Blue Coat Systems, Inc. F2Q09 (Qtr End 10/31/08) Earnings Call Transcript

Blue Coat Systems, Inc. (BCSI)

F2Q09 Earnings Call

November 25, 2008 5:00 pm ET

Executives

Dan Levy - Director of Investor Relations

Kevin Royal - Chief Financial Officer

Brian M. NeSmith - President and Chief Executive Officer

Analysts

Samuel Wilson - JMP Securities

Daniel Ives - Friedman, Billings, Ramsey

Jonathan Ruykhaver - ThinkPanmure

Erik Suppiger - Signal Hill Group

Ryan Hutchinson - Lazard Capital Markets

Rohit Chopra - Wedbush Morgan Securities

Scott Zeller - Needham & Company

Gabriel Lowy- Noble Financial

Kevin Shea - MKM Partners

Rob Owens - Pacific Crest Securities

Presentation

Operator

Welcome to second quarter fiscal year 2009 financial results conference call. (Operator instructions) I will now turn the conference over to Dan Levy, Director of Investor Relations.

Dan Levy

Good afternoon and thank you for joining us today. Kevin Royal, Blue Coat’s Senior Vice President & Chief Financial Officer, will begin today's call with an overview of financial results for the second quarter of fiscal year 2009 and the financial outlook for the Company. Brian NeSmith, Blue Coat's President and Chief Executive Officer, will then follow with his commentary and other operating highlights.

As you know, during the course of this call we will make forward-looking statements about Blue Coat Systems, Inc. and our recent acquisition of Packeteer, Inc. These include statements regarding expectations concerning market growth and business opportunities, expectations regarding future revenues, businesses, margins, tax rates, and other financial metrics, and other matters impacting Blue Coat's financial outlook and future business. All statements, other than statements of historical fact, are statements that could be deemed forward-looking statements, including any statements of expectation or belief and any statements of assumptions underlying any of the foregoing. Risks, uncertainties, and assumptions include the risks that are described from time to time in the reports filed by Blue Coat with the Securities & Exchange Commission, including but not limited to, the risks described in Blue Coat's annual report on Form 10-K for the year ended April 30, 2008, and quarterly report on Form 10-Q for the quarter ended July 31, 2008. No assurances can be given that any of the events anticipated by the forward-looking statements will transpire or occur or if any of them do what impact they will have on the results of operations or financial condition of Blue Coat. Blue Coat assumes no obligation and does not intend to update these forward-looking statements except as required by law.

Now I'll turn the call over to Kevin.

Kevin Royal

Today we are pleased to announce record net revenue of $119.0 million for the second quarter of fiscal 2009, a 16% increase compared to the net revenue of $102.5 million reported in the prior quarter, and an increase of 62% compared to net revenue of $73.4 million in the same quarter last year.

Please note that the year-ago quarterly results do not include any revenue associated with Packeteer, as the acquisition closed on June 6, 2008.

Excluding net revenue associated with the acquisition of Packeteer, net revenue for the second fiscal quarter of 2009 was $93.9 million, a 9% increase, compared to net revenue of $86.4 million reported in the prior quarter and an increase of 28% compared to net revenue of $73.4 million in the same quarter last year.

Included in the $119.0 million of net revenue is product revenue of $84.8 million, which includes sales of appliances and Blue Coat Webfilter. Product revenue in the second quarter of fiscal 2009 reflects an increase of $10.9 million compared to $73.9 million in the immediately preceding quarter. Included in product revenue is $17.0 million related to the PacketShaper product.

Now, turning to service revenue, we recognized $34.2 million in the second quarter, a $5.6 million increase over the prior quarter. Included in service revenue is $8.1 million primarily related to PacketShaper service and renewals.

Total Blue Coat Webfilter revenue was $7.8 million in the second fiscal quarter, compared to $8.7 million in the first quarter of fiscal 2009.

On a geographic basis net revenue in North America was $56.5 million, representing approximately 47% of total revenue. Net revenue in EMEA and Latin America was $42.4 million, representing approximately 36% of total revenue, and net revenue in Asia Pacific region was $20.1 million, representing approximately 17% of total revenue.

Gross margin on a non-GAAP basis increased to 76.4% in the second fiscal quarter, from 76% in the prior quarter. The increase in gross profit is primarily related to a shift in mix to higher-gross-margin products.

On a non-GAAP basis operating expenses increased approximately $4.8 million to $73.1 million in the second quarter. Included in operating expenses is $4.6 million related to integration and transition costs. As a percentage of total net revenue operating expenses decreased from 66.7 % to 61.5%.

Non-GAAP R&D expense increased approximately $1.7 million to $18.8 million in the second quarter and this increase was driven by having a full quarter of Packeteer expenses in our Q2 results.

Non-GAAP sales and marketing expense increased approximately $1.1 million to $43.2 million in the second quarter. The increase in non-GAAP sales and marketing expense was primarily due to having a full quarter of Packeteer results.

We had 121 sales teams to end the quarter, which compares to 127 at the end of Q1. This is a correction to the number previously provided of 135 at the end of our Q1. As of today, we currently have 128 sales teams on board.

Non-GAAP G&A expense in the second quarter increased approximately $2.0 million to $11.1 million in the second quarter. The increase in non-GAAP G&A expense was primarily driven by a bad debt accrual of $1.2 million as well as increased legal costs.

Non-GAAP other expense was $1.4 million in the second quarter. This compares to approximately $200,000 in our first fiscal quarter.

Given the magnitude of the recent appreciation of the U.S. dollar, re- measurement of our international subsidiary accounts, particularly in the U.K. and Euro Zone countries resulted in a larger than normal foreign exchange impact partially offset by benefits in operating expense from the payment of foreign-currency-based liabilities with a stronger U.S. dollar.

On a non-GAAP basis the company reported net income of $11.6 million, or $0.27 per diluted share in the second quarter of fiscal 2009 compared to non-GAAP net income of $6.8 million, or $0.16 per diluted share, in the prior quarter.

For purposes of calculating non-GAAP earnings per share for the quarter ended October 31, 2008, our fully diluted shares were approximately 43.6 million.

On a GAAP basis the company reported a net loss of $251,000, or $0.01 per share, in the second quarter of fiscal 2009 compared to a net loss of $5.8 million, or $0.15 per diluted share, in the prior quarter.

As a reminder, a reconciliation of non-GAAP to GAAP financial measures is included in today’s press release.

Turning to the balance sheet, we ended the quarter with cash, restricted cash, and investments of approximately $97.8 million, representing an increase of $21.5 million from the prior quarter.

Operating cash flow in the second fiscal quarter was $27.1 million compared to $5.5 million in the prior quarter. The increase in cash flow was primarily related to having a full quarter of Packeteer results in our financials as well as lower transaction costs compared to the immediately preceding quarter.

Our accounts receivable balance increased by $7.8 million during the quarter due primarily to an increase in revenue related to the Packeteer acquisition.

DSOs decreased from 58 to 56 days at the end of the second fiscal quarter.

Turning to our guidance for our third quarter of fiscal 2009, the company currently anticipates net revenue in the range of $106.0 million to $112.0 million. On a non-GAAP basis earnings per share is expected to be between $0.12 and $0.20 per diluted share. non-GAAP earnings per share excludes expense related to the write-up of acquired inventory to its assessed fair value, the amortization of intangible assets, stock-based compensation expense, and expenses associated with matters related to our stock option investigation.

On a GAAP basis, the company expects a loss between $0.03 and $0.12 per share. For planning purposes, we are using a 30% tax rate for the remainder of the year.

I would also give you an update on our Q4 operating income guidance. Due to the current economic uncertainty, we feel it is prudent to withdraw our prior guidance of 17% to 18% operating income in the fourth quarter of fiscal 2009. We are not currently issuing operating income guidance for our fiscal fourth quarter and will provide revenue and earnings per share guidance for the current quarter only.

Now, let me turn it over to Brian for his perspective on the quarter and our business going forward.

Brian M. NeSmith

Good afternoon and thank you for joining us to discuss the results of our fiscal 2009 second quarter.

I believe a large part of our success this quarter, in the face of a serious economic headwind, is enterprise IT leaders are under pressure to deliver new, advanced applications to speed organizational decision making, enhance employee productivity, and increase competitiveness.

To keep pace, companies are focusing on cost containment, increased reliance on the existing WAN for application delivery, and proactively mitigating their risk from a continuous evolving threat landscape.

These requirements align well to the core competencies of Blue Coat. Companies need to control their networks to ensure that content and applications can run optimally, while malicious exploits and unwanted applications are shut down.

The challenging business economy intensifies the need for visibility, acceleration, and security. The opportunity exists and we believe Blue Coat is uniquely positioned to capitalize on it because with Blue Coat control is yours.

Customers are responding enthusiastically to the value Blue Coat delivers with its Proxy SG and PacketShaper solutions. In the North America region this quarter we saw a strong increase in sales. We won multi-million dollar deployments with the U.S. Air Force and the U.S. Army. Another multi-million dollar deployment was at one of the largest insurance companies in the U.S., which plans to use our appliances to accelerate and secure Internet access for all of its employees and to effectively distribute video across its enterprise.

In our European region Atlas Copco, a large European manufacturing company with operations in over 80 countries, selected Blue Coat appliances to deliver important applications to its 25,000 employees located around the world.

Our Asia region had a good quarter as well, winning a notable deal with Suning Appliance Company, a large Chinese manufacturer that has deployed Blue Coat Proxy SG appliances to increase the performance of its SAP application across 700 stores and which has reduced bandwidth consumption across its WAN by 63%.

Earlier this month we announced that Sprint is offering a global managed secure WAN optimization service and managed security service based exclusively on deploying Blue Coat appliances at customer offices. In addition, British Telecomm announced a managed security and Internet acceleration service based on Blue Coat solutions. BT relies on Blue Coat appliances in its own network to secure, control, and accelerate Internet access for more than 100,000 employees. We also saw an important deployment at Telecomm New Zealand.

You should note that we achieved our success in our second fiscal quarter with fewer sales people than we had anticipated at the start of the quarter. We started Q2 with 127 teams and we ended the quarter with 121 teams. We had planned for significant growth to over 150 teams, but due to both voluntary and involuntary attrition, and lower than expected hiring, we did not achieve the sales team growth we had anticipated.

Our plan is to hire aggressively in the sales area and achieve our goal of 150 sales teams worldwide by the end of our fiscal year. Today we are at 128 sales teams.

Although we did not achieve the sales team growth this quarter, I am pleased to report that we have made significant progress with the Packeteer acquisition integration. Our sales and channel teams are now fully integrated and we are offering a new, integrated channel program to all our partners, many which are former Packeteer partners.

During Q2 we also achieved an important milestone in achieving integration between our Proxy SG and PacketShaper appliances, representing the first time a WAN optimization appliance can share traffic with, and provide visibility to, PacketShaper for additional classification and bandwidth management. The integration comes by a new software plug-in that is currently available.

As you know, our plan is to continue to offer the PacketShaper and Proxy SG products as stand-alone appliances for years to come, so creating a shared visibility of traffic with a key priority.

Shortly, we will announce the final pieces in the integration process for Packeteer and our ability to operate a single streamlined company as support contracts, price lists, and some back-end systems come together early next month.

Another milestone we achieved in Q2 was the shipping of our new Proxy Client software for accelerating files and applications to employees working at home or on the road. We have included centrally managed URL filtering and anti-mail ware and anti-phishing capabilities in the client software and we are offering this solution free of charge to our customers.

We have already seen Proxy Client serve as a decisive competitive advantage and we have won over 100 new customers with Proxy Client during the past few weeks.

During Q2 Gartner positioned Blue Coat once again in the leaders quadrant of the Secure Web Gateway Magic Quadrant. We continue to invest in the development of our security functionality and our market leadership reflects the value and uniqueness of our solution for securing, controlling, and accelerating and reducing bandwidth consumption of the connections distributed enterprises have to the Internet.

There is no doubt the economic downturn and uncertainty has created a challenging selling environment. However, our basic business fundamentals and market drivers remain sound. Because enterprises and organizations around the world must gain control of their networks, accelerate important business applications, and protect themselves from a rapidly expanding proliferation of malicious threats.

Blue Coat offers an application delivery network infrastructure that optimizes and secures the flow of information to any user on any network anywhere. Our solutions provide customers with the visibility to classify and prioritize applications, content, and user access in real time, the ability to accelerate internal, external, and real time applications across the distributor enterprise and the tools and the intelligence to secure users and information from malicious applications content and intent.

Products such as ours that offer a strong return on investment continue to sell because they provide the comprehensive application user control required to contain costs, enhance business productivity and respond quickly to changing business requirements. The application delivery network ultimately fuels a sustainable competitive advantage for our customers.

And with that, I will turn the call back over to Dan.

Dan Levy

That concludes our prepared remarks. We will now open the call for questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Samuel Wilson - JMP Securities.

Samuel Wilson - JMP Securities

Kevin, did you mention cash flow from operations, capex, and headcount?

Kevin Royal

Yes, I did mention cash flow from operations, which was about $27.0 million for the quarter. Capex for the quarter was $8.0 million and depreciation and amortization was $6.0 million.

Samuel Wilson - JMP Securities

And do you have the headcount number?

Kevin Royal

Yes, headcount was 1,278 regular full-time at the end of the second quarter and that compares with 1,276 at the end of the first quarter. We also had at the end of the second quarter 95 temporary employees and 93 at the end of the first quarter.

Samuel Wilson - JMP Securities

Brian, how strong is the federal government? You mentioned it in your prepared remarks. It sounds like it was maybe above your expectations.

And second, Packeteer did a little less revenue than you guided to three months ago. Was that simply a matter of macroeconomics or was there anything else going on there?

Brian M. NeSmith

With the federal government, I don’t think it was stronger than we expected. Usually this quarter is pretty strong in general. You look at the previous year I think we were roughly on the same order of magnitude on revenue as compared to the previous year because it’s the fiscal year end and fiscal year start for the federal government. But it was consistent with what we see on an annual basis on that segment.

As far as the Packeteer revenue, a little bit below expectations. I think the biggest driver there is probably just the amount of turnover we saw in the Packeteer sales organization has depressed that number a little bit but that’s probably the biggest factor that attributed to that.

Operator

Your next question comes from Daniel Ives - Friedman, Billings, Ramsey.

Daniel Ives - Friedman, Billings, Ramsey

With guidance for next quarter, you had a good quarter, good margins. With next quarter is it more conservatism? Is it closure rate assumptions that you are assuming? Can you walk us through how you are viewing next quarter and what you are seeing month-over-month, August, September, October.

Brian M. NeSmith

I think what a lot of people may not have grasped is how sensitive we are to the number of sales teams we have. And we saw actually a slight decrease in the number of sales teams where we had originally anticipated being up in the number of sales teams. And we are very much dependent upon those people out in the field and then generating a closing business. And we drew some attention to that this quarter.

And I think a fair amount of the reason we are seeing things sequentially down, clearly part of it is the macroeconomic environment but a big part of it is that we are also down more on the number of sales teams than we originally expected to be and that is putting some backpressure on overall revenue growth.

From a pipeline standpoint our pipeline this quarter is roughly approximately the same as what it was in the previous quarter. It is a little confusing in there because last quarter was the first quarter that we put in the Packeteer pipeline, which was not classified in the same manner that we classified it so there was some clean up there and the numbers I am not sure can be compared apples-to-apples. But effectively, in general terms, I think I would say the pipeline is probably a little better this quarter at the beginning than it was in the previous quarter.

And the biggest thing that is hurting us right now is just not having as many sales teams as I think we need to have the coverage all over the world.

Daniel Ives - Friedman, Billings, Ramsey

So closure rates next quarter, you obviously are being pretty conservative relative to ramping up those sales teams.

Brian M. NeSmith

We generally found that it takes, depending on the geography, as few as three and as many as five quarters for it to ramp to full productivity. And we lost a fair number of teams, some of them through turnover that we forced the issue and some that it was involuntary, some voluntary.

We know, no matter what, when we hire a new team, even when somebody has been hired to an existing territory, it takes them at least a couple of quarters to ramp, so we have factored that in. As we have highlighted, we finished the quarter at 121, we have hired seven teams since the beginning of the quarter and we are continuing to hire at a pretty good pace but the bulk of those hires aren’t going to contribute a lot in this quarter.

Daniel Ives - Friedman, Billings, Ramsey

Is there any change in discounting or anything that Blue Coat is doing differently in the field to get deals done or you are seeing from competitors?

Brian M. NeSmith

We haven’t changed discounting in response to any kind of competitive pressure. We did announce to our channel a change in our discount structure, which reduced our standard discount to our distribution and our reseller partners but increased the discount for deal registration, which should be a net wash of basically zero in average discount. So this is a way for us to give a partner that puts the energy into a deal, a better discount and greater protection for them to have a greater chance of winning the business.

So we decreased our average discount across all of our distributors and increased the deal discount, but the net of it was a wash. But as far as competitive pressure, no, we have not done anything in context of the environment or the competition.

Operator

Your next question comes from Jonathan Ruykhaver – ThinkPanmure.

Jonathan Ruykhaver - ThinkPanmure

The services revenue, excluding Packeteer, showed a nice acceleration on a year-over-year basis relative to the July quarter. That was even as product revenues, also if you exclude Packeteer, were showing some decelerating growth. Does that mainly reflect on timing of maintenance renewals or is there something else going on there?

Kevin Royal

I think that just reflects the continued increase in our install base, year-over-year.

Jonathan Ruykhaver - ThinkPanmure

Is there any concerted effort that has been taking place to drive renewals higher that might be having an impact?

Kevin Royal

Not really. Some years ago we started outsourcing our service renewal business and for a number of quarters, and this was a few years back, we saw a pickup in renewal rates, but I think they are fairly steady at this point.

Jonathan Ruykhaver - ThinkPanmure

You talk a lot about what sounds like growing importance of application classification. I am curious, looking at that PacketShaper technology, is there a new application. For instance, in the network security market you do hear more about the ability to classify by application and that builds policy control around that application as a more effective means to some of these network security application where there are attacks. Do you see that as a potential user case over time?

Brian M. NeSmith

I think in general, when we think about an application delivery solution, we like to highlight the visibility element. If you don’t know what is running on your network, whether it’s going across your Internet boundary or whether it’s running inside your internal wide-area network, you have no way of controlling it.

And so the PacketShaper technology allows us and affords us that ability to get much improved visibility of what’s running across that infrastructure. That visibility is applicable not only to standard enterprise applications, but also to Internet-based applications and I think it is a big deal.

And for us, I think we see a greatly expanded market in the area around monitoring and application monitoring and QoS and visibility. There is a whole segment of the market there. But it all relates back to that PacketShaper technology and the visibility it can help provide inside your infrastructure.

Jonathan Ruykhaver - ThinkPanmure

Do you have the policy control capabilities, the policy control legends, that can be used in conjunction with that application classification to really, on a fine-grained basis, prevent even more than you do today the bad and accelerate the good?

Brian M. NeSmith

The PacketShaper, its ability to provide visibility also provided the mechanisms to either slow down the traffic or block the traffic or do a variety of different things as well, inside Proxy SG. Anything that is running Web, or Web-like Proxy SG already has most of those capabilities and we didn’t need PacketShaper to provide that.

But the two combined gives you a good breadth and depth of control over what’s coming into your network and the combination of the two, not only the visibility, but obviously then be able to affect some sort of control is a big part of what the PacketShaper can provide.

Jonathan Ruykhaver - ThinkPanmure

Any update on the timing of that integrated capability with PacketShaper and Proxy SG?

Brian M. NeSmith

There will be a phase implementation. We are going to continue to enhance PacketShaper and add to that technology. I think we will be out five years from now and we will still be talking about PacketShaper sales and how much revenue we are generating on PacketShaper.

We did announce that the first step of integration, which is allowing the two products to communicate with each other so that PacketShaper had visibility into what Proxy SG was doing, which we just released a couple of months ago, but you will see through the course of calendar year 2009, those products get more and more integrated over time.

Jonathan Ruykhaver - ThinkPanmure

Kevin, other expense, $1.35 million, that was up significantly from the July quarter. Was that just because of the full quarter of interest expense on the convert?

Kevin Royal

No. In fact, it relates to our foreign currency re-measurement of our foreign subsidiary asset balances. And essentially that is offset, not entirely, but a large portion of that is offset by transaction gains, which would be classified in operating expense.

Operator

Your next question comes from Erik Suppiger - Signal Hill Group.

Erik Suppiger - Signal Hill Group

In terms of the guidance, is it reasonable for us to assume that the service revenues will continue to grow but the decline will be on the product side?

Kevin Royal

The actual service revenues, we are forecasting to be slightly up.

Erik Suppiger - Signal Hill Group

Are you still recognizing the new renewals in light of the acquisition of Packeteer? Are the renewals on the Packeteer side still generating a ramp on the service revenue or is there anything changed there?

Kevin Royal

They are generating a ramp but in relation to the entire service revenue line it is fairly slight.

Erik Suppiger - Signal Hill Group

Can you give us any sense for what kind of growth?

Kevin Royal

Yes, it is about $1.0 million, quarter-to-quarter.

Erik Suppiger - Signal Hill Group

So it was $8.1 million in the October quarter and that’s maybe $9.0 million-ish or so going forward.

Kevin Royal

Yes, for Q3.

Erik Suppiger - Signal Hill Group

And is that the rate it will be growing going after that?

Kevin Royal

In the first fiscal quarter of 2010 it should get back to more of a stable run rate, in the $11.0 million to $12.0 million range overall.

Erik Suppiger - Signal Hill Group

And if we look at the product side it sounds like the turnover was on the Packeteer sales front. Should we assume that most of the decline will come from the Packeteer PacketShaper product? Is that how we should think about it?

Brian M. NeSmith

I don’t think so. We have given quotas to the entire sales organization, so all of our sales reps are selling both PacketShaper and Proxy SG. I don’t think it’s going to be particular to any one product.

Our challenge is we just don’t have enough reps. As we highlighted, we had a little bit more turnover than we originally expected, with a slower ramp in the hiring than we originally expected and we are behind the curve on what we need to be as a combined company with the number of sales teams we have in the field.

We are going to pay a price this quarter as a result of falling short on that.

Erik Suppiger - Signal Hill Group

Do the sales reps have separate quotas for each product or is it a combined quota?

Brian M. NeSmith

It’s a combined quota.

Erik Suppiger - Signal Hill Group

And what cause that turn over in the sales reps? Was that on the Packeteer side?

Brian M. NeSmith

Mostly. It’s a little bit of where some we forced the issue, we as an organization have certain expectations about what we want reps to do and working with the channel and how we want the channel to report information and a number of the Packeteer reps didn’t necessarily want to work in that manner and were not comfortable with that and some of them quit, some of them we forced the issue with.

And we expected some of that, not quite as much as we ended up with. And we have been a little bit slower than we probably should have been in hiring back and we got caught in a situation where we are just behind, I think is the best way of putting it.

Ideally, I would have liked to have been in the 130 or 140 reps as opposed to the 121 that we ended the quarter. And you can see even now, from the end of the last quarter to today, which is roughly about three weeks, we have hired seven reps and a couple of more will start in the next week. So we are on a pretty good pace right now to catch up. The problem is every time you hire a new rep, it takes a bit before they start to have the full effect on the top line revenue.

Erik Suppiger - Signal Hill Group

Just on the Packeteer acquisition, does this change the accretion? Or in light of lower headcount is this actual comparable accretion?

Kevin Royal

I guess an update on accretion is that we have done a lot of accretions activities, integrated the Packeteer employees into Blue Coat departments and shut down some of the foreign entities so it is difficult to do the specific calculation, but we have completed all of our planned down-sizing and the revenues have been within our planned range, when you look on a combined basis. And so the Packeteer acquisition has definitely increased the profitability of the combined organization.

Erik Suppiger - Signal Hill Group

Any comments about the competition with Secure Computing in light of the acquisition with MacAfee?

Brian M. NeSmith

I haven’t really seen a change yet.

Operator

Your next question comes from Ryan Hutchinson - Lazard Capital Markets.

Ryan Hutchinson - Lazard Capital Markets

I am just trying to get a sense on guidance. Are we throwing the baby out with the bath water or how do you view it? How comfortable do you feel with the guidance you have given, just in light of the environment?

Brian M. NeSmith

We look through the pipeline, we look through the closed rates. I think a lot of the guidance is somewhat tempered by the economic environment but it’s much of matter of the fewer sales teams that we have.

That is a bigger factor than I think most people are probably getting right now and understanding on this conference call.

Ryan Hutchinson - Lazard Capital Markets

And that is my point. I am trying to figure out what’s going on there. Because it sounds, from the channel feedback, you guys have lost a lot of teams and I think everyone in the channel is trying to figure out what is going on. So just help us understand that.

Brian M. NeSmith

Like we highlighted, we have a model about how we go to market and how we work with our partners and we have been combining the Packeteer and the Blue Coat channels together and so there has been a little bit of turmoil on that front and some turnover on the part of the sales teams. And we are hiring back and in light of that I think we will be fine. But the guidance we saw down this quarter is a lot more driven off of just the reduced number of sales teams, somewhat factored by the economic environment, but a lot more driven off the reduced number of sales teams.

Ryan Hutchinson - Lazard Capital Markets

And just what is driving that?

Brian M. NeSmith

What’s driving the turnover?

Ryan Hutchinson - Lazard Capital Markets

Absolutely. I think it’s an important point this afternoon.

Brian M. NeSmith

I think, from our standpoint, any time you do an acquisition and you combine two different organizations, at times people don’t want to work in a different way or don’t want to work under the same management team, they’re just not happy with what they’re ending up with there.

Some of that reflected on the Blue Coat side, some of it reflected on the individual contributor side. I think the two combined has created a higher level of turnover than we probably originally anticipated on the field sales side.

Ryan Hutchinson - Lazard Capital Markets

Do you feel this is a cultural issue that you have on your hands?

Brian M. NeSmith

On the sales side, I think probably. Although I think the worst of it is behind us. We expected a fair amount of turnover, not quite as much as we got. And we had started looking to hire back aggressively and we just haven’t been quite as successful in that as we originally anticipated.

Ryan Hutchinson - Lazard Capital Markets

So when do you expect to remedy the situation?

Brian M. NeSmith

I think as we go into fiscal Q4 we will have substantially caught up with the hiring. We are getting good success. Roughly as we got about 2/3 of the way through last quarter we started putting a lot more attention in this area and it takes a bit of a line for the hiring machine to ramp up but it’s starting to have its effect and I think through this quarter we will continue to hire fairly aggressively and catch up and I hope by the beginning of next quarter we will be in a much more reasonable position as far as the number of sales teams.

The other aspect as well is there will be reduced churn because we will have combined our channel programs together, we will have produced an integrated price list, we will have put together an integrated channel program, and that’s a lot of changes for the channel in the organization.

The other thing that came out is we just recently completed conferences in both Europe and North America with our partners to help them and our channel partners are in the middle of digesting that information and absorbing it. So the vast majority of the change is behind us now and now we are well into the implementation phase. And I think it is fair to say we have taken a bit more of a hit than I think we originally expected on this side of things but we are in the midst of recovering from that.

Ryan Hutchinson - Lazard Capital Markets

Kevin, the expectations for hitting that operating margin target?

Kevin Royal

Actually, in my prepared remarks I mentioned that we are withdrawing the guidance we had given on the operating profit for Q4.

Ryan Hutchinson - Lazard Capital Markets

Understood, but just general sense.

Kevin Royal

For Q4?

Ryan Hutchinson - Lazard Capital Markets

No, just in terms of expectations for hitting that target over the next 12 to 18 months.

Kevin Royal

We just provide guidance in the current quarter.

Operator

Your next question comes from Rohit Chopra - Wedbush Morgan Securities.

Rohit Chopra - Wedbush Morgan Securities

Can you talk about linearity in the quarter? Was there anything different about the last quarter or the last month of the quarter?

Kevin Royal

Really no difference. In fact, it was almost exactly the same as last quarter.

Rohit Chopra - Wedbush Morgan Securities

Last quarter you were able to offer a little bit of a break out in the expense line items with Packeteer. Is there any way to that this quarter?

Kevin Royal

As far as the integration expense?

Rohit Chopra - Wedbush Morgan Securities

I think you went through some of the opex items and then you were able to call out how much was related to Packeteer.

Kevin Royal

We did that last quarter but we have really lost visibility over that with all the integration activity and combining former Packeteer employees into Blue Coat departments so we don’t have that level of detail at this point.

Brian M. NeSmith

We’re actually actively trying to integrate them so that we don’t see them as separate organizations. So if anything it is going to get increasingly more difficult to tell anything.

Rohit Chopra - Wedbush Morgan Securities

And I understand the issue with the fewer sales teams and the churn and I think you gave a good explanation about what is going on but can you give us a sense of how much of the new channel partners that you got with the Packeteer acquisition, how many are actually selling Blue Coat products? A percentage maybe.

Brian M. NeSmith

There are two different parts. So if you basically continue to think of them as Packeteer partners and Blue Coat partners, I think our main focus has been on the top 20% of the Packeteer partners, which represents a good majority of the revenue and I think almost all of them are now selling the Proxy SG products.

Last I looked, we had, out of the 2,000 or so partners, I think we had something like half of those now engaged in starting to actively sell. I don’t know the exact numbers but it is a fair number of people.

Rohit Chopra - Wedbush Morgan Securities

If you have that many more partners selling the product, isn’t there more than just not having the number of sales teams? You have added a significant number of partners who contributed the most amount of revenue for Packeteer. Is there more here behind the weakness for next quarter other than the sales team?

Brian M. NeSmith

I don’t think it is. Even with the partners, to sell a Blue Coat Proxy SG on the security side, still requires some involvement on the part of Blue Coat. Very rarely is it done completely by the channel. Security is an ever-evolving and changing landscape and there are a lot of very technical aspects to the sale that requires a Blue Coat SE or a channel partner that very literate in that area, and I wouldn’t expect a Packeteer partner that had no experience in that area at this point to really be productive.

So they can be trying to sell Blue Coat products as a former Packeteer partner, but I don’t think that we have seen a lot of revenue up tick last quarter, or even in this quarter. They are still learning.

As we go into Q4 and Q1 of next year, we will start to see some leverage out of that. But I wouldn’t expect it to be this short.

Operator

Your next question comes from Scott Zeller - Needham & Company.

Scott Zeller - Needham & Company

When you look at the groups of ours who are network-focused and those who are security-focused, the sense I was getting was that each crowd was really just trying to stick to their knitting and focus on what they know in the difficult environment. But it sounds like there has already been some big investment by Blue Coat into getting the Packeteer [inaudible] to actually sell Blue Coat. It’s different from what I was hearing. I’m hearing that people are, because of the environment, holding off. So I’m a little confused about your comments.

Brian M. NeSmith

Remember Blue Coat sells two different sets of products or sells a product to two different applications. One to the security side and one to the WAN optimization side. So it is fair to state that a fair number of the Packeteer partners are selling the Blue Coat Proxy SG but only for WAN optimization solutions.

So I think what you are highlighting is not quite as simple as that. There are some select Packeteer partners that are network-oriented that are looking to move beyond that into security. What I am highlight that is that if they are looking to do that, there is a fairly big learning curve for them to go through to be able to do that.

Scott Zeller - Needham & Company

So that is consistent with I heard, that the process is slowing a bit.

Brian M. NeSmith

But the Packeteer partners selling our WAN optimization solutions from Proxy SG is definitely occurring.

Scott Zeller - Needham & Company

That’s been going on a lot.

Brian M. NeSmith

Yes.

Scott Zeller - Needham & Company

I’m talking about those people now picking up the security side, and cash.

Brian M. NeSmith

There are some doing that, not nearly at the rate of picking up the WAN optimization solutions. And even if they are doing it, the learning curve is longer.

Scott Zeller - Needham & Company

On the question of Europe, a lot of people are asking if we are seeing softness yet. There is a lot of speculation that maybe what’s happening here would spill over to Europe. My sense is that it’s not happening yet. What sort of feedback are you getting from your channel partners?

Brian M. NeSmith

On whether Europe is softening, I would say that we have definitely seen Europe soften in the last quarter compared to the previous couple of quarters.

Scott Zeller - Needham & Company

Is there any feedback on what 2009, not guidance for Blue Coat but a sense of what your partners in Europe believe what will happen with spending?

Brian M. NeSmith

I don’t think I have heard anything unique compared to what everybody else in the industry is hearing. I think that in general we are seeing worldwide that spending is undergoing a much higher level of scrutinization and what was affecting the U.S. I think is definitely becoming a worldwide phenomenon.

Operator

Your next question comes from Gabriel Lowy- Noble Financial.

Gabriel Lowy- Noble Financial

Brian, maybe you could talk a little bit about the positioning and messaging out in the field between the PacketShaper product and the SG product and how the channel is viewing that and how they are taking it to market and maybe just give an example of the deployment, either where customer has both already or has one and might be looking at the other, or perhaps a Greenfield customer, how you go in there and sell it and who you are selling the respective products to, or are you selling it as a bundle solution?

Brian M. NeSmith

That’s a whole afternoon but let me try to jaw it down here into some simple views.

I would say that the bulk of our activity right now falls in one or two areas. In the Greenfield opportunities both PacketShaper and Proxy SG and selling Proxy SG as an upgrade to the PacketShaper install base. Those are the primary two ways that we are focusing our energy.

We still see opportunities to sell incremental PacketShaper into areas where the customers have nothing or incremental Proxy SGs where the customers have nothing. And we also see good opportunity to add Proxy SG into existing PacketShaper accounts. And in one of those two areas is where we’re putting the bulk of our energy right now.

Gabriel Lowy- Noble Financial

So PacketShaper is not really in any kind of growth mode, even though you are going to add some enhancements to it and you are saying you are going to be selling it maybe five years out. But is there any issue of cannibalization of the SG, particularly as they get all of the PacketShaper visibility loaded on board? Does that PacketShaper revenue run rate sort of maintain itself or do you start to see some erosion as the channel gets up to speed, as you hire the more sales guy, as you port the capabilities onto SG, why would customers continue or new customers want to buy the PacketShaper product?

Brian M. NeSmith

I don’t think, with all the functionality that PacketShaper has on the Proxy SG to start with, so there will always be situations where the customers want the richer set of what PacketShaper contains, especially around some of the fine-grained quality of service control in specific environments.

The broad statement you highlighted is generically true, although I think we are more than a couple of quarters away before we see that trend start to kick in. I believe in the next two to three quarters, I think we are going to continue to see PacketShaper revenue be fairly decent and probably steady at where it is right now. I don’t think it will materially change one way or another.

And even as we enhance Proxy SG with more capability, you will still see some PacketShaper sales for customers that want to continue to get some of that fine-grained control.

Gabriel Lowy- Noble Financial

Just curious from a competitive standpoint, when you look at what Rapaport is doing with their services platform, creating partnerships with the likes of Netscout and Opnet and others, within the steel heads, is there any type of go-to-market competitive issue there or basically selling two boxes versus one, in terms of what they are doing even though a lot of the licensing revenue in their case flows through to the third-party provider?

Brian M. NeSmith

If you are talking about the next couple of quarters where there are two boxes, if you are talking about a pure Greenfield situation, that would be the reality. A lot of our situations where we’re selling there, you have already got PacketShaper installed and you are incrementally adding a Proxy SG. The customer has already bought off on using the reporting tools and the management mechanisms that Packeteer had sold them as part as part of PacketShaper and we can lever selling Proxy SG into that install base.

Gabriel Lowy- Noble Financial

And then for the Proxy SG customers that don’t have PacketShaper it’s basically on upsale on the additional visibility functionality.

Brian M. NeSmith

That’s right. And as we integrate them to, I do believe long term, who gets what percentage of the margin gets to be an issue, in a platform sale.

Gabriel Lowy- Noble Financial

Cisco has done some enhancements as well recently. Have you seen any impact of that, or in general what are you seeing or feeling in the customer base on Cisco, both in terms of the product enhancements as well as anything they are doing on pricing that is different?

Brian M. NeSmith

I haven’t seen anything on the pricing side. In the WAN optimization part of things, I haven’t seen any change in pricing. They are with their security product, on selected cases, discounting very heavily in the security product that they have that competes with our security gateway business.

As far as functionality, the latest WAN optimization release, I haven’t really seen much of a change competitively.

Operator

Your next question comes from Kevin Shea - MKM Partners.

Kevin Shea - MKM Partners

Just wondering with your guidance, do you expect stronger deterioration in the United States or EMEA, meaning where your sales teams seem to be dealing with the strongest headwinds?

Also just wondering if there were any incentives that pulls revenue forward into the October quarter, which might have helped soften your guidance for next quarter?

Brian M. NeSmith

The second part is easy to answer since we didn’t do anything special as far as incentives that would have pulled revenue from one quarter to another.

I think in general, what was infecting the U.S. in the summer of last year now is a worldwide challenge. So I expect we are generally going to see softness across all three regions.

Operator

Your next question comes from Rob Owens - Pacific Crest Securities.

Rob Owens - Pacific Crest Securities

Just to be clear, you just said to expect softness across all three regions, yet primarily your guide down is a function of sales teams, so you are not expecting any deterioration in the close rate this quarter.

So if there is any material deterioration in the close rate, how much would it take for the quarter to be at risk?

Brian M. NeSmith

We did factor the close rate down a bit so it wasn’t just the reduction in sales teams, although I think that was the larger factor. We did build in a little bit of deterioration in the close rate overall in the number there. So we definitely feel there is some impact from the macro economic conditions in that.

Exactly how much of a deterioration? I couldn’t tell you exactly. Obviously if it continues to go south further than what we expected we would end up at the lower end of our guidance. We gave a fairly wide range in guidance. I think that reflects some of the uncertainty that we see associated with the close rate. That range of guidance is wider than I think we have done in a very long time so that probably gives you some sense that we do have some uncertainty there.

Rob Owens - Pacific Crest Securities

Can you help us understand how November started out, relative to how you closed October?

Brian M. NeSmith

No, we can’t. We will tell you what we did as of the end of last quarter but we don’t normally give in-quarter updates.

Rob Owens - Pacific Crest Securities

With regard to some of your sales turnover, was that across all geos?

Brian M. NeSmith

Actually, I think it was a little more heavily weighted to North America and to Europe, on the Packeteer side of things.

Rob Owens - Pacific Crest Securities

So if I look at the fact that your international revenues, both in Asia Pacific and EMEA Latin America are flat sequentially, is that more a function of this turnover or more a function of what you are seeing in those geos from an economic standpoint?

Because this was the first full quarter of Packeteer so I guess I would have expected a little bit of improvement sequentially.

Brian M. NeSmith

I think it’s probably a little bit of both. But I think it’s probably more related to we just needed more sales teams out there. We don’t have the coverage that we should have around the world. 121 sales teams at the end of the quarter when we should have been closer to 140, and 19 sales teams at full productivity is a lot of revenue. So we’re definitely hurt by that.

Rob Owens - Pacific Crest Securities

Have you in any way slowed your hiring as a function of this environment or are you full speed ahead?

Brian M. NeSmith

I think it is fair to state over the last three months we have put almost every spending category under a much higher level of scrutiny than we have historically for a long time, including hiring. Anything to do with any kind of significant capital spending, anything that consumes a lot of cash. We are moving very strongly to continue hiring the number of sales teams back and we are making selective investments in certain parts of R&D and certain parts of support. But across other functions we have, in certain cases, pulled back.

But it’s not a simple not hire, it’s selectively invest and it is subjective to a much higher level of scrutiny is the best way of putting it.

Operator

Your last question comes from Ryan Hutchinson - Lazard Capital Markets.

Ryan Hutchinson - Lazard Capital Markets

I don’t mean to beat a dead horse but I’m having trouble trying to figure out why it is so tough to hire sales teams in a recession, why it has been difficult for you to hire sales teams. Or do you feel like you have back-filled the whole situation and you feel comfortable with that?

Brian M. NeSmith

I don’t think it is especially tough. I think that we expected some turnover and we got more than we expected and we fell behind in the hiring. I think we didn’t give it as much attention as it probably deserved. I don’t think it’s particularly tough. I didn’t mean to leave you that impression. I don’t think it is. I think we just didn’t give it all the attention it probably deserved and we are definitely behind where we should have been.

Operator

There are no further questions.

Dan Levy

We would like to thank you for joining us on today’s call. A replay of the call will be available at 320-365-3844, pass code 968268 beginning Tuesday, November 25, 2008, at 7:00 pm ET. An audio archive will also be available on our website.

Operator

This concludes today’s conference call.

Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited.

THE INFORMATION CONTAINED HERE IS A TEXTUAL REPRESENTATION OF THE APPLICABLE COMPANY'S CONFERENCE CALL, CONFERENCE PRESENTATION OR OTHER AUDIO PRESENTATION, AND WHILE EFFORTS ARE MADE TO PROVIDE AN ACCURATE TRANSCRIPTION, THERE MAY BE MATERIAL ERRORS, OMISSIONS, OR INACCURACIES IN THE REPORTING OF THE SUBSTANCE OF THE AUDIO PRESENTATIONS. IN NO WAY DOES SEEKING ALPHA ASSUME ANY RESPONSIBILITY FOR ANY INVESTMENT OR OTHER DECISIONS MADE BASED UPON THE INFORMATION PROVIDED ON THIS WEB SITE OR IN ANY TRANSCRIPT. USERS ARE ADVISED TO REVIEW THE APPLICABLE COMPANY'S AUDIO PRESENTATION ITSELF AND THE APPLICABLE COMPANY'S SEC FILINGS BEFORE MAKING ANY INVESTMENT OR OTHER DECISIONS.

If you have any additional questions about our online transcripts, please contact us at: [e-mail]. Thank you!