquisition cost over the net assets acquired in business combinations, is amortized over its estimated useful life which is three years. Costs incurred for acquiring trademarks, copyrights and patents are capitalized and amortized using the straight line method over their estimated useful lives, which range from three to five years. Amortization of goodwill and intangibles increased 146.2% to $16.5 million in the three months ended May 31, 2001 from $6.7 million in the three months ended May 31, 2000. As a percentage of total revenue, amortization of goodwill and intangibles expense increased to 64.5% in the three months ended May 31, 2001 from 30.2% in the three months ended May 31, 2000. These increases were primarily due to acquisitions completed in the fiscal year ended February 28, 2001. Other income (expense), net Other income (expense), net consists of interest income earned on cash deposited in money market accounts and other short- and long-term investments, net of interest expense incurred on capital leases. Other income (expense), net decreased 18.3% to income of $4.5 million in the three months ended May 31, 2001 from income of $5.5 million in the three months ended May 31, 2000. As a percentage of total revenue, other income (expense), net decreased to 17.5% in the three months ended May 31, 2001 from 24.7% in the three months ended May 31, 2000. These decreases resulted from lower average cash and investment balances in the three months ended May 31, 2001 as compared to the three months ended May 31, 2000 due primarily to the use of a portion of the proceeds from the sale of common stock in our initial and secondary public offerings in August 1999 and February 2000, respectively, and a reduction in average interest rates in the first quarter of fiscal 2002 as compared to the first quarter of fiscal 2001. Provision for income taxes Provision for income taxes decreased to zero for the three months ended May 31, 2001 from $60,000 in the three months ended May 31, 2000. The decrease in provision for income taxes for the three months ended May 31, 2001 was primarily due to a decrease in foreign taxes paid. Liquidity and Capital Resources We have historically derived a significant portion of our liquidity and operating capital from the sale of equity securities, including private sales of preferred stock and the sale of common stock in our initial and secondary public offerings, and cash flows from operations. At May 31, 2001, we had cash and investments of $294.6 million, which is comprised of $72.5 million in cash and cash equivalents, $47.1 million of short-term, fixed income investments and $175.0 million of long-term, fixed income investments. At May 31, 2001, cash and cash equivalents totaled $72.5 million, a decrease of $12.8 million as compared to February 28, 2001. The decrease in cash and cash equivalents resulted from the purchase of net investments in debt and equity securities of $4.5 million, cash used by operations of $2.2 million, $2.6 million for the purchase of office and computer equipment, and repayment of notes payable of $2.8 million. This was partially offset by the receipt of $0.8 million in proceeds from exercise of stock options and warrants during the three months ended May 31, 2001. Cash used by operations of $2.2 million in the three months ended May 31, 2001, represented the net loss of $27.6 million, an increase in inventory of $0.6 million, an increase in prepaid expenses of $0.7 million, a decrease in accounts payable of $5.8 million, and a decrease in accrued expenses of $1.7 million, partially offset by an a decrease in accounts receivable of $7.6 million, an increase in deferred revenue of $0.5 million, and net non cash charges of $26.0 million. Cash used in operations includes $3.7 million representing costs incurred related to merger and acquisition activities. Excluding these costs, our recurring operations generated positive cash flow of $1.5 million during the three months ended May 31, 2001. Merger and acquisition costs is a non-GAAP measure and includes costs incurred in connection with investigating potential acquisitions and costs incurred related to completed acquisitions. Non-GAAP information is not prepared in accordance with GAAP and is not intended to be superior to GAAP information. Cash used in investing activities for the three months ended May 31, 2001 was comprised of the purchase of investments in debt securities, net of maturities, of $4.5 million, and purchases of property and equipment totaling $2.6 million. Cash used in financing activities of $1.9 million for the three months ended May 31, 2001 was primarily comprised of $0.8 million in proceeds from the exercise of stock options and warrants and repayment of notes payable of Planning Technologies, Inc., which we acquired in January 2001 in a transaction accounted for as a pooling of interests, of $2.8 million. Factors Affecting Future Results Risks Related to our Linux-based Open Source Business Model Our open source software business model is unproven. We have not demonstrated the success of our open source business model, which gives our customers the right to freely copy and distribute our software. No other company has built a successful open source business. Few open source software products have gained widespread commercial acceptance partly due to the lack of viable open source industry participants to offer adequate service and support on a long term basis. In addition, open source vendors are not able to provide industry standard warranties and indemnities for their products, since these products have been developed largely by independent parties over whom open source vendors exercise no control or supervision. If open source software should fail to gain widespread commercial acceptance, we would not be able to sustain our revenue growth and our business could fail. We depend on the support of Linux developers not employed by the us to release major product upgrades and maintain market share. We may not be able to release major product upgrades of Red Hat Linux on a timely basis because the heart of Red Hat Linux, the Linux kernel, is maintained by third parties. Linus Torvalds, the original developer of the Linux kernel, and a small group of independent engineers are primarily responsible for the development and evolution of the Linux kernel. If this group of developers fails to further develop the Linux kernel or if Mr. Torvalds or other prominent Linux developers, such as Alan Cox, David Miller or Stephen Tweedie, were to join one of our competitors or no longer work on the Linux kernel, we would have to either rely on another party to further develop the kernel or develop it ourselves. We cannot predict whether enhancements to the kernel would be available from reliable alternative sources. We could be forced to rely to a greater extent on our own development efforts, which would increase our development expenses and may delay our product release and upgrade schedules. In addition, any failure on the part of the kernel developers to further develop and enhance the kernel could stifle the development of additional Linux-based applications. We may not be able to effectively assemble and test our software because it consists largely of code developed by independent third parties over whom we exercise no control, which could result in unreliable products and damage to our reputation. Red Hat Linux, in compressed form, consists of approximately 1.1 gigabytes of code. Of that total, in excess of 1,000 megabytes have been developed by independent third parties, including approximately 10 megabytes of code contained in the Linux kernel. Included within the 1.1 gigabytes of code are more than 800 distinct software components developed by thousands of individual programmers which we must assemble and test before we can release a new version of Red Hat Linux. If these components are not reliable, Red Hat Linux could fail, resulting in serious damage to our reputation and potential litigation. Although we attempt to assemble only the best available components, we cannot be sure that we will be able to identify the highest quality and most reliable components or successfully assemble and test them. In addition, if these components were no longer available, we would have to develop them ourselves, which would significantly increase our development expenses. The scarcity of software applications for Linux-based operating systems could prevent commercial adoption of our products. Our products will not gain widespread commercial adoption until there are more third-party software applications designed to operate on Linux-based operating systems. These applications include word processors, databases, accounting packages, spreadsheets, e-mail programs, Internet browsers, presentation and graphics software and personal productivity applications. We intend to encourage the development of additional applications that operate on Linux-based operating systems by attracting third-party developers to the Linux platform, by providing open source tools to create these applications and by maintaining our existing developer relationships through marketing and technical support for third-party developers. If we are not successful in achieving these goals, however, our products will not gain widespread commercial acceptance and we will not be able to maintain our product sales growth. We may not be able to generate revenue from sales of Red Hat Linux if users can more quickly download it from the Internet. Anyone can download a free copy of Red Hat Linux from the Internet. However, because this download can take up to 36 hours using a standard telephone connection, many of our users choose to buy the shrink-wrapped version of Red Hat Linux. If hardware and data transmission technology advances in the future to the point where increased bandwidth allows users to more quickly download our products from the Internet, users may no longer choose to purchase Red Hat Linux. This could lead to a significant loss of product revenue. We may not succeed in shifting our business focus from traditional shrink- wrapped software sales to offering subscription-based product and services offerings. We are focusing our sales and marketing efforts on providing subscription-based products and services as opposed to relying on sales of shrink-wrapped software. This change has required us to expend significant financial and managerial resources and may ultimately prove unsuccessful. The failure to successfully implement this transition of our sales model could materially adversely affect our operating results. Our customers may find it difficult to install and implement Red Hat Linux, which could lead to customer dissatisfaction and damage our reputation. Installation and implementation of Red Hat Linux often involves a significant commitment of resources, financial and otherwise, by our customers. This process can be lengthy due to the size and complexity of our products and the need to purchase and install new applications. The failure by us to attract and retain services personnel to support our customers, the failure of companies with which we have strategic alliances to commit sufficient resources towards the installation and implementation of our products, or a delay in implementation for any other reason could result in dissatisfied customers. This could damage our reputation and the Red Hat brand and result in decreased revenue. We may be unable to predict the future course of open source technology development, which could reduce the market appeal of our products and damage our reputation. We do not exercise control over many aspects of the development of open source technology. Historically, different groups of open source software programmers have competed with each other to develop new technology. Typically one of those groups develops the technology that becomes more widely used than that developed by others. If we adopt new technology and incorporate it into our products, and competing technology becomes more widely used, the market appeal of our products may be reduced, which could harm our reputation, diminish the Red Hat brand and result in decreased revenue. Risks Related to our Financial Results and Condition Our limited operating history in the new and developing market for Linux-based operating systems makes it difficult to evaluate our business. Red Hat was formed in March 1993. We began offering Red Hat Linux in October 1994. Our limited operating history and the developing market for Linux-based operating systems makes it difficult to evaluate the risks and uncertainties that we face. Our failure to address these risks and uncertainties could cause our business results to suffer and result in the loss of all or part of your investment. We have limited combined operating history with the companies we have acquired since our initial public offering and may have difficulty integrating these businesses. The successful integration of the operations, products, services and personnel of Red Hat and the seven companies we have acquired since our initial public offering -- Cygnus Solutions, Hell's Kitchen Systems, Inc., Bluecurve, Inc., WireSpeed Communications Corporation, C2Net Software, Inc. Akopia, Inc., and Planning Technologies, Inc. -- is important to the future financial performance of the combined enterprise. The anticipated benefits of these acquisitions may not be achieved unless, among other things, the operations, products, services and personnel of the acquired companies are successfully combined with those of Red Hat in a timely and efficient manner. Integration of these companies' operations, products, services and personnel may be hampered because, among other things: . the products and services offered by each of the acquired companies and Red Hat are highly complex and have been developed independently; . integration of the product lines of Red Hat and each of the acquired companies will require the coordination of separate development and engineering teams from each company; and . the employees and management of the acquired companies and Red Hat are located in disparate geographical regions. In addition, the costs associated with integrating these companies' operations, products, services and personnel may be substantial and could include, among other things: . employee redeployment or relocation; and . the combination of research and development teams and processes. Any of these difficulties and costs encountered in the transition process, could divert the attention of management, and could have an adverse impact on the revenues and operating results of the combined enterprise. We expect to incur substantial losses on a GAAP basis for the foreseeable future. We have incurred operating losses in six of our previous seven fiscal years, including our most recent fiscal year ended February 28, 2001. We expect to incur significant losses on a GAAP basis for the foreseeable future, as we substantially increase our sales and marketing, research and development and administrative expenses. In addition, we are investing considerable resources in our Red Hat Network initiative and to expand our professional services offerings. As a result, we cannot be certain when or if we will achieve sustained profitability. Failure to become and remain profitable may adversely affect the market price of our common stock and our ability to raise capital and continue operations. You should not rely on our quarterly results of operations as an indication of our future results because they fluctuate significantly and are difficult to forecast. Due to our limited combined operating history and the unpredictability of our business, our revenue and operating results may fluctuate significantly from quarter to quarter and are difficult to forecast. We base our current and projected future expense levels in part on our estimates of future revenue. Our expenses are, to a large extent, fixed in the short term. We may not be able to adjust our spending quickly if our revenue falls short of our expectations. Accordingly, a revenue shortfall in a particular quarter would have a disproportionate adverse effect on our operating results for that quarter. You should not rely on quarter-to-quarter comparisons of our results of operations as an indication of our future performance. Our future operating results may fall below expectations of securities analysts or investors, which would likely cause the market price of our common stock to decline significantly. We may not be able to effectively attract additional enterprise customers and preserve relationships with current enterprise customers, which could adversely affect revenue. Historically, we focused our sales and marketing efforts on product sales to individuals. We have recently, however, begun to focus our efforts on expanding our enterprise customer base. To this end, we have invested extensively to attract enterprise customers. These enterprise customers expect diverse and extensive service programs, and if we are unable to continue to successfully expand and enhance our service offerings, we may not be able to meet these customers' needs or attract new customers, and, consequently, our revenue would suffer. Our failure to update and modernize our internal systems, procedures and controls may prevent the implementation of our business strategies in a rapidly evolving market and may constrain our future growth. Our operational and financial systems, procedures and controls, which were adequate for a small private company, are becoming outdated as we grow. Since March 1, 1999 we have increased the number of employees more than tenfold. To accommodate this growth, we have evaluated our financial and operational systems, procedures and controls. Although we have revised or are in the process of revising and updating most of them, if we continue our rapid growth, we may not be able to improve our transaction processing and reporting systems and procedures, or expand and train our expanding workforce quickly enough to maintain a competitive position in our markets. In addition, failure to quickly replace obsolete systems, procedures and controls could impede our management's decision-making abilities. This, in turn, may impair our ability to pursue business opportunities and may hamper future growth. We may not be able to generate enough additional revenue from our international expansion to offset the costs associated with establishing and maintaining foreign operations. A key component of our growth strategy is to expand our presence in foreign markets. We have established subsidiaries or offices in Canada, Ireland, the United Kingdom, Germany, Italy, Japan, France, Singapore and Australia, and are considering further expansion worldwide. We may also enter other markets as opportunities arise. It will be costly to establish international facilities and operations, promote our brand internationally, and develop localized web sites and other systems. Revenue from international activities may not offset the expense of establishing and maintaining these foreign operations. In addition, because we have little experience in marketing and distributing products or services for these markets, we may not benefit from any first-to- market advantages. Our management team may not be able to successfully implement our business strategies because it has only recently begun to work together. Our business is highly dependent on the ability of our management to work together effectively to meet the demands of our growth. Several members of our senior management have been employed by us for a relatively short period of time. These individuals have not previously worked together as a management team. The failure of our management team to work together effectively could prevent efficient decision-making by our executive team, affecting product development and sales and marketing efforts, which would negatively impact our operating results. We depend on our key personnel. Our future success depends on the continued services of a number of key officers, including our Chief Executive Officer and President, Matthew J. Szulik, our Chief Operating Officer, Timothy J. Buckley, our Executive Vice President of Engineering, Paul Cormier, and our Chief Financial Officer, Kevin B. Thompson. The loss of the technical knowledge and industry expertise of any of these people could seriously impede our success. Moreover, the loss of one or a group of our key employees, particularly to a competitor, and any resulting loss of customers could reduce our market share and diminish the Red Hat brand. With our declining stock price we may have increased difficulty in attracting and retaining highly skilled employees. As with most technology companies, a key component of our compensation package for our employees is stock options. With the decline in our stock price, many of the options granted in the last 18 months are now out of the money. In order to retain our highly skilled workforce, we may be compelled to grant new options. If such new options are granted, they are likely to have a dilutive effect on our stockholders. We may lack the financial and operational resources needed to increase our market share and compete effectively with Microsoft, other established operating systems developers, software development tools developers and other service and support providers. In the market for operating systems, we face significant competition from larger companies with greater financial resources and name recognition than we have. These competitors, which offer hardware-independent multi-user operating systems for Intel platforms and/or UNIX-based operating systems, include Microsoft, Novell, IBM, Sun Microsystems, The Santa Cruz Operation, AT&T, Compaq, Hewlett- Packard, Olivetti and Unisys. Some of these competitors currently, or may in the future, produce and market open source operating systems. We also face competition in the market for software development tools and operating systems for special purpose computing, including embedded systems. Our competitors in this market, some of which have greater market share than we do, include Wind River Systems, Integrated Systems Incorporated, Green Hills Software, and the Metrowerks subsidiary of Motorola. Some of these companies currently produce or use open source software as part of their product offerings. We may not be able to compete effectively in this market if customers choose proprietary solutions. If the demand for open source solutions in this market expands, however, we could lose market share as existing competitors reposition or new companies emerge to address the opportunity. As we increase our services offerings, we may face competition from larger and more capable companies that currently service and support the Linux operating system as well as other operating systems, particularly UNIX-based operating systems, due to the fact that Linux-and UNIX-based operating systems share many common features. These companies, including IBM and Hewlett-Packard, may be able to leverage their existing service organizations and provide higher levels of support on a more cost-effective basis than we can. We may not be able to compete successfully with these current or potential competitors. We may not be able to match the promotional activities and pricing policies offered by other suppliers of Linux-based and other open source operating systems, which could result in a loss of market share. In the new and rapidly evolving market for Linux-based operating systems, we face intense competition from a number of other suppliers of Linux-based operating systems. We also face competition to a lesser extent from developers of non-Linux-based open source operating systems such as BSD-based operating systems. BSD-based operating systems such as FreeBSD, NetBSD and OpenBSD are open source operating systems produced by communities of developers working together via the Internet, and which are published and distributed by Walnut Creek CD-ROM, among others. We expect competition in broader open source operating systems and the Linux-based operating systems market to intensify. In addition, companies like Sun Microsystems and IBM, which are more established and have larger customer bases than we do, have indicated a growing interest in the market for Linux-based operating systems. With the recent acquisition of BSDi by Wind River Systems, we will face increased competition in providing open source solutions in the embedded space. These companies may be able to undertake more extensive promotional activities, adopt more aggressive pricing policies, and offer more attractive terms to their customers than we can. Furthermore, because Linux-based operating systems can be downloaded from the Internet for free or purchased at a nominal cost and modified and re-sold with few restrictions, traditional barriers to entry are minimal. Accordingly, it is possible that new competitors or alliances among existing competitors may emerge and rapidly acquire significant market share. If we fail to establish and maintain strategic distribution and other collaborative relationships with industry-leading companies, we may not be able to attract and retain a larger customer base. Our success depends on our ability to continue to establish and maintain strategic distribution and other collaborative relationships with industry- leading hardware manufacturers, distributors, software vendors and enterprise solutions providers. These relationships allow us to offer our products and services to a much larger customer base than we would otherwise be able to through our direct sales and marketing efforts. We may not be able to maintain these relationships or replace them on attractive terms. In addition, our existing strategic relationships do not, and any future strategic relationships may not, afford us any exclusive marketing or distribution rights. As a result, the companies with which we have strategic alliances are free to pursue alternative technologies and to develop alternative products and services in addition to or in lieu of our products and services, either on their own or in collaboration with others, including our competitors. Moreover, we cannot guarantee that the companies with which we have strategic relationships will market our products effectively or continue to devote the resources necessary to provide us with effective sales, marketing and technical support. We may not be able to meet the operational and financial challenges that we will encounter as our international operations expand. As we expand our international operations, we will face a number of additional challenges associated with the conduct of business overseas. For example: . we may have difficulty managing and administering a globally-dispersed business; . fluctuations in exchange rates may negatively affect our operating results; . we may not be able to repatriate the earnings of our foreign operations; . we have to comply with a wide variety of foreign laws with which we are not familiar; . we may not be able to adequately protect our trademarks overseas due to the uncertainty of laws and enforcement in certain countries relating to the protection of intellectual property rights; . reductions in business activity during the summer months in Europe and certain other parts of the world could negatively impact the operating results of our foreign operations; . export controls could prevent us from shipping our products into and from some markets; . multiple and possibly overlapping tax structures could significantly reduce the financial performance of our foreign operations; . changes in import/export duties and quotas could affect the competitive pricing of our products and services and reduce our market share in some countries; and . economic or political instability in some international markets could result in the forfeiture of some foreign assets and the loss of sums spent developing and marketing those assets. Expanding our services business will be costly and may not result in any benefit to us. We have expanded our strategic focus to place additional emphasis on consulting, custom engineering and development, education and support services. We cannot be certain that our customers will engage our professional services organization to assist with support, consulting, embedded development, training and implementation of our products. We also cannot be certain that we can attract or retain a sufficient number of the highly qualified services personnel that the expansion of our services business will need. In addition, this expansion has required, and will continue to require, significant additional expenses and development, financial and operational resources. The need for these additional resources will place further strain on our management, financial and operational resources and may make it more difficult for us to achieve and maintain profitability. Attempts to expand by means of business combinations and strategic alliances may not be successful and may harm our operational efficiency, financial performance and relationships with employees and third parties. We may continue to expand our operations or market presence by entering into additional business combinations, investments, joint ventures or other strategic alliances with hardware manufacturers, software vendors, Internet companies, open source software developers or other companies both in the United States and internationally. Our ability to expand in this way may be limited due to the many financial and operational risks accompanying these transactions. For example: . we may have difficulty assimilating the operations, technology and personnel of the combined companies; . our business may be disrupted by the allocation of resources to consummate these transactions; . we may have problems retaining key technical and managerial personnel from acquired companies; . we may experience one-time in-process research and development charges and ongoing expenses associated with amortization of goodwill and other purchased intangible assets; . our stockholders will suffer dilution if we issue equity to fund these transactions; . acquired businesses may initially be unprofitable resulting in our assumption of operating losses and increased expenses; . our reputation may be harmed if the open source development community does not approve of these transactions; . our relationships with existing employees, customers and business partners may be weakened or terminated as a result of these transactions; and . our investment activities, particularly with respect to emerging-growth technology companies, are inherently risky and we may not realize any benefit from such activities. Risks Related to our Internet Strategy We may fail to promote and enhance our web site effectively, which may prevent us from attracting new visitors, advertisers or electronic commerce partners to our web site. In order to attract and retain Internet users, service customers, and electronic commerce partners, we intend to substantially increase our expenditures for enhancing and further developing our web site. Our success in promoting and enhancing the redhat.com web site will also depend on our ability to provide high quality service delivery, content, features and functionality. If we fail to promote our web site successfully or if visitors to our web site or customers do not perceive our services to be useful, current or of high quality, our ability to generate revenue from our web site will be significantly impaired. Visitors to our web site could experience delays and decreased performance during periods of heavy traffic, which could result in dissatisfaction with our web site and damage to our reputation. Our web site must accommodate a high volume of traffic and deliver frequently updated information. Our web site has in the past experienced slower response times or decreased traffic for a variety of reasons. These occurrences have not had a material impact on our business. These types of occurrences in the future, however, could materially adversely affect our reputation and brand name and could cause users to perceive our web site as not functioning properly. Under these circumstances, our users might choose another web site or other methods to obtain Linux-based operating systems, services, or Linux-related information. Our Internet strategy will fail if the infrastructure of the Internet is not continually developed and maintained. The success of our Internet strategy will depend in large part on the continued development and maintenance of the infrastructure of the Internet. Because global commerce and the online exchange of information is new and evolving, we cannot predict with any certainty that the Internet will be a viable commercial marketplace in the long term. The Internet has experienced, and we expect it to continue to experience, significant growth in the number of users and amount of traffic. If the Internet continues to experience an increased number of users, frequency of use or increased bandwidth requirements of users, it may not be able to support the demands placed upon it by this growth, and its performance and reliability may suffer. Furthermore, the Internet has experienced a variety of outages and other delays as a result of damage to portions of its infrastructure, and could face similar outages and delays in the future. Any outage or delay could affect the level of Internet usage, as well as the volume of traffic on our web site. In addition, the Internet could lose its viability due to increased governmental regulation and delays in the development or adoption of new standards and protocols to handle increased levels of activity. If the necessary infrastructure, standards or protocols or complementary products, services or facilities are not developed, or if the Internet does not become a viable commercial marketplace, our Internet strategy will not succeed. We are vulnerable to unexpected network interruptions caused by system failures, which may result in reduced visitor traffic on our web site, decreased revenue and harm to our reputation. Substantially all of our communications hardware and other hardware related to our web site is located at our facilities, although we have back-up and co- location hardware for our web site located at third-party facilities. Fire, floods, hurricanes, tornadoes, earthquakes, power loss, telecommunications failures, break-ins and similar events could damage these systems. In addition, although we have implemented network security measures, our servers are vulnerable to computer viruses, electronic break-ins, human error and other similar disruptive problems which could adversely affect our systems and web site. Although we try to prevent unauthorized access to our systems, we cannot eliminate this risk entirely. We could lose revenue and suffer damage to our reputation if our systems were affected by any of these occurrences. Our insurance policies may not adequately compensate us for any losses that may occur due to failures or interruptions in our systems. We do not presently have any secondary "off-site" systems or a formal disaster recovery plan. Risks Related to Legal Uncertainty We could be prevented from selling or developing our products if the GNU General Public License and similar licenses under which our products are developed and licensed are not enforceable. The Linux kernel and the Red Hat Linux operating system have been developed and licensed under the GNU General Public License and similar licenses. These licenses state that any program licensed under them may be liberally copied, modified and distributed. We know of no circumstance under which these licenses have been challenged or interpreted in court. Accordingly, it is possible that a court would hold these licenses to be unenforceable in the event that someone were to file a claim asserting proprietary rights in a program developed and distributed under them. Any ruling by a court that these licenses are not enforceable, or that Linux-based operating systems, or significant portions of them, may not be liberally copied, modified or distributed, would have the effect of preventing us from selling or developing our products. Our products may contain defects that may be costly to correct, delay market acceptance of our products and expose us to litigation. Despite testing by us and our customers, errors have been and may continue to be found in our products after commencement of commercial shipments. This risk is exacerbated by the fact that most of the code in our products is developed by independent parties over whom we exercise no supervision or control. If errors are discovered, we may have to make significant expenditures of capital to eliminate them and yet may not be able to successfully correct them in a timely manner or at all. Errors and failures in our products could result in a loss of, or delay in, market acceptance of our products and could damage our reputation and our ability to convince commercial users of the benefits of Linux-based operating systems and other open source software products. In addition, failures in our products could cause system failures for our customers who may assert warranty and other claims for substantial damages against us. Although our license agreements with our customers typically contain provisions designed to limit our exposure to potential product liability claims, it is possible that these provisions may not be effective or enforceable under the laws of some jurisdictions. Our insurance policies may not adequately limit our exposure to this type of claim. These claims, even if unsuccessful, could be costly and time consuming to defend. We are vulnerable to claims that our products infringe third-party intellectual property rights particularly because our products are comprised of many distinct software components developed by thousands of independent parties. We may be exposed to future litigation based on claims that our products infringe the intellectual property rights of others. This risk is exacerbated by the fact that most of the code in our products is developed by independent parties over whom we exercise no supervision or control. Claims of infringement could require us to reengineer our products or seek to obtain licenses from third parties in order to continue offering our products. In addition, an adverse legal decision affecting our intellectual property, or the use of significant resources to defend against this type of claim, could place a significant strain on our financial resources and harm our reputation. Our efforts to protect our trademarks may not be adequate to prevent third parties from misappropriating our intellectual property rights. Our most valuable intellectual property is our collection of trademarks. The protective steps we have taken in the past have been, and may in the future continue to be, inadequate to deter misappropriation of our trademark rights. Although we do not believe that we have suffered any material harm from misappropriation to date, we may be unable to detect the unauthorized use of, or take appropriate steps to enforce, our trademark rights. We have registered some of our trademarks in the United States, Europe and Australia and have other trademark applications pending in the United States, Europe, Australia, Canada, Europe and Japan. Effective trademark protection may not be available in every country in which we offer or intend to offer our products and services. Failure to adequately protect our trademark rights could damage or even destroy the Red Hat brand and impair our ability to compete effectively. Furthermore, defending or enforcing our trademark rights could result in the expenditure of significant financial and managerial resources. We may be sued as a result of information published or posted on or accessible from our redhat.com web site. We may be subjected to claims for defamation, negligence, copyright or trademark infringement or other claims relating to the information we publish on our web site. These types of claims have been brought, sometimes successfully, against online services in the past, and can be costly to defend. We may also be subjected to claims based on content that is accessible from our web site through links to other web sites or through content and materials that may be posted by visitors to our web site. We believe that the scope and amount of our commercial and general liability insurance is appropriate, given our current financial position. However, this insurance may not adequately protect us against these types of claims. We have not been a party to any lawsuit of this type to date. Risks Related to the Market for Our Common Stock Our stock price has been extremely volatile and you may not be able to resell your shares at or above your purchase price. The trading price of our common stock has been and is likely to continue to be highly volatile and could be subject to wide fluctuations in response to factors such as: . actual or anticipated variations in quarterly operating results; . new products or services offered by Red Hat or our competitors; . changes in financial estimates by securities analysts; . conditions or trends in the Internet, Linux and software industries; . changes in the economic performance and/or market valuations of other Internet, Linux and software industries; . announcements by us or our competitors of significant acquisitions, strategic partnerships, joint ventures or capital commitments; . additions or departures of key personnel; . sales of common stock; and . other events or factors, many of which are beyond our control. In addition, the stock market in general, and the NASDAQ National Market and the market for Internet-related and technology companies in particular, has experienced extreme price and volume fluctuations that have often been unrelated or disproportionate to the operating performance of such companies. In addition, broad market and industry factors may materially adversely affect the market price of our common stock, regardless of our actual operating performance. In the past, following periods of volatility in the market price of a company's securities, securities class-action litigation has often been instituted against such companies. Such litigation, if instituted, could result in substantial costs and a diversion of management's attention and resources, which would materially adversely affect our business, financial condition and operating results. ITEM 3. Quantitative and Qualitative Disclosures about Market Risk Interest Rate Risk The primary objective of Red Hat's investment activities is to preserve principal and liquidity while at the same time maximizing yields without significantly increasing risk. To achieve this objective, the Company maintains its portfolio of cash equivalents, short-term and long-term investments in a variety of fixed-income securities, including both government and corporate obligations and money market funds. Red Hat did not hold derivative financial instruments as of May 31, 2001, and has never held such investments in the past. Foreign Currency Risk Approximately 22.1% of the Company's revenues for the three months ended May 31, 2001 were generated by sales outside the United States. The Company is 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 in determining net income. Additionally, the assets and liabilities of the Company's non-U.S. operations are translated into U.S. dollars at exchange rates in effect as of the applicable balance sheet dates, and revenue and expense accounts of these operations are translated at average exchange rates during the month the transactions occur. Unrealized translation gains and losses will be included as an adjustment to stockholders' equity. PART II - OTHER INFORMATION ITEM 2: CHANGES IN SECURITIES AND USE OF PROCEEDS Use of Proceeds On August 11, 1999 the Securities and Exchange Commission declared effective the Company's Registration Statement on Form S-1 (File number 333-80051), relating to the initial public offering of the Company's Common Stock, $.0001 par value. The offering commenced on August 11, 1999 and all shares covered by the Registration Statement were sold. The proceeds to the Company, net of underwriting discounts and costs, was approximately $88.5 million. Measured on a cash out-flow basis only, all of the proceeds have been used to fund working capital requirements from the effective date of the registration statement (August 11, 1999) through May 31, 2001. None of the net proceeds from the IPO were used to pay, directly or indirectly, directors, officers, persons owning ten percent or more of the Company's equity securities, or affiliates of the Company. ITEM 6: EXHIBITS AND REPORTS ON FORM 8-K a. List of Exhibits: None b. Reports on Form 8-K On March 5, 2001, the Company filed a Current Report on Form 8-K to report, under Item 5, the completion of its acquisition of Planning Technologies, Inc. SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. Date: July 12, 2001 RED HAT, INC. By: /s/ MATTHEW J. SZULIK ------------------------ Matthew J. Szulik President and Chief Executive Officer (Officer on behalf of the Registrant) By: /s/ KEVIN B. THOMPSON ------------------------ Kevin B. Thompson Chief Financial Officer (Principal Financial Officer)