Seeking Alpha
We cover over 5K calls/quarter
Profile| Send Message|
( followers)  

Executives

Rob Dougherty – F.D. Ashton Partners

Thomas Reilly – President, Chief Operating Officer, Director

Stewart Griersoni – Chef Financial Officer

Analysts

Rob Breza – RBC Capital Markets

Jonathan Ruykhaver – Think Equity Partners

Phil Rueppel – Wachovia Securities

Erik Suppiger – Signal Hill Capital Group

Craig Nankervis – First Analysis

Keith Weiss – Morgan Stanley

Scott Zeller – Needham & Company

Jay Meier – Feltl & Company

ArcSight, Inc. (ARST) F2Q09 Earnings Call December 9, 2008 5:00 PM ET

Operator

Welcome to the ArcSight second quarter 2009 financial results conference call. (Operator Instructions) At this time I would like to turn the conference over to Rob Dougherty with F.D. Ashton Partners.

Rob Dougherty

Hello and thanks for joining us today for the ArcSight second quarter fiscal 2009 conference call. On the call today are Tom Reilly, President and COO and Stewart Griersoni, CFO of ArcSight.

During the course of this call we will make forward-looking statements regarding future events and the future financial performance of the company. Generally these statements are identified by the use of words such as except, believe, anticipate, intend and other words that denote future events. These forward-looking statements are subject to material risks and uncertainties that could cause actual results to differ materially from those in the forward-looking statements.

We caution you to consider the important risk factors that could cause actual results to differ materially from those in the forward-looking statements in the press release and on this conference call. These risk factors are described in our press release and are more fully detailed under the caption “Risk Factors” in the ArcSight quarterly report on Form 10Q as filed with the SEC on September 15, 2008 and the company’s other filings with the SEC.

During this call we will present both GAAP and non-GAAP financial measures. Non-GAAP measures exclude amortization of intangibles and stock-based compensation expenses. These non-GAAP measures are not intended to be considered in isolation from, a substitute for or superior to our GAAP results and we encourage you to consider all measures when analyzing ArcSight’s performance.

For complete information regarding our non-GAAP financial information, the most directly comparable GAAP measures and a quantitative reconciliation of those figures, please refer to today’s press release regarding our second quarter fiscal 2009 results. The press release has also been furnished to the SEC as part of a Form 8K.

In addition please note that the date of this conference call is December 9, 2008 and any forward-looking statements that we make today are based on assumptions that we believe to be reasonable as of this date. We undertake no obligation to update these statements as a result of new information or future events.

Lastly, this conference call is the property of ArcSight and any recording, reproduction or rebroadcast of this conference call without the express written permission of ArcSight is strictly prohibited.

Now I’ll turn the call over to Tom Reilly, President and CEO of ArcSight.

Thomas Reilly

Thank you Rob. Thank you to everyone for joining us today on our fiscal 2009 second quarter earnings conference call. I appreciate these are difficult times for the investors and shareholders on this call. It seems that every day you are faced with more bad news whether it is a disappointing jobs report, faltering retail sales, new bankruptcies or industries in turmoil looking for bailouts.

In bright contrast, I am very pleased to share a different outlook and report to you very positive news and business results. I am pleased to report that ArcSight had another successful quarter in which we achieved record revenue. Total revenue for the second quarter fiscal 2009 was $32.8 million a 33% year-over-year increase. I am pleased to report that ArcSight was profitable on both a GAAP and non-GAAP basis during the quarter and our bottom line performance exceeded expectations. I am very proud to report that in Q2 we continued to hire new employees and we added 53 new customers to our roster.

In light of the difficult economic conditions which are facing many businesses, we are proud to demonstrate that pockets of high growth still exist, that companies can make strong profits, that there are new jobs being filled and that there are technologies that continue to deliver returns and demonstrate business value.

While we are not 100% immune to the economic downturn and we experienced our fair share of projects that slipped and areas of geographic weakness, I believe that our business will be that much stronger when some of the market conditions outside our control diminish.

In the interim I am pleased that our value proposition remains important to businesses world wide and that our recent high growth has out performed many of the other segments you may track.

I suspect many of our world wide employees are listening to this call, anxious to hear the results of their hard work. I wish to thank all of you for staying focused during these times, for delivering extraordinary results and for developing solutions that help our clients protect their businesses. I welcome our new employees and new customers to the ArcSight family.

As expected the governed vertical is particularly strong in the second quarter with the U.S. government ending its fiscal year on September 30. We believe there will be continuing demand from government agencies both here in the U.S. and abroad as they continue to secure themselves from cyber attacks as well as comply with government mandates.

For example, on October 1 of this year the Senate Homeland Security and Governmental Affairs Committee recommended that the Senate pass the Federal Information Security Management Act, also known as FISMA, of 2008 in order to update the prior Act from 2002. The new Act would increase the visibility of security controls applied to information systems within government agencies and we believe that if passed should continue to fuel our business.

When Russia invaded Georgia in early August the world witnessed what may be the first instance of a cyber attack coinciding with a land attack. While the Russian government has denied involvement in the cyber attacks what is indisputable is that the IT infrastructures of Georgian media, communications and transportation companies were attacked. Once the Russian army crossed into South Ossetia the cyber attack spread to computers throughout the Georgian government including the National Bank of Georgia.

The end result was the inability of the government to access its own website, limiting its ability to communicate online and connect with a sympathetic audience around the world. More recently, there are reports of a malicious worm outbreak spreading throughout the Pentagon of unknown origins resulting in aggressive reactive measures to prevent unprotected devices from accessing secure networks.

We are seeing increasing focus by government organizations collaborating with the private sector to put regulations, plans and resources in place to protect government organizations and national critical infrastructures.

This past quarter we saw a significant amount of growth from the energy and utilities vertical. This is one of several industries that manage critical components of the nation’s infrastructure. The ability to disrupt energy production and power distribution through cyber attacks has been receiving increased amounts of attention and stresses the importance of having the ability to monitor and detect threats that could severely impact or cripple the delivery of critical services.

One significant win was with a hydroelectric company that needed to monitor SCADA devices in order to protect their services. SCADA is an industry acronym that refers to the industrial control systems used in industries such as energy, petrochemical, telecommunications, transportation, water and waste control. Our log management and SIM offerings were selected by this company to monitor for potential security breaches in their remote power generating facilities.

Looking beyond critical infrastructure and the Federal sector we experienced balanced results across all verticals in line with historical performance. In the financial services sector the recent market turmoil causing mergers, bankruptcies and layoffs has created an environment in which changing IT infrastructures are susceptible to cyber criminal activity and insider threat. As a result, organizations must be more diligent in protecting their IT systems from malicious outsiders but also monitoring potentially disgruntled employees who fear they may soon lose their jobs or they may disagree with the business decisions put in place by senior management.

With fraud top of mind, we anticipate that the huge and unprecedented financial bailouts will lead to increased industry regulations, IT controls and government oversight. In the second quarter we added a dozen new financial service customers and expanded projects within several existing customers.

One significant win in financial services this past quarter occurred when one of our customers was unexpectedly acquired by a larger bank. The acquiring bank needed to put fraud controls in place quickly and evaluated their in-house monitoring ability versus the advanced capability in use by our customer. The acquiring bank recognized the maturity of our customer’s deployment and therefore decided to leverage their newly acquired license terms to expand their technology into the larger, combined entity, resulting in a significant sale for ArcSight.

We believe that the strength of our technology coupled with our licensing model provide us the opportunity to grow our business and expand our revenue opportunity whether a client is acquiring or being acquired.

Beyond the sectors I have just provided examples of we are seeing balanced performance and opportunities across all of the verticals and segments. These opportunities are driven by the increasing compliance mandates, increasing government regulations and increasing security threats across the globe. Companies of all sizes, in all verticals, both public and private sector in the U.S. and abroad are putting the proper controls in place to protect their businesses and satisfy auditors.

We are pursuing a very large market opportunity. So I will now spend some time updating you on our forward growth strategies we introduced at the time of our IPO in order to continue our leadership and growth.

Our first growth strategy is to continue acquiring new customers by further penetrating the global 2000, expanding internationally and reaching into the mid-market. We added 53 new customers in the quarter generating 51% of our product revenue. We continue to expand our addressable market with the penetration of the mid-market which we categorize as companies with less than $1 billion in annual revenue.

This penetration is largely driven through the reach of our channel partners. International contributions in the quarter represented 19% of revenue. While this is down from prior periods due primarily to the stronger revenue in the Americas driven by government spending, actual revenues on a year-over-year basis grew by 32% in the EMEA region and 3% in APAC. As I mentioned earlier, we are not 100% immune to the slowing economy and one of the regions we are experiencing some weakness in is in Western Europe.

This weakness is evidenced by increased project scrutiny, extended negotiations and longer sales cycles; however the volume of activity remains at a level where we expect to capture many of the deals that slip.

In the APAC region we are successfully adding a large number of new customers primarily with sales of our logger clients through channel partners. Many of these new customers purchase logger at a lower initial ASP but represent a significant up-sell opportunity in the future. In the quarter we added new customers in many geographies including Thailand, Taiwan, Australia, Turkey, Holland, Switzerland and the Middle East.

Our second growth initiative is to drive revenue from our existing customers by expanding their use of our platform across their enterprise with new use cases. Add-on purchases from existing customers represented 49% of product revenue in the quarter. These add-on purchases are an important aspect of our growth strategy. Ultimately we want every client to license the ArcSight platform across their entire IT infrastructure so they can monitor every device, every system, every application and every individual that interacts with it.

We continue to execute on this growth strategy and the visibility we have from selling to our installed base is particularly comforting in the current economic environment.

Our third growth initiative is to launch new and innovative products and applications that open up new markets or address specific compliance mandates in these cases. We recently launched Logger 3.0, a single appliance that captures, stores, alerts, searches and reports on log data of all types. We have seen explosive growth in the amount of log data being generated and stored as more users access more networks and systems requiring more logging for compliance, security, forensics and IT operations.

Logger 3.0 can capture up to 100,000 events per second and can search up to 3 million events per second while storing up to 35 terabytes of log information all on a single appliance. A recent industry report from Info Pro found that ArcSight’s Logger product is the number one solution in consideration for companies that expect to make a log management purchase decision in the coming year.

Finally, our fourth strategy is to broaden our distribution capabilities and focus on making our channel partners more productive. We have transitioned from recruiting new partners to training and enabling our partner’s sales and service organizations on the positioning, installation and support of our products. This past quarter we extensively trained our world wide channel on the differentiating features and pricing offered with Logger 3.0.

We expect many new wins with this channel ready offering. We introduced our new Partner Portal, rolled out new channel sales tools and enhanced our joint marketing programs. A number of our new client wins have resulted from the reach and unique industry skill sets of our channel partners.

Our four-point strategy for growth is working. Just last month, leading market research firm IEC identified ArcSight as the top vendor in the security information event management space and second in the broader security management software category. We earned the number one market share position by having garnered nearly 19% of total SIM revenue in 2007.

Developing market leading products, continually innovating new solutions, driving strategic partnerships and maintaining expense discipline are the things within our control and they continue to drive our business. Earlier this year when we decided to become a public company we were confident at that time that our value proposition would withstand a difficult economy. Little did we know how tested our thesis would be with the turmoil and rough economic conditions that unfolded unexpectedly and globally?

Yet, despite these broad challenges we have continued to perform and achieve high growth which gives me great confidence that we can successfully weather some pretty tough storms.

However, as we learned this past year the challenges we are experiencing now may pale in comparison to the unknown conditions ahead. We remain sensitive and cautious to the ever changing markets and the potential for yet more crises to unfold. We also remain optimistic that our value proposition resonates strongly in these times since security threats are becoming more complex, compliance mandates are increasing globally and businesses are increasingly focused on protecting their critical assets.

I would now like to turn the call over to Stewart to discuss our financials in greater detail.

Stewart Griersoni

As previously mentioned for the second quarter ended October 31, 2008 we had total revenue of $32.8 million representing year-over-year growth of 33%. We reported non-GAAP net income of $3.6 million or $0.11 per diluted share. This excludes stock based compensation expense of $1.5 million and amortization of intangibles of $210,000.

We reported GAAP net income of $1.8 million or $0.06 per diluted share. This is our fifth consecutive quarter in which we have generated net income on a non-GAAP basis.

We continue to be able to drive revenue growth from both our installed base which contributed 49% of product revenue in the quarter as well as through new customer additions. As Tom noted we added 53 new customers in the quarter representing 51% of product revenue.

We had one customer that contributed more than 10% of quarterly revenue. This was one of the large deals we closed back in the fourth quarter of fiscal 2008 for which revenue recognition was delayed at that time as the result of certain delivery milestones. We were able to successfully meet these milestones in the current quarter which enabled us to recognize the revenue.

Overall product revenue grew 22% on a year-over-year basis and represented 58% of total revenues.

On a non-GAAP basis gross margin for the quarter was 83%. Similar to last quarter revenues from appliances was roughly 1/3 of total product revenue with blended product gross margins of approximately 90%.

Non-GAAP operating costs increased to $23.1 million from $19.6 million in the prior-year quarter while remaining relatively flat on a sequential basis from Q1. We added 14 new employees in the quarter to bring our total employee count at October 31 to 385. We expect as a result of certain higher periodic expenses in the first half of the year such as sales kick offs, sales club and our users conference that our operating expense run rate for the second half of the year is well in hand. As a result of strong revenue results and proven cost controls we generated Q2 non-GAAP operating margin of $4 million or 12% of revenue.

We are continuing to carefully manage our cost structure in this difficult environment to delicately balance our growth objectives with the investments needed to support this growth. The strong Q2 operating margin reflects the potential leverage in our operating model when we over achieve our revenue targets.

Turning to the balance sheet, we ended the second quarter with cash and cash equivalents of $75.7 million, an increase of $1.5 million from the prior quarter. We generated $0.7 million in cash from operations and used roughly $0.5 million in capital expenditures and generated $1.3 million related to financing activities primarily driven by proceeds from the exercise of stock options.

We continue to invest our cash in highly rated conservative investment vehicles.

In accordance with GAAP and as discussed on prior calls, we net down accounts receivable and deferred revenue for sales transactions that are recognized on a cash basis. As a result, in order to understand the change in accounts receivable and deferred revenue from period to period one must take the impact of the net down into consideration. Deferred revenue of $39.5 million at October 31, 2008 was net of $9.3 million of sales transactions that are recognized as revenue on a cash basis. This compares to the first quarter deferred revenue of $40.8 million that was net of $7 million of cash basis transactions.

Accordingly, gross deferred revenue increased by approximately $1.1 million from the first quarter to the second quarter of fiscal 2009. More importantly, despite the recognition of the greater than 10% customer in the quarter that was recognized off the balance sheet, gross product deferred revenue was marginally up on a sequential basis. This is a further indication of our strong sales in Q2.

Accounts receivable was $23.2 million at October 31, 2008 compared to $17.3 million at the end of the first quarter. Once again, both of these balances are net of $9.3 million and $7 million respectively for cash basis transactions. Consistent with our standard practice we continue to evaluate the credit worthiness of our customers and re-sellers.

Our DSO for the quarter was 65 days which is in line with our stated target of 60-70 days.

I will now provide guidance for the third quarter of fiscal 2009. Given the uncertainty created by the current economic environment we remain cautious about the market conditions in coming periods. We currently expect revenues for the third quarter of fiscal 2009 to be in the range of $32-34 million which represents significant growth of 16-23% over the prior year.

Non-GAAP net income for the third quarter of fiscal 2009 is expected to be in the range of $2 million to $3.2 million or $0.06 to $0.10 per diluted share excluding stock based compensation expense and amortization of intangibles.

Given the significant under certainty of the broader economic markets and the unknown impact this might have on customer IT spending in 2009 we believe it is not prudent to provide guidance beyond the current quarter. Therefore we are not providing an update of our fiscal 2009 guidance at this time.

I will now turn the call back over to Tom to provide his concluding remarks.

Thomas Reilly

Thank you Stewart. We continue to demonstrate that our compliance and security management solutions are delivering critical and compelling value to customers that need to protect their businesses and demonstrate compliance controls. We believe that the market is large, both broad and deep, so we remain focused on executing our growth strategy and we believe we are well positioned as a market leader in SIM to further advance our position as the vendor of choice.

This concludes our prepared comments for today. We will now take your questions.

Question-and-Answer Session

Operator

(Operator Instructions) The first question comes from the line of Rob Breza – RBC Capital Markets.

Rob Breza – RBC Capital Markets

Tom could you talk a little about the volume? You said you saw the volume in Europe. What did you see from a volume and transaction perspective in North America? As a follow-up, Stewart could you talk about any FX impact in the quarter as well?

Thomas Reilly

The volume in the Americas is consistent with what we would have expected and consistent with our growth expectations. What we saw in Europe is an equal amount of volume but more difficulty in getting visibility into when deals will close. That was just a change we saw in Europe. We haven’t seen the level of activity in our pipeline drop.

Stewart Griersoni

On the FX question, most of our deals are in U.S. dollars and so we don’t have any pure FX impact if that is what you are implying.

Operator

The next question comes from Jonathan Ruykhaver – Think Equity Partners.

Jonathan Ruykhaver – Think Equity Partners

I’ve got a question on the Logger 3.0 product. I know it was recently introduced but any commentary on feedback in the channel or on the customer side and where in the market is it targeted? I know it is SMB focused but you also see use cases within the larger enterprise market potentially.

Thomas Reilly

The Logger 3.0 introduces really new performance scalability enhancements as well as ease of use capabilities. It brings value to both our installed base and enterprise customers who are using ESM and want to off load storage and get better performance out of their correlation engine so we see good up take in our installed base and large enterprise customers. However, it also has stand alone value for those mid-market customers who don’t want the advanced capabilities. So we are seeing the primary entry point into the mid-market and in large part going through our channel partners who prefer that appliance form factor in a quick to deploy solution.

Jonathan Ruykhaver – Think Equity Partners

Are you seeing more success with that product, the Logger appliance, than you are seeing with the ESM appliance?

Thomas Reilly

We are moving more of the Logger appliance and we are seeing a lot of appliance move in the APAC region where there are some laws requiring log retention specifically. So on a volume basis we are probably moving more Logger appliances.

Jonathan Ruykhaver – Think Equity Partners

I believe you said growth, correct me if I’m wrong, in APAC was only in the low single digits. Is that accurate?

Thomas Reilly

That is.

Jonathan Ruykhaver – Think Equity Partners

So I guess as you suggest the lack of an appliance in APAC historically may be one of the reasons why they haven’t gotten as much growth. Do you see that changing with Logger 3.0?

Thomas Reilly

There are two things. We reported earlier that we wanted to re-tool our leadership team in Asia and we did that earlier this year. We are very pleased with our leadership team in place and how they are developing partnerships. In conjunction with that we believe the appliance form factor is the preferred purchasing mechanism in that region. That is why we are seeing the adoption of Logger appliance sales.

Jonathan Ruykhaver – Think Equity Partners

How long has that leadership been in place at this point?

Thomas Reilly

Roughly six months.

Jonathan Ruykhaver – Think Equity Partners

I didn’t hear the percent of sales that came from financial services and government?

Stewart Griersoni

We didn’t share those. Just to be fair to everyone on the call government was north of 30% this past quarter. If you recall in other quarters it has been down in the 20% range but that is not all that surprising given the U.S. government fiscal year end. Financial services has remained in line where it has been in prior quarters which is high teens to low 20’s. So it has been very consistent from a performance perspective.

Jonathan Ruykhaver – Think Equity Partners

Was there a meaningful foreign government impact to that north of 30% number?

Stewart Griersoni

That is primarily driven by U.S. government. It is their fiscal year end September 30 although that number I gave you does encompass world wide governments but it is largely driven this quarter by U.S.

Operator

The next question comes from Phil Rueppel – Wachovia Securities.

Phil Rueppel – Wachovia Securities

As you look out and express caution is it across all of the segments and in particular I know the federal government was obviously strong and you talked about as they entered the New Year the positive impacts of FISMA potentially but any additional caution around the new administration, continuing resolution, etc?

Thomas Reilly

No. We spend quite a bit of time trying to understand that. We don’t think the new administration will have any impact. We think what we do is apolitical and there is a heightened sense of urgency with recent attacks. So from a government perspective we don’t expect any change there. In financial services we do anticipate and expect there will be increased regulation and oversight which hopefully drives more demand for our solutions not only into new companies but deeper into our existing clients as concerns of fraud and application margin becomes increasingly prevalent.

Phil Rueppel – Wachovia Securities

The retail sector is also an area that has been hard hit. Are the issues there offset by the need for continued PCI compliance?

Thomas Reilly

Yes it is. This past quarter on a percentage basis retail was a lesser percentage however we continue to see activity there and PCI is the continuing driver in the retail sector. Just the heightened need to protect consumer identities.

Phil Rueppel – Wachovia Securities

Stewart, G&A was tracking a bit ahead of our expectations. Any of the one-time expenses you either talked about or didn’t in that number or is that just kind of the level we should expect going forward?

Stewart Griersoni

I think the level you are seeing if you look at this as tracking over the last few quarters obviously this is our first year of stocks so there are a significant amount of costs in particular as it relates to this year and you will see costs in every quarter related to that. My expectation as we get into next year and beyond as we start to rationalize some of those costs there will be ongoing stock costs but that is obviously a big factor in terms of those being periodic costs if you will but they are in every quarter of this year.

Operator

The next question comes from Erik Suppiger – Signal Hill Capital Group.

Erik Suppiger – Signal Hill Capital Group

First off can you give us any color on the customer that was 10%? Was that part of the government or the financial revenue you had talked about?

Thomas Reilly

No, we don’t typically talk about any one vertical that was part of. But it was one of, if you recall back in Q4 we did talk about a small number of large deals that were back in Q4 that were deferred. It was one of those deals. We don’t get into which particular sector it was part of.

Erik Suppiger – Signal Hill Capital Group

On the geographic basis can you give us the dollar amounts for the different geographies? While you are getting that you said the energy sector picked up. Did that grow to 10%? Can you give us any color there on how that was contributing?

Thomas Reilly

On the energy sector?

Erik Suppiger – Signal Hill Capital Group

I think you said you saw some increased demand there?

Stewart Griersoni

That vertical has typically, we have actually been selling into that vertical as we do across all verticals and it has been a fairly regular contributor. I think there was a tick up this past quarter that it just spiked up into as opposed to being in the medium single digits up to the low double digits. I think this is in line with some of the commentary you heard from us around companies like this looking to protect their infrastructure. What is interesting I think about that too is it shows the flexibility of our product in that it can collect information from what you would consider to be non-traditional device types? So certainly SCADA devices is well beyond the traditional perimeter security or network devices we may be known for. That is probably what is interesting about that.

Erik Suppiger – Signal Hill Capital Group

Any thoughts is that going to stay at the double digit contribution level? Or do you think it was an anomaly for it to spike up?

Thomas Reilly

We expect that cyber warfare and companies moving to protect critical infrastructure, which will be a collaboration between government and the private sector, 75% of critical infrastructure is owned by the private sector, will be a continuing driver for our business. What is unknown is the timing of that from a quarter-to-quarter basis but I think we will continue to find great opportunity there.

Erik Suppiger – Signal Hill Capital Group

So you are not sure whether the energy sector stays in this range just in general? The private sector is what you see as picking up?

Thomas Reilly

The private sector relative to critical infrastructure. So that includes transportation, petrochemical, water supply, nuclear reactors. There are quite a bit of different types of businesses we can pursue there.

Stewart Griersoni

Back to you on your breakdown by geography, and this should have been on the slides being presented in conjunction with this web cast. I think EMEA was $4.7 million. This is total revenue. APAC was $1.4 million and the Americas was $26.7 million.

Operator

The next question comes from Craig Nankervis – First Analysis.

Craig Nankervis – First Analysis

First of all, Tom I wonder if you could comment on how much of the recent merger activity among the large financial institutions is a net positive. Perhaps you had some losses you alluded to sort of an up-sell from one of your customers that was acquired. Could you comment overall is this a catalyst in the near-term for you?

Thomas Reilly

First let me answer it this way. I am not aware of any negative results. I am aware of positive results. The reason there is positive results is the need and value of our solution increases with changing IT landscapes. So any time you have to integrate the new IT infrastructure and move individuals on and off the IT infrastructure you introduce new applications. Whether that is a company you are acquiring or a business you are trying to integrate with you introduce new security risk.

So when we see these mergers we are pursuing them as opportunities. We get to those accounts as quickly as possible and explain how we can help protect their businesses especially in the financial markets where there is concern about account executives trying to take their customer information or account data with them, employees that may be getting laid off and might want to leave a time bomb behind. There are so many heightened concerns we can address in all these scenarios. So we haven’t seen any down side yet. None that I am aware of and we have been able to find up side.

Craig Nankervis – First Analysis

How about can you characterize revenue that you are seeing from your new partnerships? McAfee, Oracle, HP? Any update on that front?

Thomas Reilly

No specific updates. When you are working with these large organizations it takes time to get the joint value proposition propagated through both sales forces. So these partnerships are intended to solidify our position and our competitive capabilities at the high end and I think they are delivering on those results.

Craig Nankervis – First Analysis

Are they contributing to your pipeline as you look ahead at this point?

Thomas Reilly

I don’t have the information necessarily to answer that. What I am comfortable saying is those accounts in our pipeline where we intersect with those partners we are at a much more competitive advantage.

Craig Nankervis – First Analysis

Stewart, the services line saw I believe the largest sequential increase in many quarters. Is that a one time dynamic? Is there a new trend in services going forward? I wonder if you can speak to that.

Stewart Griersoni

There is a relatively new service offering we have brought to the market which is staffing and managing the security operation centers for large enterprises. So that has certainly been a catalyst visa vie prior periods on our service revenue. These are typically one-year engagements where we are either coming and supplementing an existing organization or in some cases building it up from scratch. So that would be what you are seeing there. Right now that is a selective offering. It is with some significantly large enterprises we are doing with this service. We are seeing strong interest in the market place.

Craig Nankervis – First Analysis

Did you characterize the percent of revenue from the channel versus direct? Do you talk in those terms?

Stewart Griersoni

We don’t typically give numbers around that. One of the reasons is we continue, as the investment we are making in the channel continue to mature and we can understand the true impact to the company in terms of what does it do for accelerating business and what does it do for incremental business to the table as well as stand alone business, I’ll give you the sense that from a contribution point of view it was probably in line with the prior quarter. I think as Tom mentioned we shifted our focus somewhat from recruiting now to training the channel partners. Certainly in the last quarter one of the bigger pieces of the focus there was really training them on 3.0 so they were aligned with the launch of that product.

Craig Nankervis – First Analysis

Lastly, on the guidance at the high end you are looking for revenue to be up $1 million or so sequentially yet on the bottom line you are looking for earnings to be just a tad below where you came in this quarter. Any comment on how to reconcile that?

Stewart Griersoni

No. I think it is consistent with prior quarters. Our view is we are going to provide guidance to our investors and to Wall Street that is based on what we have comfort from where we can see at the time we give that guidance. Clearly these are just uncertain times and that restricts some of the visibility as we look forward and I think probably the biggest question is what is going to happen in 2009 to IT budgets. So that is what is driving the guidance we are giving. We feel the $32-34 are numbers we feel we can deliver in Q3.

Operator

The next question comes from Keith Weiss – Morgan Stanley.

Keith Weiss – Morgan Stanley

I wanted to just quickly revisit that guidance question and maybe ask it a little bit in a different way. By my calculations it looks like the mid point of the guidance range would imply operating margins coming down by almost 300-400 basis points or said another way total expenses going up by $1.5-2 million from quarter-to-quarter. I thought you guys had front end loaded a lot of the hiring in the quarter so perhaps maybe you could help us understand what would drive expense growth? Am I correct in my sort of back end calculation and what would drive expense growth sequentially into the third quarter that would lead to that kind of operating margin decline sequentially?

Stewart Griersoni

We did particularly on the sales side front load a lot of our hiring. As you can imagine we did hiring in Q1. We continued to hire in Q2. Those expenses all roll into the latter half of the year. So for example in Q2 any hires you make in the quarter you don’t have the full hit of that expense in the quarter particularly if you hired someone in the last month of that quarter. Your assumptions are right in the sense that we are continuing to grow expenses and I think when you look at, and I made this comment in my prepared remarks, but the margins we achieved in Q2 is largely prudent cost containment but at the same time when you over achieve on your revenue top line it just gives you a sense of the revenue that drives to the bottom line.

So, as we look forward we are looking from a cost perspective to continue to spend more and you are right in the terms of the way you are looking at it on the back of the envelope.

Keith Weiss – Morgan Stanley

Am I correct in my thinking the majority of the hiring was front end loaded in the year so we should see a lower rate of net new hires as we go through the back half of the year?

Stewart Griersoni

That is the way we had planned it and that is certainly what is consistent with our prior conversations. Yes.

Keith Weiss – Morgan Stanley

At your user conference you released your fraud prevention solution. Can you give us any update on sort of the initial response to that product and perhaps what the initial up take of that has been?

Thomas Reilly

It is probably one of the things we are more excited about especially in financial services around fraud prevention. So I would say we are seeing a lot of interest and activity with our anti-fraud accelerator solution which translates into executing on a broader strategy called enterprise view where we want to expand the footprint of our solutions in our customers monitoring their applications and their users. That strategy was rolled out and is called Enterprise View which we continue to see good interest and activity driving our business.

Operator

The next question comes from Scott Zeller – Needham & Company.

Scott Zeller – Needham & Company

Another guidance question. Could you tell us, it was pretty clear in EMEA you saw some extension of the cycles for deals but domestically your caution in guidance is it based on what you don’t see and what you think might happen or are you actually seeing deterioration that leads you to be cautious in the U.S.?

Thomas Reilly

I would not say we are seeing any deterioration. We are seeing the expected amount of activity and opportunities we are pursuing in large part reacting to somewhat what we are seeing in EMEA now which is a little more difficulty in pinning down customers to decision time frames. So we are not seeing opportunities go away. We still pursue them whereas many other segments opportunities are just going away. The budgets are just gone or what have you. We continue to pursue them but they are a little harder to pin down. Those of you that know us we are quite fanatical about our forecasting and pipeline monitoring so this is just one indicator where it gives us some of the caution.

Scott Zeller – Needham & Company

From your channel work with the Logger product are you able to read at all the tone of spending for SMB domestically? Is there any sort of hint in there as to what is happening with SMB stability or is it difficult to tell?

Thomas Reilly

I would say we don’t have any indicators. I would tell you that our premise is that if there were to be a slow down we would probably see it in the SMB before we see it at the enterprise. But we don’t have any indicators of that. The reason I share with you our premise is that we have the strength of being very solid at the global 2000, clear dominance in market leadership there and value propositions that continue to resonate with our customers who are looking to get better ROI out of their existing investments versus introducing new technologies.

Scott Zeller – Needham & Company

Lastly, any guidance on tax rate for the January quarter?

Stewart Griersoni

I think if you look at the last two quarters it was right around 30% effective tax rate guidance. I would assume that going forward.

Operator

The next question comes from Jay Meier – Feltl & Company.

Jay Meier – Feltl & Company

First, Stewart can you give me the breakdown of the deferred revenue pseudo backlog numbers again? I know what the deferred revenue is on achieved, but what was the stuff that isn’t on the balance sheet?

Stewart Griersoni

The $9.3 million of net downs?

Jay Meier – Feltl & Company

Yes.

Stewart Griersoni

So the deferred revenue was $39.5 million net of $9.3 million of net cash basis sales transactions.

Jay Meier – Feltl & Company

As far as going back to a previous question about operating expenses and they seem to be trending a little higher and maybe triangulating back to this new service offering, I wonder are your operating expense increases related to that new offering? Are you incurring incremental spend because you need to send additional teams of people out to those deployments? And secondly, is that service offering in lieu, can we look at that like a subscription model or something like that? Or is that in lieu of typical product offerings or would it include product offerings?

Thomas Reilly

As we win these kinds of deals and particularly where there is a staffing element involved we hire the people to deliver the service and those costs are sitting in your cost of sales line item. So you are not seeing for example on the operating cost structure other than the management component back here at Corporate to run that business but that has a marginal impact on operating expenses. Really as the revenue grows you are getting an offset of costs on your cost of sales line item. Then typically those are existing customers who have licensed our technology and then are coming to us and asking us to help them deliver on their security operations center services. So those are people that are regular customers from a purchasing product perspective. So not as you would typically think of as a SAS type model where the fees include both the product elements as well as the service element. They are separate.

Jay Meier – Feltl & Company

So it is not a SIM outsourcing business model?

Thomas Reilly

Right. This is purely service. This is delivering the staffing and management oversight on their security operations center. They pay separately for the products and those are typically perpetual licenses as most of our other business is.

Jay Meier – Feltl & Company

It is interesting we had such a bump in federal spending and cyber security is clearly a huge terror point for our Department of Homeland Security, etc. Are you seeing any new…there is a lot of new standards and a lot of new best practices being implemented and recommended by [NIS]? Are you seeing any traction in federal requirements or laws, FISMA 2.0, what is your visibility of new demand components from the federal government that could actually require this type of capability?

Thomas Reilly

We expect the FISMA regulation to move through the Senate and be essentially a mandate that helps drive our business. We expect that to be applied to even broader aspects of government operations. Then even today many of you don’t get the benefit of receiving the Chronicle, but here in San Francisco we open up the business section and the front page of our business section was President Elect Obama’s picture and the article was about a think tank that recommends that Obama accelerate investments in cyber warfare protections in protecting not only government institutions but protecting all aspects of connectivity to the network including citizens and what have you.

I think just looking at the tea leaves there is a lot more to come. Our system integrator partners in the federal sector are very engaged with us in drawing out long-term architecture plans and really trying to understand where the Department of Homeland Security or the New Cyber Czar if that comes about how that plays out. So specific regulations, none that I can point to right now. Lots of activity and concerns, plans in place, proof of concepts, projects underway, plenty of that.

Operator

There appear to be no further questions. I would like to go ahead and turn things back to Mr. Reilly for any additional or closing comments.

Thomas Reilly

Thank you for taking the time to listen to our earnings call. Thank you for the very insightful questions and following our business. We are very pleased to have performed well this past quarter and we are very pleased to have the value proposition we get to deliver and so I look forward to talking with many of you and updating you on our next quarter’s results. Thank you.

Operator

That does conclude today’s conference call. Thank you for your participation. You may disconnect at this time.

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: transcripts@seekingalpha.com. Thank you!

Source: ArcSight, Inc. F2Q09 (Qtr End 10/31/08) Earnings Call Transcript
This Transcript
All Transcripts