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Websense Inc. (NASDAQ:WBSN)

Q3 2008 Earnings Call

October 28, 2008 5:00 pm ET

Executives

Dudley Mendenhall – CFO

Douglas Wride – President

Gene Hodges - CEO

Analysts

Eric Martinuzzi – Craig-Hallum

Samuel Wilson – JMP Securities

Todd Raker – Deutsche Bank

Rob Owens – Pacific Crest

Sterling Auty – J.P. Morgan

Brad Zelnick – Bank of America

Daniel Ives - Freidman, Billings

Walter Pritchard – Cowan & Co.

Fred Zeigel – Soleil Securities

Operator

Welcome to the Websense third quarter 2008 earnings conference call. (Operator Instructions) I would now like to introduce your host Kate Patterson, Websense's Vice President of Corporate Communications and Investor Relations.

Kate Patterson

Good afternoon everyone and thank your for joining me to discuss third quarter financial results. With me on the call today are Gene Hodges, Websense's CEO, Dudley Mendenhall, our CFO and Doug Wride, our President.

Before turning the call over to Dudley, let me remind you that during this conference call, management may make forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Such statements are subject to known and unknown risks, uncertainties and other factors that may cause the company's actual results to be materially different from historical results or any preliminary results expressed or implied during the call.

The potential risks and uncertainties which contribute to the uncertain nature of the statements include among others, risks associated with integrating acquired products and businesses, launching new product offerings, customers acceptance of the company's services and products, see structures in the changing market, the success of Websense brand development effort, the volatile and competitive nature of the internet and security industries, changes in domestic and international market conditions, the volatility in currency exchange rates, risks relating to the required use of cash for debt services, the risks of ongoing compliance through the covenants and the senior credit facility, risks related to changes in accounting interpretation, and other risks and uncertainties described in Websense's public filings with the Securities and Exchange Commission.

The information in this call related to financial results, projections and other forward-looking statements is based on current expectations and we expressly disclaim any responsibility to update forward-looking statements should circumstances change. Our discussion also included financial measures that are numerical measures that can't be calculated in accordance with generally accepted accounting principals. The company believes the non-GAAP financial measures enhance investors' ability to evaluate the company's operating results and compare the current operating results with historical operating results. For more information, please consult the press release that was issued this afternoon and which is also posted on the investor relations portion of the company's web site.

I will now turn the call over to our Chief Financial Officer, Dudley Mendenhall.

Dudley Mendenhall

Let me start by walking you through some financial highlights for the third quarter and then we'll move on to guidance.

Billings for the second quarter came in at $82.7 million up about 4% compared to the combined billings of $79.1 million for SurfControl and Websense in Q3 a year ago, and down 5% sequentially. The sequential decline was due to the seasonal decline in the SurfControl billings up for renewal compared to the June quarter.

Billings for core products excluding discontinued products acquired with SurfControl were up 7% year over year. Consistent with our year over year growth in billings in the quarter seats under subscription grew by more than 1 million during Q3 to a total of 43.3 million seats. Average contract to ratio increased slightly to 21.8 months in Q2 to 21.1 months in Q3, but is down compared to the year ago level of 23.1 months.

The year over year decline is due to the mix shift of one year contracts in the quarter which was 55% of the total compared to 50% in 2007. We believe that the relative increase in one year contracts due to the mix of SurfControl billings which had shorter average contract ratio than Websense and it may also reflect a certain amount of cautiousness around the macro economic environment.

The growth in our billings despite the decline in year over year contract duration suggest a solid demand for our product and reflects our success in customer retention as well as the introduction of new products. We view the higher level of one year billings as a great opportunity since these customers are up for renewal sooner which provides us with a natural opportunity to both cross sell and up sell our new product offerings.

We also continue to have very positive migration trends and during the quarter more than one-third of the SurfControl renewal base migrated to the Websense product suite.

Turning to revenue, non-GAAP revenue was $86.8 million, part of the Q3 impact of a non-cash write down of SurfControl's deferred revenue in the amount of $10.2 million as required by purchase accounting rules. The revenue performance was consistent with our expectations of a modest sequential decline from Q2 revenue of $88.2 million.

Non-GAAP operating expenses of $60.5 million were flat sequentially. The operating margin was 30.3% in the quarter above our target range of 29% to 30%. For the year we still expect to finish in our target range of 29% to 30% but the total operating margin will decline in the fourth quarter as we increase sales expense with the typical surge in Q4 billings coupled with the previously forecasted modest sequential decline in revenues.

Non-GAAP operating income was $26.3 million. Our non-GAAP revenue performance and improved operating margins allowed us to post strong non-GAAP earnings per share of $0.34 in the third quarter. The non-GAAP earnings per share number excludes the negative impact of acquisition related expenses, the deferred revenue write down and stock based compensation as detailed in the press release.

In April 2007, when we announced plans to acquire SurfControl, we expected the combination to be accredited to non-GAAP earnings by at least 20% and we continue to exceed that objective by a wide margin. On a year to date basis, non-GAAP net income has increased 61% from $30.4 million in the first nine months of 2007 to $48.8 million in the first nine months of 2008.

Turning to our cash flows and balance sheets, our GAAP cash flow from operations for Q3 was approximately $19.4 million after cash outflows of approximately $1 million associated with acquisition and transitional related items. The strong cash flow performance compares with cash flow of $13.9 million in the third quarter of 2007 and reflects the higher billings level post acquisition.

We remain on track to generate more than $75 million in cash flow from operations excluding cash acquisition expenses, an increase of more than $20 million over 2007 levels and which exceeds our initial cash flow accretion estimates of $15 million when we announced the acquisition in April of 2007.

The company's balance sheet remains strong with cash and marketable securities of $63.4 million and total GAAP deferred revenue of $307.7 million at quarter end. Accounts receivable increased $3.1 million sequentially, $64.6 million reflecting slightly longer international collections. DSO's were approximately 67 days in the quarter, up slight from Q2 levels but within our target range of 65 to 70 days.

Our confidence in the ability to generate cash allowed us to make pre-payments on our long term debt totaling $15 million. Additionally, we repaid a further $5 million after the quarter closed bringing total principal payments to date to $75 million and reducing long term debt to $135 million versus $210 million at this time last year. During the quarter, we repurchased a total of 252,000 shares for approximately $5 million.

Now turning to our forward guidance; we are tightening our billings guidance for full year 2008 to $345 million to $350 million, implying a Q4 billings range of $107.5 million to $112 million. Until the recent dislocation in the foreign exchange markets, we were solidly at the mid to upper range of our previous guidance range of $345 million to $355 million. At current exchange rates, particularly for the Euro and the British Pound, we are facing an FX challenge of $3 million to $4 million for our Q4 billings forecast.

Let me be clear that at this point this revision is strictly due to foreign exchange as we are not experiencing any declines in renewal rates. There is no significant shortening of contract duration other than previously described and we continue to see strong potential in our new business pipeline.

On the revenue side, we are increasing the range of non-GAAP revenue to $344 million to $346 million due to the strength of our billings year to date, shorter contract duration in the first half of the year as discussed and stronger linearity in bookings. We are raising the upper end of our non-GAAP EPS range to $1.36 which assumes no change in foreign exchange rates.

We are making incremental investments in sales personnel and technical support in the fourth quarter to support the roll out of our new product suite which will cause expenses to increase more than the seasonal increase in billings would account for. We think that this is the right time to be aggressive with these investments just as competitors are pulling back.

Looking forward to 2009, we continue to feel strongly about our potential to grow billings 10% or more due to the strength of our renewal base, coupled with our new product suite which provides us with excellent opportunities to grow new business and up sell and cross sell to existing customers.

The strongest testament to this growth potential is the 7% growth in our core products that we generated in the third quarter which did not include material billings from our new security suite. Further, we continue to see strong potential in 2009 to migrate SurfControl customers to the Websense product suite.

I do want to remind you however, that one of the characteristics of our subscription model is that there is a lag of about three to four quarters before a change in the billings growth rate shows up in the revenue growth rate. Therefore, the revenue growth rate will lag to billings growth rate in the first half of 2009.

Finally, we will continue to closely monitor the significant uncertainties in the global macro economic environment and foreign exchange markets and will update you accordingly about our prospective for growth in 2009. To the extent that the economic environment has an impact on billings in 2009, it will likely be in the form of shorter contract duration which has the impact of lowering cash flow but increasing revenue and resulting EPS in the period.

To summarize, we have posted an outstanding financial performance here to date in 2008. We are pace to exceed our objectives for cash flow and earnings accretion and we have done an excellent job of retaining migrating SurfControl customers. Our top line billings have resumed growth and our pipeline for new business is starting to expand with the new products. All of this sets the stage for strong top line billings performance in 2009 and I remain confident in our potential to achieve that growth.

With that, let me turn the call over to Doug Wride so he can give you some additional details on our initiatives with our channel partners.

Douglas Wride

As I mentioned on the last earnings call, now that the SurfControl integration has been successfully completed, I'm spending more and more of my time working side by side with David Roberts and Jeff Haggart to further to expand and develop our channels as well as on global operations.

Our commitment to our channel partners is unwavering and I'm please to report we continue to see our positions strengthening with our channel partners. With the current economic turmoil and industry consolidation, now is an excellent time to invest in taking these relationships to the next level.

Our increasingly focused efforts have been validated with several recent channel surveys and awards. Most recently, VAR Business recently published its 2008 annual report card issue which identifies how vendor channel partner programs stack up, Websense was named number two in the network security category behind number one Trend, beating our Symantec, MacAfee and other competitors. Last year we were ranked number four so we're shooting for number one next year.

We were also named to the 2008 CRN Channel Champion list and we received top honors in Everything Channel's 2008 VAR Business partner program guide. Out of the 100's of vendor program entries received by VAR Business, the Websense Channel Connect Global Partner Program was named among the top 12 partner programs to watch. Our Channel Partner Program was among the select few to receive a gold, five star overall rating.

In the second quarter, I as well as a number of our other senior executives spent a fair amount of time interacting with our channel partners in the Asia Pacific region. During the third quarter, we expanded that involvement to the U.S. and held high level reviews with executives at a number of key partners across the U.S. working towards how we might jointly improve our success.

These interactions always cover a wide variety of topics but generally include, positive discussions around our new product offerings and the increased need for channel training as the portfolio of Websense solutions expands.

We also formalized a Virtual Advisory Council for partners to provide us with immediate feedback on new programs and tell us first hand how we can make their relationship with Websense more productive. As a result of this feedback, we took significant steps to be more visible and accessible including increased opportunities for sales and technical product training for the sales, service and engineering personnel of our partners, both in our offices and in the field.

Demand for training has been high and these courses have been well received. By the end of this year, we expect to have four to five times the number of partner FE certified on the web security gateway as we have FE's within our own Websense sales team. That represents good leverage of the abilities of our channel partners.

Also, the development of a sales forced based PRM system that will offer more robust features for lead management, deal registration, renewal protection and much more. Presentations and joint events throughout the world for the launch of Web Security D7 and Web Security Gateway have also been held.

Further demonstrating our commitment to channel partners, we recently added a Vice President channel for North America, John Deagan. John joins us after many years at Microsoft, Corel and Borland and reports to David Roberts. We're very excited to bring someone of his caliber and experience on board.

Over the next few weeks, I and a number of Websense senior executives will be in Ania for our annual partner conference in that part of the world with the goal of increasing executive communication with partners in these markets.

In addition to my work with David and Jeff, I continue to spend time on the global operational aspects of our growing business. In September we signed a lease that will double our office space in Beijing. We continue to see this location as an opportunity to increase our technical head count in a very cost effective manner.

We expect to move into this new facility in Q1 of next year. This location is across the street from our current offices and it should allow us to comfortably house this team as it continues to grow in the future.

Through my years with Websense, I feel as optimistic as ever as we near 2009. The current economic environment notwithstanding, we've made tremendous progress this year. We have all of the pieces in place to be successful. New products and a compelling product road map, strong and continuing to improve channel relations and a committed and talented team focused on execution.

It's too bad the global economy seems to be correcting, but we proved our ability to thrive in tough economic times in the "bubble recession" and I have no doubt we will continue to thrive through this downturn.

Now let me turn you over to Gene.

Gene Hodges

Q3 was the fourth consecutive quarter of solid Websense delivery on financial commitments. We believe this shows the effectiveness of our multi-product, data centric security strategy and our execution during our two acquisitions.

The quarter also showed solid cross functional execution by all the Websense teams, led this quarter by the brilliant and innovative execution of the Websense engineering organization. The third quarter resulted in rapid consolidation of our industry segment as well. We've anticipated the consolidation in our strategy and know that to compete effectively against our larger competitors, we have to have what John McCormick calls, clear blue water differentiation in our technology.

With the release of the most effective technology for the protection against modern Web 2.0 type web security threats, we are now confident we have that technology in our core market. With the release of the industry's most effective in point data loss prevention client, we have a lead in our fastest growing market segment.

We are competitive in our third focus segment of In The Cloud Security Services and expect to gain leadership over the next 18 months by integrating the policy management of our On Premises and In The Cloud offerings. We'll start with Web security in the second half of 2009. Taken all together, Websense today offers a clearly superior set of products to protect customers' most essential information, and that technology is the fulcrum that we will use to leverage growth in 2009.

As promised, Websense returned to billings growth in the third quarter. The growth was modest but the areas which achieved the best success show our opportunity for the future clearly. Websense overall growth for the quarter was 4%. We also watched the growth of the continuing products very closely.

These are the products that we did not end of light with the SurfControl acquisition. Growth in these same store sales products, so to speak, were 7% year over year. The United States returned a growth in the third quarter. This is exciting news to us as the U.S. has shown flat or negative growth for an extended period, and clearly face the difficult macro economic environment in Q3.

There was no single silver bullet that contributed to this return to growth. Whether the U.S. grew through a series of small contributions from across our product line, the U.S. has been relatively fast on the uptake with regard to our new Web Security gateway, and we enjoyed about $2 million of orders for the Web Security gateway in the United States in the third quarter.

SurfControl upgrades were secured on over one third of the SurfControl web filtering renewal base as measured by the renewal value, and this is up significantly from Q2. Our Version 7 product exceeds the SurfControl web filter product in every major feature area. The availability of future upgrades to the Web Security gateway's real prime characterization technology gives us yet another step that SurfControl never offered.

And finally, a dramatic improvement in SurfControl customer satisfaction driven by excellent execution and improved technical support all contributed to this strong set of upgrades from the surf base.

Data loss prevention continued delivering good growth and we believe we'll see a very solid Q4 in the U.S. We also saw our first significant In The Cloud security service orders in the U.S. in the third quarter. We even generated over $2 million in new business in S&B in the U.S. as we shifted our focus to one driven by partnership between local resellers and our own new business S&B sales team.

Collectively, all these small contributions to new business growth resulted in a recovery that was very dramatic in U.S. new business generation. Combined with historical consistent renewals, the U.S. grew. It wasn't magic. It's just the start of the execution of our overall strategy even with a tough economic climate.

Our new business generation in Q3 is just a few percentage points of billing off the rate we need to achieve in the U.S. in 2009 to deliver the 10% plus billings growth that we're committed to. There's still work to do to get this increased new business growth, but we're well on our way to sustainable new business growth in what has been Websense's toughest market to crack for growth.

Also remember that these results were achieved with a reduction in U.S. of direct sales spend of about 20% from the combined SurfControl and Websense sales forces of last third quarter. Given our expectations that we'll be adding sales manpower in the U.S. in 2009, and that the new business pipeline generation that we've seen to date in Q4, shows additional improvement, we feel very confident about our ability to grow the U.S. in 2009.

I've spent all this time talking about the U.S. because it shows what we want to do across the world in microcosms in 2009. Our strategy focuses on achieving steady improvement in new business and upgrades in multiple areas including web security and filtering, coupled with continued solid renewal and retention performance.

Our growth in many international regions continues to be strong as it has been for the past two and a half years. Our growth in Latin America, Australia, Asia, Eastern Europe, the Middle East and Israel sizzles. Conversely however, growth in Central Europe and the U.K. were disappointing. Some of this was caused by foreign exchange rates, but most of the shortfall came from a slowness in driving new business pipeline generation earlier in the year during the SurfControl integration.

We have some catching up to do and we're working hard to build our new business pipeline in these regions and we've seen a good uptick in the first early weeks of Q4. Overall, the biggest and most positive change that we saw in Q3 was the improvement in our competiveness from our invigorated product set.

It was clear in competitive deals, in North American, in Europe and in Asia for where ever we fought for secure gateway projects that our competitive posture has significantly improved. This is true both against our larger competitors and against legacy competitors like Blue Coat.

The first element of this improved competitiveness came from having the world's first broadly effective real time malware and objectionable content blocking solution and this shift in our web security gateway just two weeks before the end of the quarter. The second element came from showing distributing customers that only Websense can deliver a proven web security solution that combines In The Cloud components with On Premise components.

You'll hear our competitors start to talk about such solutions, but their offerings fall far short of what we offer today. In fact, often if they have web security at all, it is OEM from us.

Our future with the web security gateway looks very bright. One way to quantify this is that the value of the upgrade portion of web security gateway products is about half the total value of new business we see around the globe from web filtering. So, just 30 days after launching this new opportunity from growth with the web security gateway, it's already half of what our largest prior growth engine was.

Almost all of this increased opportunity for WSG has been generated in mature markets like the U.S. and Europe, whereas the new web filtering opportunities as you would expect, come predominately from emerging or partially developed markets where web filtering adoption is relatively low. Taken together, Websense now has a powerful one-two punch that can help us grow in our core market segment around the world.

We see all these opportunities continuing in Q4 and into 2009. The one way is long for both sets of opportunities. The macro situation's future impact however, is impossible for us to predict. In my opinion, it's who is first to try to play junior macro economist and pretend we know what's going to happen next.

Instead in our remarks and answers today, we're going to focus on what we know from our business and interaction with our customers and you can figure out what's going to happen with the economy.

Obviously, we're very positive about the opportunities we have from our new product cycle, about our improved competitiveness and about our sales teams ability to drive new business with these new products. This optimism comes from our Q3 results and the continued performance we've seen so far three weeks into Q4, this happening even in a dim macro climate.

Remember, we have strong cash flow and our subscription model assures a strong flow of revenue through 2009, even in these pretty dire economic times. We plan to major acquisitions for the foreseeable future as we build a broad and strong product line and a large enough distribution footprint, that this can hold us well into 2010.

We completed our path to acquisition and integration activities and hence the vast majority of one time cash outflows for acquisition integrations are behind us. We've consistently prepaid debt, lightening our debt load by $75 million since the close of the Surf acquisition and our business remains wonderfully capital un-intensive.

All this means we have the advantage of channeling all our free cash flows into share repurchase, accelerating the debt retirement or to further reduce debt costs or insuring liquidity if the external situation gets much, much grimmer. Like you, our customers know this and they are assured that Websense is a survivor and that's a help in these tough economic times.

In Q3 and so far this quarter, the number of customers cancelling renewals for economic reasons seems still to be insignificant. We don't see more than a couple of handfuls and they're mostly smaller customers. Feedback from our customers about how our products fare in discussions over budget cuts is clear and it's very positive.

CSO's see Web 2.0 threats as real and something they're concerned about, and they're addressing those threats near the top of their 2009 budget list. Although data loss prevention projects are almost always new spending, they also remain ranked near the top of the list and in fact, many customers see data loss prevention projects as becoming even more important in times of staff cuts and rapid merger and acquisition activity.

These are the circumstances where our customers company's essential information is often most at risk. We have a relatively small exposure to the large financial services players who have been most affected by the current turmoil. These accounts were early adopters and they happen to have extremely low price points, so even if we lost a few, we were actually at very low risk.

So far, we've seen the renewals continue to come in time. In fact, not only in finance but across the board even in companies that are experiencing significant financial stress.

Finally, our solutions are a small part of the overall IT budget and even of the IT security budget. Customers don't simply seem to see us as a way they can move the budget needle. So far, net net we are not seeing customers cancel or significantly shorten their subscriptions or cancel new products or new projects in the areas where we compete.

Our competitive outlook has also improved on several fronts in addition to our improved product competitiveness. Our new larger competitors have weaker web security solutions and they compete more on value than on price. This means that our price points are holding and as we compete with the new products, we even see them increasing significantly as customers upgrade.

Secure computing and message labs are in the midst of being acquired and for a few quarters at least, they are less competitive as their new owners have to prove they can maintain competitiveness in the web security technologies through the acquisition integration process. Blue Coat is in the midst of the Packateer acquisition integration. They're clearly experiencing challenging financial times and our new web security gateway product makes us significantly more competitive with Blue Coat for procurements that include proxy cash and web security solutions.

Some of our much smaller regional competitors who typically compete predominantly on price although they have far inferior products, are having cash flow problems and those competitors have to convince prospective customers that they'll even be around next year. So all in all, the competitive perspective is very positive for Websense at this time.

In Q3 and so far in Q4, by far the biggest impact we've seen from the economic situation is in foreign exchange and you've heard Dudley discuss it. Let me emphasize one more time, our pipelines for both new and renewal business that we're seeing are in exactly where we planned them to be in local currencies around the world, but the dollar's strengthening has been unprecedented. We'll see how the rest of the quarter and 2009 plays out.

When all these factors are taken together, we still see double digit growth for 2009. Unlike many companies, we have many more opportunities for growth in 2009 than we did in 2008, and hence, much more propulsion than most to make way against what many call strong financial headwinds.

The last two years have been times of rapid and tough change for Websense internally as we made acquisitions and built this new product line. Now, the external market is chaotic. But Websense has the luxury of being stable, focused and committed with many exciting opportunities ahead of us and the future looks much brighter than the overall macro climate.

Now I'll turn the call over to the operator for your questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Eric Martinuzzi – Craig-Hallum.

Eric Martinuzzi – Craig-Hallum

For the marketing effort, the Gateway offering, you had some success in Q3. As you're marketing this through an indirect method, you've got to have the channel up to speed. What are you giving them, what tools are you giving them to convince the install base that Gateway upgrade is worthwhile?

Gene Hodges

There are three sets of convincing material. The first has to do with the threats and we'll be happy to pass this stuff along to you. The bottom line is that the bad guys are starting to stage their attacks differently on the web and their moving from porn sites and hacker sites to the high volume sites that we all go to every day; the community networking sites and other sites with user generated content. That type of attack requires a new type of technology and we have a unique situation in having that technology.

The second set of material has to do with proving the stability of our product and the effectiveness of our product at high speed since these new technologies are what geeks call 'in-line'. Every bit that goes through the pipe has to go through your product, and you need to make sure that it's very stable. Our older technologies did not have that aspect.

The third set are comparative tests which show the effectiveness of our product in stopping malware attacks as well as blocking objectionable content, and we have that material against all the major competitors. As Doug said, money always gets them excited.

Douglas Wride

Our reseller channel is in business to sell stuff and if they don't they go out of business. So they look to the most exciting problems and the most exciting solutions, and that's what Gene spoke to, and what I was speaking to earlier was that we're out training and making sure that the executive level of these key channel partners are bought into making Websense a significant part of what they offer to their install base on a day to day basis.

Eric Martinuzzi – Craig-Hallum

The adjusted gross margins down sequentially, what's your outlook for Q4 on the gross margins?

Dudley Mendenhall

Gross margin will stay relatively stable as a percentage of revenues so I wouldn't expect to see any major move there.

Operator

Your next question comes from Samuel Wilson – JMP Securities.

Samuel Wilson – JMP Securities

What was head count for the quarter?

Gene Hodges

1,238.

Samuel Wilson – JMP Securities

What was CapEx for the quarter?

Gene Hodges

About $3 million.

Samuel Wilson – JMP Securities

You mentioned about one-third of the install base of Surf during the quarter transitioned, I think last quarter was 15%. If you were to add up in total so far, how much of the SurfControl install base do you think has converted to Websense?

Gene Hodges

It's less than 5%. Surf has about a 24 month contract ratio, maybe it's 5% or 6%. Most of that opportunity is still ahead of us. Something that you should understand in terms of our strategy, this is a two step move with the Surf install base, our strategy has always been to first upgrade to Websense Security Suite and then to go back again to upgrade them to the Websense Security Gateway a year later. So that is predominantly a 2010 focus.

Samuel Wilson – JMP Securities

How would you overall rate your success at retaining SurfControl customers?

Gene Hodges

We are slightly ahead of our plan from April 2007. We talked about this a couple of times and there's been some noise in the investment community. We're significantly ahead of the Surf upgrade plan, and this is the quarter where we really go into high gear. We always wanted to have the V7 products there and to let things settle down before we started to push hard on the upgrades or else you're likely to get a negative reaction from the customer base.

Samuel Wilson – JMP Securities

Did you mention the DLP number for the quarter?

Gene Hodges

24.

Operator

Your next question comes from Todd Raker – Deutsche Bank.

Todd Raker – Deutsche Bank

Seats were actually up over 1 million this quarter. That's the first time we've seen seats up in quite awhile. Can you talk about what drove that? I know you talked in your prepared commentary that ASP's receivables were relatively unchanged. Were there any large deals or what's the big driver there?

Gene Hodges

The seat growth was driven by the drips and drabs in new business and that was coming from across the product line. Given the pricing as you would expect in the Web Security Gateway sales will add an appreciable number of seats and that's probably the biggest uptick. We had a good quarter for large six figure deals. We had I believe one $1 million deal and that was a big Web Security Gateway deal.

Predominantly new business, displacement of a competitor at a price point 3X our typical Web Security Suite ASP.

Todd Raker – Deutsche Bank

Are you seeing any indication that your channel partners are having trouble financing transactions given the credit environment?

Dudley Mendenhall

We aren't seeing an issue at all. A big part of our business goes through Ingram Micro which obviously has a very decent credit rating. But we haven't seen any problem at all at this point.

Operator

Your next question comes from Rob Owens – Pacific Crest.

Rob Owens – Pacific Crest

When you sell the Web Security Gateway, what type of price list are you seeing versus a traditional renewal?

Gene Hodges

It's 30% up from Web Security Suite.

Rob Owens – Pacific Crest

Are you getting into any bake offs with other vendors when you're selling Security Gateway at this point or is it more just convincing the customer that they need this type of protection?

Gene Hodges

Most of the enterprise deals are bake offs and we are winning a very, very high percentage of those.

Rob Owens – Pacific Crest

Who are you seeing most frequently?

Gene Hodges

We're seeing Secure. We're seeing Sysco. We're seeing Trend. We're seeing Pyon Chong once in awhile, much more heavily in Europe.

Rob Owens – Pacific Crest

On the Web Security Gateway front, I'm not sure I understood your commentary around it being half the value of filtering. Is that with regard to orders or potential billings or what the market size is? Could you clarify that for me?

Gene Hodges

That's a new business pipeline comment. When we look at our opportunity for closing new customer web filtering deals which was our largest growth driver, most of that coming out of Europe and Asia, the uplift only, so I'm not counting the whole order, just the true incremental amount of Web Security if half of that.

So basically, our biggest engine has a small engine that's half its size, and we're watching the pipelines fairly heavily because the enterprise new business in two to three quarters out in terms of the selling cycle.

Operator

Your next question comes from Sterling Auty – J.P. Morgan.

Sterling Auty – J.P. Morgan

Can you give us an idea of what the FX impact on the September billing and possible the revenue and expense?

Dudley Mendenhall

Year over year in the third quarter, FX was largely neutral with really it falling in the last couple of weeks. The impact in the third quarter was relatively muted on a year over year comparison. We had a little bit of headwind at the very end there on billings, a little bit of a pick up on operating expenses, but for the first two and a half months of the quarter, the FX was very neutral on operating expense.

Sterling Auty – J.P. Morgan

On renewal rates, I think in the past renewal rates had been 75% to 80%. Can you give some commentary as to how the renewal rates across the entire business are now trending versus what you've seen in the past?

Gene Hodges

We really haven't seen much of a change. As we've said in the past, we do better than that in enterprise and a little bit below that in SMV where you have a little higher turn rate, so 75% to 80% continues to be a very good range for us in terms of renewal rates. I think as we continue to have successful migration trends with uplift that will help that renewal rate.

Douglas Wride

I would add that historically SurfControl's renewal rates were lower so we are now seeing the combined rate of Websense going forward and that' 75% to 80% range. So we see that as an improvement of what the one plus one would have been.

Sterling Auty – J.P. Morgan

What was the geographic split on revenue in the quarter?

Dudley Mendenhall

Traditionally this quarter now with SurfControl tends to drop on the international side because of their renewal year end being in June, so it was 48% versus 46% a year ago.

Operator

Your next question comes from Brad Zelnick – Bank of America.

Brad Zelnick – Bank of America

In your prepared you commented about the uncertainty in the macro environment potentially resulting in a reduced contract length. Have your thoughts changed at all on the contract length and when we talk about your billings growth expectation in 2009, what assumptions do you make on contract length there?

Dudley Mendenhall

We are making an assumption that it won't change from the historic average. If you go back over the last three or four quarters, we've only had one quarter where we had an abnormally low rate which was the first quarter of this year. The other quarters have trended back into that range of an average of 22 months and so we're not assuming anything different than that approximate amount in our 2009 forecast.

Brad Zelnick – Bank of America

Can you give us any sense of what renewal rates were on a dollar basis?

Dudley Mendenhall

We're speaking to renewals being in that 75% to 80% range on a billings basis.

Operator

Your next question comes from Daniel Ives - Freidman, Billings.

Daniel Ives - Freidman, Billings

You had a very good improvement on the SurfConrol migrations, but with less than 5% converted, what's your expectations going forward on the migration process? Is it going to be higher than one-third?

Gene Hodges

We think it will probably edge up from there. We don't guide on a product by product basis but we do think it will edge up from there.

Douglas Wride

I would just add that with the release of our V7 as Gene was saying, now we have a significant differentiation between the former SurfControl web security product from the V7 product we offer and the time is now to really step up to web security improved technology.

Operator

Your next question comes from Walter Pritchard – Cowan & Co.

Walter Pritchard – Cowan & Co.

I'm wondering as you look at your hiring on the sales side and ramping that up, and you've also got the new products, I'm just wondering if you can help us understand directionally which of those two factors, the new products and the sales ramp are most important in you getting to that growth rate that's probably above market and above what most of your peers are going to be?

Gene Hodges

I think we'll want to wait until January to get into details on that since we haven't finished our sales manpower planning. I think it's fair to say that we expect a productivity improvement from current sales staff on new business next year. That will be significant. We don't expect much productivity improvement on renewal yield which is outstanding in our sales force, and then we'll add people on top of that new business productivity.

Walter Pritchard – Cowan & Co.

On the DLP side, there continues to be a lot of consolidation in that market and companies going back and doing second acquisitions in that space. Do you think you have everything you need there? Is there other functionality that you need to put into that suite to be able to keep up with what seems to be everybody pushing forward in that market?

Gene Hodges

First I want to correct myself. DLP billings for the quarter was $2.2 million not $.24 million. We think we have everything we need to be specific and probably what you're thinking of is we don't need to buy an encryption company. We have in fact I think a good set of partnerships with PGP, with Voltage for being able to handle the in point functions outside of anti-virus that we don't do.

I'm very happy MacAfee just bought Laconics. They're going to have a very difficult integration job to ship what we just shipped which is an integrated gateway and in point product and Symantec is going to remain a very tough competitor. They are bigger than we are as you know, but our win rate against them is improving every quarter.

Operator

Your next question comes from Fred Zeigel – Soleil Securities.

Fred Zeigel – Soleil Securities

Any plans or programs to try to go after in particular the message labs and secure computing customer base?

Gene Hodges

Obviously.

Fred Zeigel – Soleil Securities

Anything more specific?

Gene Hodges

They would clearly return the favor and did. At the time we were acquiring SurfControl, they were smaller companies. MacAfee and Symantec are tough competitors. As you know, I know a little bit about MacAfee and have competed against Symantec for most of my career. They're going to be tough competitors, but we'll just make it more interesting for them

Operator

There are no further questions. I'd like to turn the conference back over to Miss Patterson for any additional or closing remarks.

Kate Patterson

Before we close today, I just want to outline our calendar for the fourth quarter in terms of conference participation. We'll be speaking at the AEA Classic in San Diego, November 3 & 4, at the UBS Global Services and Technology Conference on November 18, at the Credit Suisse Conference in Phoenix on December 3, and the Nasdaq Euro Conference on December 2 in London and at the Global Conference December 10 in San Francisco. Hope to see you there.

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