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McAfee, Inc. (MFE)

Q1 2006 Earnings Conference Call

April 27 2006, 4:30 PM EST

Executives

Kelsey Doherty - Senior Director of Investor Relations

George Samenuk - Chairman of the Board and CEO

Eric Brown - COO and CFO

Kevin Weiss - President

Bill Kerrigan - EVP of Consumer

Analysts

Ed Maguire - Merrill Lynch

John DiFucci - Bear Stearns

Gregg Moskowitz - Susquehanna Financial Group

Daniel Ives - Friedman, Billings, Ramsey

Todd Raker - Deutsche Bank

Walter Pritchard - Cowen and Company

Michael Turits - Prudential Equity Group

Horacio Zambrano - Wedbush Morgan Securities

Chris Hovis - Morgan Keegan

Robert Stimson - WR Hambrecht

Brian Markovich - Morgan Stanley

Sarah Friar - Goldman Sachs

Georgy Grigoriyants - Thomas Weisel Partners

Gene Munster - Piper Jaffray

Kevin Buttigieg - AG Edwards

Katherine Egbert - Jefferies & Co.

Presentation

Operator

Hello. Welcome and thank you for holding for today's teleconference. I would like to hand the call over to Ms. Kelsey Doherty, Senior Director of Investor Relations at McAfee. Ma'am, you may begin.

Kelsey Doherty

Good afternoon and thank you for joining us. Today, we will be discussing our earnings results for the first quarter of 2006. With me are George Samenuk, our Chairman and Chief Executive Officer; and Eric Brown, our Chief Operating Officer and Chief Financial Officer. Kevin Weiss, our President, and Bill Kerrigan, our Executive Vice President of Consumer, are also here and available to answer questions during the Q&A portion of the call.

Please note that today's conference call is being recorded and will be available for replay on McAfee's Investor Relations homepage, at investor.mcafee.com. I ask for your attention, while I review some cautionary language, and then I will pass the call over to George and Eric.

This conference call, including the question-and-answer session, may contain forward-looking statements. These statements include those regarding future operating margins and operating expense expectations; revenue and earnings guidance for the second quarter and full year 2006; expected revenue realization rates, new and future product introductions and shipments and the revenue opportunity associated with them; future partner opportunities; the success of McAfee's multi-channel multi-partner distribution strategy; future subscriber and market growth expectations; our expectations with respect to SiteAdvisor and other measures that may project future enterprise, SMB and consumer results.

Forward-looking statements are based on management's current expectations and are subject to risks and uncertainties, including that McAfee may not achieve its planned revenue realization rates; succeed in its efforts to grow its business; build upon its technology leadership; or capture market share; that the Company may not benefit from its strategic alliances or partnerships, as anticipated; that customers may not respond as favorably as anticipated to the Company's product or technical support offerings; or that the Company may not satisfactorily anticipate or meet its customers' needs or expectations.

In addition, a number of operational and other factors from new product introductions, the mix of products and services sold, the size of deals closed in the quarter; the amount of revenue deferred in the quarter; the charges we may take for acquisitions or dispositions; the competition we face in the market; to the greater macroeconomic environment; to name a few, may cause our revenues, gross margins and operating results to fluctuate significantly from period to period.

We caution listeners that actual results may vary, perhaps materially, from the forward-looking statements referenced in this call, including any forward-looking statements made during the question-and-answer session. We encourage listeners to review the Company's filings with the Securities and Exchange Commission, including the Company's 2005 10-K, filed March 1, 2006, for more detailed information on the risks and the uncertainties related to the Company and its business.

I also would like to note that for your reference we have provided supplementary financial analysis included breakouts of net revenue and bookings into product groups, year-over-year and sequential growth rates, and other financial metrics. You can find this supplementary information in our earnings press release and on our Investor Relations website. A pro forma to GAAP reconciliation of the first quarter financial numbers discussed in this conference call is attached to the press release issued by the Company this afternoon.

I will now turn the call over to our Chairman and Chief Executive Officer, George Samenuk.

George Samenuk

Good afternoon and thank you all for joining us today. I am very pleased to report that McAfee had a great first quarter. We continue to see double-digit year-over-year bookings growth, which is driving strong company results and record high deferred revenue balances.

McAfee's net revenue for the first quarter was $272 million, representing 16% growth year-over-year, excluding divested Labs business. Year-over-year revenue grew in every region; 8% in North America, 31% in Europe, 14% in Asia Pacific, 26% in Japan, and 35% in Latin America.

GAAP net income was $41 million for the first quarter or $0.25 per share. Pro forma net income was $62 million, representing 35% growth in net income year-over-year. Pro forma earnings per share were $0.37, growing 37% year-over-year.

Bookings in the first quarter were $318 million, representing 13% growth year-over-year. Bookings were up across every region. The breakdown of the first quarter bookings was 56% for North America and 44% for the rest of the world.

During the first quarter, we closed 231 deals over $100,000; including 15 deals over $500,000 and one deal over $1 million.

Revenue from our corporate business was $160 million, up 14% year-over-year, excluding the divested McAfee Labs business. As we mentioned during our fourth quarter 2005 earnings call, we will be reporting combined corporate revenue for both SMB and large enterprises businesses on an ongoing basis.

Bookings for McAfee's large enterprise business were $91 million, growing 12% year-over-year. In particular, this quarter we saw solid demand for our intrusion prevention and risk management solutions. We also now have more than 45 million customer desktops managed by our McAfee ePolicy Orchestrator Console.

2006 has already been an exciting product year for McAfee. Since our last conference call, we have launched three new security solutions, which are being favorably received by customers, partners and industry analysts.

In February, we introduced our first network access control product, Policy Enforcer. This product delivers an enterprise-ready approach to mitigating risks to corporate assets caused by non-compliant endpoint systems. While it is very early in the sales cycle, customer interest is high. Early adopters include Excel, a UK-based global supply chain management and global forwarding company, which purchased McAfee Policy Enforcer in combination with VirusScan.

Two weeks ago, we brought to market IntruShield 3.1, the industry's most comprehensive and proven intrusion prevention solution, along with its new IntruShield Security Manager Appliance, a powerful pre-configured appliance that manages IntruShield deployments. With this product, McAfee maintains its market leadership providing a proven network intrusion prevention solution that delivers simplified management and expanded coverage in addition to its renowned zero-day protection.

At the beginning of April, we launched McAfee Total Protection Solution, or TOPS, offering the industry's most comprehensive and integrated security solution for corporate customers around the world. This is an industry first; true integration of critical security capabilities managed through a single console, designed to reduce the complexity and cost of security management.

While our competitors offer a similar solution through multiple point products, no other company offers the integrated capabilities of anti-virus, anti-spyware, anti-spam, host intrusion prevention, centralized policy management and network access control.

In today's security world, it's not unusual for some large enterprises to have in excess of 50 different security products installed in their environment. With TOPS, customers will save money and time by deploying a single security agent and managing their environment with a single console. We believe that TOPS represents the most compelling value proposition in the market today for our customers.

It has been just one year since we introduced McAfee's award-winning Enterprise AntiSpyware. Demand for the product, which is developed completely in-house with a nominal investment, continues to show strength in the marketplace. Two customers who purchased AntiSpyware this quarter, were a leading UK financial services company, which bought AntiSpyware in combination with VirusScan and Host Intrusion Prevention solutions; and, the Dutch Ministry of Transport, Public Works and Water Management, which bought both AntiSpyware and VirusScan.

In enterprises, where installed McAfee security solutions are coming up for support renewal, we are continuing to see customers purchase additional security products from us during the renewal process. This underscores that our strategy of creating and supporting best-of-breed security technologies integrated through our ePolicy Orchestrator is resonating with McAfee customers.

Among those who renewed support agreements and chose to deploy additional security technologies in the first quarter were:

  • Goldman Sachs, which chose Foundstone services to complement its current deployment of McAfee products;
  • JCPenney, which purchased AntiSpyware in combination with additional nodes of VirusScan;
  • The European Commission, which added AntiSpyware as well as additional nodes of VirusScan; and
  • Time Warner Cable, which purchased IntruShield to supplement its current installations.

Bookings from McAfee's SMB business were $78 million, growing 3% year-over-year. Transforming McAfee from its direct sales legacy to a channel focused and partnered-driven organization is the work of hundreds of people inside of McAfee. Over the last 2.5 years, we have been building a global network of partners in our security alliance, rebuilding our IT systems to support the partner community and delivering products with the needs of the small and medium-sized business customers in mind. We are happy with our progress and pleased to announce that the partner community has acknowledged us as well.

In the first quarter, McAfee received Computer Reseller News' highest recognition, Channel Champion. As a Channel Champion, McAfee received top marks on a technical basis for reliability, scalability, price and performance; while on the channel category, we were measured on our responsiveness to the channel, our training, partner programs and the ability for our partners to build a business around our products.

Just this month, McAfee was recognized by CMP Media's VAR Business Magazine as a certified Five-Star Partner, acknowledging our commitment to programs for IT integrators, resellers and consultants. Resellers worldwide see the value that can be delivered through a partnership with McAfee, including our new Total Protection Solutions for small and medium-sized businesses. The McAfee team will continue to work to drive results in this very important segment.

Our consumer business continues to deliver double-digit growth. Revenue from our consumer business was $112 million, up 20% year-over-year. Overall consumer bookings in the first quarter were $148 million and grew 20% year-over-year. Retail bookings were $18 million, down 19% year-over-year. The decrease in retail bookings is consistent with the weakness seen in this segment as many consumers are migrating to online delivery for their security needs.

Our online partner-driven strategy of delivering security as a service drove results again this quarter. Online consumer revenue was $98 million, up 30% year-over-year. Online consumer bookings were $130 million, up 29% year-over-year. This is the 10th quarter in a row where we have seen year-over-year revenue and bookings growth in our online business of more than 25%.

McAfee has been offering security as a service online for seven years. And we are the proven leaders providing daily updates and version-less software to users worldwide. Our subscriber base continues to grow. We added 1.9 million net new subscribers during the first quarter, bringing our total number of online subscribers to 19.2 million. As of March 31st, subscriptions per subscriber were 1.69, illustrating that consumers continue to purchase multiple layers of security in today's evolving threat environment.

And we're pleased to have purchased SiteAdvisor and its talented group of employees and patent-cutting technology are already being recognized by industry analysts and the press and adopted by consumers around the world. SiteAdvisor fundamentally changes the relationship with McAfee and its consumers.

Online safety is evolving from traditional, technically-driven threat to a new class of social engineering, including adware, spyware, spam, identity theft and other scams. Making the Internet experience safe is one of McAfee's top priorities. We believe with SiteAdvisor, McAfee is very well-positioned to address this important need.

McAfee's SiteAdvisor subscribers will be alerted to adware, spam and online scams before they become a problem, so consumers stay safe as they search, browse and transact online. In creating the most comprehensive site reputation score in the market, SiteAdvisor has already tested sites representing 95% of the web traffic, downloaded more than 725,000 pieces of software and submitted e-mail addresses to more than 2.5 million sites using patent-pending web crawlers and automated testing infrastructure. This acquisition positions McAfee to become the security product consumers need for a safe internet experience.

This is just the beginning. We see many of application opportunities for this product, which we will be discussing further at our Analyst Day on June 6th. You'll be able to meet the CEO of SiteAdvisor that day also.

Now, I'd like to provide you an update on several strategic first quarter partnership developments. Our relationship with Dell continues to be strong. Beginning on February 1st through April 30, 2006, McAfee has default status with Dell, meaning that all Dell computers in North America will automatically ship with a 90-day free trial of McAfee security products, if a user chooses not to buy security products at the point of sale. From May 1st through July 31, 2006, McAfee will move to global status as both Dell-recommended and Dell-default.

In Germany, Web.de, the country's second-largest Internet portal will be offering McAfee Security products to its web, Internet access and e-mail customers and will be using McAfee to scan e- mail traffic. Web.de now reaches one in three German Internet users.

In India, one of the leading private-sector providers of telecommunications services will bundle McAfee Security products for their broadband customers. Their current Internet access customer base exceeds 1.2 million and is growing rapidly.

Finally, TRENDnet, one of the largest and fastest-growing privately owned networking companies will bundle a 30-day trial of McAfee Internet Suite with their wireless routers. They are estimated to ship 1.2 million units this year.

Strategic partnerships are essential to executing our strategy. These arrangements allow McAfee to extend their reach into geographies and unpenetrated markets, capturing customers that we would not have acquired through a traditional consumer product delivery.

In addition to our strategic partnerships, we have expanded our reach into seven new countries with localize language products this quarter, including China, Korea, and Eastern Europe, as the demand for our products continues to grow on a global basis.

We are applying a similar business strategy in our mobile business, making us the market leader. During the first quarter, we reduced McAfee VirusScanMobile as an aftermarket solution available on our website. This is the only security product designed from the ground up for mobile protection. A yearlong subscription for the service is $29.99.

Today McAfee announced Cingular, the largest wireless company in the United States, is teaming up with McAfee to offer mobile securities solutions for the Symbian Series 60, Microsoft Windows Mobile smart phone and pocket PC wireless devices. Customers will be able to purchase a one-year subscription through Cingular.

McAfee is well positioned to meet the needs of device manufacturers, operators, the enterprise market and end-users. We currently support more than 100 mobile devices that are in the hands of over 25 million consumers worldwide, far exceeding the aggregate deployments of all competitors combined in the market.

Now, I'll pass the call over to Eric to go over the financial results in more detail.

Eric Brown

Thank you, George. First quarter consolidated net revenue was $272 million. Q1 2006 revenue for McAfee increased by 16% versus the $234 million reported in Q1 2005. Please note that our first quarter of 2005 comparables exclude $1.7 million in revenue from the divested Labs business.

North American revenue of $151 million accounted for 55% of first quarter 2006 revenue compared to 59% in Q1 of 2005. International revenue of $121 million accounted for 45% of first quarter of 2006 revenue compared to 41% in Q1 of 2005.

On a GAAP basis, Q1 2006 net income was $41 million or $0.25 per share on a diluted basis compared to $36 million or $0.21 per share on a diluted basis in Q1 of 2005. Pro forma net income for the first quarter was $62 million, an increase of 35% over Q1 2005 pro forma net income of $46 million. Pro forma earnings per share for the first quarter of 2006 were $0.37, growing 37% year-over-year.

During the quarter, we saw year-over-year growth across all geographies for most product lines and a stable pricing environment. Bookings for Q1 2006 were $318 million, an increase of 13% over Q1 of 2005. We continue to spend money to align our marketing and sales efforts with those of our partners both in the consumer and SMB channels.

Funding for these programs is accounted for as contra revenue, not operating expense and comes directly off of top line revenue. Examples of contra revenue include rebates, market development funds, co-funded marketing and promotional programs. This type of spending is very typical for a channel centric company, and we will continue to make strategic investments in partnerships where the investment returns are attractive and we can drive results.

As many of you are aware, deals that included Foundstone during Q4 2005 were treated as ratable with no upfront revenue component because we had not yet established VSOE or vendor-specific objective evidence for the maintenance components of Foundstone, We are pleased to report that at the end of Q1 of 2006 we have established all VSOE for Foundstone.

Pro forma gross margins for the quarter were 85%, an increase over Q4 2005, which were 81%. During Q1, we successfully addressed the expense overruns in our European free fulfillment and logistics operations, which we noted in our Q4 of 2005 call. These adjustments resulted in cost improvements in EMEA, where we will continue to look for additional savings opportunities.

Total pro forma operating expenses were $159 million or 59% of revenue in the first quarter of 2006 compared to 61% in the first quarter of 2005. Pro forma sales and marketing expenses were $80 million or 29% of net revenue, representing a dollar increase of approximately $5 million from the fourth quarter of 2005. This sequential increase in expense is associated with ongoing investment in channel-related sales personnel as we continue to focus on our partner driven strategy.

Pro forma research and development costs were $47 million or 17% of net revenue representing a slight increase from the fourth quarter of 2005. We continue to make investments in research and development worldwide to keep McAfee the security technology leader. One example of the benefit of our investments in R&D is our patent portfolio. We added 15 patents in the first quarter bringing our total to 199 patents.

Pro forma G&A expenses were $32 million or 12% of net revenue. This was consistent with our expected guidance range of 11% to 13% heading into the quarter. Operating expenses for the quarter were at the low end of our expectations on an absolute dollar basis, with total operating expense increasing by $7 million sequentially.

Our pro forma operating margin for Q1 2006 was 26.6%, slightly exceeding our expectations of 24% to 26% and higher than the 24% we reported in Q1 2005. Other income for the quarter was $11.9 million compared to $4.3 million in Q1 2005 and $7.4 million in Q4 2005 reflecting year-over-year increased cash balances, improved cash management, and improved foreign exchange strategies.

Total head count at the end of the first quarter of 2006 was 3,464 an increase of 174 employees versus the 3,290 reported at the end of Q4 2005. DSO for Q1 2006 were 41 days, a reduction of 15 days versus the prior year quarter as we collected cash from the fourth quarter of 2005 receivables.

As previously announced, the company's pro forma tax rate increased to 27% in Q1 2006 compared to 25% in Q1 2005.

Deferred revenue was $776 million at the end of Q1 2006, another all-time high for McAfee. Short-term deferred grew by $28 million to end the quarter at $599 million and long-term deferred grew by $2 million to end the quarter at $177 million.

We ended the first quarter with cash, cash equivalents, and investments of $1.138 billion, a net decrease of $119 million compared to the fourth quarter balance of $1.257 billion. This fourth quarter balance excluded the restricted cash set aside for the settlement with the SEC.

During the quarter, we generated approximately $48 million in cash from operations on a GAAP basis. Please note our first quarter 2006 GAAP operating cash flow was negatively impacted by a one-time, non-recurring $50 million payment to the SEC. On the cash flow statement, the SEC settlement is accounted for as a cash outflow from operating activities and a cash inflow from investing activities.

On a normalized basis, operating cash flow for the quarter was $98 million. The cash flow summary breakdown is as follows: First, starting with GAAP net income of $41 million, we add $15 million for depreciation and amortization; we had $14 million of non-cash adjustments to reconcile to net income, including deferred taxes, stock comp and other; and we subtract $22 million for changes in working capital, deferred revenue, and other items, which includes a one-time nonrecurring payment of $50 million to the SEC. This nets out to a total of approximately $48 million in GAAP operating cash flow.

Below the operating cash flow line, we used $230 million for purchases of common stock. We generated $18 million in cash from stock options exercises and issuance of stock under the ESPP plan. We generated an additional $3 million from other items and we used $10.2 million for capital spending in the first quarter.

Cash flow generation is a significant metric in McAfee's overall financial profile. For the trailing 12 months ended March 31, 2006, McAfee generated approximately $367 million of GAAP operating cash flow or $417 million on a normalized basis excluding the SEC settlement. We spent $30 million in trailing 12 months CapEx which translates to an annualized free cash flow of $337 million or $387 million on a normalized basis.

As of April 20, 2006, McAfee had an enterprise value of approximately $2.9 billion. This implies that McAfee is trading at an EV to free cash flow multiple of approximately 8.5X or 7.4X on a normalized basis.

McAfee completed its outstanding share repurchase program during the first quarter of 2006, spending the remaining $230 million outstanding authorization and buying approximately 9.6 million shares. I'm pleased to announce that our Board of Directors authorized a new share repurchase program, allowing the company to spend up to $250 million in share repurchases through October 25, 2007.

In anticipation of questions regarding our SiteAdvisor purchase, the total purchase price was $70 million, consisting of approximately $61 million of cash payments to former SiteAdvisor shareholders, and $9 million of contingent cash payments to certain individuals over the next two years. Please note that this is a Q2 transaction and is not reflected in our Q1 financial statements.

Metrics. Now, some comments on expected changes to our metrics and first quarter of 2006 10-Q presentation. As previously noted, one to ten node transactions will now be reported in SMB bookings, not consumer. In addition, we will no longer break out SMB revenue, but will report SMB and enterprise revenue as corporate revenue. Details are posted to the Investor Relations portion of our website under quarterly results. We will continue to provide enterprise and SMB bookings metrics through the end of 2006.

Finally, we will be expanding the revenue and cost of goods sold line item presentations in our first quarter 10-Q income statement from two line items into three line items. The three line items for revenue and cost of goods sold will be reported as: product, which consists of hardware and perpetual licenses; subscriptions, which consists of subscription-based offerings; and service and support, which consists of maintenance, consulting, and training. We believe this new presentation is consistent with the way we currently manage our business as we look to grow the subscription component of both our corporate and consumer businesses.

Guidance. The following updated guidance replaces and supersedes any previous guidance with respect to future periods and is valid as of today only. I would like to remind listeners that guidance is based upon management's current expectations and that actual results may vary, perhaps materially, from those results anticipated in this guidance.

For the second quarter of 2006, we expect net revenue between $260 million to $280 million. We expect that our pro forma gross profit margins will be in the 83% to 86% range.

We expect second quarter pro forma earnings per share between $0.27 and $0.32 per share on a diluted basis and a pro forma operating income margin of approximately 21% to 23%. We expect our diluted share count to range between 161 million and 163 million diluted shares in the second quarter. We assume a pro forma tax rate of 27% for the second quarter of 2006.

On a pro forma basis for the second quarter of 2006, we're expecting the following in terms of operating expenses: G&A expenses to range from 11% to 13% of revenue; R&D expenses to range from 18% to 20% of revenue; sales and marketing expenses to range from 31% to 33% of revenue.

We are updating financial guidance for the full year 2006. We expect 2006 full-year net revenue to range between approximately $1.050 billion and $1.150 billion. We expect that our pro forma gross profit margins will be in the 81% to 83% range.

Excluding, among other items stock-based compensation expense under FAS 123R, we expect pro forma EPS to range between approximately $1.25 and $1.40 per diluted share. This EPS range assumes a higher full year 2006 pro forma tax rate of 27% and an average of approximately 163 million to 165 million diluted shares for the full year of 2006.

We expect full year pro forma operating income margin to range between 22% and 24%. On a pro forma basis for the full year of 2006, we're expecting the following in terms of operating expenses: G&A expenses to range from 10% to 14% of revenue; R&D expenses to range from 15% to 19% of revenue; sales and marketing expenses to range from 28% to 32% of revenue.

Guidance under FAS 123-R. Our current best estimate for pre-tax stock compensation charges under FAS 123-R is a total 2006 expense ranging from $56 million to $60 million This takes into account existing year end 2005 equity instruments and estimated net new issuance in 2006.

I will now turn the call over to George to conclude.

George Samenuk

Thanks, Eric. McAfee had a great start to 2006. We grew bookings 13%, revenue 16%, and pro forma earnings per shares 37% year-over-year. We completed our share repurchase program, spending $230 million. We launched TOPS for small, medium and enterprise customers delivering an integrated solution with unmatched functionality and a compelling value proposition to the market.

Finally, we purchased SiteAdvisor, bringing this next generation technology into the McAfee product line. The McAfee team is excited about 2006. We look forward to the upcoming opportunities and challenges as we focus on execution in the second quarter and the rest of the year.

Thank you and we look forward to your questions.

Kelsey Doherty

Before the operator polls for questions I would like to inform you that McAfee will be presenting at the JP Morgan conference in San Francisco on May 23; the Friedman Billings Ramsey conference in New York on May 31; the SG Cowen conference in New York on June 1; and the Wachovia conference in Nantucket on June 27. Additionally, our annual meeting of shareholders will be held May 25 at the Hilton Hotel in New York City.

Finally, we would like to remind you all that our 2006 Analyst Day will be held on June 6 in New York. Invitations were sent out earlier this week and we look forward to seeing you there.

Operator, you may now poll for questions.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from Gregg Moskowitz -Susquehanna Financial Group.

Gregg Moskowitz - Susquehanna Financial Group

Okay. Thanks very much and congratulations on a good quarter, gentlemen. Corporate revenues certainly were strong. I realized maybe some of that carried over from revenue not recognized in Q4 due to Foundstone and a lack of VSOE, but still an impressive revenue number nonetheless.

Can you comment on the nature of that strength was it enterprise or SMB? Also, if you can you address what you're seeing from a macro perspective in security spending in light of the weakness reported by some of your peers?

Eric Brown

In regards to the first portion of the question, just to be clear on Foundstone, anything that was deferred at the end of last year is still rolling off in a ratable fashion. The fact that we've established VSOE for Foundstone Q1 2006 means that it's just a prospective benefit. So there is no catch-up benefit in regard to previous deferred accelerated forward into the P&L. Could you repeat the second half of your question, please?

George Samenuk

It was on the economic conditions. What are you seeing out there? Certainly, we're seeing strength in McAfee. We saw many of our security competitors and other security vendors not have a good first quarter. We saw the strongest start probably I have seen my six years at McAfee in first quarter of 2006. So we are seeing pretty darn good spending and customers going to our very innovative products; products that continue to get better every quarter by Christopher Bolin and our great engineering team on a worldwide basis.

There was one final question on the revenue breakdown between corporate and SMB. We don't break that out. Next question, please.

Operator

Our next question comes from Daniel Ives - Friedman Billings Ramsey.

Daniel Ives - Friedman Billings Ramsey

Congrats on the quarter. Can you talk about the IPS market specifically, how you see the market maturing and reception you're getting on McAfee products? Thanks.

Kevin Weiss

Hi, this is Kevin Weiss. The projections for the IPS market were that it was going to start to slow down, but that's not what we're seeing. In fact we're seeing continued growth in new customers acquiring IPS solutions from McAfee. We continue to see the same people out there in the marketplace between 3Com, ISS, and McAfee. We see this as a market that will not start to die off, but we see it, in fact, as having some legs here for the foreseeable future.

Daniel Ives - Friedman Billings Ramsey

Thank you.

Operator

Our next question comes from Todd Raker - Deutsche Bank.

Todd Raker - Deutsche Bank

Hi guys nice job in the quarter. I was hoping you would give us a little more insight in terms of guidance. Significant decline in operating margins projected here for Q2. Can you just quantify headcount additions, where are you guys spending incremental money and how much of this is you guys just being conservative and keeping the bar low?

Eric Brown

Hi. This is Eric Brown. Our thinking in regards to Q2 is as follows. As you know, we had results other than what we would have expected in the fourth quarter of 2005. So as we opened the year, we were bit more cautious in terms of adding headcount and additional expense.

As we look to Q2, our confidence level is higher. We are continuing to add headcount in sales, quota-bearing personnel. We are also expanding headcount in our Bangalore-based research facility, that's worked out extremely well for us. We are also looking to spend more in terms of channel programs in terms of our promotions, contra revenues, et cetera. So the contour of the profiles in terms of operating expense, it changes a bit as we move out of Q1 into the second quarter.

Todd Raker - Deutsche Bank

Thank you.

Operator

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

Walter Pritchard - Cowen and Co.

Great. Thanks. Eric I was wondering if you could simply address gross margins. It looks like you're projecting them to come down here in the second quarter. I know it sounds like you go back on at Dell. Maybe that's part of it. If you could walk us through why you are looking for gross margin pressure after you seemed to snap back from the issues you had in Q4.

Eric Brown

Yes. What we have seen is, you know we can operate in any given quarter in an 81% to 86% gross profit range. So it's hard to pin down to one percentage point what it will be on a steady-state basis. The reality is that it is going to fluctuate a couple points up or down. It's a function of the quarter. The seasonality of the quarter, we saw that in Q4 last year.

The other thing is the programs that we do put in place. SO to the extent we're looking to accelerate bookings activities through increased channel spend in the form of, again, contra and other channel promotions, that will reduce or manifest itself as a reduction in the gross profit percentage. So other things that fall through that category would include revenue share in the consumer business.

I think the takeaway here is that it's not going to settle in quarter-to-quarter at a precise number. We are expecting variations and it's a function of seasonality in our business and the timing of certain programs.

Operator

Our next question comes from Michael Turits - Prudential Equity Group.

Michael Turits - Prudential Equity Group

Looks like a strong cash flow quarter. Any update on your cash flow guidance for the year at this point?

Eric Brown

Yes, just to be clear we don't provide cash flow guidance. We talked a bit more about cash flow last time because we wanted to prep the investor and analyst community for the GAAP presentation of operating cash flow in this quarter.

Just to recall what we are expecting to see in the GAAP cash flow statement. GAAP operating cash flow of $48 million, which includes the $50 million one-time non-recurring payment to the SEC. Normalized operating cash flow for the quarter is $98 million, which is consistent with what we've seen in prior quarters and a year ago.

Other than that though, we are not providing formal 2006 operating cash flow guidance but we will note upcoming, extraordinary events as we have done with this one-time $50 million settlement, so that everyone is clear on what the normalized numbers look like.

Operator

Our next question comes from Horacio Zambrano of Wedbush Morgan Securities.

Horacio Zambrano - Wedbush Morgan Securities

Thank you. Could you talk a little bit about the down year in retail? I know it's been falling off every quarter. But this seemed particularly acute on the revenue side. Could you talk about any sort of acceleration and deterioration of that market segment?

Bill Kerrigan

This is Bill Kerrigan. Retail continues to be an important channel for McAfee but clearly our strategic intent is with our ISP and PC OEM and online partners where we showed outstanding growth. So part of it is a market segment. I think the segment is soft. It is certainly decreasing as a participant in the overall consumer spend for security. Clearly our focus, while we will maintain a presence in retail, is very much energized on our online partners.

Operator

Our next question comes from Chris Hovis - Morgan Keegan.

Chris Hovis - Morgan Keegan

Congrats on the quarter, guys. With regards to cash flow, I know that was just asked in terms of guidance, the phone was breaking up. Could you repeat what you said Eric, with regards to your cash flow guidance?

Eric Brown

Okay. I'll get a little closer to the microphone here. Yes, the question was, is there any kind of updated guidance on cash flow? The answer is that we don't provide cash flow guidance. However, we did talk in more specific terms about cash flow 90 days ago in terms of conditioning people what to expect in the first quarter of 2006. So to be clear, the 2006 GAAP operating cash flow line will read $48 million.

This includes and is negatively impacted by this one-time, non-recurring payment to the SEC. So stripping that out and normalizing the operating cash flow, its $98 million for the first quarter of 2006, which is consistent with what we have seen in prior quarters.

So again, we're not going to be providing operating cash flow guidance, but we will, as necessary, provide additional details in terms of upcoming kind of extraordinary non-recurring events, as we did last quarter.

Operator

Our next question comes from Robert Stimson of WR Hambrecht.

Robert Stimson - WR Hambrecht

Good afternoon, everybody. Just a quick question for you, George, maybe Eric can help with this. Could you just maybe reconcile the bookings number year-over-year and how we should read it? Obviously, it was a pretty good number, 13%. The consumer business was up 20% and corporate business was up about 8%.How should we read that? Is it basically, the consumer number that is driving that? Or it's just a timing issue and corporate is probably growing more in the double-digit arena?

Eric Brown

I think the way to look at it is as follows: I think that that there has been in other sub-segments of the security space, a little bit of softness in terms of the year-over-year growth rates. I think what we saw overall is a very solid year-over-year performance, in every segment and in every geography.

So we have a fairly broad set of products and offerings across both enterprise SMB and consumer. Moreover the fact that we have the most highly evolved software and service model in the consumer business I think that we're further insulated perhaps from some of the other things that are affecting point solutions security companies. So the net takeaway, I think should be one of balance across segments, product lines, and geographies.

Operator

Our next question comes from Brian Markovich - Morgan Stanley.

Brian Markovich - Morgan Stanley

Hi. Good afternoon. I was wondering if you could comment a little bit about the rebate activity over past year or so, relative to prior years. Specifically looking at rebates, returns and incentives from your filing doubling over the prior years?

Bill Kerrigan

This is Bill Kerrigan. Consistent with comments I have made on the last couple of calls, in the retail environment -- and very specifically in North America -- there is very aggressive promotional activity going on across the security space. New entrants into that market, more products and more manufacturers on the shelf has driven promotional activity very specifically in the North American retail to higher levels than we've seen in prior quarters.

Operator

Our next question comes from Sarah Friar - Goldman Sachs.

Sarah Friar - Goldman Sachs

Hi, guys. Just on the SMB side, bookings are actually up nicely 16% year-over-year. I know this is an area that's troubled you in the past, but you've been turning it around. So could you talk a little bit about the jump back this quarter, I think finally working there? I know there's also resignation of your head of channel here in Americas that unnerved some folks. Can you talk about your plans to replace him and maybe some color on his departure?

Bill Kerrigan

First of all, let me correct you. The bookings in SMB were not up 16%, there were up 3% year-over-year.

Sarah Friar - Goldman Sachs

Okay.

Bill Kerrigan

Alright. We're seeing very good progress in our conversion in the SMB space. I think we had commented a couple years ago about how we were declining 20% plus, particularly in North America. We seem to have turned that around.

Now I will tell you that we have a very deep bench at McAfee. We have made an investment in the channel, particularly in North America, taken our headcount that covers the channel to drive not only SMB programs but our entire product portfolio from somewhere in the neighborhood of 40 heads to well over 100 heads in 2006.

We will be looking to put a new person in place to lead that organization. But Jim Lewandowski has been here for the last 33 months leading the charge in North America and the Americas. Jim is here and his team is here and very strong.

Operator

Our next question comes from Georgy Grigoriyants - Thomas Weisel Partners.

Georgy Grigoriyants - Thomas Weisel Partners

Hi guys, good job on the quarter, just a quick question here. What do we see in pricing on the enterprise space? Do we see the pricing pressure, do we see prices being stable on Antivirus?

Kevin Weiss

We again on this quarter, we have not seen a deterioration in our core pricing from any prior years at all. In fact in a couple places and a couple of segments we've actually seen prices tick up a little bit.

So we feel pretty good about it. I don't think there is anything that you need to worry about from a pricing war perspective or anything else. We continue to focus on the channel just like our competitors do, and we think that our product portfolio speaks for itself.

The recent announcement that we just had with TOPS is a leading-edge solution in the marketplace and we think that will allow us to continue to grow share in this area.

Operator

Our next question comes from Gene Munster - Piper Jaffray.

Gene Munster - Piper Jaffray

Good afternoon. The interest and other income line this quarter was up a little bit from last quarter. Anything specific that went on there?

Eric Brown

A couple things went on there. What we have done is concentrating and pooling our cash into higher yielding but still very high-quality short-term investment accounts. So we have done a lot of work putting all available cash in the highest possible yielding accounts, be it in EMEA or the US. But predominantly US-dollar based. There has been some good progress there.

Secondly of course, the overall US interest-rate environment has continued to rise over the past several quarters. That has helped us as well.

Third, we have been more effective in handling FX exposure gain or loss as it flows through our P/L. That's really what accounts for the $4.5 million or so sequential improvement on the other income line item.

Gene Munster - Piper Jaffray

Is this the baseline going forward then, the $12 million?

Eric Brown

Well I think that it is a reasonable starting point. Again, I say reasonable in that the interest-rate environment could change. We're not perfect in terms of forecasting which way that may go in the future.

But overall, we think that we've reached a level again of efficiency of our overall operations where it is going to be above that $10 million mark.

The other thing that might impact it is the net cash balances, absent any additional repurchase or any additional cash-based, security-focused acquisitions. The cash balance would go up, drive it up and conversely to the extent that we continue to repurchase shares and the purchase of security-focused companies, that number would go down. But nonetheless it constitutes a reasonable baseline, prospectively.

Operator

Our next question comes from Kevin Buttigieg - AG Edwards.

Kevin Buttigieg - AG Edwards

Thank you. Just a question with regards to the booking calculations. I understand how contra revenues are treated against your revenue calculation, but do you include an estimate for contra when it comes to your bookings calculations? Or are they represented on a gross basis?

Eric Brown

Yes, just to be clear. We don't provide any bookings guidance. The second point of clarification, when we present the bookings, we have gross overall bookings which are not reported anywhere. We net from that retail contra spending only. That is what is reflected in the bookings metrics that we report.

Now below that bookings number, the $318 million would be all other forms of contra, say in the enterprise SMB side of the house. So you have to deduct from that $318 million amount for other forms of contra spending in the corporate side of the business and consumer non-retail side of the business.

Operator

Thank you. Our next question comes from Katherine Egbert of Jefferies.

Katherine Egbert - Jefferies & Co.

Hi. I have two -- one is...

Kelsey Doherty

Katherine, you are actually cutting in and out.

Katherine Egbert - Jefferies & Co.

Is this little bit better?

Kelsey Doherty

A little bit.

Katherine Egbert - Jefferies & Co.

Okay. So really quick. Why have you decided to combine the SMB and the Enterprise segment? Also, if I heard you right Eric, you're going to stop giving out the bookings numbers at the end of this year? If that's true, why are you doing that?

Eric Brown

Let's see. Well first of all, in terms of combining the revenue line item, the definition of SMB is determined in a fashion based on node range cut-offs. Frankly different companies will use different cut-offs and different definitions for SMB. Frankly, it is not comparable company to company. Sometimes it is more confusing than it is helpful.

In terms of the statements, in terms of providing the bookings breakout prospectively, we will continue to do so, certainly through the end of 2006.

Finally, to provide more transparency, what you are going to see in the upcoming first quarter 10-Q filing, you're going to see a split, what used to be just two revenue line items into three revenue line items.

So we are going to be providing the investment community visibility on product revenue, which will be defined as a hardware product and perpetual licenses; and subscription revenue, which will include dot com subscriptions and other forms of subscription revenue of the corporate business such as MBS.

The third line item will be services, expert services, consulting services, education, and maintenance or technical support. So in fact we're actually expanding the visibility on the revenue.

Below that, we will of course be splitting the cost of goods line items from two lines into the companion three line items.

Kelsey Doherty

Just to be clear on the bookings. We will continue to provide bookings after the end of this year for our corporate business and our consumer business. What we are planning to do is fold SMB up into what would be defined as our new corporate line item.

Operator

Our next question comes from Ed Maguire - Merrill Lynch.

Ed Maguire - Merrill Lynch

Yes, good afternoon. Could you talk about the go to market strategy for the SiteAdvisor service and what you are thinking about pricing there?

Bill Kerrigan

Sure Ed, great question. First of all, I want everybody to understand SiteAdvisor gives us a fundamental opportunity to change the relationship between McAfee and its subscribers. Unlike traditional consumer security which you only may touch every day or every week, in fact we try to make that experience very silent just saying, we protect you.

SiteAdvisor is visible. It provides value to the consumer every time they touch a website, every time they do a search. I am sure you will hear other people make claims that they do something similar. I would ask you to test them a little bit in terms of the depth of capability versus SiteAdvisor.

We have not found anybody who has fully vetted 95% of the Internet. We have not found anybody who has tested the 700,000 plus software downloads we have tested or has an automated system for fully registering and going through the e-mail process which gives us unique insight into spam.

What we have announced is May 15th the launch of McAfee SiteAdvisor. We will retain that as a fee-based product and we will be sharing a very detailed product roadmap on integration into existing McAfee products as well as multiple new cross segment offers at Analyst Day in June.

George Samenuk

Perhaps in my 30 years in technology, we have never been more wowed by a technology like SiteAdvisor. Chris Dixon and that Boston-based team have outstanding, talented professionals that really have developed what we believe -- and I think a lot of other of our competitors and other partners believe -- is the breakthrough technology for consumers.

So you're going to be hearing a lot about this at Analyst Day. It not only affects consumers, it will affect SMB and corporate customers, too. So we're building a great road map with this team and providing them with some new people to continue to grow this SiteAdvisor technology. So to say we're thrilled about it is an understatement.

Ed Maguire - Merrill Lynch

Thank you.

Operator

We have a question from John DiFucci - Bear Stearns.

John DiFucci - Bear Stearns

Hi, guys. You guys appear to be at a pretty dynamic point in your business model. How much of an effect do you think that the offering of longer-term contracts has had on bookings, deferred revenue, and cash flow at least year-over-year?

Last quarter in the 10-K you came out with different allocations in different sub-segments for revenue. You talked about some changes earlier in the call. Just curious, are you going to give us historical so we can try to look for trend lines and try to help us with our modeling of these metrics going forward?

Eric Brown

Good question. First of all when we file the 1Q06 10-Q we'll present a new three line item revenue and COGS format along with that same three line item format for the prior year's quarter of Q1 2005. So you'll be able to see, on a comparable basis, how things compare using the new presentation format.

In regards to the lengthening of contracts, I think, it's pretty important to kind of roll back the clock 90 days or so when you're taking about our fourth quarter. You know the fourth quarter was a very heavy maintenance renewal quarter. It just gets back to the historic very common enterprise technology, back-end loaded sale of products in the fourth quarter. That's where more licenses tend to get sold so you have more maintenance renewals that come up in that period versus any other quarter.

In the fourth quarter of 2005 we saw the incremental build of deferred being more or less equally distributed between long-term and short-term. I think also, we have experienced a bit of budget flush last year where customers wanted to go deeper and longer with us. We were very happy to do those transactions.

If you look at the first quarter of 2006 results, it's a more normal quarter, no back-end loaded seasonality, we had a net increase in deferred revenue of $30 million and $28 million out of that $30 million were short-term. So the net change in overall long-term deferred was frankly negligible. So what we see is kind of a steady, predictable replenishment of the short-term deferred and no unusual deal mechanics in terms of selling longer-term discounted deals to hit a bookings number. We had a very clean and as predicted quarter and evolution of short-term deferred.

Kelsey Doherty

Thank you very much for joining us this afternoon. We look forward to following up with many of you and seeing a lot of you at the events that we're going to be participating in, in the next couple of months.

Operator

Thank you, participants. That does conclude today's conference. You may disconnect at this time. Everyone, have a great day.

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Source: McAfee, Inc. Q1 2006 Earnings Conference Call Transcript (MFE)
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