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Infoblox (NYSE:BLOX)

F1Q13 Earnings Call

November 28, 2012 4:30 p.m. ET

Executives

Jane Underwood - IR

Robert Thomas - President and CEO

Remo Canessa - CFO

Analysts

Jonathan Ruykhaver - Stephens

Eric Suppiger - JMP Securities

Amitabh Passi - UBS

Kent Schofield - Goldman Sachs

Ehud Gelblum - Morgan Stanley

Sanjit Singh - Wedbush Securities

Operator

Ladies and gentlemen, thank you for standing by. Welcome to the Infoblox first quarter results conference call. [Operator instructions.] I would now like to turn the conference over to your host, Jane Underwood. Please go ahead.

Jane Underwood

Thank you. Good afternoon, and thank you for joining us to discuss Infoblox’s financial results for the first quarter of fiscal 2013. With me on today’s call are Robert Thomas, our president and chief executive officer, and Remo Canessa, our chief financial officer.

By now, everyone should have access to our earnings announcement, which we released this afternoon. This announcement may also be found on our website at www.infoblox.com in the investor relations section.

Before I turn the call over to Robert, let me remind you that the presentation we’ll be making today includes forward looking statements. These statements and other comments are not guarantees of future performance, but rather are subject to risks and uncertainties. Our actual results may differ significantly from those projected or suggested in any forward looking statements.

For a more complete discussion of the risks and uncertainties that could impact our future operating results and financial condition, please see our annual report on Form 10-K filed with the Securities and Exchange Commission on September 14, 2012.

For the sake of clarity, unless otherwise noted, all numbers we will talk about today will be on an adjusted non-GAAP basis. Please refer to the tables in our press release and the investor relations portion of our website for a reconciliation of GAAP to the non-GAAP numbers we will be discussing.

Now I’d like to turn the call over to Robert.

Robert Thomas

Thank you, Jane, and good afternoon. We had an outstanding start to our new fiscal year, with impressive revenue growth, strong product momentum, and improved operating leverage. I’m particularly pleased with our execution, as we reported double digit sequential revenue and product revenue growth against a cautious macroeconomic backdrop.

I believe our top line performance reflects our leadership in the DDI market, and our ability to succeed in an environment where customers are focused on increasing network accuracy and uptime while reducing expenses.

Revenue for the first quarter grew 26% year over year, and 10% sequentially, to a record $49.5 million. In the quarter, demand was strong across all geographic regions. Importantly, we had a great quarter outside of the United States, with sequential growth in both Europe and the Asia-Pacific region.

In the first quarter, existing customers continued to be a big part of our success. And complementing the strong demand from our customer base, new customer acquisition was also robust, and included many of the world’s leading companies.

From a bottom line perspective, non-GAAP operating margin was 6.9% for the quarter. We’re very encouraged by the prospects and strengths of our business. Our investment, execution, and focus on network automation, along with strong secular trends such as BYOD, virtualization, and cloud computing are creating a healthy selling environment for Infoblox.

Now I’d like to turn the call over to Remo to further discuss our financial results.

Remo Canessa

Thank you, Robert. I would like to remind everyone that the results I will be discussing are non-GAAP financial results, and exclude stock based compensation expenses, amortization of intangibles, and the tax impact of these adjustments. All share counts that I’ll be providing will be on a fully diluted average share basis.

As Robert mentioned, we are very pleased with our strong execution in the October quarter, which allowed us to exceed our financial targets. Revenue in the quarter grew to $49.5 million, which represents a 26% increase over the October quarter last year, and a 10% increase over the July quarter.

Product revenue in the October quarter was $27.1 million, or 55% of total revenue, which increased 19% from the October quarter last year, and was up 12% from the July quarter. Overall, the adoption of our next generation DDI appliances has been very strong. In the October quarter, approximately 83% of our DDI product revenue was from our new next generation of appliances.

Service and support revenue was $22.4 million, or 45% of total revenue, an increase of 34% over the October quarter last year and 7% over the July quarter. The increase in our service support revenue is primarily due to the amortization of support contracts and, to a lesser extent, an increase in professional services.

From a geographic perspective, in the October quarter Americas revenue grew 30% over the October quarter last year, and 10% over the July quarter, representing approximately 66% of our total revenue. EMEA revenue increased 33% over the October quarter last year, and 8% over the July quarter, representing approximately 24% of our revenue. The rest of the world revenue decreased 5% from the October quarter of last year, but was up 15% over the July quarter, representing approximately 10% of our revenue.

Product gross margin was 80% in the October quarter, compared with 81% in the October quarter last year, and 77% in the July quarter. The sequential increase was better than expected, as we experienced less discounting and increased mix of higher margin products.

Service and support gross margin was 82% for the October quarter, compared with 79% in the October quarter last year and 81% in the July quarter. The increase in service support gross margin reflects cost efficiencies from our services and support organization, along with increased revenue growth. As a result, total gross margin in the October quarter was 81% compared with 80% in the October quarter last year and 79% in the July quarter.

In the October quarter, total operating expenses were $36.7 million, which is an increase of $6.6 million compared to the October quarter of last year. As a percentage of revenue, operating expenses decreased to 74% from 76%.

On a year over year basis, R&D increased 5%, and was 18% of total revenue, compared with 22% last year. Sales and marketing increased 25% and was 46% of revenue, compared with 47% last year. G&A increased 49% and was 10% of revenue, compared with 8% last year.

In the October quarter, total operating expenses increased sequentially by 7% from the July quarter. On a quarter-over-quarter basis, R&D increased 4%, sales and marketing increased 4%, and G&A increased 31%. The increase in R&D is due to higher compensation expenses. The increase in sales and marketing is related to holding our annual worldwide sales kickoff meeting, along with increased investments in marketing programs and events. The increase in G&A is primarily due to approximately $800,000 of nonrecurring expenses related to to the completion of our follow-on offering.

Operating margin for the October quarter was 6.9% compared with 3.6% in the October quarter of last year and 2.5% in the July quarter. The operating margin improvement was due to exceeding our revenue and gross margin targets, along with operating expenses decreasing as a percentage of revenue.

Net income in the quarter was $3.1 million, or $0.06 per share. This compares to net income of $800,000, or $0.02 per share, in the October quarter last year. In the July quarter, net income was $700,000, or $0.01 per share.

As of October 31, 2012, we had $168 million in cash, cash equivalents, and short term investments. We had a record net cash provided by operating activities of $8.9 million in the October quarter.

Total deferred revenue increased by $13.1 million, representing a 20% increase in deferred revenue balance when compared to the deferred revenue balance when compared to the October quarter last year and a $1.6 million increase since the end of the July quarter. Deferred revenue primarily represents support contracts that amortize over the contract period, and to a smaller extent, channel inventory.

Now, I’d like to provide guidance January quarter and our fiscal year 2013, and I am pleased to announce that we have raised guidance in all areas. As a reminder, these numbers are non-GAAP, which excludes stock based compensation expense, amortization of intangibles, and the tax impact of these adjustments.

For the January quarter, we expect revenue to be in the range of $50 million to $51.5 million, or year over year growth of 21-24%. We are targeting gross margin to be approximately 78%. We anticipate operating margin to be between 4-5%. We expect EPS to be between $0.03 and $0.04, using approximately 53 million shares.

For our fiscal year 2013, we expect revenue to be in the range of $204 million to $208 million, or year over year growth of 21-23%. We anticipate operating margin to be between 5-6%, and we expect EPS to be in the range of $0.17 to $0.21, using approximately 54.5 million shares.

In closing, we are very pleased with the performance in the October quarter, and we believe our market leadership and the strength of our products are clearly evident in our revenue results. Going forward, we see a tremendous market opportunity before us. Our great architecture and automated network control solutions are unique, and sit at the crossroads of today’s leading network trends.

Now I’d like to turn the call back over to Robert.

Robert Thomas

Thank you, Remo. DNS and DHCP are the building blocks and essential glue between the network infrastructure and all IP-based applications. Any disruption to these network services can cause businesses to stop being operational.

During last month’s hurricane, several of our East Coast customers experienced power outages at their data centers. One particular customer, a prominent publishing and financial information firm, experienced a communications outage between two of its New Jersey data centers.

With Infoblox’s unique active to active DHCP fail over capability, both locations were able to operate independently for the entire outage and to resync transparently when the fiber service was restored. As a result, services operated seamlessly, and the client devices on the network never saw the outage.

In the first quarter, we had many great customer wins. I’d now like to take a moment to discuss a couple that highlight the network challenges that organizations face, and how our products help solve their problems.

The first customer is a leading provider of information solutions for the science, legal, and business sectors. This customer was experiencing tremendous IP address management issues and DNS outages, because they had disparate DNS services located all over the world, with no central management capabilities.

The customer purchased our Trinzic and NetMRI appliances to provide complete and accurate DNS and IP address management. The customer also bought our recently introduced load balancer management module to centrally manage their F5 appliances from the Infoblox management interface.

This customer example highlights the opportunity we have to sell our full portfolio of automation solutions to solve a customer’s complete network challenges. The second customer is a luxury hotel and casino resort in Las Vegas. This company wanted to deliver a world-class wireless experience to its customers, so they could roam the entire property and never lose Internet access.

Infoblox was chosen as a part of the overall wireless solution, because of our Trinzic appliance’s ability to provide high availability and fault-tolerant DHCP services. And in the first quarter, we complemented our sales efforts by introducing IPAM Express, our free software offering that allows organizations to automatically identify and allocate up to 2,000 IP addresses.

IPAM Express is a great lead-generation tool as it introduces organizations to the compelling advantages of our commercial-grade IPAM solution. We’re already off to a strong start, and have seen significant increase in the number of qualified leads.

Product innovation continues to be a key priority in executing on our growth strategy. I believe fiscal 2013 will be one of the strongest periods for new product introduction in the company’s history. Our plan is to continue to leverage our leadership in DDI innovation and further monetize our grid architecture. The grid is a control and automation platform with a single authoritative network database. Its highly extensible technology provides a powerful found on which we can rapidly innovate.

Over the next few months, we’re introducing several new products, including solutions targeted at the security market. As the threat environment continues to evolve, more and more security breaches are DNS-based, with DNS enabling the transmission of malware and botnets throughout an organization’s network. We are leveraging our DNS expertise to introduce solutions with unique protection capabilities that traditional security providers cannot deliver.

In addition, we’ll be adding significant new automation features and capabilities to our existing Trinzic and NetMRI series of appliances. Our focus is to continue to enhance and expand our product portfolio, including new use cases for network automation. We now have a growing base of over 6,100 customers, and we view them as prime candidates for additional new business.

In closing, we are very pleased with our strong start to the new fiscal year. We continue to lead the market in both share and technology innovation. In a more challenging IT and spending environment, we believe customers continue to place high value on our solutions, which maximize reliability, protection, and uptime of the network, while providing a compelling ROI.

With that, Remo and I will be happy to take your questions.

Jane Underwood

Thank you, Robert. That concludes today’s prepared remarks. Operator, we’d now like to open up the call to analysts’ questions.

Question-and-Answer Session

Operator

Thank you. [Operator instructions.] And the first quarter is going to be from Jonathan Ruykhaver with Stephens. Please go ahead.

Jonathan Ruykhaver - Stephens

I’m kind of curious. Can you provide some color around what you’re seeing in the service provider vertical? Maybe give us a feel as to how big that is as a percentage of revenue? And also, what the mix looks like between service providers that are using Infoblox for managed services and the other side of the equation, which is the need to support core DNS/DHCP requirements.

Robert Thomas

On the service provider front, service provider business continues to be important to us, of course. It was a little lower this quarter than the previous quarter. And that’s probably what we expected from it, I think. We probably think it will be up next quarter as well. It’s a bit cyclical in some of the buying patterns of service providers.

And as you probably know, we introduced a thing called the 4030, a very high-end product, back in April. And we have that in test in a number of service providers today. A couple of small sales, but nothing significant yet. But I think there’s big opportunity for us there as well. The testing cycle is a bit long.

Managed services, while we’re doing business in that space, is probably not the area that is the strongest for us at the moment. I think that’s going to take some time to develop over the next several quarters. We, as you know, have arrangements with Verizon and AT&T in that area, but it’s a little bit of a long gestation period, which I think is what we’ve been saying for a while now. But we have hope for that over time.

And I missed the last part of the question, about DNS core services? What was that?

Jonathan Ruykhaver - Stephens

I guess I was getting back to your mentioning the 4030 DNS caching product to address DNS resolution issues, just what kind of activity you’re seeing around that type of infrastructure.

Robert Thomas

Well, I think a lot of interest in that particular product, and in DNS services, customer-facing services as well. As I said, we expect to do some decent business with the 4030. But as I said, it was released in April. The testing cycles in service providers are relatively long. So we haven’t seen that bear any significant fruit yet. But I think that will come a little bit later.

Jonathan Ruykhaver - Stephens

And I guess in terms of the growth we saw in license revenue, was there any specific concentration you can speak to from a vertical standpoint that drove that? Or was it really broad-based?

Robert Thomas

No, very broad-based across all verticals. No 10% customer for the quarter. So no single customer contributed to that. We had a pretty healthy deal pipeline going into Q1. A lot of reasonable sized deals, but very evenly spread across different verticals.

Jonathan Ruykhaver - Stephens

There’s been a lot of discussion and speculation regarding the impact of SDN, software defined networking, on networking vendors. And I’m just curious, could you share your sense as to what kind of impact SDN could have on the DDI marketplace?

Robert Thomas

You know, I think it’s very, very early days for SDN. And you’re right, there’s a lot of interest in it. I think it all started with VMware’s acquisition. SDN’s been around a little while. I think it’s definitely a trend that many large organizations would like to pursue, because it frees them from the chains of their existing switching and routing suppliers and lets them use more conventional hardware in networking.

So I think it’s definitely something that, in time, will become something. I think for a DDI vendor, it really is irrelevant. I think core network services, such as DNS and DHCP, are essential no matter whether it’s an SDN network or a non-SDN network. So I don’t think it matters.

I think we are unique, though, because of this grid technology that we’ve developed, that we actually have a control plane vehicle. And that’s what the grid really is. It’s a control plane. That could be incredibly useful in an SDN environment.

I think even more useful in a hybrid environment as people are shifting from traditional switching and routing and other network appliances to an SDN model. You need some kind of control plane to manage that environment and that capability, so it puts us in a unique position. So for DDI vendors generally, I don’t think SDN has a significant impact. But for us, I think it could present a unique opportunity.

Operator

And the next question is going to be from Eric Suppiger with JMP Securities. Please go ahead sir.

Eric Suppiger - JMP Securities

Last quarter, Japan was slow. Did you benefit from much of a recovery of the business that you lost in Japan?

Remo Canessa

It did come back, as we had mentioned on the last conference call. We expected it to come back in Q1, and it did. On a quarter to quarter basis, APAC in total, which Japan was a large contributor, increased 15%.

Eric Suppiger - JMP Securities

Any comments about linearity with the quarter in light of Hurricane Sandy or any thoughts about linearity in general?

Remo Canessa

Linearity in the quarter was better than the prior quarter. Sandy, there was a little bit of impact on the part of Sandy, but not significant.

Eric Suppiger - JMP Securities

And then if I look at the guidance that you gave for the year, the midpoint of the growth is about 22%. You grew 24-25% this quarter. Is there any reason why we would see any slowing from here? Did this benefit from some of the Japan business, and that maybe inflated it? Why would we see the growth rate slow from here?

Remo Canessa

I don’t think it’s slowing that much, and we’ve raised guidance substantially. I think the last guidance we gave, on the last call, was $195 million to $202 million, and currently it’s $204 million to $208 million. We had an outstanding Q1, and also, we didn’t give guidance for Q2, but the consensus, our guidance is $50 million to $51.5 million. Again, we feel this is prudent guidance. We feel that based on our pipeline we’re comfortable with this. And we’ll just see how things play out.

Eric Suppiger - JMP Securities

Seasonality, for modeling. How might we think of the remaining three quarters? Would you expect a strong Q4 and slower growth in the Q2 and Q3 range? How should we think about that?

Remo Canessa

We’re not giving any guidance other than the guidance we gave in our conference call, which is for Q2 and for the full year. I’ll let you determine what you think it should be for each of the quarters.

Operator

The next question is going to be from Amitabh Passi. Please go ahead. He’s with UBS.

Amitabh Passi - UBS

Remo, I was wondering if you could provide us any more color on your full year guidance in terms of expectations for gross margins. You seem to be trending ahead of your guidance for the last couple of quarters. So just hoping you can help us understand what you’re embedding for your full year guidance for gross margin and opex.

Remo Canessa

We did not give guidance for gross margin for the full year. We did give guidance, though, for Q2. What we’d indicated before was that we expected gross margin at 76% for Q1. And we actually came in at 81%. It was an outstanding quarter for us on a gross margin basis, based on a mix shift toward the higher gross margin product, and less discounting related to our products, and in particular related to our next generation products.

Our guidance for Q2 is 78%. I’d like to see how things kind of go through related to the rest of the year. Again, the guidance that we gave related to our operating profitability is 5-6%, which is substantially up from where it was before. So again, I’d like to take a look at one more quarter, and see where we’re at. And then we’ll see where the guidance is going forward from the gross margin perspective.

Amitabh Passi - UBS

And I apologize if you said this already. The 78% guidance for next quarter, what’s driving the sequential decline? Are you anticipating greater discounts? Or is it just mix?

Remo Canessa

Yeah, it’s both. It’s both the discount mix as well as during the quarter the next generation was 83%. That’s going to go up. So those factors will, I believe, have a downward impact on the margin, to the 78% type range.

Amitabh Passi - UBS

And then how do we think about the momentum with NetMRI and your load balance module. Can you give us any sense in terms of customer adds, percentage of revenue, any sense of how those two vectors are trending?

Robert Thomas

I think we’ve said in the past that load balance manager, to start with, is just a very, very new product, only introduced a quarter ago. So it’s a little too early to tell. Of course, we’ve seen some sales of that already, but given that our sales cycle is in the 6-9 month range, and that product was released about a quarter go, I think we’ve got a way to go before we see what the pipeline looks like. But we’re feeling quietly confident about it.

NetMRI improved over the quarter, and we’re seeing a few larger NetMRI deals. And I think even looking into this quarter we see a few larger NetMRI deals as well. And as you know, we are blending NetMRI technology with DDI technology to deliver some of the other automated solutions we have. So over time, it will be difficult to separate NetMRI from DDI revenue as these things become blended. That is progressing in the right direction, I think.

Operator

The next question is going to be from Kent Schofield with Goldman Sachs. Please go ahead sir.

Kent Schofield - Goldman Sachs

You’ve alluded to this a little bit, but can you talk about now that you’ve had the new Trinzic product set out in the field for a while, has the competitive win rate been improving? How is it faring against the competition?

Robert Thomas

I would say our competitive win rate has definitely not declined. I feel, and it’s only just anecdotal - so I couldn’t really pin it on hard statistics - that we’re doing a little better competitively than we have in the past.

There are a lot of new features in that product in the kind of environment we’re in, where networks have to be up and running all the time, and the kind of hardened reliability and failover and dual capabilities, with redundancy built into that product, helped that happen. So I think we have become more competitive with our product range. I think it’s moved us ahead of the competition in terms of the things we do.

It might still be too early to see whether that translates into a higher win rate than in the past, but our win rate is pretty high. I mean, we win against our number-one competition 8-8.5 times out of 10. So it’s hard to see that improving much.

Our sales guys did a particularly good job in the latest quarter of holding price, and as we said, our discount rates went down. Some of that is associated with, I think, the new product and its uniqueness. So we may see a slight increase in margin because of the things we offer. And maybe that’s more likely to be the manifestation of the new product capabilities rather than a change in a loss rate, which is already extremely low.

Kent Schofield - Goldman Sachs

And then any update on a push toward software only type product attach, versus the hardware attach?

Robert Thomas

I think at least for the foreseeable future, meaning four quarters or so out, the bulk of our business will continue to be appliance-based. We are introducing new capabilities. Our software load balance manager is a good example of it, and you’ll see some of that in the next quarter. Some other examples of it, where new software modules are being delivered that have functionality that can run on existing appliances that customers have today. So there’s going to be a mix of appliances that form the base foundation of a grid, and then add-on software features, which will be a pure software add with a higher gross margin, of course, as that happens.

Shifting to an entire software model where we just deliver a binary, and people buy their own hardware to run it on, is something that I don’t think is going to happen any time soon. We do have customers who run virtual instances of our products on off-the-shelf servers. It’s still a small part of our business, but some customers do it. But given that we sell to the networking community, usually people like to be in control of the functionality they’re running from both a hardware and software point of view. I think we’ll continue to sell appliances for quite a while.

Kent Schofield - Goldman Sachs

Remo, you mentioned the channel inventory as part of the deferred revenue dynamic. I know it’s a secondary factor, but where there any outsized impacts, randomly, this last quarter? Or was it all pretty standard operating?

Remo Canessa

Channel inventory actually came down during the quarter, substantially.

Operator

Ehud Gelblum with Morgan Stanley is next. Go ahead, sir.

Ehud Gelblum - Morgan Stanley

Just trying to put a couple of pieces together, and just trying to understand kind of a narrative. So last quarter, from what I remember, you were looking for more of the new appliances to be sold than the 60% that you got. This quarter, it went up to 83%, so you’re doing very nicely with selling those new Trinzic appliances. But gross margin went up, when originally the narrative, I think, was that the new appliances had higher expenses so that they would actually pressure gross margin.

So somehow, between last quarter and this quarter, you’re selling more of the lower gross margin Trinzic appliances, so something kicked in from last quarter, but the gross margin went up as well. And then next quarter, you’re saying gross margin goes down, because that number goes up even higher. The percentage goes up even higher. So I’m just trying to understand the moving parts behind gross margin and what is making that go. If you could add some color around that.

Remo Canessa

I’ll try. [laughter] The gross margin, we did exceed substantially, for a couple of reasons. One is the discounting we give, or have, with our customers was less. And in particular, that discounting was less for those newer products. In addition, we had a slight mix shift in the quarter related to higher-end products.

So next quarter, going from an overall gross margin of 81% down to 78%, it’s those two factors saying that we’re going to go back to, or normalize, toward mix shift. So lower-end type products, related to going back to our normal discounting that we’ve had in the past.

And also, there’s going to be a higher percentage related to the next-generation product, which does come at a lower margin. In addition, one of the things I didn’t mention before is that our gross margin on support was up.

The gross margin on support was 82.4%, which is higher than we expected also. So those factors that I mentioned before about the license, in addition to support being higher, was what contributed to the higher margin that we had. And I would expect all those to come more in line to that 78% type gross margin in Q2.

Robert Thomas

I would say, to just expand it a little bit, if we saw the same trends this quarter, that is, discounting reduced - we weren’t discounting as much - and a move to the higher-end products, which have a higher gross margin, then we would see an increased margin. But just because in one quarter we saw a lot of discounting and a shift mix to higher-end appliances, we couldn’t, I think, in good face, say we’d expect to see the same thing happen this quarter. So there was an unusual shift to the high end, and we held discounting under good control. If we can continue to do that, of course, then we’ll see a benefit in the margin.

Ehud Gelblum - Morgan Stanley

But if I can just, again, try and rephrase. So, the prior quarter you had trouble selling the new Trinzic products for some reason, and this quarter not only did that trouble go away, but it’s almost as though you raised the prices and got rid of the discounting, and they started selling better.

Robert Thomas

Actually, it’s a misconception that we had trouble with the new Trinzic product. We’ve never had any trouble selling the product. We’ve never said we had any trouble selling the product.

Ehud Gelblum - Morgan Stanley

Fine, but people went for the older product, as opposed to the new product.

Robert Thomas

Yes, and I think we explained that on the last call. Our sales cycle is six to nine months, and as you make a product transition from an old product to a new product, a lot of sales campaigns you’re halfway through our two-thirds of the way through. Shifting some customers to the new platform works, because they see the benefit, and they’re willing to do it.

Shifting other customers to the new platform sometimes doesn’t, because they went through lengthy evaluation cycles, and their internal procedures say that they have to evaluate new hardware and new platforms if they buy it in their own network, and they’re not willing to do that. So they’ll stick with the older products.

And some customers who were willing to shift from the older product to the new product weren’t willing to pay the increased price for it, so we delivered the older product. So it wasn’t so much a problem with the new product. I think it’s been extremely well-received. It was more of the length of our sales cycle, and where we were in certain sales campaigns. And we probably overestimated the number of customers we could switch to the newer product, partway through a sales campaign.

Ehud Gelblum - Morgan Stanley

Okay. Again, I didn’t want to say there were problems with it, but it didn’t sell as fast as you thought. So should we be looking at it maybe as a function of timing as to how long it took to prove in, and that it just took a little bit longer for the right customers to decide that this is where they wanted to go, and that may have caused a little bit of a pause last quarter as they were still evaluating, but now they came in and the product is so much superior that discounting was never needed initially? That was sort of a conservative assumption, that you needed a discount in the first place? And that it was more a matter of timing? Is that the way to look at it?

Robert Thomas

I’ll answer that in a different way, and tell me whether I’ve answered the question. As you make this transition from one product to another, and the price is higher on the second product, as we said, and as you said, in that transition period quite often it’s difficult to get the customer to pay a higher price, even a new prospect, if he knows that there was another product range, and it’s still in the price book, and it was a bit lower.

So I think we do face a quarter or two of transition where we’re unable to harvest the benefit of that higher price, because we’ve got two products in the price book, and some customers have been exposed to both. And some existing customers, who have a network of old products and new products want to add the new products, and they bought the old products at a different price. So we need to get them to the newer increased pricing over time, and it’s not just a binary thing where you can switch one on and the other off.

So I think that is something that we’ve been going through. I think we’re pretty much through that. As Remo said, 83% of all the DDI appliances we sold, or was revenue, was the new product. And this quarter is going to be higher. We have basically none of the old product to sell anyway anymore. There’s no inventory, and we’re not building anymore. So it will be much higher this quarter as well.

Ehud Gelblum - Morgan Stanley

So, two quick things. One is at what point in the quarter did you realize it was as strong as it ended up being? Did it happen in the third month? Or did it happen before that? And sort of when did you get that sense? And second is now that your gross margin appears to be higher, and people seem to be buying the Trinzic at the price points you originally intended, does that change your view of your long term or even your medium-term gross margin range?

Remo Canessa

I can’t really comment on when we felt stronger during the quarter, because I can’t recall. But one of the things we talked about, I believe, is that we do have a very extensive sales forecasting process where we do meet weekly with a bunch of people, Robert and myself. So I think we’ve got a pretty good handle on the sales forecasting. And I can’t remember when we felt better…

Robert Thomas

I think maybe to add to that answer, linearity in the quarter improved for us, so the fact that linearity in the quarter improved could give you some indication of how we felt about where we were going to be during the quarter.

Remo Canessa

And your next question was about gross margin? Is that the question…

Ehud Gelblum - Morgan Stanley

Does that change your outlook on where your gross margins could be longer term?

Remo Canessa

Initially, the answer was 76% or what we had talked about a while ago, and that was for the Q1 quarter.

Ehud Gelblum - Morgan Stanley

That’s the near term. I’m talking longer term, now that you’ve kind of proven out that people are willing to buy these products at higher gross margins.

Remo Canessa

Yeah. Again, from my perspective, based on what we saw in Q1, and what we’re forecasting for Q2, we’d expect stronger gross margin going forward than we initially thought.

Operator

And the next question is going to be from Sanjit Singh with Wedbush Securities. Please go ahead sir.

Sanjit Singh - Wedbush Securities

First, regarding the new product rollout, if you could give us some timelines on when these products might come out. Is it a Q2/Q3 timeframe? And with these new product rollouts, does that drive a kind of refresh opportunity within the installed base? How should we think about that as a catalyst for growth?

Robert Thomas

The new products I referred to will come out this quarter, so in Q2 for us. One is pure software-based, which will be a module that existing customers buy, or a new customer, of course, will have to buy an appliance to run it on. Another will be an appliance that they attach to the grid and run as another appliance.

So it’s not really a refresh opportunity within our customer base at all. It’s added functionality and new functionality in the security space that will give them additional benefits in [unintelligible] environment that they didn’t have in the past. So it doesn’t replace anything. It’s additive. And as I mentioned earlier, our sales cycle is six to nine months. So while we have factored it into our overall numbers, we wouldn’t expect to see significant revenue from new products for three quarters or so, because of that length of sales cycle.

Sanjit Singh - Wedbush Securities

And then regarding competition on some of the newer competitors, we saw Windows Server 8 come out. And I think SolarWinds announced a kind of low-end IPAM solution that they’re coming out with. Is there anything, at least from a buzz standpoint, that your customers are saying in terms of evaluating some of these other solutions? Has it had any impact on your pipeline, or timing of deals?

Robert Thomas

I think no impact on pipeline or timing at the moment, and I think in the SolarWinds case, they generally address a lower-end market problem than we do. So we rarely see them in competition. Many of the customers that we sell to today have SolarWinds products for other things. But we rarely see them in head-to-head competition, because they don’t have, I would say, a system-wide IPAM solution, as we do. So not much impact from them.

Microsoft, of course, is a big name, and every customer we sell to today has Microsoft installed somewhere in their organization. So they will look at the Microsoft offering, but again, it’s very localized to the server it runs on. It doesn’t provide a system-wide view of IP addresses, or DNS, and so on. You can’t manage from a single console. So while I think a lot of customers will look at the Microsoft offering to see what it does and how it works, and whether it has a place, I doubt that it will cause us much problem in the near to medium term.

Sanjit Singh - Wedbush Securities

And my final question is regarding the investments in sales and in channel that you mentioned last quarter. There’s been a nice raised guidance on operating margin as well as EPS. The raised margin, is that purely a function of higher gross margins and revenue? Or are investments in the sales channel kind of normalizing at current levels? How should we think about your investment program?

Remo Canessa

Well, we’re going to continue to invest in sales and marketing, as we mentioned on the call before. So that investment you’re going to see in sales and marketing. As we’ve talked about before, we see a very large market opportunity in this market. And we want to make sure that we invest properly into it. So you’re going to see increased investments in sales and marketing as we go forward.

Sanjit Singh - Wedbush Securities

So to clarify, the increase in guidance is mostly a function of higher-than-expected revenue growth and gross margin?

Remo Canessa

It’s a combination of all that. It’s the revenue. It’s also higher gross margin than we initially anticipated. And also, what we thought we were going to invest at the beginning of the year we’re going to continue on that program to make those investments in the company.

Operator

The next question is going to be from Eric Suppiger with JMP Securities. Go ahead, sir.

Eric Suppiger - JMP Securities

Just a follow up. You had mentioned that your channel inventory came down dramatically. What was the reason for that? Was that just stocking for the new product last quarter?

Remo Canessa

No. Our channel inventory I said came down significantly. And the reason for that is just better execution on the part of our sales organization, through sell-through.

Robert Thomas

And I think the other thing that we’ve done over the last two or three quarters is set up a European distribution center ourselves, so we have a facility now in Amsterdam where we hold product. So the time of delivery from us in California to a distributor in Europe, for example, is significantly less. So they don’t have to carry the kind of inventory they carry to be able to meet the same kind of [unintelligible] for their customers. And we did that because we thought it was a good business practice for us to provide better service to distributors, and lower the cost of inventory for them. And we’ve seen that bear a lot of fruit.

Eric Suppiger - JMP Securities

And that took place in the October quarter?

Robert Thomas

We established it two or three quarters ago, and we’ve been refining the model over the last two or three quarters. And I think we’ve got it pretty close to where we want it to be now.

Eric Suppiger - JMP Securities

And then one other quick one, just on the discounting. You had said that you’re discounting less than you thought. Just to be clear, you did not have great visibility into what kind of discounting that you would need to have for the new chassis, and that’s where the surprise was from your perspective, is that a reasonable assessment?

Robert Thomas

I think it’s a combination of things. I think the sales force, and the sales management are very motivated to sell our value, we typically find we sell, I don’t know, 15-25% more than our competition when we’re head-to-head with them, and still beat them. And so our guys are very good at selling our value.

So I think they’re probably improving their capability of doing that. We’ve almost passed through this transition from old product to new, where the ability to take a few more dollars on the new product, because it’s got a higher price, we can leverage, because we’re leaving the old product behind now.

So we’re a bit more able to do that, I think. And I think we might be a little bit better off competitively because of the new product range, because we have things that our competition doesn’t have, and customers might be willing to pay a little bit more for. So I think it’s a combination of things.

Operator

And at this time, I would like to turn the conference back to your host, Jane Underwood.

Jane Underwood

Thank you. I’d like to thank you for joining us on today’s call. A replay will be made available at 800-475-6701 beginning on November 28, 2012 at 4 pm Pacific, and an audio archive will also be available on our website. Have a great day, and we look forward to speaking with you again soon. Thank you.

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