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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

For the quarterly period ended November 30, 2003

OR

For the transition period from             to            .

Commission File Number: 000-26281

RED HAT, INC.

(Exact name of registrant as specified in its charter)

Delaware

(State of Incorporation)

06-1364380

(I.R.S. Employer Identification No.)

1801 Varsity Drive, Raleigh, North Carolina 27606

(Address of principal executive offices, including Zip Code)

(919) 754-3700

(Registrant’s telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  x    No  ¨

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).     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 November 30, 2003, there were 175,260,239 shares of common stock outstanding.

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RED HAT, INC.

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PART I – FINANCIAL INFORMATION

ITEM 1: FINANCIAL STATEMENTS

RED HAT, INC.

CONSOLIDATED BALANCE SHEETS

(In thousands – except share amounts)

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

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RED HAT, INC.

CONSOLIDATED STATEMENTS OF OPERATIONS

(In thousands - except per share amounts)

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

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RED HAT, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands)

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

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NOTE 1-Organization

Red Hat, Inc. together with its subsidiaries (“Red Hat” or the “Company”) is the global leader in providing an enterprise operating system based on open source technology to large enterprises for their information technology infrastructure. Red Hat delivers a single open source operating system, Red Hat Enterprise Linux AS, ES and WS, from the mainframe to the Intel server to the embedded device and the ability to remotely manage this platform. The Company has developed an enterprise operating system that meets most of the functionality requirements and performance demands of the information technology infrastructure of large enterprises and those third-party hardware and third-party software applications that are critical to large enterprises. In October 2003, the Company released Red Hat Enterprise Linux 3. Red Hat Enterprise Linux 3 provides a stable operating system that enables customers to realize the benefits of open source software across their information technology infrastructure—from the desktop to the largest server. Red Hat Enterprise Linux 3 is a set of engineering, consulting, and managed services offerings that enable large enterprises to capture the significant cost, performance and scalability benefits of their enterprise systems.

NOTE 2 - Summary of Significant Accounting Policies

Unaudited Interim Financial Information

The interim consolidated financial statements as of and for the quarter ended November 30, 2003 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 accounting principles generally accepted in the United States of America. The consolidated balance sheet at February 28, 2003 has been derived from the audited consolidated financial statements at that date. Operating results for the three and nine month periods ended November 30, 2003 are not necessarily indicative of the results that may be expected for the fiscal year ending February 29, 2004. Certain information and footnote disclosures normally included in annual financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been omitted in accordance with the rules and regulations for interim reporting of the SEC. These interim consolidated financial statements should be read in conjunction with the consolidated financial statements and notes thereto contained in the Company’s Annual Report on Form 10-K for the year ended February 28, 2003 filed with the SEC.

Principles of Consolidation

The accompanying consolidated financial statements include the accounts of the Company and all of its wholly-owned subsidiaries. Entities which are not wholly-owned, but for which a controlling financial interest is maintained by the Company are consolidated. The non-controlling interest of these entities is presented as a separate component of stockholders’ equity. 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 of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the balance sheet date and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.

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Impairment of Long-Lived Assets

The Company evaluates the recoverability of its property and equipment and other assets in accordance with Statement of Financial Accounting Standards No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets” (“SFAS 144”). SFAS 144 requires that one accounting model be used for long-lived assets to be disposed of by sale, whether previously held and used or newly acquired, and broadens the presentation of discontinued operations to include more disposal transactions. An impairment loss is recognized when the net book value of such assets exceeds the estimated future undiscounted cash flows attributable to the assets or the business to which the assets relate. Impairment losses are measured as the amount by which the carrying value exceeds the fair value of the assets.

Accounts Receivable

Accounts receivable are presented net of an allowance for doubtful accounts. Included in accounts receivable at November 30, 2003 is approximately $12.0 million of subscription bookings which are also included in deferred revenue at November 30, 2003. These receivables have standard terms and are expected to be collected in the normal course of business.

Revenue Recognition

The Company recognizes revenue in accordance with Statement of Position No. 97-2, “Software Revenue Recognition” (“SOP 97-2”), as amended by SOP 98-4 and SOP 98-9, and Staff Accounting Bulletin No. 101 (“SAB 101”). Revenue recognition in accordance with these pronouncements can be complex due to the nature and variability of sales transactions.

Subscription Revenue

Subscription revenue is comprised of enterprise, retail and embedded revenues.

Enterprise subscription revenue is comprised primarily of revenue from sales of Red Hat Enterprise Linux software solutions, Stronghold Enterprise Secure Web Server, software development tools, and technical support and maintenance fees. During fiscal 2004, the Company released Red Hat Enterprise Linux 3. Red Hat Enterprise Linux products have a one year base subscription period. The base subscription entitles the end user to one year of maintenance, which entitles the end user to configuration support and updates and upgrades to the technology, when and if available, during the term of the subscriptions. The Company recognizes revenue from the sale of enterprise offerings ratably over the period of the subscription. Subscription relationships with large enterprise customers typically have contracts with multiple elements (i.e., delivered and undelivered products, maintenance and other services). The Company allocates revenue to each component of the contract based on objective evidence of its fair value, which is specific to the Company. The fair value of each element is based on the price if sold separately. Enterprise subscription revenue also includes revenue from large Unix to Linux migration arrangements which were sold prior to the release of Red Hat Enterprise Linux in May 2002. Revenue from these arrangements has generally been recognized ratably over the term of the arrangement as no other pattern of performance is discernible nor had there been specific evidence of the fair value of the elements of these arrangements. The predominant portion of these arrangements reached maturity during the second quarter of fiscal 2004. Upon maturity, many of these customers have purchased subscriptions to Red Hat Enterprise Linux. With the release of Red Hat Enterprise Linux, the Company has specific evidence of the fair value of the elements of these larger enterprise arrangements and allocates revenue accordingly.

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The Company sells Red Hat Enterprise Linux subscription solutions through four channels: direct sales, original equipment manufacturers (OEMs), value-added resellers, and the Internet. Revenue recognition periods for each channel are based on the subscription period that the end users of the subscriptions receive from Red Hat, which is generally one year.

In addition, enterprise subscription revenue is partially derived from sales of subscriptions to Red Hat Enterprise Network, and several other enterprise technologies that we distribute such as Red Hat Content Management Server and Red Hat Portal Server. Red Hat Content Management Server and Red Hat Portal Server are available as a layered technology on Red Hat Enterprise Linux as well as other operating systems. Red Hat Network is an Internet-based or inside the corporate firewall based systems management service to assure the security, availability and reliability of Red Hat Enterprise Linux, and other Red Hat enterprise software solutions. Red Hat Enterprise Network is sold in the form of a monthly or annual subscription. Revenue is recognized ratably over the subscription period.

Through its retail distributors, the Company sells Red Hat Linux consumer products. Red Hat Professional Workstation is the retail product currently offered, however Red Hat also sold two different versions of Red Hat Linux (8.0 and 9) during the three and nine months ended November 30, 2003. Each version has a different level of Red Hat support and software applications provided. Red Hat also provides certain subscription services with Red Hat Linux for a period of time, not exceeding two months for no additional fee. The Company recognizes all of the revenue from the sale of Red Hat Linux ratably over the period that the subscription services are provided. A reserve for sales returns is recognized for sales of retail 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 return rate experienced by the Company over its last three retail product releases has averaged 18.0%. The fee is fixed and determinable, collection of the resulting receivable is probable and product returns are estimable.

Embedded subscription consists of revenue for technical support and maintenance services provided pursuant to software compiling, debugging, and optimization agreements. Revenue is recognized ratably over the term of the agreement, which is typically 12 months.

Services Revenue

Services revenue is comprised of enterprise technology services and embedded development. Enterprise technology services are comprised of revenue for enterprise consulting and engineering services, and customer training and education. Enterprise technology services are provided under agreements where customers pay the Company on a fixed fee or hourly basis to assist in the deployment of enterprise technologies. Enterprise technology engineering services represent revenues earned under fixed fee arrangements with our OEM partners to add functionality to our Red Hat Enterprise Linux line of technologies. Revenues under hourly arrangements are recognized as work is performed. Revenues under fixed fee arrangements are recognized either on a percentage of completion basis or upon passage of time dependent upon the terms of each individual engagement. Revenue from customer training and education is recognized at the date the services are performed.

Embedded development services are contracts for software compiling, debugging, and optimization. Revenue is recognized on the percentage-of-completion method, provided that the Company has the ability to make reliable estimates of progress towards completion, the fee for such services is fixed and determinable and collection of the resulting receivable is probable.

Stock-Based Compensation

The Company accounts for stock-based compensation based on the provisions of Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB 25”), which states that no compensation expense is recorded for stock options or other stock-based awards to employees that are

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granted with an exercise price equal to or above the market value per share of the Company’s common stock on the grant date. Deferred compensation is amortized to compensation expense over the vesting period of the stock option.

SFAS No. 123 “Accounting for Stock-Based Compensation” (“SFAS 123”), as amended by SFAS No. 148 “Accounting for Stock-Based Compensation-Transition and Disclosure-an Amendment of FASB Statement No. 123” (SFAS 148”), requires the Company to disclose pro forma information regarding stock option grants issued to its employees. SFAS 123 specifies certain valuation techniques that produce estimated compensation charges that are included in the pro forma results below. These amounts have not been reflected in the Company’s Consolidated Statement of Operations because APB 25 specifies that no compensation charge arises when the exercise price of employees’ stock options equals the market value of the underlying stock at the grant date, as in the case of options granted to the Company’s employees. The fair value of options was estimated using the following assumptions for the three months ended November 30, 2003 and 2002:

The following table illustrates the effect on net loss and earnings per share if the Company had applied the fair value recognition provisions of SFAS 123 to stock based employee compensation:

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The weighted average estimated fair value of employee stock options granted was $9.44 and $3.59 per share during the three months ended November 30, 2003 and 2002, respectively.

Net Loss Per Common Share

The Company computes net income (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 income (loss) per common share (“Basic EPS”) is computed by dividing net income (loss) by the weighted average number of common shares outstanding. Diluted net income (loss) per common share (“Diluted EPS”) is computed by dividing net income (loss) by the weighted average number of common shares and dilutive potential common share equivalents then outstanding. Potential common shares consist of shares issuable upon the exercise of stock options. The calculation of net loss per share available to common stockholders does not include 8,424,217 potential shares of common stock equivalents for the nine months ended November 30, 2002 as their impact on net loss per share would be antidilutive.

Segment Reporting

Management identifies the Company’s operating segments primarily based on differences in the nature of its products and services and on geographic location. The Company’s operating segments are enterprise and embedded. These segments reflect the Company’s primary focus, sales of Red Hat Enterprise Linux and Red Hat Enterprise Network subscriptions to large enterprises, and the fact that management has decided to maintain a small but strategic presence in the embedded systems market. Retail subscription revenue is included in the enterprise segment. Performance of these segments is evaluated based on their respective gross profit margins as disclosed in the Company’s Consolidated Statements 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.

The Company has international sales offices in the United Kingdom, France, Italy, Ireland, Germany, Hong Kong, Korea, Australia and Japan. The Company manages its international business on a Europe-

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wide and Asia Pacific-wide basis. The following disclosure aggregates individually immaterial international operations and separately discloses the significant international operations at and for the three and nine months ended November 30, 2003 and 2002 (in thousands):

General and Administrative-Mergers and Acquisitions Expense

General and administrative-mergers and acquisitions expense primarily consists of severance and related expenses incurred in connection with redundancies identified pursuant to mergers and acquisitions completed by the Company. The Company incurred no general and administrative–mergers and acquisitions expense in the three and nine month periods ended November 30, 2003. General and administrative–mergers and acquisitions expense during the nine month period ended November 30, 2002 totaled $2.3 million.

Comprehensive Income

The Company’s items of accumulated other comprehensive income (loss) during the three and nine months ended November 30, 2003 totaled $0.6 million and $(1.7) million, respectively, and are comprised of an unrealized loss on investments in marketable debt securities of $0.2 million and $2.8 million, respectively, and a foreign currency translation adjustment of $0.8 million and $1.2 million, respectively. The Company’s items of other comprehensive income (loss) during the three and nine months ended November 30, 2002 totaled $(62,000) and $4.2 million, respectively, and are comprised of an unrealized gain (loss) on investments in marketable debt securities of $(31,000) and $3.6 million, respectively, and a foreign currency translation adjustment of $(31,000) and $0.7 million, respectively. As of November 30, 2003, the Company holds investments in debt securities with a net unrealized gain of $3.8 million.

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Recent Accounting Pronouncements

In January 2003, the FASB issued Interpretation No. 46 (“FIN 46”), “Consolidation of Variable Interest Entities.” FIN 46 requires an investor with a majority of the variable interests in a variable interest entity to consolidate the entity and also requires majority and significant variable interest investors to provide certain disclosures. A variable interest entity is an entity in which the equity investors do not have a controlling interest or the equity investment at risk is insufficient to finance the entity’s activities without receiving additional subordinated financial support for the other parties. FIN 46 applies immediately to variable interest entities created after January 31, 2003, and to variable interest entities in which an interest is obtained after that date. FIN 46 will apply as of February 29, 2004 to variable interest entities considered to be special-purpose entities. FIN 46 is required to be applied to all other variable interest entities beginning with the Company’s fiscal first quarter ending May 31, 2004. The Company is still considering the impact of certain provisions of FIN 46 and believes that the adoption of FIN 46 will not have a material impact on its Consolidated Statements of Operations or its financial position.

In April 2003, the FASB issued SFAS No. 149 “Amendment of Statement 133 on Derivative Instruments and Hedging Activities” (“SFAS 149”). FASB Statements No. 133 “Accounting for Derivative Instruments and Hedging Activities” (“SFAS 133”) and No. 138, “Accounting for Certain Derivative Instruments and Certain Hedging Activities”, establish accounting and reporting standards for derivative instruments including derivatives embedded in other contracts (collectively referred to as derivatives) and for hedging activities. SFAS 149 amends SFAS 133 for certain decisions made by the FASB as part of the Derivatives Implementation Group (DIG) process. SFAS 149 contains amendments relating to FASB Concepts Statement No. 7, “Using Cash Flow Information and Present Value in Accounting Measurements”, and SFAS No. 65, “Accounting for Certain Mortgage Banking Activities”, SFAS No. 91 “Accounting for Nonrefundable Fees and Costs Associated with Originating or Acquiring Loans and Initial Direct Costs of Leases”, SFAS No. 95, “Statement of Cash Flows”, and SFAS No. 126, “Exemption from Certain Required Disclosures about Financial Instruments for Certain Nonpublic Entities”. As the Company does not currently engage in hedging activities nor hold any derivative financial instruments, the adoption of SFAS No. 149 will not impact its financial position.

In May 2003, the FASB issued SFAS No. 150 “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity” (“SFAS 150”). SFAS 150 establishes standards for classification and measurement in the statement of financial position of certain financial instruments with characteristics of both liabilities and equity. It requires classification of a financial instrument that is within its scope as a liability (or an asset in some circumstances) because that financial instrument embodies an obligation of the issuer. SFAS 150 is effective for financial instruments entered into or modified after May 31, 2003, and otherwise shall be effective on September 1, 2003. The Company currently has no financial instruments which are impacted by SFAS 150, therefore, the adoption of SFAS 150 will not have a material impact on its financial position.

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NOTE 3 - Goodwill and Identifiable Intangible Assets

Identifiable intangible assets consist primarily of trademarks, copyrights and patents, which are amortized over the estimated useful life ranging from three to 15 years. The following is a summary of identifiable intangible assets (in thousands):

In conjunction with the adoption of SFAS 142, the Company completed the required transitional impairment test as of August 31, 2002 and the annual impairment test as of February 28, 2003 and no goodwill impairment was deemed necessary. The following is a summary of goodwill by segment for the three and nine months ended November 30, 2003 (in thousands):

No impairments were required to be recognized during the nine months ended November 30, 2003 or the year ended February 28, 2003.

NOTE 4 - Legal Proceedings

Red Hat Professional Consulting, Inc., formerly PTI, a wholly-owned subsidiary of the Company acquired in February 2001, along with its former directors and some of its former principal shareholders is a

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defendant in a suit brought in Superior Court of Dekalb County, Georgia, by a former employee. The plaintiff asserts, among other things, breach of various employment agreements. PTI has filed an answer, affirmative defenses and counterclaims denying all liability and has filed a motion to dismiss which remains pending. All discovery in the matter is complete. The Company has been indemnified in this matter by the former PTI shareholders and further believes that the likelihood of a material loss is remote.

Commencing on or about March 29, 2001, the Company and certain of its officers and directors were named as defendants in a series of purported class action suits arising out of the Company’s initial public offering and secondary offering. On August 8, 2001, Chief Judge Mukasey of the federal district court for the Southern District of New York issued an order that transferred all of the so-called IPO allocation actions, including the complaints involving the Company, to one judge for coordinated pre-trial proceedings. The court has consolidated the actions by issuer, and the Red Hat actions have been consolidated into a single action. The plaintiffs contend that the defendants violated federal securities laws by issuing registration statements and prospectuses that contained materially false and misleading information and failed to disclose material information. Plaintiffs also challenge certain IPO allocation practices by underwriters and the lack of disclosure thereof in initial public offering documents. On April 19, 2002, plaintiffs filed amended complaints in each of the 310 consolidated actions, including the Red Hat action. The relief sought consists of unspecified damages. No discovery has occurred to date. The individual director and officer defendants have been dismissed from the case without prejudice. The Company believes these complaints are without merit and will defend itself vigorously in this matter. No assurance can be given, however, that this matter will be resolved in the Company’s favor. The Company, among other issuers, the plaintiffs, and the insurers have agreed, in concept, to a proposed settlement whereby the Company would be released from this litigation. That proposed settlement has not been submitted to the court for its consideration, and there is no certainty that the court will approve the settlement.

Commencing May 23, 2002, the Company was named as defendant in a suit brought by The Monotype Corporation in federal district court for the Northern District of Illinois alleging copyright and trademark infringement. The plaintiff contended that the Company infringed certain of plaintiff’s font software copyrights and related trademarks in the Company’s retail distributions, versions 5.2 through the initial release of version 7.3. On December 4, 2002, the plaintiff filed a second amended complaint adding allegations of violations of the Lanham Act, as well as the state unfair and deceptive trade practices acts under Illinois and North Carolina law. The relief sought consisted of unspecified damages. The Company counterclaimed alleging plaintiff’s copyrights and trademarks are unenforceable and/or invalid. In December 2003, the parties entered into a license agreement for which provides the Company the right to distribute a number of Monotype’s commercial fonts over a 5 year period. The Company recorded a charge of $500,000 in the third quarter of fiscal 2004 related to this license agreement. In conjunction with the license, the parties entered into a mutual release and all claims asserted by each party were dismissed with prejudice.

Commencing August 4, 2003, the Company filed suit against The SCO Group, Inc. (“SCO”) in the U.S. District Court for the District of Delaware (Civil Action No. 03-722 SLR) (the “Action”) seeking a declaratory judgment that the Company is not infringing any of SCO’s intellectual property rights. In addition, the Company has asserted claims against SCO under Delaware and federal law, including deceptive trade practices, unfair competition, tortious interference with prospective business opportunities, trade libel and violations of the Lanham Act. The Company contends that SCO has made false and misleading public statements alleging that software code, in which SCO claims to own copyrights and trade secrets, was misappropriated and incorporated into the Company’s product and has threatened legal action. On September 15, 2003, SCO filed a Motion to Dismiss contending, among other things, that there exists no actual controversy that would warrant the declaratory judgment the Company seeks. The Company filed an opposition to the Motion to Dismiss and intends to vigorously prosecute the Action. At this early stage of the proceedings no assurance can be given as to the outcome.

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Note 5 – Subsequent Event

On December 23, 2003 the Company acquired Sistina Software, Inc. (“Sistina”) for consideration at closing valued at $31.0 million and comprised of 1,979,874 shares of Red Hat common stock, the assumption of Sistina’s outstanding options and warrants, and a nominal amount of cash to avoid the issuance of fractional shares. In addition, the transaction includes $12.0 million of contingent consideration based on an earn-out carved into three tranches. The earn-out is based on the achievement of certain bookings targets for the technologies and services previously sold by Sistina over the period beginning on December 23, 2003 and ending March 31, 2005. Shares issued under the earn-out will be determined based on the average closing price of the Company’s common stock during the 10 trading days prior to issuance of each tranche of such earn-out shares. The Company preliminarily estimates that the excess of purchase price over the fair values of tangible net assets acquired will be approximately $27.1 million, excluding the effect of any earn-out shares which may be issued in the future.

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ITEM 2 - MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Forward-looking statements in this Quarterly Report on Form 10-Q are made pursuant to the safe harbor provisions of Section 21E of the Securities Exchange Act of 1934. Investors are cautioned that statements in this Quarterly Report on Form 10-Q that are not strictly historical statements, including, without limitation, statements regarding current or future financial performance, management’s plans and objectives for future operations, product plans and performance, management’s assessment of market factors, and statements regarding the strategy and plans of Red Hat and its strategic partners, constitute forward-looking statements. These forward-looking statements are not guarantees of Red Hat’s future performance and are subject to a number of risks and uncertainties that could cause Red Hat’s actual results in the future to differ materially from the 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, copies of which may be accessed through the SEC’s web site at http://www.sec.gov.

OVERVIEW

We are the global leader in providing an enterprise operating system and related systems management services based on open source technology for the information technology infrastructure requirements of large enterprises. We have developed an enterprise operating system, Red Hat Enterprise Linux, which was launched in May 2002. Since the original release, we have expanded our offerings to include Red Hat Enterprise Linux AS, Red Hat Enterprise Linux ES and Red Hat Enterprise Linux WS. The release of these additional offerings has allowed us to provide a Red Hat Enterprise Linux operating system that, we believe, is suitable from a price and functionality perspective for most application areas of the information technology infrastructure of the large enterprise, including the technical/developer workstation, the middle tier of the information technology infrastructure and the data center. Unlike most proprietary software companies, we sell our enterprise software to our customers in the form of a renewable annual subscription. Our customers pay us an annual subscription fee for as long as they need to maintain a certified version of our software. Under our standard subscription agreements, prices to customers for the first annual renewal term are generally at the same price per installed system as during the initial one-year term, and for any subsequent renewal terms are based on current list prices. For our large enterprise customers, renewal rates often also reflect discounts for increased subscription volume. Our subscription business model provides increased visibility into the sources of our enterprise subscription revenues as we generally recognize revenues from the sale of subscriptions ratably over the period of the subscription.

Our current version of Red Hat Enterprise Linux is Red Hat Enterprise Linux 3, which was released in late October 2003. Red Hat Enterprise Linux 3 represents a major milestone for us as it significantly expands the number of hardware platforms that Red Hat Enterprise Linux supports and adds, we believe, most of the important functionality needed by the large enterprise to allow deployment of Red Hat Enterprise Linux as the operating system in the most mission critical application areas of the large enterprise.

Red Hat Enterprise Linux has become the most widely used Linux platform for deployment in mission critical areas of the IT infrastructure of large enterprises. We have developed a broad level of acceptance for Red Hat Enterprise Linux by gaining support from leading manufacturers of Intel-based hardware and leading independent software vendors upon which the large enterprise relies. Over the last 12 months, we have signed global strategic agreements with Dell, HP, IBM, Fujitsu, NEC, Hitachi and Fujitsu Siemens, many of the leading providers of Intel-based server and workstation hardware. Each of these companies has agreed to support our Red Hat Enterprise Linux offerings on certain of their Intel-based servers and workstations. In addition, each of these companies has agreed to pre-load Red Hat Enterprise Linux on certain of their Intel-based servers and workstations and sell the hardware and Red Hat Enterprise Linux to their customers as a pre-configured solution. We believe that the distribution of Red Hat Enterprise Linux and our layered infrastructure technologies by these companies will be one of our most critical channels of distribution. We have attracted support for Red Hat Enterprise Linux from many of the independent software vendors to the large enterprise, including support, from among others, Oracle (Oracle 9i Database, Oracle 9i Application Server, Oracle E-Business Suite and Oracle.com), IBM (Websphere, DB2, Lotus, Tivoli, Rational), VERITAS, EMC/Legato, Peoplesoft, Network Appliances, Computer Associates, Tibco, SAP, Synopsys, BMC, and Checkpoint. There are currently over 175 independent software vendors that have certified over 475 applications on Red Hat Enterprise Linux.

We view Red Hat Enterprise Linux 3 as the foundation upon which we will build an open source architecture for the enterprise. It is our strategy to provide an open source alternative to many of the proprietary infrastructure software applications currently used by large enterprises. However, we believe it is essential to our success that we provide our customers choice at all times, which means that we will aim to ensure that competing proprietary infrastructure software performs as well on our Red Hat Enterprise Linux platform as any open source infrastructure software that we distribute. Each layer of our open source architecture for which our customers subscribe will result in additional incremental annual revenues.

We currently provide our customers with a suite of systems management services, Red Hat Network, that allows them to manage their Red Hat Enterprise Linux deployments in an automated fashion. Red Hat Network is an integrated systems management service that provides the ability to configure, update and monitor the performance of Red Hat Enterprise Linux. Our systems management offerings extend the value we provide our customers by reducing the management cost of their Red Hat Enterprise Linux-based infrastructure. We intend to deliver new systems management services that will continue to enhance the manageability of the infrastructure solutions that we deliver. In addition, we have developed a complete suite of training offerings and consulting services that enable large enterprise customers to capture the significant cost, performance and scalability benefits of our enterprise technologies.

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CRITICAL ACCOUNTING POLICIES

Our critical accounting policies include the following:

Revenue Recognition

We recognize revenue in accordance with Statement of Position No. 97-2, “Software Revenue Recognition” (“SOP 97-2”), as amended by SOP 98-4 and SOP 98-9, and Staff Accounting Bulletin No. 101 (“SAB 101”). Revenue recognition in accordance with these pronouncements can be complex due to the nature and variability of our sales transactions.

Subscription Revenue

Subscription revenue is comprised of enterprise, retail and embedded revenues.

Enterprise subscription revenue is comprised primarily of revenue from sales of Red Hat Enterprise Linux software solutions, Stronghold Enterprise Secure Web Server, software development tools, and technical support and maintenance fees. During fiscal 2003, we released the first of our Red Hat Enterprise Linux offerings, Red Hat AS, ES and WS. Our Red Hat Enterprise Linux products have a one year base subscription period. The base subscription entitles the end user to one year of maintenance, which entitles the end user to configuration support and updates and upgrades to the technology, when and if available, during the term of the subscriptions. We recognize revenue from the sale of our

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enterprise offerings ratably over the period of the subscription. Our subscription relationships with our large enterprise customers typically have contracts with multiple elements (i.e., delivered and undelivered products, maintenance and other services). We allocate revenue to each component of the contract based on objective evidence of its fair value, which is specific to us. The fair value of each element is based on the price if sold separately. Enterprise subscription revenue also includes revenue from several large Unix to Linux migration arrangements which were sold prior to the release of Red Hat Enterprise Linux in August 2002. Revenue from these arrangements has been recognized ratably over the term of the arrangement, as no other pattern of performance has been discernible nor has there been specific evidence of the fair value of the elements of these arrangements. These arrangements all reached maturity during the second quarter of fiscal 2004 and have been replaced by subscriptions to Red Hat Enterprise Linux. With the release of Red Hat Enterprise Linux, we believe that we now have specific evidence of the fair value of the elements of these larger enterprise arrangements and allocate between elements and recognize revenue accordingly.

Our current release is Red Hat Enterprise Linux 3.0 which was released in October 2003. Our prior release was Red Hat Enterprise Linux 2.1 which was first shipped in May 2002. We sell Red Hat Enterprise Linux subscription solutions through four channels: direct sales, original equipment manufacturers (“OEMs”), value-added resellers and the Internet. Revenue recognition periods for each channel are based on the subscription period with Red Hat that the end purchasers of the subscriptions from these channels receive, which is generally one year.

In addition, our enterprise subscription revenue is partially derived from sales of subscriptions to Red Hat Enterprise Network, and several other enterprise technologies that we distribute. Red Hat Network is an Internet-based or inside the corporate firewall based systems management service to assure the security, availability and reliability of Red Hat Enterprise Linux, and other Red Hat software solutions. Red Hat Enterprise Network is sold in the form of a monthly or annual subscription. Revenue is recognized ratably over the subscription period.

Through our retail distributors, we sell Red Hat Linux consumer products. The retail product is currently offered in one version: Red Hat Professional Workstation. During fiscal 2004, we sold three different releases of Red Hat Linux (Red Hat Linux 8.0, Red Hat Linux 9 and Red Hat Professional Workstation). We have historically provided certain support and subscription services with Red Hat Linux for a period of time, not exceeding two months, for no additional fee. We recognize all of the revenue from the sale of Red Hat Linux ratably over the period that the subscription services are provided. A reserve for sales returns is recognized for sales of retail 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 return rate experienced by the Company over its last three retail product releases has averaged 18.0%. The fee is fixed and determinable, collection of the resulting receivable is probable and product returns are estimable.

Embedded subscription revenue consists of revenue for technical support and maintenance services provided pursuant to software compiling, debugging, and optimization agreements. Revenue is recognized ratably over the term of the agreement, which is typically 12 months.

Services Revenue

Services revenue is comprised of enterprise technology services and embedded development.

Enterprise technology services is comprised of revenue for enterprise consulting and engineering services, and customer training and education. Enterprise technology services are provided under agreements whereby customers pay us on a fixed fee or hourly basis to assist in the deployment of our enterprise technologies. Enterprise technology engineering services represent revenues earned under arrangements with our OEM partners to add functionality to our Red Hat Enterprise Linux line of technologies and is generally recognized on a percentage of completion basis. Revenue from customer training and education is recognized at the date the services are performed.

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Embedded development services are contracts for compiling, debugging, and optimization of various open source software technologies. Revenue is recognized on the percentage-of-completion method, provided that we have the ability to make reliable estimates of progress towards completion, the fee for such services is fixed and determinable and collection of the resulting receivable is probable.

Impairment of Long-Lived Assets

The Company evaluates the recoverability of its property and equipment and other assets in accordance with Statement of Financial Accounting Standards No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets” (“SFAS 144”). SFAS 144 requires that one accounting model be used for long-lived assets to be disposed of by sale, whether previously held and used or newly acquired, and broadens the presentation of discontinued operations to include more disposal transactions. An impairment loss is recognized when the net book value of such assets exceeds the estimated future undiscounted cash flows attributable to the assets or the business to which the assets relate. Impairment losses are measured as the amount by which the carrying value exceeds the fair value of the assets.

RESULTS OF OPERATIONS

Three Months Ended November 30, 2003 and November 30, 2002

Total revenue

Total revenue increased 36.3% to $33.1 million in the three months ended November 30, 2003 from $24.3 million in the three months ended November 30, 2002. This increase was driven by significant growth in our enterprise subscription revenues partially offset by a decline in the embedded segment of our business.

Subscription revenue

Subscription revenue is comprised of revenue recognized from the sale of subscriptions to our enterprise technologies (Red Hat Enterprise Linux and Red Hat Enterprise Network), retail technologies and embedded support arrangements. Subscription revenue increased to $22.0 million for the three months ended November 30, 2003 from $13.2 million for the three months ended November 30, 2002.

Enterprise technologies subscription

Enterprise technologies revenue primarily relates to both direct and indirect sales of Red Hat Enterprise Linux and Red Hat Enterprise Network. Enterprise technologies revenue increased 158.0% to $17.8 million for the three months ended November 30, 2003 from $6.9 million for the three months ended November 30, 2002. The increase is directly related to the subscriptions of Red Hat Enterprise Linux sold in previous quarters. These Enterprise offerings are important as they are sold with renewable subscriptions and generally have twelve month revenue recognition periods to match the related support obligation. As a result of our twelve month revenue recognition policy, for each unit sold in a given quarter, we recognize a portion of the revenue related to that unit in the current quarter, based on the period of time between the date of the sale and the end of the quarter, and the remainder in subsequent quarters. For the three month period ended November 30, 2003, we sold approximately 33,000 new subscriptions to our Red Hat Linux AS, ES and WS platforms compared to 12,000 subscriptions to Red Hat Enterprise Linux 2.1 in the same period in fiscal 2003.

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Retail

Retail revenue, which consists of sales of Red Hat Linux to consumers through either value added resellers or distributors, decreased 32.9% to $3.7 million for the three months ended November 30, 2003 from $5.6 million for the three months ended November 30, 2002. We will continue to address the consumer market, however, this market is no longer a strategic source of revenue for the Company but instead represents a channel for providing leading edge technology to sophisticated users. These users will help us improve new technology to the point it has the stability to be introduced into our Enterprise offerings. We expect retail revenues will decrease as a percentage of our total revenue and in absolute dollar amount for the remainder of fiscal 2004.

Embedded subscription

Embedded subscription revenue decreased 34.3% to $466,000 for the three months ended November 30, 2003 from $709,000 for the three months ended November 30, 2002. The decrease in embedded markets is primarily due to the continued weak performance of the semiconductor and telecommunications industries which has impacted research and development spending. We expect to maintain a small and strategic presence in this market as we believe that a Linux/open source platform will provide a significant value advantage in the embedded market in the future.

Services revenue

Enterprise technologies services

Enterprise technologies services include fees received from enterprise customers for deployment of Red Hat Enterprise technologies, customer training and education fees and fees received for adding certain functionality to Red Hat Enterprise Linux for our major hardware partners. Enterprise technologies services revenue decreased 1.8% to $9.9 million in the three months ended November 30, 2003 from $10.1 million in the three months ended November 30, 2002. The decrease in enterprise technologies services revenue is primarily due to a decrease in fees received for adding certain functionality to Red Hat Enterprise Linux for our major hardware partners of $1.6 million and lower enterprise consulting revenues partially offset by an increase in revenues from our customer training and education business of $2.1 million.

Embedded services

Embedded services revenue increased 17.0% to $1.2 million for the three months ended November 30, 2003 from $1.1 million for the three months ended November 30, 2002. The $200,000 increase in embedded services revenues is due to an increase in embedded bookings in the second quarter of fiscal 2004 which resulted in a higher amount of custom engineering work delivered in the third quarter.

Cost of revenue

Cost of enterprise subscription revenue

Cost of enterprise subscription revenue primarily consists of expenses we incur to manufacture, package, distribute, support and maintain our solutions. These costs include expenses for physical media, literature and packaging, fulfillment and shipping and labor related costs to provide technical support and maintenance. Cost of subscription revenue increased 17.5% to $2.7 million in the three months ended November 30, 2003 from $2.3 million in the three

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months ended November 30, 2002. As a percentage of related revenue, cost of enterprise subscription revenue decreased to 12.5% in the three months ended November 30, 2003, compared to 18.3% in the three months ended November 30, 2002. Consistent with our increase in enterprise subscription revenue, the costs associated with delivering the physical product and a high level of technical support, which is included with our Red Hat Enterprise Linux offerings, have increased as well. However, gross margins on enterprise subscription revenues have continued to show improvement.

Cost of enterprise services revenue

Cost of enterprise services revenue is primarily comprised of salaries and related costs — including non-cash, stock-based compensation charges — incurred for our personnel to deliver custom development, open source consulting engineering, training and education, and hardware certification services. Cost of services revenue increased 9.1% to $5.4 million in the three months ended November 30, 2003 from $4.9 million in the three months ended November 30, 2002. This increase is related to the continued growth in our global learning services revenues which has required additional personnel and classroom costs partially offset by a decrease in the number of consultants in our professional consulting organization. Our gross margins as a percentage of revenues for our enterprise services business have been consistent over the last twelve months.

Gross Profit

Gross profit increased 49.0% to $24.0 million in the three months ended November 30, 2003 from $16.1 million in the three months ended November 30, 2002. This increase was primarily due to the increase in subscription revenues of our high gross margin Red Hat Enterprise Linux and Red Hat Enterprise Network offerings. The Embedded segment had gross profit of $623,000 in the three months ended November 30, 2003 as compared to $767,000 in the three months ended November 30, 2002.

Operating expenses

Sales and marketing

Sales and marketing expense consists primarily of salaries, commissions 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 increased 23.8% to $10.2 million in the three months ended November 30, 2003 from $8.3 million in the three months ended November 30, 2002. This increase was primarily due to expansion of our international sales force both in our direct and partner management teams in order to accelerate the adoption of Red Hat Enterprise Linux in the European and Asian markets. We expect to continue to make selective investments in the expansion of our global business which could cause sales and marketing costs to continue to increase in the future.

Research and development

Research and development expense consists primarily of personnel and related costs — including non-cash, stock-based compensation charges — for development of software technologies and systems management offerings. Research and development expense increased 27.7% to $7.2 million in the three months ended November 30, 2003 from $5.7 million in the three months ended November 30, 2002. The increase in research and development expense resulted from an increase in engineering personnel to support the development and integration of Red Hat Enterprise Linux and Red Hat Enterprise Network.

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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. General and administrative-mergers and acquisition expense primarily consists of severance and related expenses incurred in connection with redundancies identified pursuant to mergers and acquisitions completed by the Company, as well as, the costs of certain individuals within the Company who are dedicated to seeking out and identifying potential acquisition candidates. General and administrative expense increased 4.3% to $5.0 million in the three months ended November 30, 2003 from $4.8 million in the three months ended November 30, 2002. This increase relates primarily to increased administrative costs as a result of international expansion activities, increased health and directors and officers’ insurance costs, increased bad debt expense related to our increase in revenues and increased legal costs. We expect our general and administrative expenses in future periods to increase in absolute terms as our business continues to expand.

Other income (expense), net

Other income (expense), net consists of interest income earned on cash deposited in money market accounts and invested in short- and long-term fixed income instruments, net of interest expense incurred on short-term debt and capital leases and foreign currency revaluation gains and losses, net. Interest income, net, decreased to $2.6 million in the three months ended November 30, 2003 from $3.1 million in the three months ended November 30, 2002. These amounts are net of interest expense of $117,000 in the three months ended November 30, 2003 and $115,000 in the three months ended November 30, 2002. The decrease is the result of a reduction in the amount of interest income earned on our cash and investments due to lower market interest rates and a foreign currency loss of $129,000 in the current quarter as compared to a foreign currency gain in the three months ended November 30, 2002.

Nine Months Ended November 30, 2003 and November 30, 2002

Total revenue

Total revenue increased 37.0% to $89.1 million in the nine months ended November 30, 2003 from $65.0 million in the nine months ended November 30, 2002. This increase was driven by significant growth in our enterprise subscription revenues of our business partially offset by a slight decline in the embedded segment of our business.

Subscription revenue

Subscription revenue increased to $57.9 million for the nine months ended November 30, 2003 from $34.2 million for the nine months ended November 30, 2002.

Enterprise technologies subscription

Enterprise technologies revenue primarily relates to both direct and indirect sales of Red Hat Enterprise Linux and other related software solutions. Enterprise technologies revenue increased 133.3% to $45.0 million for the nine months ended November 30, 2003 from $19.3 million for the nine months ended November 30, 2002. The increase is directly related to the subscriptions to Red Hat Enterprise Linux sold in previous quarters. These Enterprise offerings are important as they are sold with renewable subscriptions and generally have twelve month revenue recognition periods to match the related support obligation. As a result of our twelve month revenue recognition policy, for each subscription sold in a given quarter, we recognize a portion of the revenue related to that unit in the current quarter, based on the period of time between the date of the sale and the end of the quarter, and the remainder in subsequent quarters. For the nine month period ended November 30, 2003, we sold approximately 82,700 subscriptions to our Red Hat Linux AS, ES and WS platforms compared to 20,000 subscriptions to Red Hat Enterprise Linux 2.1 in the same period in fiscal 2003.

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Retail

Retail revenue, which consists of sales of Red Hat Linux to consumers through either value added resellers or distributors, decreased 8.5% to $11.3 million for the nine months ended November 30, 2003 from $12.4 million for the nine months ended November 30, 2002. We will continue to address the consumer market, however, this market is no longer a strategic source of revenue for the Company but instead represents a channel for providing leading edge technology to sophisticated users. These users will help us improve new technology to the point it has the stability to be introduced into our Enterprise offerings.

Embedded subscription

Embedded subscription revenue decreased 36.2% to $1.6 million for the nine months ended November 30, 2003 from $2.5 million for the nine months ended November 30, 2002. The decrease in embedded markets is primarily due to the continued weak performance of the semiconductor and telecommunications industries which has impacted research and development spending. We will continue to maintain a small and strategic presence in this market as we believe that a Linux/open source platform will provide a significant value advantage in the embedded market in the future.

Services revenue

Enterprise technologies services

Enterprise technologies services include fees received from enterprise customers for deployment of Red Hat Enterprise technologies, customer training and education fees and fees received for adding certain functionality to Red Hat Enterprise Linux for our major hardware partners. Enterprise technologies services revenue increased 0.9% to $28.1 million in the nine months ended November 30, 2003 from $27.8 million in the nine months ended November 30, 2002. The increase in enterprise technologies services revenue is primarily due to an increase of $4.8 million in revenues from our customer training and education business which experienced record enrollment partially offset by a decrease of $2.6 million in fees received for adding certain functionality to Red Hat Enterprise Linux for our major hardware partners. The remaining decrease is primarily due to a decrease in enterprise consulting revenue.

Embedded services

Embedded services revenue was essentially flat at $3.1 million for the nine months ended November 30, 2003 as compared to $3.0 million in the nine months ended November 30, 2002.

Cost of revenue

Cost of enterprise subscription revenue

Cost of enterprise subscription revenue primarily consists of expenses we incur to manufacture, package, distribute, support and maintain our solutions. These costs include expenses for physical media, literature and packaging, fulfillment and shipping and labor related costs to provide technical support and maintenance for Red Hat Enterprise Linux. Cost of subscription revenue increased 29.5% to $7.9 million in the nine months ended November 30, 2003 from $6.1 million in the nine months ended November 30, 2002. As a percentage of related revenue, cost of enterprise subscription revenue decreased to 14.0% in the nine months ended November 30, 2003 compared to 19.2% for the nine months ended November 30, 2002. Consistent with our increase in enterprise subscription revenue, the costs associated with delivering the physical product and a high level of technical support, which is included with our Red Hat Enterprise Linux offerings, have increased as well, however, our gross margins on our enterprise subscription offerings have continued to improve.

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Cost of enterprise services revenue

Cost of services revenue is primarily comprised of salaries, commissions and related costs incurred for our personnel to deliver custom development, open source consulting engineering, training and education, and hardware certification services. Cost of services revenue increased 11.3% to $15.2 million in the nine months ended November 30, 2003 from $13.7 million in the nine months ended November 30, 2002. The increase is related to the increase in revenue generated by our global learning services organization, partially offset by a small decrease in the average number of personnel in our professional consulting organization in the nine months ended November 30, 2003 as compared to the nine months ended November 30, 2002.

Gross Profit

Gross profit increased 50.8% to $63.3 million in the nine months ended November 30, 2003 from $42.0 million in the nine months ended November 30, 2002. This increase was primarily due to the increase in subscription revenue and gross margins related to our Red Hat Enterprise Linux and Red Hat Enterprise Network offerings.

Operating expenses

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 increased 15.6% to $28.8 million in the nine months ended November 30, 2003 from $24.9 million in the nine months ended November 30, 2002. This increase was primarily due to an expansion of our International sales force in order to accelerate the adoption of Red Hat Enterprise Linux in the European and Asian markets.

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 technologies. Research and development expense increased 22.5% to $19.6 million in the nine months ended November 30, 2003 from $16.0 million in the nine months ended November 30, 2002. The increase in research and development expense resulted from an increase in engineering personnel to support the development and integration of our Red Hat Enterprise Linux family of technologies and related subscription offerings such as the Red Hat Enterprise Clustering Suite.

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. Mergers and acquisition expense primarily consists of severance and related expenses incurred in connection with redundancies identified pursuant to mergers and acquisitions completed by the Company. General and administrative expense decreased 5.3% to $14.2 million in the nine months ended November 30, 2003 from $15.0 million in the nine months ended November 30, 2002. This decrease relates primarily to a reduction in merger and acquisition activity and stock-based compensation charges partially offset by increased administrative costs as a result of international expansion activities, increased health and directors and officers’ insurance costs and increased bad debt expense related to our increase in revenues.

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