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Executives

Matthew T. Medeiros – Chief Exec. Officer, President

Rob Selvi – Chief Financial Officer and VP

Robert B. Knauff – Chief Accounting Officer, VP of Fin. and Corp. Controller

Frederick M. Gonzalez – VP, Corp. Sec. and Gen. Counsel

Analysts

Scott Zeller – Needham & Company

[Matt Hindenburg] – RBC Capital Markets

[Ken Muff] – Robert Baird

SonicWALL Inc. (SNWL) Q3 2008 Earnings Call October 28, 2008 5:00 PM ET

Operator

Good day and welcome to the SonicWALL 3rd quarter 2008 earnings conference call. (Operator Instruction) At this time I would like to turn the conference over to Ms. Kelly Blough.

Kelly Blough

Welcome to our 3rd quarter 2008 earnings conference call. With us today are Matt Medeiros, President and CEO of SonicWALL and Rob Selvi, CFO.

Before we begin, I would like to remind everyone that during this conference call we will be making forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 as amended and Section 21E of the Securities Exchange Act of 1934 as amended.

Forward-looking statements include without limitation, revenue GAAP and non-GAAP earning per share and gross margin guidance for the fourth quarter of 2008, expectations for future product introductions and the market acceptance of new updated and existing products and our positioning for revenue, profitability and market share growth.

All forward-looking statements made on this call are subject to risks, uncertainness and assumptions that could cause actual results or events to differ materially from those contained in the forward-looking statements.

For a detailed description of the risk and uncertainties that could cause actual results to differ materially from those expressed or implied in these forward-looking statements, as well as the risks related to our business in general, we refer you to the periodic reports that the company has filed from time to time with the SEC, including discussion and risk factor section of the company’s annual report on Form-10K for year ended December 31, 2007.

The company undertakes no obligation to update forward-looking statements at any time or for any reason. In addition the following information include non-GAAP results, which exclude ammonization of purchased technology and the cost of goods sold, amortization of intangible assets and operating expenses, restructuring charges and stock-based compensation expense.

Please see our web site and our Form-8K filed with the SEC earlier today for reconciliation of non-GAAP and GAAP results. I will now turn the call over to Matt Medeiros.

Matt Medeiros

Good afternoon and thank you for joining us. SonicWALLs total revenue grew 5% year-over-year to $53.3 million. Expense management and improved operating margin resulted in non-GAAP earning per share of $.08 and GAAP earnings per share of $.01.

SonicWALL has experienced positive cash flow from the ops from operations to the last 14 quarters. We have been profitable on a non-GAAP basis in each quarter over the past five years. We have $166 million in cash and total investments with no debt.

Our balance sheet strength provides us with the stability necessary to stay focused on our strategic objectives, which provides reassurance to our customers and channel partners. We’ve been talking about the [lack] economy and the impact of North Americans SMB market for the past several quarters.

It is fair to say that SonicWALL experienced a slowing in demand in North America earlier than other companies, due in part to our market leading position in the SMB segment. Our view was that the general economy was challenged well before the impact of Fannie Mae, Freddie Mac, Washington Mutual, AIG and Lehman Brothers.

At the end of the third quarter as the world began to understand the impact of the global financial meltdown, revenues fell off sequentially, particularly in Asia and in Europe. So, we’re very pleased that even in the midst of this challenging economy, our total revenue grew 5% year-over-year driven by subscription services growth of 24%.

Our new UTM profit line represents a bright spot in our Q3 results, growing 14%, year-over-year. In fact, over the last three quarters since the launch of the NSA product line, our UTM business has grown 14%, compared to 3% growth in the first three quarters of 2007. Our expansion up markets and the development of these award winning UTM products, present new opportunities for us in the mid-tier and enterprise markets.

It allows us to broaden our customer base. Our new UTM architecture and innovative technology makes us competitive against incumbent vendors such as Juniper and Cisco. And because our products are more affordable and offer a strong advantage in total cost of ownership, SonicWALL solutions represents a compelling alternative to the premium priced offering in today’s price sensitive economy.

SonicWALLs products are receiving strong validations and excellent reviews in industry analyst and channel partners. We are very proud to have recently received the Ark award from [Barr Business], as their company of the year in security appliances category. SonicWALL took the top spot for technical innovation, including [inaudible] of product features and functionalities, quality and reliability, compatibility; ease of integration.

SonicWALLs partner program also received praise, winning in categories of reseller return on investment and ease of doing business. We are also proud to have been named one of the top five strategic security vendors for 2008 in a channel survey conducted by [Barr Business], which rank SonicWALL alongside industry powerhouses [Semantics], Cisco, HP and Microsoft.

In September we received a strong review from CRN for our new NSA 2400. The CRN review also offered praise for our post-sale technical support organization, providing further validation of our decision to in-source this function to achieve improved customer satisfaction and cost efficiency.

The newest SonicWALL offering the NSA 240 is also receiving excellent reviews. The NSA 240 is the final products in our series of our next generation multi-core unified threat management appliances. The dual core NSA 240 is designed specifically for small businesses and branch offices, and establishes a new standard for technical performance at its price point.

Just last week, the publication eWeek gave the NSA 240 a strong endorsement for its robust and comprehensive technical features, its manageability and its affordability. As I mentioned previously, our refreshed product portfolio has made us more competitive and positioned us as a compelling alternative to premium priced vendors.

We saw the benefit of this in the third quarter with customers supplying SonicWALL solutions throughout their organizations. For example, ETM Capital a long-time [Albanville] customer added SonicWALL UTM solutions in the third quarter, replacing its CheckPoint firewall.

American Greetings, a longstanding customer utilizing our TV products in their branch offices, deployed SonicWALL at its headquarters replacing Junipers SSL-VPN appliances with the SonicWALL SSL-VPN 2500.

MSG, the largest online marketplace serving the global manufacturing community, chose SonicWALLs NSA 2400, 3500, and 4500 appliances over Cisco and Watchguard solutions. [Front safe] in the Nordics, replaced their existing Cisco firewall with E-class NSA 7500.

[Denry] of Germany chose to deploy our E-class NSA solutions at their headquarters and has replaced their CheckPoint UTM devices in their subsidiaries with TZ products. [Senator Penn] in Germany also deployed our E-class NSA products at their headquarters and displaced the Watchguard solution with our TZ and their subsidiaries.

And [System] in Sweden purchased an entire fleet of SonicWALL security solutions, including NSA 4500, 2400, TZ 190, E-class SSL-VPN, GMF and e-mail security. And finally [Chesko] of Hong Kong chose our E-class SSL-VPN solution over the competition, based in part upon our superior support services, again validating our new in-source support team for Asia.

Customer wins and product reviews such as these, validate our strengths of our technical platform in our competitive position. We weren’t immune to the weakening in the demand conditions that occurred at the end of September. The typical third quarter tends to be back-end loaded.

As you know, a high percentage of our larger, mid-tier, and enterprise deals are received in the last couple of weeks of the typical quarter. We experienced an interruption in this pattern. The number of larger deals being postponed into view of the broader economic uncertainties that came into light.

The postponement of these larger deals contributed to a weaker than expected revenue performance in the quarter. While some of these deals have since closed, we remain cautious regarding the world wide demand environment. Now let me hand it over to Rob to review our financials.

Rob Selvi

Good afternoon everyone. In the third quarter of 2008, SonicWALL generated $53.3 million in revenue, within our guidance range of $53 to $56 million. As a percent of total revenue, UTM solutions contributed 77%, secure content management solutions contributed 10%, SSL VPN solutions contributed 9% and CDP contributed 4%.

Total revenue units shipped in the quarter were 45,000. Product revenue was $21.4 million, down 10% sequentially and 16% year-over-year. The decline in product revenue was primarily the result in the decline in average net revenue per unit, which is a function of product mix.

As a percent of total product revenue, 72% was generated from product with average net revenue per unit below $1500, 20% was generated from products with average net revenue per unity of $1500 to $5000, and 8% was generated from products with average net revenue per unit above $5000. License and services revenue of $31.8 million was relatively level sequentially, an increase of 24% over the same period last year.

The levels of sequential performance in license and services revenue was primarily the result of increased sales of our comprehensive gateway security service, offset by a reduction in license sales. The year-over-year increase in license and services revenue was the result of increased sales of comprehensive gateway security, clank client antivirus, e-mail security and customer support services.

License and services revenue represented 60% of total revenue in the quarter. License revenue represented 7% of total license and services revenue during the quarter, as compared to 9% in the prior quarter and 8% in same period last year.

Total subscription services billings were $33 million, up 3% over the prior quarter and up 3% over the same period last year. Multi-year subscriptions accounted for approximately 25% of subscription service billings in the third quarter.

On a percentage basis, North America represented 67%, and international represented 33% of total revenue. Europe, the Middle East and Africa contributed 19%. Asia-Pacific and Japan contributed 11% and Latin America contributed 3%.

Non-GAAP gross margin was 70.7%, compared to 71.1% in the second quarter. Product gross margin declined to 51% from 55% in the second quarter, once again due primarily to product mix along with higher freight and manufacturing cost.

Non-GAAP operating expense declined subsequently by $3.3 million. The decrease in expenses primarily reflects the decreases in variable selling and other incentive expenses, third party support costs, payroll taxes and 401 K match costs, contractor expenses, marketing programs, and travel expenses.

In terms of non-GAAP results, the total operating expenses represented approximately 60% of revenue for the quarter, compared to 64% in the prior quarter. Operating expenses for research and development represented 19.8% of revenue.

Sales and marketing expenses represented 34.6% of revenue, and general and administrative expenses represented 6% of revenue. At the end of the third quarter total regular employee headcount was 841 compared to 741 at the end of the second quarter.

This increase primarily reflected hiring in Bangor, India and Tempi, Arizona related to the completion of our transition to an in-source support model for the North America and Asia- Pacific regions.

GAAP earnings for the third quarter were $600,000 or $.01 per diluted share. Stock-base compensation expense before tax primarily associated with the expensing in stock options was approximately $2.8 million.

For the quarter, non-GAAP tax expense was $2.4 million against non-GAAP income before taxes of $6.6 million. Non-GAAP net earnings for the third quarter with $4.1 million or $.08 per diluted share. Non-GAAP net earnings for the third quarter excluded a million dollars of amortization of purchased intangible assets and $2.8 million of stock-based compensation expense.

And now I’ll review the balance sheet and cash flow statement. During the quarter, we generated operating cash flow of $5.5 million. Total cash, cash equivalence and short term investments were $99 million.

During the third quarter, we reclassified $11.7 million of mortgage back securities from short-term to long-term investments. This is in addition to the roughly $55 million in [auction] rate securities that we reclassified during the first quarter this year.

These [inaudible] investments currently lack short-term liquidity. Although we continue to believe that par value represents the fair value of these investments because of the overall quality of the underlying investments and the anticipated future market for them.

In October, we also received an offer from one of our investment providers to sell approximately $45 million of our [auction] rate securities at par value at any time during the two year period beginning June 30, 2010, further bolstering our view of the longer term value of these securities is sound.

For the reclassified mortgage back securities, unrealized losses have been recognized and other comprehensive income of $3.8 million. We will continue to monitor the market for value indication updates on these securities. And for more detailed information regarding these investments, please see the periodic reports we file with SEC.

Net accounts receivable were $22.4 million in the third quarter, compared to $23.9 million in the prior quarter. DSO was 38 days, level with the prior quarter. Net inventories were $7.6 million in the third quarter, compared to $7.5 million in the previous quarter and $5.1 million in the same period last year.

Net inventories consist of inventory of two of our top U.S distributors and finished goods at our third party manufactures and logistics provider. The year-over-year increase in net inventories is primarily associated with stocking of NSA products.

Total annualized inventory turns on a non-GAAP basis for nine times, level with the second quarter. Deferred revenue of $106.1 million was level sequentially and increased 16%, in comparison to the same period last year.

Of the total deferred revenue balance 89.8 million or 85% is attributable to subscription services. For comparison purposes, subscription services deferred revenue was $87.6 million or 83% of the total deferred revenue balance in the second quarter of 2008 and $77.5 million or 85% of the total deferred revenue balance in the third quarter of 2007.

I will now complete my comments with guidance for the fourth quarter of 2008. We remain concerned about the impact of the current economic environment on our business and expect fourth quarter revenue in the range of $50 to $54 million.

Our expectations for gross margin in the quarter are in the range of 71 to 72%. We expect earnings in the fourth quarter to be in the range of $0.05 to $0.07 per diluted share on the non-GAAP basis and GAAP earnings of nil to $0.02 per diluted share. Now I will turn the call back over to Matt to conclude.

Matthew Medeiros

We are all aware of the uncertainties in today's economy and market conditions. There are clearly factors that will influence our business performance that are out of our control. SonicWALL will continue to execute against their strategy.

In the coming quarter we will introduce new releases of our CDP product, email security and SSL-VPN. We are advancing our technical platform, investing in higher growth international markets and improving our operational efficiencies. We believe the company has never been better positioned. I want to thank all of our employees and partners for their contribution in a challenged market. Kelly.

Kelly Blough

Operator, please poll for questions.

Question-and-Answer Session

Operator

(Operator Instructions)

Kelly Blough

Before we take our first question I would like to remind everyone that SonicWALL will be presenting at the Barkley's Global Tech Conference on December 9th in San Francisco. We hope to see you there.

Operator

We will take our first question from Scott Zeller – Needham & Company

Scott Zeller – Needham & Company

I wanted to ask about the former [Aventale] business. Could you tell us if some of the purchase – it seems like some of the more expensive units were less as a percentage of revenue. Could you tell us if people who are looking at the former [Aventale] were just not doing deals at all or were they actually trading down to a less expensive box.

Matthew Medeiros

Yes, Scott, thank you for the question. Scott, look it, I think it was really reflective of the fall off in overall demand in the last two weeks of September. As I've noted most of our larger, higher end deals happened in the last two weeks. I'm pleased to announce that several of those deals did convert into orders in October, but I really think it was based on kind of the issues that we had talked about earlier that the demand just fell short in the last two weeks.

Scott Zeller – Needham & Company

So, it's not as if people were trading down to a different solution, it was just a timing issue.

Matthew Medeiros

No, I think some of the successes are customer wins that I pointed out. We had some really good success with what we think are major customers, customers that will help us build momentum behind our E Class SSL-VPN products, taking out competitor products like Juniper and others. So, we're pretty excited about the opportunity still left in the marketplace for sure.

Scott Zeller – Needham & Company

Regarding the trending in SMB, you gave some color about the [Maya] and Asia. I've heard from other field contacts that the mid-market world is stabilizing somewhat after a really bad start to the calendar year. Are you seeing, this is domestically I'm speaking of, are you seeing any stabilization in the mid-market?

Matthew Medeiros

Yes, if you look at linearity, actually we're seeing some stabilization both at the SMB and the mid-market. We saw payroll numbers increase in SMB as late as the ADP report for September. We are anticipating that SMB and North America will recover first only because we saw the slide starting to take shape two years ago and we think that our channel partners and that our end customers have already kind of, if you will, reacted to the marketplace and clearly we think the demand is kind of leveling off, but we see some bright spots in it.

Our next question from Robert Brezina – RBC Capital Markets

[Matt Hindenburg] – RBC Capital Markets

This is actually [Matt Hindenburg] sitting in for Rob, how are you? I had a question around the headcount. I think it was Rob saying that it was up about 100 sequentially mostly in India and in Tempe.

Can you give us an idea – in these challenging times we often look to companies to control what they can actually control because a lot of times the macro conditions are out of their hand, can you give us a sense with that kind of a headcount rise, where do you think you can go from here to control expenses if demand continues to be soft?

Matthew Medeiros

I think the adjustments that we've made in India in terms of the aggregate number of heads and in Tempe, Arizona for that matter, with respect to the support organization is behind us, so that full expense burden was introduced in Q3 and will be with us going forward.

Of course we're scrutinizing our operations to find efficiencies wherever we can and we want to do those at the same time without disturbing important investments in our business, in particularly in research and development and in sales and marketing and for G&A for that matter.

I think we are at pretty good efficiency right now and I think we demonstrated pretty good efficiency in the third quarter. So, I don't think our situation as we sit here today in terms of our reaction to the market is really one about a strategy of trying to cost reduce ourselves into prosperity.

I think we have to maintain a steady hand at the moment and stay invested against the important business imperatives that we're invested against right now. I think we hope to see improvements in the demand conditions going forward, and with that we'll see additional efficiency on the P&L.

[Matt Hindenburg] – RBC Capital Markets

And on the sales force stability with the move to Tempe, can you give us an update on, I guess, the stability there of just the sales force in general, I guess both direct and indirect, in terms of sort of some of the changes that have gone on over the past 12 plus months?

Matthew Medeiros

Yes, Matt, the stability is actually quite good. We've always been very excited about the opportunity of Tempe. For us, it represented a bit of a more stable workforce than what we were experiencing here as far as turnover in our inside sales group here in Sunnyvale. And the turnover rate has been quite low in Tempe, which we are very pleased with.

Also, the quality of people that we're being able to recruit into our firm, I think, is clearly meeting and if not exceeding the expectation. So, I think we feel very good about our Tempe organization. I'm excited about the leadership. We continue to refine our channel programs here in North America, of which Tempe is a very important part on how we can focus on customers that buy occasionally from SonicWALL. Having that ability in Tempe now to be able to get to those customers to have customers buy more than occasionally from us is a great opportunity for us.

Matt, I'd like to go back and just for the benefit of everybody else, you asked a very important question about headcount related to support. I just want to remind people that the additional headcount that we put on our payroll was taken out in support costs through a third party. Just so that we're clear here, we added 100 people, but we also eliminated over 100 people worth of contract labor through our third party support outsource support organization.

[Matt Hindenburg] – RBC Capital Markets

That's great. In terms of the, I think it was Rob again who kind of gave the breakout on ESPs and with I believe it was 67% less than $1,500, was that due to discounting or just, could you maybe talk about discounting in general and maybe why that shift happened?

Rob Selvi

It was actually 79% with less than $1,500 and the big shift you will recall last quarter we were talking about the fact that in the first two quarters of the year, 37% of our total product revenue was at average revenue per unit above $1,500. And we had a shift in that category to 21%, which looked pretty alarming at face value, but what you need to understand is that within the product line there are certain anchor products that are almost on the line with respect to $1,500 average revenue per unit.

And in the quarter, our [inaudible] $3,500, which had been in the above $1,500 category in Q2, had dropped below $1,500 by just a small amount in Q3 and so that got classified in the less than $1,500. That was responsible for about a 9% shift in the categories meaning below $1,500 and above $1,500.

Matt Hindenburg] – RBC Capital Markets

One last question on cash with I guess about $3.00 per share in the stock, I think it closed today at about $4.60. Can you give us a sense –I think the existing buy back has run out. Can you give us a sense for future uses of cash?

Matthew Medeiros

I think as you know we have some impairment in the investment portfolio, so I don't think it's totally fair based on my comments that I made earlier about auction rate securities and mortgage back securities. You're right in terms of the calculation on total cash and investments including long-term investments, but it's really that $99 million figure that relates to cash and equivalent, so it's not quite the overage that it might appear to be just based on the gross number.

As far as stock repurchase activity, we have nothing to announce today in terms of extensions to the program that we completed last quarter. I guess to be technically correct we completed it in the first day of this quarter as far as settlements, but we don't have anything to talk about in that regards today.

Operator

Your next question from [Ken Muff] – Robert Baird

[Ken Muff] – Robert Baird

Looking at the geography, anything you'd kind of separate from kind of normal demand and also maybe some currency headwinds, I mean this quarter we had quite a dramatic change in currency evaluations and I’m just wondering if that caused any kind of headwinds or additional headwinds in Europe or Asia [inaudible] or do you just see this the softening of demand there first of all.

Matthew Medeiros

Yes, Ken, I think we're really just facing kid of a softness of demand and I think no doubt that in Q4, and it's part of the consideration of our guidance, we think the currency will be impacting the business. Clearly the euro and the pound are making substantial adjustments to the dollar.

It helps us in the sense that our costs are lower at running our business in Europe. On the other hand we don’t want our products to get too out of line and again we've taken all of this into consideration on our guidance.

[Ken Muff] – Robert Baird

On the product side with the kind of tempered guidance this next quarter, where would you kind of see any kind of noticeable change or softness or is it more across all your products or do you see it more in the SSL-VPN side or do you see it in some of the UTM products that just came out or anymore kind of – any sense you have there would be helpful.

Matthew Medeiros

Yes, I think it's mixed and I think what we'll see is very typical of any new product introduction. We'll see a bit of a spike up on all the new products, but I don't think that there's any one product category that we have that is being prejudiced by this economy. I think it's in fact a very – it's been across all of it. The demand is weak across all of the technologies that we serve and I don't think that there's any sort of prejudicial behavior behind any one product.

[Ken Muff] – Robert Baird

As you kind of look to the guidance here, what are some of the underlined assumptions that you made there? Is it just the bars are just – they're kind of in a lethargic mode right where you've got the economy just significantly falling off. Does that infer – I'm just trying to figure out how kind of conservative or kind of mainstream it is?

Matthew Medeiros

I think one of the most important tendencies that we look at is employment and we've been tracking employment for quite some time. As I mentioned, we saw a bit of a spike or at least some increase a very small increase in small business payroll through ADPs payroll reported September, but we're very much looking at the overall global economy from a prospective of employment. With the return of employment, we'll see people I think starting to pick up and buying more infrastructures.

[Ken Muff] – Robert Baird

What would you say even in the kind of more challenging environment, what would be your kind of best selling new product that you have, do you think for next year.

Matthew Medeiros

Yes, Ken I think it's our new [inaudible] series of UTM devices that we put out. The NSA products are not just winning awards, they are at a substantial benefit to total cost of ownership for the end customer. I see demand, I see our pipeline and that's where I see an awful lot of opportunity for us, not just in Q4, but in the coming quarters.

I am excited, though, about the new product releases that we'll be doing this quarter around CDP. That's one of the few products that if we get this right, we'll have an opportunity to create demand. We are in the process of releasing our very first major revision to SSL-VPN since the acquisition of [Aventale] and I am pleased to tell you that I think we've got some features here that the competition is going to really be surprised over, and the end customers are going to truly enjoy.

And some of the demand that we fulfilled already this quarter has been with our new SSL-VPN product, so I'm pretty excited about that opportunity. And finally, we are going to have an email released – email 7.0 and we're demonstrating currently 97% effectiveness in spam capture and that to me, especially in this economy is a great opportunity for people to keep their employees more productive.

So across all cylinders of our product lines, we're feeling pretty good about the product releases that we've made previous to this quarter and what we're doing in Q4.

Unidentified Corporate Participant

And at the same time we're feeling pretty cautious about the overall environment and I think until we see some improvement there, that's privy and appropriate for us.

Operator

Ladies and gentleman this concludes the question and answers session and now concludes today's SonicWALL teleconference. Thank you for joining us today.

Kelly Blough

Thanks, everyone.

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