Quest Software, Inc. Q3 2008 Earnings Call Transcript

Quest Software, Inc. (QSFT)

Q3 2008 Earnings Call

October 30, 2008 5:00 pm ET

Executives

Stephen Wyman – Assistant Treasurer

Vincent C. Smith – Executive Chairman of the Board

Scott J. Davidson – Chief Financial Officer & Senior Vice President

Douglas F. Garn – President, Chief Executive Officer & Director

Analysts

Tim Klasell – Thomas Weisel Partners

Kirk Materne – Bank of America Securities

Derek Bingham - Goldman Sachs

Mark Murphy - Piper Jaffray

Aaron Schwartz - J.P. Morgan

Walter Pritchard - Cowen and Company.

Presentation

Operator

Welcome to the Quest Software third quarter earnings release conference call. Today’s conference is being recorded. With us today are Vinnie Smith, Executive Chairman, Scott Davidson, Chief Financial Officer, Stephen Wyman, Assistant Treasurer and Doug Garn, President, Chief Executive Officer. At this time I would like to turn the conference over to Mr. Stephen Wyman, please go ahead sir.

Stephen Wyman

Welcome everyone to Quest Software’s third Quarter call. Of course, I am thrilled to have on the call with us today, Vinnie Smith, Executive Chairman, Doug Garn, President and Chief Executive Officer and Scott Davidson, Chief Financial Officer. Scott, Doug and Vinnie will share some thoughts on the quarter that ended September 30, 2008 and then we will open up the call for Q&A.

Our call is being webcast from our investor relations website and you can get a copy of our press release issued just a short while ago on this website as well. A replay of this call will be available on this site or using the instructions noted in our release. At this point let me turn briefly to our safe harbor statement.

Some of the statements we make today may be considered forward-looking including statements regarding our anticipated revenue and operating markets in the future periods, other statements about our plans, prospects and strategies and statements regarding our intention to commence a tender offer to repurchase shares of our common stock.

These statements involve a number of risks and uncertainties that could cause actual results to differ materially. Please also note that these forward-looking statements reflect our opinions only as of the date of this presentation and we undertake no obligation to revise or publically release the results of any revisions to these forward-looking statements in light of new information or future events.

Please refer to our SEC filings including our annual report on Form 10K for the year ending December 31, 2007, our first and second quarter 2008 reports on Form 10Q as well as our Q3 earnings release for more detailed descriptions of the risk factors that may affect our results. Copies of these documents can be obtained from the SEC at www.SEC.gov or by visiting the investor relations section of our website.

Also, please note that certain of these financial measures were used on this call such as EPS, net income, operating margin and operating income are expressed on a non-GAAP basis and have been adjusted to exclude various charges including amortization of intangibles, share based compensation expense and expenses of our stock option investigation. We report our GAAP results as well as provide a GAAP to non-GAAP reconciliation in our earnings press release. A copy of which is available on the Investor Relations area of our website at www.Quest.com and with that it is my pleasure to turn the call over to Vinnie.

Vincent C. Smith

Obviously with Doug’s new role we will be transitioning different responsibilities over to Doug and one of those responsibilities is a good portion of this call. In this call we thought we would start with Doug who will review the operations for the quarter and Scott will follow with specifics on the finances and then I will follow-up with thoughts on our markets and our broader thoughts for 2009. With that let me hand the call over to Doug.

Douglas F. Garn

First let me start by saying that I am proud of being the CEO of Quest and to be participating on this, my first call. The fact that we executed very well in a tough environment in Q3 certainly made the quarter exciting and one that I am very proud of, the energy the focus and the execution of our team was in our goal and delivery and impressive results. I look forward to seeing at same energy in Q4 and onward.

To begin I would like to give you some perspective on deal metrics then I will touch on the sales regions and close with some comments across product groups. In regard to the deal highlights, we had an 8% increase in deals over $100,000 this past quarter compared to Q3 of 2007. Taken a cut of the deals over $100,000 the average deal size this quarter was $295,000 versus $246,000 in Q3 of 2007.

The revenue split in Q3 was 64% North America, 36% rest of world which was similar to Q3 of2007. It was a 5% delta from last quarter, though. We did seven deals greater than $1 million which is an all time high for Quest. Comparatively, we closed four transactions over $1 million in Q3, 2007. What is great is that these large transactions were driven by a wide range of products. The products represented are identity and access management suite, our whole range of migration products, our suite of AD management tools and lastly a large transaction that was predominantly made up of our Foglight tools.

On a regional basis our North American public sector team which represents federal, state, local and higher Ed had its best quarter performance ever. They closed four transactions in excess of $1 million, the largest being a multi-million dollar deal in the identity management product portfolio. The third quarter is generally the most integral of this group given the time in the budgets and that team executed extremely well.

Our EMEA year results were mixed with certain parts of the region experiencing some rollover effect from the US economic issues as a result EMEA slowed a bit in Q3 as I mentioned earlier. North America Commercial had a solid quarter in light of economic worries that existed late in the quarter and contributed several of the million dollar transactions. As a side note, Latin America had a very solid quarter in Q3.

Our APAC region was led by Australia. Australia came on very strong from previous quarters it had an exceptional performance in Q3. As you can see our diverse product portfolio and strategy coupled with our broad reach of global locations allowed Quest to deliver a solid Q3. Our maintenance revenues continue to perform well. This is attributed to our product developers, customer support teams and support renewal teams that this part of our business remains a consistent, vibrant part of Quest. It also shows that customers are committed to our products as well.

Now let us take a few moments to talk about our product areas. One of the great things about our product pieces is our ability to manage our portfolio products within different market segments. It is a great testament to the leadership teams that run those product areas and I just wanted to make sure I highlighted that.

Let’s start with the database management group, the database management business worldwide showed continued stability. In the Oracle market we continue to see steady performance within our development products. Our strategy to focus on specific end user types and deliver the right product for the right user is clearly working and resonating with our customers.

[Inaudible] continues to be the de-facto standard for the Oracle database developers and SQL server manager products are as well an emerging area for us and we are focused on broadening our database management footprint and working to capture the available market. In Q3 we rolled out new SQL server versions including light speed for our flagship backup and recovery products.

Overall, we remain extremely bullish on the SQL server market as we tighten our portfolio and continue to enable customers to meet the challenges of their growing SQL environments. The application management business experienced growth in deal sizes larger than $50,000 which is important in that segment. We are seeing the emergence for deals for managing physical and virtual infrastructures and are well positioned for growth as this trend accelerates.

Wins in the Americas, one is our US public sector team closed a seven figure deal with a major municipal government agency. The agency will use Foglight to manage the composite data-center infrastructure including [Sebel], CRM and complex custom job applications. A major household name in the US retail sector as well is now using Foglight to manage critical business services from the time end users initiate a transaction to the point where the transaction is executed into the database.

We also count a leading construction firm in Australia who turned to Foglight to effectively manage their extensive Oracle environment. On the product front, Foglight released an integration model enabling connections to over 300 technologies allowing customers to use Foglight to manage a broad and diverse environment with one tool.

Now let’s move to Windows, Windows continues to drive a significant portion of growth. With Windows being so integral to our business we made two important acquisitions this quarter which strengthen and extend our Microsoft portfolio. One of those acquisitions was the NetPro acquisition, it closed on September 12^th. The NetPro acquisition allows us to speed the development of new features for organizations looking for a single vendor to streamline their management of Windows active directory, exchange, share point and SQL server.

The product rationalization between the two organizations was announced on October 15^th, with the release of a white paper and web seminars for partners and customers. The combined product lineup is the most comprehensive on the market today for Windows management. The second acquisition is Akonix. That acquisition was completed on August 15^th. We closed the Akonix acquisition to strengthen our product portfolio around the security and compliance of real time communications.

This acquisition deepens our management capabilities for strategic communication, platforms, instant messaging, VOIP, Blackberry and video conferencing. It enhances our archive manager solutions and extends our reach to customers on non-Microsoft platforms such as IBM Sametime, [Jabra], Reuters & Bloomberg.

In the area of identity and access management we launched the Quest One identity solution. Quest One is a set of enabling technologies to improve efficiency, enhance security and ensure compliance with integral and external regulations. It includes solutions for single sign-on, provisioning password synchronization and management, directory consolidation and strong authentication and compliance.

Speaking of identity and access management, we had a large transaction for our Quest Authentication services which was formally known as Vintela with a federal agency. Our exchange migration and management products as well had a particularly strong quarter in Q3. Another transaction that our public sector team closed in Q3 was with our Quest Management products that allow you to extend the system’s management environment and the system’s center environment from Microsoft.

Now let’s move on to our virtualization management area within our business. We continue to see great momentum both in the server and desktop areas of our business. On the server side, Vizioncore continues to deliver strong results. We added a large number of new customers which just continues to grow our already substantial customer base. We signed an important OEM agreement with Dell that allows Dell to bundle Vizioncore solutions with Dell hardware and VMWare software.

As you know, Dell is the number one reseller of VMWare software globally so this will further accelerate our rapid growth into the market. Growth continues to be higher than other areas within our portfolio across both the S&B and enterprise market spaces. On the desktop side we released a new version of [B Workspace] which includes our experience optimized protocol aimed at delivering a PC like end user experience and knocking down barriers to VDI. We had our biggest customer win to date to a UK government agency for over 10,000 users.

On the people and company front briefly, our employee total at the end of Q3 was 3,510 which includes all subsidiaries which compares to 2,992 at the end of Q3 from last year. That number, the 2007 number obviously did not include Vizioncore or Scriptlogic which are subsidiaries at this time. So in closing it was a well executed quarter across many fronts and we are already working hard in Q3 to make sure we maintain that focus and the success we had in Q3.

Now I am going to hand it off to Scott Davidson to share the financial details.

Scott J. Davidson

Overall, what Doug said is we feel very good about the Q3 results. So at the summary level total revenues were $187.6 million for the quarter an increase of 23% year-over-year. This includes approximately $1.4 million from NetPro which closed in September. Excluding NetPro the total net growth rate would have been 22%. Non-GAAP operating income was $41.5 million, non-GAAP diluted earnings per share was $0.25.

Q3 cash flow from operations was $35.8 million. Deferred revenue was approximately $312 million, a $62 million or 25% increase from Q3 of last year. I will get into the quarter now in a little bit more detail. License revenues were $86.7 million compared to $69.6 million in Q3 2007, this is a 25% increase year-over-year. Services revenue inclusive of professional services were $100.9 million representing an $18.3 million increase or a 22% growth rate over the comparable quarter in 2007.

Along product lines licensed revenue growth was driven primarily by the Window Management and the Virtualization Management product areas. Maintenance revenue growth was driven by our Windows Management products including the benefits from Scriptlogic and PassGo which were approximately 20% of the overall dollar increase. Also contributing to the growth and maintenance revenues but to a lesser extent were maintenance renewals on our database and virtualization management products.

Looking at the revenue mix for the quarter, although licensed revenue grew slightly faster than services revenue this quarter licensed revenues represented 46% of the total revenues while certain services generated the 54% balance. We saw a similar mix in the comparable quarter last year. Geographically, North American operations generated 64% of the total revenues for the quarter with particular strength noted in our public sector business. The rest of the world operations generated the remaining 36% and again this was consistent with a year ago quarter.

Moving to expenses I would like to remind you that the Q3 2008 non-GAAP results presented today exclude the amortization of share based compensation, acquired in process R&D charges, amortization of certain acquisition related intangible assets and ongoing expenses associated with the stock option investigation.

The earnings press release includes a reconciliation of differences between the as reported GAAP and the non-GAAP financial results. Total expenses on a non-GAAP basis were $146 million which was a 17% increase over Q3 of 2007. Of this amount approximately 75% can be attributed to increased labor related expenses and higher costs related to foreign exchange. Total expenses decreased by approximately $8.6 million sequentially as we benefitted from a strengthening dollar and headcount reductions made late in the second quarter.

The operating expenses decreased sequentially by approximately $8 million with 11% related to lower costs due to foreign currency, 42% related to the reduction in headcount which was made late in the second quarter and the balance associated with outside services and travel. Average headcount increased 9% compared to the third quarter of 2007 and has Doug said total headcount was about 3,500. That has about 145 people from NetPro included in that number. Of that 145 people that is a 32% reduction in their pre-deal headcount and the expectation for NetPro is that it will be accretive in 2009.

Turning now to the expense line items, sales and marketing expenses for Q3 were $75.4 million or 40% of the total revenue as compared to $63.6 million and 42% of the total revenue in the same quarter a year ago. Of the increase, approximately three quarters is associated with increased labor related expenses including the impact from foreign exchange, another 12% can be ascribed to the severance and retirement expenses.

Discretionary marketing can account for the rest of the increase, sales and marketing were down 5% sequentially from a reduction in average headcount. Research and development expenses in the third quarter were $35.9 million or approximately 19% in total revenue. This compared to expenses of $28.2 million or approximately 19% of total revenue in a year ago quarter. Approximately two thirds of the increase was related to labor in addition to higher costs related to foreign exchange.

Research and development expenses were also down 5% sequentially primarily due to a reduction again in average headcount. General and administrative expenses were $17.9 million or approximately 9.5% of total revenue in the quarter as compared to expenses of $18.2 million which was approximately 12% of total revenue during Q3 of last year. G&A expenses decreased 11% or approximately $2.3 million on a sequential basis. The reduction of G&A was related to a reduction in labor costs, professional accounting and legal fees.

Costs related to our previous restatement associated with the legal indemnification were approximately $1 million this quarter. Looking at income, GAAP operating margins were 15% in the quarter and GAAP operating income was $27.8 million. Non-GAAP operating income was $41.5 million generating the non-GAAP operating margin of approximately 22.1%. Other income expense net in the quarter was a net expense of $6.5 million versus a net benefit of $7 million in Q3 of 2007.

The primary drive of year-over-year change is related to the strength of the US dollar and as we have discussed before the predominant amount of our foreign exchange exposure is revealed within the other income and expense lines. Our GAAP effective income tax rate for the year-to-date basis was approximately 16% compared to 41% in a similar nine month period in the prior year.

The comparative difference is the result of several factors including the projected mix of income between high and low tax jurisdictions, the closure of an Internal Revenue Service examination of prior period tax returns that resulted in the reduction of the average tax rate during 2008 and the booking of a valuation allowance in certain jurisdictions that resulted in an increase to the effective tax rate during the first nine months of 2007.

Our year-to-date 2008 non-GAAP tax rate was 24% compared to 32% in the first nine months in 2007 primarily due to the forecasted mix of pre-tax income and the impact from the IRS adjustment mentioned previously. GAAP net income for the quarter was $17.3 million and GAAP EPS was $0.16. Non-GAAP net income was $26.8 million and non-GAAP diluted EPS was $0.25. Fully diluted weighted average shares outstanding was approximately 107 million shares.

Now, turning to the cash flow statement and the balance sheet. As of September 30, 2008 cash and investment balances were approximately $375 million. This represents a decrease of $44.8 million over the comparable balance in June 2008. The decrease in cash and investments is primarily due to the company’s acquisition of NetPro for approximately $75 million net of cash acquired. Capital expenditures for the quarter were $2.7 million. Cash flow from operations was approximately $36 million in the quarter compared to $31 million in Q3 of 2007.

DSOs was 58 days which was an eight day improvement over the 66 days in Q3 2007. Days sales outstanding was 58 days in Q2 of 2008. Deferred revenues increased 25% to approximately $312 million up $62 million year-over-year. 13% of the dollar increase was related to the NetPro acquisition.

Now, let’s talk about guidance. For 2008 we continue to see opportunities in the primary market. Given this and higher than expected revenues in Q3 we are revising the revenue range to $725 million to $740 million. This includes the expected impact from NetPro but is also tempered by our concerns surrounding the economic environment. As to margins and including the impact from NetPro GAAP operating margins are expected to be 10% to 11.5% for the year which implies a non-GAAP operating margin range of 17% to 18.5%.

The non-GAAP guidance excludes approximately $31.2 million related to the amortization of acquisition related intangible assets, $1 million for in process R&D acquired in May, 2008, $16.8 million of share based compensation expense and $3.2 million in ongoing expenses associated with the stock option investigation. The last item that I wanted to touch on is the tender offer. We intend to initiate and launch the tender offer on or before November 7^th for 140 million of our common stock.

We continue to evaluate financing proposals which would enable us to increase the size of the tender should terms become amenable. However, given the anticipated pricing and restricted covenants on the business combined with uncertainty in the debt markets the plan is to move forward with $140 million tender utilizing available cash resources. This concludes my part of prepared remarks and now let me turn it over to Vinnie.

Vincent C. Smith

What I thought I’d do is do just a quick couple of points on Q3. I had five thoughts, first when I looked at the quarter and we evaluated it the products came in about how we thought they would. There was good balance between the database, application, virtualization and Windows so everything performed nicely in the quarter and it was a good quarter and it was very balanced.

The next piece of the way I’m looking at the quarter and then on a go forward basis is we did a lot of large deals in the quarter for us but we’re not reliant on large deals. What I mean by that is I think in the future the concern on the economy anyways is that customers are going to be more difficult or demanding when it comes to large deals. So, let me give you a couple of examples, in the Northeast which is highly concentrated with banking, we actually had a really nice quarter.

One of the reasons for that is that in the last couple of years they’ve been transitioning away from doing as many large deals and have moved towards more of a volume business. So not as many $1 million deals but a lot more $100,000 to $400,000 deals. That’s a little different than the UK where they have been running their business very effectively over the last couple of years and doing large transactions over $1 million, many in the banking sector and so when this quarter hit they had a more challenging quarter and it is not because they are any less strong in sales or sales management it was just they had become very adept at large deals and I think that part of the market is much more difficult.

So, when I look at our mix of how we achieve our numbers I don’t feel that we’re that vulnerable that we rely on that many large deals and we’ve got a good pulse on it so that is a big issue I think that we all should be concerned with moving in to ’09. Another data point on large deals, during the quarter we sampled how much of our large deal mix is from the financial sector and it turns out, and I thought this percentage was going to be something like 50% of our deals over $500,000 would be in finance but it turns out that it is only 20% are in banking or insurance. That was a nice number to give you a better feel for it.

Another point in the quarter is renewals came in strong and for me that’s an indicator that we don’t have a ton of shelf wear out there and it also implies that customers are getting strong ROI from their investment with Quest which is nice. The next point on the quarter was we did two acquisitions and the people here working here and also the companies that we acquired Akonix and NetPro, we did a fantastic job integrating these businesses in to Quest. Very quickly and adeptly and I think that work that was done by both the acquired and acquiree is really going to payoff in Q4 and next year. So, a job well done.

Then the last point on the quarter, we’ve been doing I think in my opinion a good job managing our expenses this year. We obviously did a layoff earlier in this year in preparation for seeing some tougher times in front of us. We executed that well. I don’t think we hurt the company or damaged the company by taking some of those costs out. So, I think that we should really look and say that was pretty smart on our part earlier in the year.

Moving on to Q4 and 2009, I think the expense piece will stay where we are now in that we will be very careful as far as moving up expenditures given the economic climate and so we’re going to look for enhanced productivity out of our works because we still want to obviously grow the revenue and grow profits but we’re not going to press forward and spend really heavily in to the economic situation that we’re facing.

Another point on Q4 and 2009, we’re going to use our balance sheet to buy back stock as Scott just mentioned. He gave you some details on the buyback and so we’re excited about moving forward on that and getting it going shortly here. The next piece is we’re working very diligently on how we go to market and whether we do that profitably and efficiently and we’re fine tuning those levers right now to be more effective in 2009. I think that will help us achieve some greater productivity in our organization without having to grow expenditures that much year-over-year.

The next point on ’09 is I think we will continue to see more transition in the channel business as our virtualization business and our S&B business grows, those are dominated by almost entirely the channel, we distribute for the channel there and so as those businesses grow a greater portion of Quest will be delivered through the channel which is nice. Another piece on ’09 that I think we’re going to experience is we’re just becoming such a powerful force in the Microsoft marketplace, similar to the place we achieved in Oracle and that allowed us to increase our profitability in that area. So, I see our Microsoft business obtaining that leadership position and we’ll be able to drill a little bit better profitability out of Microsoft and I think we’re seeing that in ’08 and we’ll continue to see that in ’09.

On the virtualization front we have had a hot hand in the product mix that we brought together in to the marketplace over the last couple of years. That’s really exciting to be a part of that marketplace and to move in so fast and have product in to so many customers so quickly and the markets continue to grow quickly. Those are the up sides. The downside is we’re going to get more competition from established vendors from VMWare itself, Microsoft and possibly Symantec entering in to some of the areas where we are running.

So, we are moving fast in the virtualization space, we are moving more product in to the space which is really exciting. The market is growing but again, we’re going to face more competition and so we’re keeping our hands very close to the virtualization business and it’s been a fantastic contributor over the last year.

One last point and then I’ll turn it over to questions and that is currently we do almost zero third party financing within Quest and that part of the industry has dried up as almost all financing has and so that will not impact Quest as I know that was a hot issue for certain software companies that rely on financing their deals. Absolutely not an issue here because we do almost zero third party financing.

That’s the conclusion of my thoughts on Q4 2009 and I want to open up the call for questions but before I do that I want to let you guys know that it’s Mr. Garn’s birthday today. He’s rolling his eyes right now. It’s his birthday was well as his first earnings call which is very nice. Let’s go to questions.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from Tim Klasell – Thomas Weisel Partners.

Tim Klasell – Thomas Weisel Partners

Just a couple of questions here, the first one is to you Scott, with the currency sort of moving around and moving the numbers around I know there’s a wide range of estimates out there. Can you give us sort of a formula approach to how currency will affect both the op ex and the other income lines and which currencies we should be watching.

Scott J. Davidson

The op ex line where we’re impacted by currency is really twofold there. On the sales line in particular for our non-US subsidiaries we obviously pay our sales people and all of our expenses are in local currency but there’s a local offset because we sell product in local currency so that’s somewhat of a natural offset. Where it impacts us more on op ex than anywhere else is in certain parts of the world like Russia for example or Israel or even Canada where we have expenses that are in local currency because that is where we do a lot of our R&D but there’s not a natural offset.

A large part of the business we do with Canada actually is in US dollars. So, there’s no natural offset. Just to give you an idea in the quarter, between the revenues and the op ex the revenue impact from currency was a positive $2.2 million and the expense impact was about a -$3.2 million so about $1 million delta. That was somewhat smaller impact. Down below the line on the OI&E line, because and we’ve had this discussion on other calls, because we’re a US dollar functional company on a worldwide basis what you’re seeing is effectively the remeasurement of our balance sheets outside of the US whereby we take a rate against let’s say the AR balance or the net of the AR balance or the cash against your monetary expenses.

That net impact gets changed or effected if you will by the change in currency. To model that for you guys is very difficult because you don’t understand the balances of each of our individual entities. So, I can’t give you too much guidance on how to model that but what I can tell you is that if you look at situations as we’ve seen in the last year or so where the dollar weakened substantially on a sequential basis that’s going to have a negative impact to our OI&E line.

So, from a currency perspective, the biggest currencies you need to pay attention to as it relates to us is Pound Sterling, the Euro, the Canadian Dollar and generally to a lesser extent the Ruble and the Israeli Shekel. But, it is a hard thing to model and frankly one of the things that is on the development plan for 2009 is to try and hedge that OI&E line because they’re known exposures and the impact that we took this quarter in many cases are unrealized losses, they’re not realized so it’s an accounting exposure as opposed to an economic exposure but it does create this volatility on the quarterly basis that is somewhat difficult.

Tim Klasell – Thomas Weisel Partners

What are you sort of modeling in for the Q4 guidance?

Scott J. Davidson

When we provide the guidance we provide the guidance down to the operating income number so we’ve got it modeled internally but we’re not providing any external modeling. I think as you can see you could have a wide range of modeling if you will. I would presume given what we’ve seen at least this quarter with respect to continued weakness of the dollar, that I wouldn’t expect dramatic increases in OI&E next quarter.

The first two quarters of this year we had a positive benefit from foreign exchange to the tune of about $4.7 million so on a year-over-year basis it sort of nets out in many cases but on a quarterly basis sometimes as we saw unprecedented movements of the dollar it can impact it drastically within a quarter.

Tim Klasell – Thomas Weisel Partners

Then the next question has to go over the NetPro acquisition and just your acquisition strategy overall. That was more a consolidation if you will acquisition, different than you guys have done in the past. With prices coming down across the board for companies out there what is your M&A strategy? Should we hold the same of thinking adds around Windows and virtualization and the channel or could we see some more consolidation type acquisition?

Vincent C. Smith

Things are getting obviously cheaper from a valuation, especially in the public market. The private guys sometimes don’t realize how closely linked they are to the public valuations. They like to deny that when our valuations aren’t applying so that’s sometimes a tough sale on the private side. I don’t know if our strategy is really going to change any in that we’re not altering the way we look at companies and we’re not looking to do more consolidation plays. It hasn’t affected us yet although we do take notice and realize that companies that could be in adjacent markets thus could be more attractive at these prices, we haven’t really gotten serious on it.

Operator

Our next question comes from Kirk Materne – Bank of America Securities.

Kirk Materne – Bank of America Securities

I guess Vinnie or Scott can one of you guys talk a little bit about you mentioned Vinnie, I think heading in to next year trying to look at some of your go to market models given that you have a little bit more of a portfolio of products and other companies are a little more focused on one area. Can you talk a little bit about which of the product lines you can get perhaps a little bit better leverage out of the indirect channel with or just give us some idea in terms of what you’re thinking?

I’m assuming it’s getting better leverage out of the channel because you guys have been mostly direct. But, can you just expand on that a little bit to start.

Vincent C. Smith

I’m going to bring Doug in to this but just so you guys know we do 100% of our business with S&Bs and with the virtualization products through the channel today.

Douglas F. Garn

As well as our Windows [Geogroup], so about 10,000 users below we go through all channels.

Vincent C. Smith

So that was a commitment we made a couple of years ago and its really flourished and paid off. We have learned a lot as a company and so those businesses have been growing fast than our core business and so they become a greater percentage. In fact, it’s becoming much more meaningful. But frankly, when we’ve been fine tuning our go to market for ’09 we’ve been involving channels, we have been also fine tuning how we direct our dedicated sales force.

Douglas F. Garn

For this next year we know – in the years past Quest was not as effective from a channel perspective. Two years ago we made a huge push to again become a real player there. I think it’s begun to happen, I think we’ve begun to see a real acceptance within the channel community and next year some of the growth that we’re expecting to get in to our top line revenues side we know needs to come from increased acceptance and product being driven through the channel partners.

It’s absolutely one of my top priorities. In fact, later this month I’m going to be meeting with some of our top partners here in AV for two days and really continue to work on a strategy and some of the products are the SQL server products, Foglight actually has some channel opportunities, our identify and access management products, we’re in fact considering going almost exclusive from a channel perspective or very strongly with the channel focus where two years ago we would never even have talked about that.

Kirk Materne - Bank of America

My only follow up question is for Scott. Your maintenance revenue continues to grow as a percentage of your total revenue. I assume as we head into ’09 assuming that the top line trajectory doesn’t change dramatically, should that continue to have a relatively positive impact on your overall margin structure? Is there anything else I should be thinking about?

I realize you don’t want to give specific guidance but just directionally is there anything else we should be thinking about in terms of incremental expenses you guys want to take on? My sense would be that if that continues to grow at a faster rate it should have a positive lift on your operating margins heading into next year.

Scott J. Davidson

The economics of the maintenance revenue clearly is that it has a higher margin. In the past as we’ve attacked newer growth markets like virtualization for example, we’ve spent or we’ve invested that money as the case may be. I think what I would say is that dovetailing with some of the comments that Vinnie made earlier we’re going to be sort of judicious on the expense increases next year. Ideally you would like that to mean some more would drop to the bottom line but we’re starting to formulate the 2009 numbers as we speak right now.

As you might be aware of and we all live in this today that 2009 is a moving target given the economy so without spending into it assuming we get the revenue growth that we would like to have then that should positively impact margins. We’ll work with that and we’ll talk about that in January. But from an economic perspective you’re on target there.

Operator

Our next question comes from Derek Bingham - Goldman Sachs.

Derek Bingham - Goldman Sachs

My question is on the guidance. Obviously the macro is what it is but even that said it would look to be very conservative in terms of what you’re expecting for license growth on a sequential basis relative to what you typically see. I’m just looking for thoughts on, is that because you’re reading the papers and you want to be conservative or is there more to it that you’ve seen maybe in the last couple weeks of the September quarter or the first few weeks of this quarter that make you more concerned about lack of budget flush?

Scott J. Davidson

At the highest level looking at sequential growth quarter-to-quarter from the Q3 that we just had into Q4 could probably be a little bit cloudy because we just had a quarter where we did seven deals over $1 million which is very atypical for us. What I look at when we put together the view of the guidance was what is the year-over-year growth or the sequential growth back from ’06 to ’07 and what do we think it will be from ’07 and ’08. ’06 to ’07 the license growth was about 7% and we know what’s going on from an economic perspective today so when we set the guidance ranges for the sequential growth this quarter, the range is anywhere from a license down 9% to a license up 5%. Conceptually on a sequential basis we’d be pretty close to where we were last year sequentially albeit in a much worse environment and I think we’d be pretty happy if we got there. But we’re protecting some of our downside with the low end of the range on the guidance.

The other thing that I’ll say is that it’s important to note that in the guidance there isn’t a huge impact on the license line from NetPro in Q3. So Q3 NetPro added a total revenue impact I said of about $1.4 million. While we do expect some benefit of NetPro, it’s as I said in my opening comments that we’ve got to temper some of that guidance. I think at a 5% increase given the economy out there we feel that’s about where we should be while we also protect downside.

Derek Bingham - Goldman Sachs

Can you give any sense on NetPro and we’ve seen some numbers in terms of what kind of run rate NetPro was on I guess exiting ’07 or the beginning of this year? Do you have some sense of what we might expect as we think about modeling that out on a top line perspective?

Scott J. Davidson

Next year we’re going to talk about the overall number. The NetPro will be glued into the Windows business. We don’t want to break it out separately. We did this quarter to give you an idea. The issue for those of you who may have seen or heard NetPro historical numbers or forecasted numbers, they did not have VSOE so a lot of the revenue was structured under a pro forma revenue recognition model.

They didn’t sell a pro forma model but that’s how it had to be accounted for because of the way the deals were structured. That’s why we were only able to recognize about $1.4 million in the quarter. Without getting into what their bookings run rate is because we don’t like to talk about that, the GAAP impact was obviously significantly less than that. But it’ll be embedded into our guidance next year when we talk about it. But you can get an idea of where it was based on what we recognized in the two weeks ending this quarter.

Operator

Our next question comes from Mark Murphy - Piper Jaffray.

Mark Murphy - Piper Jaffray

Doug, the tone of your comments is a little different than what we’re hearing from most of the other software companies out there. I think typically what we’re hearing is they’re referencing a softer demand environment at the end of September and probably getting worse in October, and most of them are reducing their guidance for the year. Can you just comment on whether you’re at a point where you’re just not seeing a slowdown at this point? And to go along with that, what kind of close rate assumptions have you baked into Q4 just to try to account for the spending environment?

Scott J. Davidson

I’m going to jump in here for a second before I let Doug speak. I did just say that last year we grew sequentially 7% and now we’re expecting a range of anywhere from, this is on the license line, down 9% year-over-year to up 5%. By my math that’s a softer number. But when we talk about building expenses against that for next year it doesn’t imply anything into the ’09 number yet but what you’ve seen through the year from us is a continued management on the expense side whereby our initial margin guidance was 16% to 17%; then was 17.5% to 18.5%; and is now 17% to 18.5%.

On the expense side all we did was shear off about 50 basis points on the low end of the range and that’s due to the NetPro acquisition which was specifically after we provided guidance. I think on the whole when you look at last year’s sequential guidance and the range this year, it would imply a little bit more of a softer economy clearly than what we’ve seen in years past.

Douglas F. Garn

When we came into the last few weeks of Q3, Vinnie made the comment that in fact we did begin to see some softening in particularly in Europe, mostly in the UK but to some degree in the [DOC] region as well but not as much, our public sector business had a great quarter and they took advantage of the federal spending and it was just awesome to watch.

But then you look at the North America commercial, one of the advantages we have is even though we did do seven transactions that were over $1 million we also do a tremendous amount of our business in the $100,000 to $250,000 range which even today even in the difficult economic times, if there’s enough business value those transactions will continue to go through; at least that’s what we’re experiencing.

We did go into Q4 and we sat down with all of our sales leaders. They’re nervous just like anybody else which is I think reflected in the guidance that Scott has given. We are nervously optimistic that we can do well.

Mark Murphy - Piper Jaffray

Doug, just as a follow up, can I get your thoughts on some of the recent Microsoft announcements? They announced the launch of a Cloud-Based OS and an online platform and moving some productivity applications to an on-demand model.

I know that a lot of that is going to evolve over a very, very long-term timeframe but as you think about that technology direction and your Windows business, does it increase your opportunity by creating an environment that’s harder to manage because it’s like a hybrid architecture or does it somehow erode the management opportunity of more of the systems are being implemented and possibly managed in the cloud? How are you thinking about that with the understanding that you do have a lot of momentum in your Windows business?

Douglas F. Garn

I actually think that between Vinnie and I, Vinnie’s probably the better guy. His long-term role at Quest has really always been to look into the future. So even though I have a variety of views, they’re really not as relevant as Vinnie’s. And I just turned 50 today so I’m old and decrepit so my brain is a little useless so I’ll let Vinnie handle it.

Vincent C. Smith

I think that’s a really good question because these clouds are coming and it’s not clear what position they’re going to take in our life, whether you’re a corporate user of IT or whether you’re a home user, it’s obvious how powerful they’ve become. There are limitations in the cloud that need to be dealt with around security and going through firewalls.

So we’re working on solutions that enable you to use the cloud as well as your internal operations because we think there’s going to be a hybrid solution for a period of time, many years, where corporations will not be letting go of massive parts of their IT but they’ll be augmenting or supplementing it with the Cloud. We’re at work to build products that will enable us to work and cooperative with Cloud providers. That’s good and there’s really rich opportunities we believe there because the cost of the Clouds look on the front anyway, we may not have seen the real price of the Clouds but on the face of them they look cheap.

Overall if we all moved into the Cloud, it’s hard for us to build the business we know today in that model. So there’s real risk there. If we all moved off of Exchange and into Gmail, we’d have one guy to sell to and that would be a little bit different proposition for us. There’s that mix between the two as you indicated in your question and we’re playing for a future where Clouds are real, companies are going to make their own IT shops look more like Clouds, and they’re going to rent space from third party Clouds.

Operator

Our next question comes from Aaron Schwartz - J.P. Morgan.

Aaron Schwartz - J.P. Morgan

Scott, I had a question about the margin guidance. It looks like at the midpoint Q4 margins could be somewhere in the flattish range or even down a little bit if we look at it below the midpoint, sequential margin move from Q3 to Q4. Is that entirely NetPro, because it does seem like you took a lot of costs out of NetPro initially and I’m just wondering if this goes back to the [inaudible] you talked about with NetPro impacting the Q4 margins?

Scott J. Davidson

Yes. The guidance prior to NetPro was 17.5% to 18%. I’d say 50 basis points of that margin is primarily NetPro. The other thing is if you think about the margin guidance, we clearly had exceptional margin improvement on a sequential basis, some of which was driven by the headcount reductions we talked about it and some of it came from currency. We know that the Q4 number on the expense side for sales in particular should go up if the revenues go up on a percentage basis because of your commission costs. So that’s going to erode a little bit but you should be thinking about on the full year basis the difference primarily being NetPro.

Aaron Schwartz - J.P. Morgan

A couple of times on this call and even on the call you had earlier in the month you alluded to maybe having a slight shift in the balance of growth and profitability. I’m just wondering if you look out into ’09 and beyond, I know you’re not giving guidance around that, but do you look to manage the margin of your business at a particular revenue level or would you look to possibly adjust to manage to a particular margin level if things get a little tougher on the revenue side?

Vincent C. Smith

It’s a balance in that we’re looking to do a little bit of both. We’re looking to increase some margin next year and we’re not certain as all you guys on the call know who the heck knows what the IT purchasing climate’s going to be like in ’09. We’re trying to decide what to spend in ’09, how much to spend into it and if we don’t need target number one, do we still need target number two and what margins does that drive. That’s how we’re building our ’09 models and then from that comes our spend plan.

We’re taking a relatively conservative stance in ’09 from a growth point of view right now, which means we’re not going to be spending quickly into ’09 at first anyway and that means we’re also looking to give you a little bit more margin. Not give you but let the company generate a little bit more margin. It’s definitely a more complex situation and hard to get a feel for ’09 purchasing climate.

And the other thing is that it follows form with the question that Kirk asked before which is what do you think the mix is going to be between maintenance and license. To the extent that maintenance is a larger proportion, there’s availability there on the margin side you would expect.

Vincent C. Smith

Does that answer it? I’m not trying to be evasive.

Aaron Schwartz - J.P. Morgan

It does. I know you’re not giving guidance so it’s a little tough. I’m just wondering if your margin is predicated on a particular revenue line to where if things get tough, the margin would suffer or if things do get tough and the revenue falls a little below your initial thoughts, would you adjust to hit a particular margin target?

Vincent C. Smith

Let me answer it this way. Things have gotten incrementally tougher since we started the beginning of the year and the margins have gotten incrementally better. That’s because we moved early and we were a little bit fortunate on that, and now we’re moving early and we’re doing our ’09 planning to be able to try to let the business give a little more margin. But if we start missing our internal revenue numbers, it’s going to be hard for us to retreat quick enough on spend.

Operator

Our next question comes from Walter Pritchard - Cowen and Company.

Walter Pritchard - Cowen and Company

One question on the virtualization business and how you’re running that business. You previously run that as separate businesses as you’ve acquired some assets and I understand you’re starting to consolidate that. I’m just wondering, is that driven by a desire to put together a more holistic product strategy or is that more of eliminating redundancies in some of the overhead expenses and maybe sales expenses?

Douglas F. Garn

Today we continue to run the virtualization business separately. When you look at how Vinnie and I actually split up our responsibilities, I’m running much of the whole rest of the business and Vinnie is running the virtualization which is both the Vizioncore and the VDI on Quest so the desktop and server side.

So, we really will continue to keep it separate. We think it needs to remains separate as when you’re in a growth market like that you really want to try and treat it differently, allow it to behave differently, allow it to respond to the market differently which it has continued to do. It is an extremely successful part of our business.

Now, there are some pinnacles that are beginning to reach in to each other where we’re beginning to share some technology between our Foglight infrastructure, we’re trying to do some integrating of our backup and recovery strategies across different platforms but that doesn’t mean we’re going to integrate those different businesses. In fact, I don’t see at any point in the foreseeable future where we’ll blend in the virtualization side of the business.

Walter Pritchard - Cowen and Company

How much are you pressing there in terms of trying to get the margin of that business up a little bit? I know it’s growing phenomenally so that’s probably the priority but in terms of looking out to 2009 and maybe getting margins up a bit more, is that a significant driver of that dynamic?

Vincent C. Smith

In the virtualization business we are not driven by margin and I think it has to do with its growth profile. We think we have a really rich opportunity to grow a business rapidly so the first priority isn’t margin although we’re careful and we want to spend money wisely it’s not of the size and scale where we’d like to get really a high level margin out of it so we want to run it fast while we can while we’re smart with our spend, we don’t want to be foolish with it.

But, actually because of its growth we haven’t been having to spend the money fast enough, it’s actually throwing off a fair amount of cash which is cool. But, that begs the question if it’s growing that well are you not spending hard enough against the opportunity and so that’s the balance.

Operator

There appears to be no further questions at this time. Mr. Garn I’d like to turn the conference back over to you for any closing or additional remarks.

Douglas F. Garn

I would first of all like to thank our shareholders that have invested in Quest. I certainly would like to thank our customers, those of you who might be listening and most importantly I truly want to – I know we have a whole host of employees out there who are listening to the call and it is really exciting the quarter that we had and we truly appreciate the work that all of you have done and it’s great to have you guys a part of Quest. I’m glad you guys got to celebrate this momentums moment with me. Vinnie is rubbing his head going, “No.” Anyways thanks very much and you guys have a great day and we’ll talk to you all later.

Operator

This concludes today’s conference call. Thank you for joining and have a wonderful day.

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