McAfee, Inc. Q3 2008 Earnings Call Transcript

| About: McAfee Inc. (MFE)

McAfee, Inc. (MFE) Q3 2008 Earnings Call Transcript October 30, 2008 4:30 PM ET

Executives

Kelsey Doherty – VP, IR

Dave DeWalt – President and CEO

Rocky Pimentel – COO and CFO

Analysts

John Dorris [ph] – Raymond James

Rob Owens – Pacific Crest Securities

Adam Holt – Morgan Stanley

John DiFucci – JP Morgan

Philip Rueppel – Wachovia Securities

Heather Bellini – UBS

Phil Winslow – Credit Suisse

Daniel Ives – FBR

Todd Raker – Deutsche Bank

Brad Zelnick – Bank of America

Garrett Bekker – Merrill Lynch

Operator

Good afternoon, ladies and gentlemen. My name is Tina, and I will be your conference operator today. At this time, I would like to welcome everyone to the McAfee third quarter 2008 earnings conference call. All lines have been placed on mute to prevent any background noise. After the speakers’ remarks, there will be a question-and-answer session. (Operator instructions) Thank you. Ms. Doherty, you may begin your conference.

Kelsey Doherty

Thank you, Tina. Good afternoon and thank you for joining us this afternoon. Today's conference call is being recorded and will be available for replay on McAfee's Investor Relations homepage at investor.mcafee.com. On today's call are our Chief Executive Officer and President, Dave DeWalt, and our Chief Operating Officer and Chief Financial Officer, Rocky Pimentel. Dave will open the call with an overview of the quarter, a discussion of current market conditions and our corporate strategy, then Rocky will provide the financial details of the quarter and guidance. Dave will close the call with a quick wrap-up and then we will be pleased to take your questions.

You will find in our press release and on the Investor Relations section of our website a GAAP to non-GAAP reconciliation of the third quarter 2008 financial results discussed in this conference call. The link is investor.mcafee.com. And our results are posted under quarterly results. We will post our prepared remarks to the website following the conclusion of today's call. This conference call, including the question-and-answer session, will contain forward-looking statements.

These statements include, among others, those regarding market trends, our strategic positioning, guidance on revenue, operating income margins and earnings levels for the fourth quarter of 2008, expectations regarding the benefits of our recent acquisitions and of our planned acquisition of Secure Computing, including those regarding future plans for the Secure Computing business, the expected closing date of the acquisition, the expected level and scope of security threats in future periods; expectations regarding the industry shift to security suites; expected industry growth rates of the market segments in which McAfee participates; expected new and future product introductions and the revenue opportunity associated with them; expected integrations of products from our pending acquisition of Secure Computing and recent acquisitions with McAfee’s existing product lines; expectations regarding McAfee's business momentum, market position, business segments, statements regarding future partnership opportunities and our future growth opportunities, specific growth initiatives and strategies outlined for 2008 in McAfee's business; plans regarding investments in our global systems and infrastructure and future strategic acquisitions and other uses of cash by McAfee.

Forward-looking statements are based on management's current expectations and are subject to risks and uncertainties, including that McAfee may not achieve its planned revenue realization rates, particularly the aftermath of the current credit crisis and related global economic turmoil, succeed in its efforts to grow its business or effectively combat the security threats of the future, build upon its technology leadership or capture market share, or benefit from its acquisitions, strategic relationships or partnerships or its partnership distribution network as anticipated.

We may not benefit from our investments and systems personnel and infrastructure as anticipated. McAfee may not respond as favorably as anticipated to the company's product or technical support offerings, the company may not satisfactorily anticipate or meet its customers’ needs or expectations, and the industry shift to security suites may not be adapted to the extent anticipated.

The company's product and service offerings may not continue to interoperate effectively with newly developed operating systems, the company may experience delays in product development or the release of previously announced products, the company may choose not to deliver a previously announced product, the company may experience delays or losses in revenue resulting from outages in the integrated systems on which it is highly dependent.

In addition, a number of operational and other factors, including new product introductions, the mix of products and services sold, the size of deals closed in a quarter, the amount of revenue deferred in a quarter, the integration of acquired businesses and products, changes in senior management, the competition we face in the market, currency fluctuations, and the greater macroeconomic environment including the current credit crisis and related global economic turmoil may cause our revenue, gross margins and operating results to fluctuate significantly from period to period.

We caution listeners that actual results may vary perhaps materially from the forward-looking statements referenced in this call, including any forward-looking statements made during the question-and-answer session. We encourage listeners to review the risk factors contained in today's press release as well as the company's filings with the Securities and Exchange Commission, including the company's annual report on Form 10-K filed February 27, 2008 and most recently filed quarterly report filed on Form 10-Q, August 7, 2008 for more detailed information on the risks and uncertainties related to the company and its business. We do not undertake to update any forward-looking statements.

Now, with all of that behind me, it's my pleasure to turn the call over to our CEO and President, Dave DeWalt.

Dave DeWalt

Okay. Thank you, Kelsey. Good afternoon and welcome, everyone, and thank you for joining us today. The third quarter was a very good quarter for McAfee continuing the momentum we have seen throughout the past six quarters. The strength of our business model and our focus on security market leadership is driving our performance. We exceeded both revenue and non-GAAP earnings per share expectations in the third quarter. On a year-over-year basis, revenue grew 27% to $410 million, marking our 11th consecutive quarter of double-digit year-over-year revenue growth. We also had double-digit year-over-year growth in non-GAAP operating income of $96 million, non-GAAP net income of $82 million, and non-GAAP earnings per share of $0.53, a quarterly record for McAfee.

Third quarter bookings increased 22% year-over-year. We closed 28 transactions over $1 million in the enterprise space, a quarterly record indicating that enterprises continue to standardize their security with McAfee. Most importantly, the business model is well balanced with double-digit year-over-year bookings growth in all market segments; consumer; small businesses, which grew approximately 60%; mid-market, which grew approximately 18%; and enterprise; as well as across all five of our geographies.

North American revenue was $219 million, an increase of 32% from last year’s third quarter and accounted for 53% of the business. This was a record revenue quarter for North America. International revenue was $191 million, an increase of 22% from last year’s third quarter and accounted for 47% of the business. With double-digit revenue growth across all of our international segments as well including European, the Middle East and Africa growing at 24%, Asia Pacific growing at 16%, Latin America at 42%, and Japan at 10%.

Corporate revenue was $247 million, up 33% year-over-year and another record revenue quarter for the corporate business. On the consumer side, revenue was $163 million, up 20% year-over-year and another record revenue quarter for the consumer business. This is the 14th out of 15th consecutive quarters in which the consumer revenue grew double digits year-over-year. McAfee reported third quarter deferred revenue of $1.1 billion and at quarter-end had just over $1 billion in cash and marketable securities on the balance sheet.

As you can see from our results, the sales force upgrade and improvements in our go-to-market model are working. We’ve invested in the sales force and channel globally. We know how to sell security, how to structure closed plans, and how to close transactions. Overall, we executed well in Q3 and did not see deals deferred, or discounting pressure because of recent and ongoing economic conditions. We believe we have a durable business model that positions us for sustainable growth.

First, security spending remains a priority for our customers. We believe that is a technology must have. While overall IT budgets may contract, customers are telling us most recently at our first user conference held last week that they intend to increase and consolidate security spend with a vendor who can offer the most complete and integrated solutions. And we continue to see evidence of this throughout our business.

Secondly, McAfee operates a balanced business model. Approximately 53% of our business in Q3 was in North America, 47% came from our other four international segments. Approximately 60% of our business comes from corporate, while 40% of our business is consumer.

Third, McAfee has a very local installed base. We believe enterprises, particularly those having deployed the ePolicy Orchestrator or those protected by McAfee Total Protection suites are not likely to switch vendors. We have very high retention rates in excess of 90% in our enterprise business. In consumer, where we continue to monitor spending trends very closely, we have pursued a partner-driven distribution model where we have nearly doubled distribution over the last year. We focus on obtaining a direct relationship with our customers and our software-as-a-service delivery model is a powerful tool that has extended the economic life of a consumer with McAfee to over three years now.

Fourth, approximately 80% of our revenue during the quarter comes from the balance sheet. We operate a highly ratable model. To give you a sense of the deferred nature of our business, $209 million of revenue this quarter is service and support, up 27% year-over-year, and $167 million of subscription, up 19% year-over-year. That equates to $376 million, just over 91% of our total revenue for the quarter. The ratable nature of our business helps to reduce volatility and gives us greater visibility in future periods.

Fifth, McAfee’s business generates strong cash flows. Customers pay for purchases upfront and they pay in cash. The business has a relatively low capital expenditure requirement of approximately $40 million annually and a very healthy balance sheet. McAfee offers the rare combination of double-digit earnings and revenue growth, coupled with strong free cash flow yields.

I know from experience that growth will come from relentless focus on strategy, one which we believe is responsive to the needs of our customers and gives us the best possible positioning in today’s market. McAfee has read the industry with a strategy built on protecting the endpoint by converting point solutions to suites, interlocking those endpoint suites with the network data protection and risk and compliance, and securing new emerging platforms.

Our ability to deliver performance will be the result of the team continuing to execute successfully against the following business imperatives. The first business imperative is technology leadership. We are extending McAfee’s in-the-cloud capabilities, which began more than ten years ago with our consumer software-as-a-service solution. The combination of McAfee’s new Artemis, the first always on real-time threat prevention technology with a planned acquisition of Secure Computing’s Trusted Source services should emerge and enhance our competitive positioning and create the most intelligent set of in-the-cloud security services in the market.

We announced the world’s first unified approach to solving network access control problems with McAfee’s Unified Secure Access. What makes this solution unique is a combination of intrusion prevention coupled with network access control. Our network strategy, which has already driven triple-digit growth, should be further enhanced by this announcement. And we expect to continue our leadership position in securing new platforms with solutions like McAfee Total Protection for Virtualization, which offers proven protection for virtualized environments, lowering operational cost and simplified compliance.

The second imperative is the focus on suite-based security solutions. For McAfee, suite deployments entrench us in an organization, increasing McAfee’s ASP per customer building long-term relationships, recurring maintenance revenue, and establishing a platform in which we can sell new solutions. Customers benefit from McAfee’s technology leadership managed by ePO and a broad portfolio of solutions. They also benefit from improved return on the security investment through point product consolidation and more efficient security management.

We are focused on interlocking the endpoint with the network and plan to add suites for risk and compliance, as well as additional suites for the network to complement our existing Total Protection solutions for endpoint data, virtualizations, and mid-market businesses. An example of this is our new mid-market suite, Total Protection for Secure Businesses.

The third imperative is to execute small to medium sized security-only acquisitions. We intend to intelligently use the balance sheet to diversify our product portfolio and accelerate growth in the business. During the third quarter, we made two very important announcements on the acquisition front. The first acquisition, which we closed in Q3, Reconnex, adds to our portfolio of data protection solutions with an industry-leading technology that learns and adapts to automate the ongoing protection of data. Data protection is one of the fastest growing segments of our business, having grown about 40% year-over-year during the third quarter.

The second, our planned acquisition of Secure Computing will bring Secure Computing’s complementary portfolio of products to McAfee enhancing our network solution set for businesses of all sizes. We see growth drivers in cross-selling between our customer bases, merging our partner ecosystems, creating suites of solutions that leverage the network in the endpoint and integrating all under a single management console. With the addition of Secure, McAfee will be able to deliver complete content and data lifecycle management security.

The fourth imperative is strengthening our partner ecosystem. Through partnerships we can broaden our distribution channels, more comprehensively meet the evolving needs of our customers, pursue product innovation and drive growth in the business. Last week alone we announced ten new partnerships. These include a strategic relationship with Intel, leveraging the Intel vPro technology to provide innovative security below the operating system layer on PCs, and a relationship with HP ProCurve to jointly develop and deliver network security to solutions designed to simplifying networking and security from the edge to the network core.

In consumer, we find or extended 18 new consumer partnerships, including one with VMware to ship McAfee’s VirusScan Plus software with VMware Fusion, VMware’s awarding-winning desktop virtualization product. Also on the partnership front, our Security Innovation Alliance or SIA, we consistently hear from our customers that interoperability and simplified integration is important to them.

In response, we launched McAfee’s SIA, which we now features 34 Alliance partners including well known names such as Alcatel-Lucent, ArcSite, and now CommVault. We are very pleased with the third quarter results, which reflect solid execution across all geographies and customer segments. The investments we’ve made in the product portfolio, sales, personnel, and distribution capacity over the last year are delivering results, and we remain optimistic about what the team can accomplish.

I’d now like to turn the call over to Rocky who will review our quarterly performance and provide guidance for the fourth quarter. Then I’ll come back into a brief conclusion, and then we’ll take your questions. Rocky?

Rocky Pimentel

Thank you, Dave. Good afternoon, everyone. We are pleased to report third quarter 2008 revenue of $410 million, up 27% year-over-year and ahead of expectations. For the third quarter, 78% of total revenue came from deferred revenue on the balance sheet. Year-over-year we saw increased in-period revenue recognition due primarily to the impact of product mix, which reflects a more than 100% increase in sales of our Network Security Platform, formerly known as IntruShield.

We are very excited about our next generation intrusion prevention products, which are clearly gaining traction in a growing market. Please note that appliances drive greater in-period revenue recognition with a more traditional 80-20% licensing and support pricing model. Excluding the impact of foreign exchange, revenue grew 21% year-over-year. Our third quarter 2008 results include a favorable year-over-year revenue impact due to foreign exchange of approximately $21 million. Quarter-over-quarter revenue was negatively impacted by approximately $4 million due to foreign exchange.

During the third quarter, we closed 340 deals over $100,000 in value, 52 deals over $500,000 in value, and 28 deals over $1 million in value each. This compares to 8 deals over $1 million in the third quarter of 2007 and 21 deals over $1 million in the second quarter of 2008.

Highlights from our corporate business include, sales of SafeBoot data encryption grew approximately 40% year-over-year, including several transactions over $1 million. Gartner has placed McAfee in the Leader’s Quadrant and its Magic Quadrant for mobile data protection, which was published on September 23, 2008. We continue to convert customers to Total Protection Endpoint with bookings increasing more than 40% year-over-year. At the same time, penetration of ePO 4.0 is expanding with more than 50% of our customer base now deployed in live. And finally, our third quarter performance in the mid-market segment was the best we have had in more than five years.

Highlights from our consumer business include, we signed or extended 18 new consumer partnership agreements and launched 54 new or enhanced consumer online partnerships during the quarter. This brings our total number of brand name consumer partners worldwide to more than 190. We had a 22% increase in new registered trial subscriptions year-over-year with many of our new PC OEM partnerships in the early ramping phase.

We had positive year-over-year revenue growth in all of our consumer geographies, with more than 60% growth in both of our Asia Pacific and Latin American regions, demonstrating that our strategy of global expansion is working. Year-over-year, Total Protection was the fastest growing consumer product in the third quarter, growing more than 79%. And we also have launched a new partnership with AT&T displacing our major competitor, which plans to offer McAfee services to its more than 15 million broadband users.

We know from experience that when the economy slows, the level of malicious activity increases, including identity after tax to steal the personal wealth of consumers. This drives greater press attention raising the level of awareness among consumers who become more concerned about protecting themselves. This heightened awareness along with our broadened distribution through the many new partnerships we have announced. Our success in global expansion, our leadership in web security, and the release of our new consumer suites that include active protection should enhance our competitive positioning in the consumer market.

Moving down the income statement, GAAP gross profit margin for the third quarter was 76% compared with the second quarter of 2008 of 77.4% and third quarter 2007 of 75.8%. Non-GAAP gross profit margin for the third quarter was 79.6% compared with the last quarter’s 81% and a year-ago quarter gross profit margin of 78.3%. Year-over-year gross margins trended up by 130 basis points due to an increase in volume of system solutions sales and the overall mix of business sold during the third quarter of 2008.

Quarter-over-quarter, we saw record setting sales of our Network Security Platform product, which contributed to gross margins trending down slightly. Total GAAP operating expenses in the third quarter 2008 were $262 million compared with $197 million for the third quarter of 2007. Total operating expenses on a non-GAAP basis in the third quarter of 2008 were $230 million compared with $173 million for the third quarter of 2007. This year-over-year variance primarily reflects investments in future growth of the company.

First, we have diversified our product portfolio, including the acquisitions of SafeBoot, ScanAlert, and Reconnex. Second, we have invested in new consumer PC OEM relationships where certain PC OEM payments are classified as sales and marketing expense. These relationships are dilutive initially becoming increasingly profitable over time. Third, we have added to the core McAfee team, particularly in sales and marketing in the back half of 2007 and in the early part of this year to increase sales capacity and improve the coverage of model. And finally, we had a year-over-year increase in legal expenses reflecting litigation activities, some of which were concluded in the third quarter.

GAAP sales and marketing expenses for the third quarter 2008 were $136 million. Sales and marketing expenses on a non-GAAP basis in the third quarter 2008 were $127 million or 31% of revenue. This was an increase of $8 million sequentially on a non-GAAP basis, reflecting increased sales commissions and the impact of new consumer PC OEM relationships noted previously.

Third quarter 2008 GAAP research and development costs were $64 million. Third quarter 2008 research and development costs on a non-GAAP basis were $57 million or 13.9% of revenue, flat sequentially on a dollar basis. We continued to invest in research and development in order to develop industry-leading solutions to our customers. During the third quarter, 11 new patents were granted, bringing McAfee’s total patent portfolio to 344.

GAAP general and administrative expenses for the third quarter of 2008 were $52 million. On a non-GAAP basis, G&A expenses for the third quarter were $46 million or 11.2% of revenue compared to $43 million for the second quarter. This sequential increase on a non-GAAP basis is primarily associated with the litigation activities I just mentioned.

GAAP operating income for the third quarter was $49 million, resulting in an operating margin for the period of 12%. Operating income for the third quarter on a non-GAAP basis was $96 million resulting in a non-GAAP operating margin of 23.4%. Please note that third quarter non-GAAP operating margins were negatively impacted quarter-over-quarter by the impact of sales and marketing of new PC OEM relationships, a more than 1% decrease in gross margins driven by increased shipments of our Network Security Platform, increased legal expenses, and to a lesser degree, accelerated sales compensation earned during the quarter, and the acquisition of Reconnex.

GAAP other income for the quarter was $5 million. This GAAP figure includes a $12 million impairment loss on our marketable securities portfolio, resulting primarily from the recent credit market crisis. By policy, we invest in high quality investment grade securities.

Non-GAAP other income was $17 million compared with $13 million in the second quarter 2008 and $20 million in the third quarter 2007. The sequential increase was related primarily to a foreign currency gain partially offset by lower interest income associated with acquisitions and the repurchase of common stock.

Total employee headcount at the end of the quarter was 4,612. This is up 54 employees from the second quarter 2008 due to the addition of 65 employees from the acquisition of Reconnex, which closed during the quarter. We have taken action to address the current environment, which resulted in a $2.1 million restructuring charge near the end of the third quarter.

The GAAP tax rate for the quarter was 9%. On a non-GAAP basis, our tax rate was unchanged from a year ago at 27%. In the third quarter of 2008, we reported net income on a GAAP basis of $49 million, or $0.31 per share on a diluted basis. Our third quarter net income on a non-GAAP basis was $82 million, or $0.53 per diluted share, up 21% year-over-year. Non-GAAP earnings per share of $0.53 is an all-time quarterly record for McAfee.

Investors and potential investors are encouraged to review the complete reconciliation of GAAP to non-GAAP financial measures set forth in the attachment to our press release issued this afternoon.

Turning to the balance sheet, our net accounts receivable balance at the end of the third quarter 2008 was $209 million compared with $157 million for the same period last year. Days sales outstanding were 46 days for the third quarter of 2008 compared to 44 days for the third quarter of last year and flat sequentially.

As I previously mentioned, our revenue profile continues to evolve with the expansion of our appliance business. Deferred revenue at the end of the third quarter of 2008 was $1.1 billion, up 11% year-over-year. Third quarter 2008 deferred revenue reflects a negative sequential foreign exchange impact of approximately $40 million. Please note that we value our deferred revenue on a quarterly basis at the rates on the last day of the quarter.

We ended the third quarter with $818 million in short-term deferred revenue, down $25 million when compared to with the second quarter 2008. This quarter-over-quarter decrease in short-term deferred revenue was driven primarily by the strengthening dollar. Long-term deferred revenue was down by $4 million in the third quarter compared to the second quarter of 2008, ending the quarter at $239 million. We did not see unusual contract extensions during the quarter or unusual discounting. The composition of our deferred revenue balance at the end of the third quarter of 2008 was 62% related to corporate and 38% for consumer.

We ended the quarter with cash and marketable securities of $1 billion. Please note that this total reflects an outflow of cash associated with the acquisition of Reconnex, which closed in August 2008, as well as stock repurchases made during the quarter. During the quarter, we paid for the repurchase of 4 million shares of our common stock for $132 million. This brings a total number of shares repurchased to 14.5 million shares, representing an aggregate total cost of approximately $500 million.

As of today, we have approximately $250 million in authorization available for share repurchases through July 2009. In the third quarter of 2008, we generated a total GAAP operating cash flow of $87 million. Operating cash flow was down compared to last year due to the additional use of cash for working capital requirements resulting from a $25 million legal settlement, which we announced in July, and $16 million in incremental year-over-year investments in PC OEM partnerships.

At this point, I would like to remind everyone that a full cash flow statement has been included in the financial tables attached to our press release issued this afternoon. We would also like to note that we currently expect our cash flows fro the fourth quarter to be negatively impacted by a one-time cash tax payment of approximately $30 million.

Finally, we’ve recognized that Wall Street track the current health of our business by analyzing revenue plus change in deferred revenue. While this calculation is not a perfect proxy for bookings in the third quarter, this is particularly the case as the calculation does not reflect $40 million in negative foreign exchange impact to deferred revenue in order to capture the impact of contra revenue or our backlog. As Dave mentioned, third quarter bookings grew 22% year-over-year.

We would now like to provide an update on our planned acquisition of Secure Computing. On October 15, 2008, McAfee received notification from the US Department of Justice and Federal Trade Commission had granted early termination of the Hart-Scott-Rodino waiting period for the proposed acquisition. Subject to additional regulatory and appropriate Secure Computing stockholder approvals, we currently expect to close the acquisition of Secure Computing within two business days of their November 14 stockholder meeting.

We plan to issue a press release upon closing the acquisition. I look forward to updating you with further details regarding our financial expectations and strategies. I would also like to clarify that we do not intend to let non-GAAP revenue adjustments as a result of the deferred revenue write-down on Secure Computing acquisition. This is consistent with the previous acquisitions.

Now I would like to turn to discuss guidance. Although we believe McAfee is well positioned to make market gains in this environment, we are cautious as to what the spending environment may be in this quarter. The following updated guidance replaces and supercedes any previous guidance with respect to future periods and is valid as of today only. I would like to remind our listeners that guidance is based upon management's current judgments and that actual results may vary, perhaps materially, from those results anticipated in this guidance. Please see the footnotes to our press release for further details.

For the fourth quarter of 2008, we expect a revenue range of $400 million to $420 million. We expect a GAAP operating income margin of 14% to 16%. We expect an operating income margin on a non-GAAP basis of 23% to 26%. We expect a diluted share count in the range of 154 million to 158 million shares.

Also for the fourth quarter of 2008, we expect GAAP earnings per share of between $0.54 and $0.60 a share on a diluted basis. On a non-GAAP basis, we expect earnings per share in a range from $0.50 to $0.56 a share on a diluted basis.

Please note the following. Guidance for the remainder of 2008 outlined this afternoon does not contain our current expectations regarding the impact of the planned acquisition of Secure Computing. In addition, guidance does not include any impact from future stock repurchases. We plan to provide updates on the repurchase program on a quarterly basis and adjust guidance based on actual repurchase program results.

At this point, I’ll turn the call back to Dave to conclude.

Dave DeWalt

All right. Thank you, Rocky. I also want to thank the more than 4,000 McAfee employees and thousands of partners worldwide for their hard work during the quarter. And thanks to our customers, many of whom attended our first ever user conference. We came out of that very successful conference when we hosted more than 1,200 attendees from 47 countries, believing that our strategy we outlined for the outset of the year puts us right on track for continued financial performance.

Customers from the consumer to the large enterprises and partners value our focus on securities and continue expand the relationships with McAfee. While we continue to closely monitor the environment and any impact that may have on our business, the team has focused on a strong finish to the fiscal year.

Thank you for joining us this afternoon, and we look forward to answering your questions. And I’ll turn it back over to Kelsey. Kelsey?

Kelsey Doherty

Thanks, Dave. Thank you, Dave and Rocky. As the operator polls for questions, I would like to inform you that McAfee plans to attend the UBS Conference on Tuesday, November 18th in New York City and the Barclays Conference on Wednesday, December 10th in San Francisco. In addition, please mark your calendar on Friday, May15th, for McAfee’s 2009 Investor Day.

Operator, please poll for questions. In the interest of time, please limit yourself to one question per person. Thank you.

Question-and-Answer Session

Operator

(Operator instructions)

Kelsey Doherty

Tina?

Operator

Our first question will come from the line of Michael Turits with Raymond James.

John Dorris – Raymond James

Hi, guys. This is John Dorris [ph] for Mike Turits. Can you talk a little bit about what you are seeing out there in the macro environment? Are you changing any close rate assumptions or maybe bringing down quarters a little bit, or is it just business as usual?

Dave DeWalt

Sorry. John, this is Dave, Dave DeWalt. Rocky is going to handle it here too. I mean, we are obviously conscious about what we’re seeing economically around the world, but I took some care to talk to you about the business model that McAfee has and that’s what gives me – pretty bullish outlook for the fourth quarter and beyond is we are balanced across geographies. We’ve been seen double-digit across our product lines or segments, and our geographies. We get close to 80% of our business from the balance sheet. And it creates a nice mix for us. So in terms of close rates, our pipeline has never been bigger. We are in a strong position, I think, from a competitive point of view, and we have not lowered our quarters or anything else related to our model.

Operator

Our next question will come from the line of Rob Owens with Pacific Crest Securities.

Dave DeWalt

Hi, Rob.

Rob Owens – Pacific Crest Securities

Question on the DSOs, in what’s typically a back in wave quarter, I think you were flat quarter-over-quarter. What was the tone of business upon the exit of the quarter? And then given your performance versus some of your competition, are you seeing any changes in your competitive run rate? Thanks.

Rocky Pimentel

So, Rob, I’ll take the first part of that. I don’t think we’ve seen anything unusual at the close of our quarter. In fact, if anything, there were new opportunities arising that we will take advantage of in the future, and I think we felt that the business was strong right up to the close of the quarter. As Dave mentioned previously, our sales opportunity funnel continues to be as robust as it has ever been. Having said that, we are always cautious to look for signs that say, these leading data indicators may not be reliable, but at this point and given the anecdotal evidence at our user conference last week, I think we’re still making great progress in our market presence.

Dave DeWalt

Hey, Rob, this is Dave. The thing I would also add to is, we’ve really begun to focus our growth on multiple segments. And I think it showed – I called out specifically a couple of other market segments that we were pretty proud on the quarter and we think these are good signs for the future. Our small business growing at 60%. I mean, this is pretty solid if you followed McAfee. Our mid-market growing at 18%. This is pretty solid, best we’ve had in five years. Our enterprise business with 28 deals over $1 million. Again, that’s up from eight deals a year ago. So these competitive wins there are pretty obvious and these endpoint conversions we are doing to a full suite are helping customers save money. And that’s really working for the company, and we replaced a lot of competitors when we do that, and our win rate has been improving dramatically against most of the major point product vendors in the market. So you can get a sense of what’s going on there across multiple corporate segments and the consumer space (inaudible) team has done a nice job again. We’ve got double-digit growth there, 20% on a revenue basis. We’ve taken a number of partnerships. Distribution model is improving. I talked about AT&T, which was a really nice win for us. I mean, this is talking tens of millions of broadband subscriber opportunity. These are replacements of our competitors there. And we are very focused on winning this partner in channel ecosystem. And I think it’s starting to pay off. And frankly, we can even do better over time.

Kelsey Doherty

Next question, please.

Operator

Our next question will come from the line of Adam Holt with Morgan Stanley.

Adam Holt – Morgan Stanley

Good afternoon and congratulations. Looks like you actually saw a little bit of an acceleration in the consumer business. I was wondering if maybe you could drill down, you just obviously touched on some of the improvements on distribution. But where you saw some of the variables improve, was it renewal rates? Was it on the average selling price side? Did you see an uptick in subscribers? Maybe a little detail on the consumer business.

Dave DeWalt

Sure, Adam. Thanks. You’re right. I’m glad you pointed out, because as I mentioned, the corporate sides were all very balanced and want to grow, but consumers starting to hit down too. We are in a good product cycle. We’ve got a brand new release just coming now that we’ve talked about. This was a project Sapphire [ph], but it’s a brand new release that has a whole in-the-cloud computing model. We really think that’s beginning to take some shape. Our subscriptions were up. We talked about the number of sort of registered new trial conversions that are happening, up 22% there. And we are really just ramping some of the PC OEM manufacturers with shipments of our product. So, a number of these are working well. Whenever we got web components as well as the traditional security components, they have done well. So when you have it build each year, you nearly double your distribution. This is helping the company. Even if PC shipments decline as a percent in the future with the economic conditions, we are shipping on almost double the amount of distribution. So when you look at that and you got good conversion rates to our dot-com business. We talked about this 79% in our – and then really a core of security product there, the ToPS for Endpoint piece for consumers and the ASPs and the renewals. We took some care to talk about the life of the customer now. We’ve extended beyond three years. So we are seeing the consumer customer with McAfee staying longer, renewing better and staying longer. Life being over three years now. So there is a number of good signs in there, and we are taking some good market share 14 out of 15 quarters now with strong double-digit growth. And we have a good product cycle upon us too.

Kelsey Doherty

Next question, please.

Operator

Our next question will come from the line of John DiFucci with JP Morgan.

John DiFucci – JP Morgan

Thanks. Nice job, guys. I’m just curious, over the last three quarters, Dave, that you said you’ve had incremental expenses related to this push into the partnerships and into the consumer business. And is that largely behind you now? Are we going to see sort of like year-over-year net no incremental or not much incremental impact on cash flow? Or is – and you mentioned that AT&T deal here, it sounds like there is a lot of them. So I don't know, if that’s something that has already been dealt with or is this something that’s new?

Dave DeWalt

Thanks, John. This is Dave. So, let me just separate two things. One is sort of the cash payment side of things. And yes, we are pretty much done with that. AT&T wasn't a significant impact at all. We’ve really laid down a lot of the distribution engine that we feel that the – you know, sort of cash payments would come from. However, saying that, operating expense – Rocky called out in the script a few times, our PC OEM business, the way that works is you typically make those payments or you have some rev share model, a lot of times you get a lot of PC shipments occurring, but you don't have offsetting bookings or revenue to match it. So they tend to be pretty dilutive at the beginning, and then they begin to break even and they begin to be pretty profitable. And we’ve seen that full life cycle in a number of these PC OEMs already, where they do turn quite profitable for us. So, we are still in the early stages of the new ones. We are in more of the latter stages of some of the ones we have been around with, like Dell. And we feel that we can see those patterns beginning to emerge. That’s why that 22% overall bookings number was strong, as well as that 22% number in new registered subscriptions, those were good. So, we see the right balance there. But to answer your question directly, most of those PC OEM partnerships are done at this point. Those cycles are complete. Now we're just working our way through the P&L for maturity. And do you want to add to that, Rocky, just making sure they capture what they are looking for?

Rocky Pimentel

Yes, exactly.

Kelsey Doherty

Next question, please.

Operator

Our next question will come from the line of Philip Rueppel with Wachovia Securities.

Philip Rueppel – Wachovia Securities

Yes, could you – back on the consumer side, on those PC OEM deals, you mentioned some are approaching maturity, but you still have some long life on some of the newer ones. Is this the kind of thing that we could both see a peak if you don't sign any more deals in a quarter or two, or is it something that could – those life cycles could last well into calendar 2009?

Rocky Pimentel

Sure, this is Rocky. These are multi-year deals on many of them. So I think we feel like the pipeline is now primed. And as we alluded to in the comments, I mean, we are still in a very, very early cycle of the deals that we have really just announced over the last couple of quarters. So, given the current or the most recent positive results of the consumer segment and with these deals still really in the early infant stages, we have a very optimistic attitude towards gaining more market share in the consumer space.

Kelsey Doherty

Next question, please.

Operator

Our next question will come from the line of Heather Bellini with UBS.

Dave DeWalt

Hi, Heather.

Heather Bellini – UBS

And congratulations on a nice quarter in a tough market. Dave, I was wondering – and maybe this is more for Rocky. If I take a look at your change in deferred on the cash flow statement, you have had such good large deal signings this quarter. I guess I would have thought that the change in deferred on the cash flow statement, which I think was up about $10 million, actually would have been up more in line with kind of what you’ve seen over the past few September quarters. And I guess I'm just wondering, is that due to the way you are structuring these larger contracts or you are having better in-period revenue recognition, or did you see potentially something at the SMB level in terms of hesitancy and deal closings that were just made up for by the big deals?

Rocky Pimentel

Yes, Heather. I think there were two real driving factors. The success of our appliance business, which is more heavily weighted to in-period revenue, will dampen the deferred piece. And then secondly, the $40 million negative impact at the end of the quarter on deferred measurement to the foreign exchange rate as of the end of the quarter period was the other deferring factor. So, you look at the current exchange rate environment right now, obviously I think many people would agree that the dollar is at an unusually strong position. So hopefully we will see recovery – we may see some recovery and some better international results as a result of the dollar getting more normalized against those exchange rates.

Dave DeWalt

And Heather, just to add on – this is Dave. We called out pretty specific for you so there wasn't any guesswork that we had a 22% bookings year-over-year increase. That was on purpose. We wanted you to see kind of net of all the exchange rate hits that this was what happened. We also had an excess of 100% growth on our Network Security Platform, and I thought this was a pretty interesting sort of insight to kind of what’s working in our network business and what we have some opportunity with on cross-selling to the Secure Computing environment. The coupling of suites of products of the network is beginning to work. It’s the same cost economics we have seen on the endpoint. We have just added our Network Access Control components, NAC support into IPS. We have that release coming and we’ve got a portfolio of products coming in there, but 100% growth. Now, appliances tend to have, as Rocky said, a little bit more in-period realizations. So there is a couple of factors here that kind of hit that change in deferred number that you might have traditionally seen, especially year-over-year where we weren’t having as much network security business and we weren’t having as much impact from exchange rates. So those are the two major factors.

Kelsey Doherty

Next question, please.

Operator

Next question will come from the line of Phil Winslow with Credit Suisse.

Phil Winslow – Credit Suisse

Hi, guys. Great quarter. Dave, just wanted to get your sense of what you're saying is small and mid-sized business markets. Some people have mentioned that has an area of weakness during the quarter. Just curious what trends that you saw there. And then also, Rocky, as far as just foreign currency, what are you guys assuming as far as euro versus the dollar for Q4?

Dave DeWalt

So, I'll just take the first part, Phil, thank you. Yes, I was really encouraged. We are beginning to focus and be rewarded now for some of the growth in the small and mid-market businesses. This has been an area of weakness over the years for McAfee. And we have gotten better at that. We have got better product offerings now. We have really revamped our whole go-to-market model in those type of customers. We have focused our sales on a combination of channel and inside sales. Our Head of Sales, Mike DeCesare, revamped the whole go-to-market model there, and that is beginning to pay off. I mean, this was something we did really over the last three or four quarters beginning to take shape. So I would just answer to your question on the small and mid, is some of that sort of products on our execution, some of this is taking away from our competitors, and then on top of that, the combination of in-the-cloud computing with an on-premise type endpoint or network device is pretty exciting. It’s easy to use, easy to ploy. In Q3, we launched a whole suite now called ToPS for Secure Businesses. And this was just an easy to use, easy to ploy kind of model that is really getting some traction. And so we think we’ve got ourselves in a good position, vis-à-vis competition in SMB and we will see if we can keep doing. Rocky, do you want to comment on exchanges?

Rocky Pimentel

Yes. We are consistent in the way that we go about forecasting the foreign exchange rates that we use in our planning and even in our guidance. And as of – I can tell you, in the guide that we just provided you, we have been consistent, but we’ve actually been also aware of the current market environment. And so we basically used a rate that was even lower than the third quarter end rate and preparing our guidance in our view going forward. So I think we have been very cautious and thoughtful in how we expect the foreign exchange element to work in our overall model. So I think – trying to answer your question without giving you a specific number, it reflects some of the lowest points we have seen since the quarter-end on the key foreign currencies.

Kelsey Doherty

Next question, please.

Operator

Our next question will come from Daniel Ives with FBR.

Daniel Ives – FBR

Yes, thanks. Given some of the troubles we’ve seen in some of your competitors, when – call it mid-September, okay, and the credit crunch starts and the chaos go in the market, is there anything that you did in particular in those last two weeks of September to make sure that there was no damage to your business, and you were able to get these deals done as you successfully did?

Dave DeWalt

Thanks, Daniel. This is Dave. So, no. I mean, Rocky called it – we didn't see an unusual discounting. We didn't see unusual extensions. We are very focused on our enterprise segment, which is really what comes in at the end. As I mentioned earlier, we were very balanced with mid and small businesses. We grew fair on our consumer business. We have got a pretty strong sales force worldwide at this point. They have closed plans. They are focused in on their pipeline. And these deals were very mixed if you looked at the 28 deals over $1 million, many of which came in during that September period you had was a result of both America, EMEA, across the world. And certainly we didn't see any changes we got through the quarter or now. And we’ve continued to be strong closing business already, large ones already. And I think a lot of this goes to what I called earlier, which is we can save customers’ money by going with McAfee. And that works. Customers are looking to save money on security spending. It’s not that they are spending more money on IT or more on security in some cases, they are just spending more on one vendor. And if we can create a value proposition that lowers their cost of ownership, they are going to spend more money. And I think we focus very hard on that return on investment for customers. And so far so good, and we got to keep it up. And we certainly know Q4 is a big buying opportunity, a lot more budget opportunity in Q4 and the remainder of the quarters of the year. And we got to go execute even in a tough climate.

Kelsey Doherty

Next question, please.

Operator

Next question will come from the line of Todd Raker with Deutsche Bank.

Todd Raker – Deutsche Bank

Hi, great quarter. Just keying in a little bit further on the consumer, two questions for you. It would seem to be given the structure of the OEM relationships that you guys have that we’ve really haven’t even begun to see the impact of the market share gains on the P&L. So I’d love to kind of get a sense of where you guys in terms of the trial deployments becoming revenue paying deployments? And then the second question I had is, you guys have pretty good day-to-day visibility on the consumer side, can you talk about October trends on the consumer side?

Dave DeWalt

Yes, sure, Todd. I think you’re very insightful with that. And this is what we have begun to talk about and why we are aggressive on these fronts. We’ve been able to displace many of our competitors on these PC OEM builds. We feel the best asset, frankly, that McAfee has in consumers, our online business, our trial to pay conversion model, the way in which we handle online renewals and card on file. This creates a very strong year-two, year-three model with these OEMs. And many of these are just shipping. Last quarter we talked about HP and Lenovo and Acer and others that have really just begun. They were just getting the PC shipments out the door.

Some of these are just going. So we are very encouraged by the shipments. And the registrations are recurring, 22% up year-over-year on that. And again, most of them just began at the end of Q3. So if you followed us, we feel like we are just ramping into that cycle right now. We called out on the call that we were seeing Latin America and Asia Pac, you know, these were up substantially year-over-year. Many of the announcements we made with the PC manufacturers were focused very specifically a year ago and recently on the emerging markets.

And the emerging markets we felt was a good bet that the PC shipments was going to continue solidly in those markets. And we’ve put our bets down, and we’re early. I mean, these things are very dilutive still right now, the last two quarters, but they won’t be. As we move from shipment to a trial to booking to revenue to renewal, it becomes a model we’ve seen many times. So hopefully we’ve made the right strategy we think we’ve really done has been consistent with what the company has done for years. And we’re just doing a whole lot more of them, and we are doing them in locations that we think will pay off for the company. And I’m sure we will be the judge over the next year as we show this, but we are optimistic we can perform here.

Kelsey Doherty

Next question, please.

Operator

Our next question will come from the line of Brad Zelnick with Bank of America.

Brad Zelnick – Bank of America

Thanks for taking my questions, and congratulations, guys.

Dave DeWalt

Hi, Brad.

Rocky Pimentel

Hi, Brad.

Brad Zelnick – Bank of America

Hi. Just on the healthy number of large deals, were there any over $5 million deals or large mega deals in the quarter? And then also just as I try to reconcile the 22% bookings increase and I look at the cash flow statement change in deferred there, just to be clear – were all of the bookings completely built in the quarter? Thanks.

Dave DeWalt

So, we had a number of large deals over $1 million. We don’t comment on bigger deals – there was no mega deal. So this is more of just consistent large deal execution. We’ve done well there. They were balanced. One of the things I continue to look for is the mix of these in multiple theaters. We’ve begun to perform larger transactions and multiple theaters now, not just North America, but now EMEA has really been stepping up or Europe has been stepping up. We also sort of see Asia come on line with larger deals, and again it’s a little bit of going after standardization decisions. So we were up from 8 to 28, but we were only up 21 to 28 quarter-over-quarter, nice increase, but there isn’t something just off the chart. Here is a bunch of anomalies and we certainly to see the big deal pipeline continuing to grow. And we feel again that this is a nice balance for us. Can you take the other one, Rocky?

Rocky Pimentel

Yes, sure. Sure, Brad. That is a good point. We did have a growing backlog, which is transactions that have not yet been built as of the end of the quarter. So there is some element of that in the overall billings number that Dave refers to when we talk about 22% growth. So I think it gives us additional encouragement that the model is working. And we look to a good future.

Kelsey Doherty

We have time for one more question.

Operator

Our final question will come from the line of Garrett Bekker with Merrill Lynch.

Garrett Bekker – Merrill Lynch

Hi, good afternoon. Dave, I was wondering maybe you could just talk a little bit about your partnership with CommVault. Historically that’s an area that we haven’t seen a lot of synergies between security and storage. So I was just maybe curious to get your thoughts on that from a high level, and if you think maybe the customer appetite for combination security and storage solutions has changed at all.

Dave DeWalt

Hi, Garrett. This is Dave. So – thanks for pointing that out. What we saw strategically we started a year ago which was to open up the architecture of our security console called ePO, and this product was a very scalable product that touched every endpoint. And we’ve seen now deployments in hundreds of thousands of notes of our technology. And one of the areas that our customers have continued to ask us for is, can we use this beyond security? Certainly my strategy is to stay as a security company, but our customers are looking to enable everything from backup to power management to archiving to name a category that’s tangential to something you do in the endpoint virtualizations and other area.

And so what we’ve done is we opened up that architecture to allow multiple companies to integrate. One of those is CommVault. They have done a nice integration. We’ve been working together. It creates backup from the endpoint to either a cloud or to a server. And it creates a whole ecosystem of partners for McAfee to frankly compete with some of our competitors to attempt to put security and storage together. So we’re obviously looking at both offense [ph] to help with what ePO can do for our customers as well as make sure that we can create a partner ecosystem beyond just security for what we do. So – once, say, I see any new indicators that wireless come together, security is our strategy, and it’s paying off for us. But having said that, there are partnerships we can do more of, and CommVault is one good company. So, thanks, Garrett. Let’s wrap things up. I just wanted to say thank you for everybody attending and joining our third quarter 2008 call. And with that, we’ll conclude things and we’ll see you next time. Thank you.

Kelsey Doherty

Let’s conclude our call.

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