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

VMware, Inc. (NYSE:VMW)

Q4 2008 Earnings Call

January 26, 2009 5:00 pm ET

Executives

Paul A. Maritz – President, Chief Executive Officer

Mark S. Peek – Chief Financial Officer

Mike Haase - Vice President of Investor Relations

Tod Neilsen - Chief Operating Officer

Analysts

John Difucci - J.P. Morgan

Katherine Egbert - Jefferies & Co.

David Bailey - Goldman Sachs

Unidentified Analyst - UBS

Israel Hernandez - Barclays Capital

Walter Pritchard - Cowen and Company

Phil Winslow - Credit Suisse

Toni Sacconaghi - Sanford Bernstein

Todd Raker - Deutsche Bank Securities

Kash Rangan - Merrill Lynch

Laura Lederman - William Blair

Brent Thill - Citigroup

Operator

Good afternoon and welcome to VMware’s fourth quarter earnings conference call. (Operator Instructions) At this time, I would like to turn the call over to Mr. Mike Haase, Vice President of Investor Relations. Mr. Haase, you may begin your conference.

Mike Haase

Thank you. Good afternoon and welcome to VMware’s fourth quarter 2008 earnings call. With us today are Paul Maritz, President and CEO and Mark Peek, our CFO. Following prepared remarks from Paul and Mark, we will take your questions.

Please note that this call is being simultaneously webcast on our Investor Relations website. Our press release was issued today after the close of market and is also posted on the website.

I would like to remind you that statements made in today’s discussion that are not statements of historical fact are forward-looking statements subject to the safe harbor provisions under federal securities laws. This includes but is not limited to, statements regarding our financial outlook, future product offerings and projected demand. These statements are based on current expectations as of the date of this call and are subject to uncertainties and changes in condition, significance, value and effect as well as other risks detailed in documents filed with the SEC including our quarterly report on Form 10-Q for the period ending September 30, 2008 that may cause actual results to differ materially from those set forth in our statements.

In addition, during today’s call, we will discuss certain non-GAAP financial measures. These non-GAAP financial measures which are used as measures of VMware’s performance should be considered in addition to, not as a substitute for or in isolation from measures of VMware’s financial performance prepared in accordance with GAAP. You can find additional disclosures regarding these non-GAAP measures including reconciliations with comparable GAAP measures in our earnings release for the period ended December 31, 2008 and on the Investor Relations page of our website.

The webcast replay of this call will be available for the next 30 days on our company website under the Investor Relations link.

For planning purposes, VMworld Europe will be held in Cannes, France, February 24-26. Registration information is available on our website and our first quarter quiet period begins at the close of business March 17, 2009.

Finally, unless otherwise stated, all financial comparisons in this call will be in reference to our results for the comparable period of 2007.

With that, let me turn it over to Mark Peek.

Mark S. Peek

Thank you, Mike and good afternoon, everyone. We are pleased in our execution in 2008 particularly in the tumultuous economic environment of the second half of the year. We achieved strong growth, improved our operating efficiency and our expense run rate and continued to build on our strong balance sheet.

For the year, we achieved growth of 42%, nearly $1.9 billion; grew preferred revenue by $317 million; had non-GAAP operating profit of $469 million and our operating cash flows for the year were over $800 million.

I would like to thank all of the people at VMware, our partners and our customers for the many contributions in achieving these milestones in the face of the most challenging economy of our careers.

The year culminated with a strong fourth quarter. Revenue was $515 million, an increase of 25% from a year ago. Non-GAAP operating profit was a record $135 million, growing 25% from Q4 2007. Our non-GAAP operating margin was 26.2%.

As you would have expected given the strengthening of the dollar in September our year-over-year operating margin benefitted by more than 230 basis points on a constant currency basis. Remember, that we only bill in collected U.S. dollars.

Our balance sheet is strong. We finished the year with over $1.8 billion in cash and $879 million in deferred revenue. Year-over-year, cash increased 50% and deferred revenue increased 57%.

Q4 license revenues were $315 million, up 11% from last year. Services revenues were $200 million, an increase of 56% from a year ago while total deferred revenue grew by $90 million during the quarter. Software maintenance revenue was $161 million, a 57% increase from last year and professional services revenue was $39 million, up 50% compared to last year but flat sequentially to Q3. The trend in professional services revenue was due to our transitioning some of the business to our partners. Although we will continue to serve our customers directly, we want our partners to build their professionals services businesses which we believe leverages our license sales through this channel.

Enterprise license agreements as a percentage of total bookings were 23%. This was up sequentially in the seasonal fourth quarter and nearly the same percentage as Q4 of last year. We saw seasonal strengths in our ELAs from our Enterprise accounts and some weakness in the transactional business particularly with price-sensitive customers such as educational institutions. VMware is clearly a strategic solution provider in the data center as companies seek to do more with less. As we have said in the past, ELAs are important to our strategy but they do tend to cause some lumpiness in our revenue recognition as companies buy ahead to obtain greater discounts.

U.S. revenues in the fourth quarter increased 27% from last year to $274 million or 53% of total revenue. International revenue increased 22% to $241 million. Bookings growth in China was especially strong in the quarter.

Now I will provide some detail on our operating expenses. Unless otherwise noted, all references below are on a non-GAAP basis which we reconcile in the tables to our press release and on our website.

Total operating expenses in the fourth quarter increased 6.3% sequentially to $380 million. During the quarter, we acquired four businesses for a total of $48 million. Q4 operating margin was 90 basis points less due to acquisitions closed in the past 12 months. As a percentage of fourth quarter revenue, COGs declined 10.5% from 11.8% in the prior quarter. The decline was largely due to a lower mix of professional services which tend to have lower margins.

R&D expenses totaled $119 million or 23.1% of revenues as compared with 22.8% in the prior quarter. On a GAAP basis, we capitalized $48 million [inaudible 07:17] including $11 million of stock-based compensation and $37 million in cash salaries. Our accounting policy under GAAP requires us to capitalize amounts once we are in beta versions of our products.

Sales and marketing expenses were $164 million or 31.9% of revenues compared with 42.6% in Q3. The improvement was largely due to the strengthening of the U.S. dollar. G&A was $43 million or 8.3% of revenues about the same percentage as in Q3.

Our Q4 operating profit was $135 million or 26.2% of total revenue. Not unexpectedly given the currency movements that we saw in the fall, international operating expenses were $12 million lower as a result of the year-over-year strengthening of the U.S. dollar. On a constant currency basis, operating margins were positively impacted by more than 230 basis points. For the year, on a constant currency basis, international operating expenses were higher, by about $10 million or reduced our operating margins by about 50 basis points.

As mentioned during last year’s call, our expected tax rate for the fourth quarter and 2008 declined significantly as a result of the extension on the R&D credit by Congress. The non-GAAP cash rate in the quarter was a benefit of 6% and for the year, our 2008 non-GAAP tax rate was 13%. With the increase of the R&D tax credit in our non-GAAP tax rates improved non-GAAP EPS for the year and the quarter by $0.05. R&D tax benefits for the entire year was recognized in Q4 and improves the annual GAAP EPS by $0.05 per share and quarterly GAAP EPS by $0.06. The non-GAAP diluted EPS for the quarter was $0.36 on 390 million diluted shares, an increase of 38% from last year.

Now I will provide a few highlights for the full year. Total revenue for 2008 was $1.9 billion, up 42% from 2007. The revenue mix consisted of 63% license and 37% services. For the year, license revenue increased 30% and services revenue increased 67% and total deferred revenue increased by over $317 million.

Our U.S. revenues increased 37% to $988 million in 2008 and our international revenues increased 48% to $893 million. As a percentage of total revenues in 2008, U.S. revenues were 53% and international were 47%.

The non-GAAP operating margin for the year was 24.9% consistent with the guidance last January. Non-GAAP diluted EPS for the year was $1.05.

Now on to our balance sheet and cash flow statements. With each quarter, we continue to strengthen our balance sheet. Cash at year-end was over $1.84 billion, up $149 million sequentially from Q3. Since the beginning of 2008, our cash increased over $600 million or 50%. We remain invested in short-term cash and cash equivalents and have not experienced any declines in valuation of our holdings.

Total deferred revenues increased 11% sequentially to $870 million. For the year, total deferred revenues increased 57%.

Our accounts receivable were $338 million at the end of the year and our DSO for the quarter including the change in deferred revenue was approximately 50 days.

The interest rate on our $450 million note with EMC adjusts each quarter at LIBOR plus 55 basis points. For Q109, our rate is 1.99%, 245 basis points lower than Q4. Likewise, our investment rates are sequentially lower and we anticipate a decline in our Q109 investment income.

Non-GAAP operating cash flows which exclude adjustments for capitalization under FAS86 and excess tax benefits from stock-com were $246 million for the fourth quarter, an increase of 59% from Q4 2007. For 2008, non-GAAP operating cash flows were $795 million, up 58% compared to 2007. These results exceed our non-GAAP operating income largely driven by an increase in deferred maintenance revenue for which we are particularly paid upfront.

We enter 2009 with approximately 6,700 full-time employees. We added about 200 people during Q4 with over half coming from acquisitions and added 1,700 people during the year. When you factor in turnover, almost 40% of our people have been with VMware less than a year. Our team has done a great job in recruiting and on-boarding in the first half of 2008 and adjusted quickly in the second half to decelerate this growth and focus exclusively on strategic positions related to R&D and geographic expansion.

Let me now turn to our financial outlook. The current economic situation is creating a high degree of uncertainty around just how much money will be spent on IT for the foreseeable future. In many cases, we don’t believe 2009 budgets have been finalized by our customers. Companies appear to be in a period of great indecision. We believe the uncertainty is causing customers to be conservative and preserve their most basic asset, cash. A recent CFO survey indicates that IT spending will be more weighted to the back half of the year in 2009 than has historically been the case. Therefore, we believe there is a broad range of possible outcomes for the first quarter and for the year.

As I mentioned in October, revenue in the first quarter of 2009 would be down sequentially from the fourth quarter of 2008. Even without the macro-environment considerations, the first quarter of 2008 is a difficult comparison as licensed revenues was at its highest level in company history until being surpassed in this most recent quarter.

In Q1 of 2008, our ELAs as a percentage of total bookings exceed 20%; triple the percentage of Q1 2007. Because we believe customers we’ll be more conservative in their budgets early in 2009, we expect ELAs as a percentage of total bookings to decline in Q1 of this year.

Although we are not providing 2009 guidance, we do want to give you an indication of how we are planning Q1 internally. We are currently planning our business for revenue of approximately $475 million in the first quarter. This implies a decline in license revenue compared to Q1 of 2008 of as much as 10%. We also expect professional services revenue to decline sequentially from Q4.

We’re working hard to manage our expenses to achieve a healthy operating margin but much is dependent on our top-line results and we won’t sacrifice our strategic initiatives. We will continue to invest in the important initiatives we outlined for you last quarter including desktop, vCloud and emerging markets. In order to help fund these initiatives in light of the economy, we have implemented a number of austerity actions including postponing merit increases, limiting hiring to roles that fit our strategic initiatives. We continue to evaluate all aspects of our business to ensure that we are operationally efficient and that our resources and operating expense structure are appropriately focused on our long-term success. Our people are committed to getting through this difficult economy and are working diligently to ensure VMware remains the market leader for the long-term.

Taking into account seasonality, we do not expect our operating costs to change significantly from Q4 but however, remember that our international operating expenses are sensitive to movement in the U.S. dollar.

There are several items in which we can give you some direction on your models of our results but these are also subject to higher degrees of variability because of macroeconomic conditions. We anticipate our Q1 2009 weighted average share count to be approximately 390 million shares. The 2009 tax rate is expected to be approximately 16%-18%. This includes stock-based compensation, amortization of intangibles, and FAS86 capitalization representing approximately 4-5 points. This translates to a non-GAAP tax rate that will be approximately 4-5 points higher than the GAAP tax rate for the full year. In addition, new accounting rules for the tax-impacted acquisitions in 2009 and beyond will tend to make tax rates even more volatile.

We expect our capital spend excluding FAS86 for the year to be lower in 2009 than in 2008. Our current expectation is capital spending in the high single digits as a percentage of revenue for the year.

Before I hand it over to Paul, let me underscore that we are in this business for the long-term and we believe we have tremendous opportunity ahead of us to maintain our leadership. We are managing the business prudently, mindful of providing a reasonable return while making important investments in our strategic initiatives. We have great confidence in our ability to execute on the unique opportunity in front of us and I look forward to speaking with you again in April. Paul?

Paul A. Maritz

Thanks, Mark. As our financial results indicate, we delivered a good performance in the fourth quarter in very challenging economic times. The quarter was categorized by the same trends that became apparent in Q3 particularly in September when the financial meltdown really gathered steam. Business became very cautious, delaying spending, and preserving cash. Despite this, we saw comparatively strong performance in larger accounts where our customers continue to view virtualizations as both a strategic investment as well as a way to reduce cost. We also probably benefitted from some year-end budget slashing in these larger accounts where people try to get ahead of any possible 2009 budget squeezes.

As Mark noted as well, we did see some weaknesses in parts of our transactional business particularly those parts that were particularly sensitive to price such as the academic market.

On the other hand, we did achieve a record number of new customers overall for VMware infrastructure products. We were also encouraged by the adoption of our newer products. We now have over 1,500 customers for our management automation products which were introduced in the second quarter of ‘08. Disaster recovery is the big driver here with Site Recovery Manager gaining 900 customers since we introduced in June.

We also saw 50% of our Enterprise license agreements in the fourth quarter have a desktop component which was a welcome uptick there. Overall, our service customers are increasingly seeing VMware as their strategic vendor for virtualization. We do an annual customer survey which is done by an independent outside firm and in that survey, 65% of customers are now reporting that they have a VMware first virtualization policy, up from 46% in the same survey done in 2007.

In keeping with what we reported in last quarter, we have not yet seen major losses to competition. We see the major challenges coming overwhelmingly from the economy. Where we have been seeing competition is where we are consistently winning, a good example being the U.S. Army Tactical Battlefield Command solution where we won over Microsoft and other vendors due to superior resource balancing and consolidation ratios. This U.S. Army particular deal was also a desktop win for us.

From an internal perspective, we continue to work on strengthening the company. At the beginning of last year, sorry, the beginning of this year, I was very pleased to announce that Tod Neilsen had joined us as our Chief Operating Officer. By focusing on operations and execution, Tod will allow me to focus more on strategy and product development. From his Microsoft years, Tod has experienced consistent software marketing developer relations and what it takes to build an ecosystem. I saw Tod in action during some of the big battles of the ‘90s, the big system software wars against IBM, Novell, Netscape and others and since then, Tod has gained deep operational experience at BEA and Boland. I know he is going to be invaluable in helping us get to the next level. Incidentally, Tod is actually in the room with Mark and myself today and will be available during Q&A if you would like to address any questions to him.

As I described to you last quarter, we’re entering 2009 structured into two product business units, the server and the desktop, and three geographic units, the Americas, EMEA and Asia-Pacific which will enable us to strengthen our focus on execution. In addition to Tod, I am happy to report that Maurizio Carli has joined us as general manager for Europe, Middle East and Africa. Maurizio was most recently at Google and before that he ran European sales for Business Objects and before that, European sales for IBM Software. Maurizio also has deep experience in our industry and what it’s going to take to build the business.

When we last spoke, I described to you the three strategic product initiatives around which we are rallying the company, the VDC-OS or Virtual Data Center Operating System initiative, the vCloud initiative, and the vClient initiative.

In terms of the Virtual Data Center Operating System initiative, we continue to make progress. Our customers, particularly those start-ups on the path of virtualization for the immediate cost savings that they can get from using their service more efficiently, but in doing so they find that their entire data center becomes more flexible as their compute capacity becomes accrued, available and on-demand across services. They’ve begun to transform their data centers into an internal or private cloud. So what we are now seeing, that customers increasingly appreciate that virtualization is not just about individual hypervisors, but about how hypervisors can be extended and work together to provide a new compute layer or fabric which yields not just CapEx savings but OpEx savings, not just increased efficiency but increased flexibility, manageability and more importantly, fundamentally a better way to run the business.

Customers can look to this extended view of virtualization as the evolutionary way that they can build out private or internal clouds and get to new levels of efficiency and flexibility. This only happens when the extended hypervisors are designed to work together. This is why a growing number of our customers in that survey that I referred to earlier are reporting a VMware first policy.

So when you have all the virtualization sub-systems working together across services, things become more efficient and flexible and certain complex operational processes also become fundamentally simpler. For instance, development tests and staging can be done in a safe way, on operational infrastructure. You don’t have to provide an entirely separate set of infrastructure to do that. One can also move to a disaster recovery approach that allows back-up data centers in fact to be active and equally importantly, you can actually practice doing disaster recoveries in a regular way testing that the system is actually available for you when you are going to need it.

To help our customers realize these OpEx benefits, we’ve begun to release a series of solutions aimed at these specific management tasks. To date, these include our Site Recovery Manager targeted at disaster recovery, Life Cycle, Lab Manager, Stage Manager, targeted at the development test staging solutions, and we will continue to add to these solutions in 2009. For example, customers implementing our management tools for recovery are Lowe’s, GW University, the City of Pittsburgh and Brookdale Senior Living which is the largest provider of senior living facilities in the country. As I said above, we’ve got over 1,500 customers for these M&A products which we introduced in 2008.

Closely related to our core VDC-OS initiative is our vCloud initiative. vCloud initiative is about working with service providers to enable them to implement compatible software and management so that their customers in turn who are using VMware internally will have the option to flexibly move workloads from their internal data center up to the external cloud and back again. Again, we are making good progress here with leading service providers building new service offerings on our underlying VMware software, examples of these service providers being Asset Origins, SunGard, Terremark, and others.

Terremark recently introduced their Enterprise cloud offering which is a new service which allows customers to buy the giga-hertz, by the mega-byte, by the giga-byte, instead of buying by the individual server that’s being the case to-date. This way, a company just has to specify how much aggregate CPU memory and storage they want and then they will be able to treat these resources like a single pool into which they can load as many services as they want. They can have one service, five services, 500 services, it doesn’t matter. It limits the temporary incentive, it tends to get billed at a higher rate. It’s sort of like you’re able to buy a family plan for minutes for your cell phone and you can add as many cell phones for your children and spouse as you would like to your account. This allows customers able to use resources much more efficiently and not have to guess what services will need resources for one and for other organizations to cover transient spikes.

All of this is possible because of the magic of our underlying VMware software and it begins to make clear the benefits that you will get from the VDC-OS approach to building both the internal and the external cloud. Other service providers are going to provide similar products in the future also based on our underlying VMware software.

On the vClient initiative, we’ve also made good progress. As you may recall, our goal here is to provide a comprehensive desktop solution, a single framework for division of both thin and thick clients. We believe that organizations should be able to equip their people with software and information that they need and should be in an environment including the software implementation that would belong to the user, not to a particular device. When the user encounters a specific device be it a thin client or a thick client like a laptop, then the user’s environment should be automatically securely provisioned to that device. To do this, we need three things. First we need management software essentially set-up and maintained for these environment uses. Secondly, we need the means to efficiently execute these environments in the thin client environment if that’s what the user happens to be using and also to do so effectively on any thick clients such as a NetBook or a laptop.

During the fourth quarter 2008, we released a major release of our desktop management tool that is necessary to crate and manage those environments on behalf of users. This is called the VMware View 3.0 Suite.

As a result of all these efforts on our initiatives is that our products are used by more than 130,000 customers including 100% of the Fortune 100, 100% of the Global 100 and 96% of the Fortune 1000. We still see lots of opportunity ahead as our customers realize that virtualization is more than about individual service. It’s about vitalizing all the service with compatible software to achieve a true internal cloud and yield both CapEx and OpEx savings. This is going to give us the opportunity to not only attract new customers but achieve deeper penetration in our existing customers. It also provides a natural reason why customers should really prefer a VMware first policy.

Looking forward to 2009, we’re going to continue to drive forward on these three key product initiatives. As you can probably sense from our growing software capitalization balance, 2009 is going to be a year of major product introductions. We’re going to be doing a major update to our core server virtualization offerings in the context of the VDC-OS initiative. It’s premature to give details here but we and our partners are preparing a real banquet for our mutual customers. We’re also going to introduce new management and automation solutions and also extend those their availability and security in 2009. We will be significantly updating our vCloud offerings and in the best up-space, we’ll also complete the three key aspects, centralized management, improved thin client support and thick client support into 2009.

We’ve also begun long-term R&D work in promising areas, a good example being the technology investments from non-RAS86 processes, specifically for smaller devices such as mobile phones. Mark noted we made some acquisitions and this was one of the areas where we made an acquisition in the fourth quarter of 2008.

We look forward to 2009 and the benefits that we hope to provide to our customers but the first order of business is obviously surviving and thriving in what promises to be hard economic times. All of the indications we have are that the first quarter is going to be a quarter of indecision. Our discussion with customers indicates that many of them still haven’t locked in their 2009 budgets. People are hoping for better data in the direction of the overall economy and are trying to keep their options open as long as possible.

We have taken a conservative stance on the quarter and the year as a whole. We’ve trimmed our expenses levels to be able to maintain reasonable margins and preserve cash while also continuing to execute on our core initiatives and deliver this increased value to our customers. Our employees are contributing in these austerity measures such as postponing merit increases and generally tightening our belts on all expenses. We are going to continue to make hires but these are only going to be in the most strategic areas, areas where we know the payback will be very short such as in those geographies where we have little or no presence currently.

2009 has to be a year of execution. We’ll redouble our focus on selling near-term value propositions, doing more with less while also demonstrating to our customers and partners the longer-term, strategic value that they can realize by embarking on this journey with VMware. We firmly believe that virtualization is a tactical and strategic direction for our customers. For most enterprises, it offers the only realistic path to achieving meaningful, near-term efficiencies while also fundamentally transforming how they do IT in the longer term. Our plan is to continue to be the leader of this parade and be well-positioned to be one of the significant winners when the economy finally recovers.

We’ll open up for questions now and we’d like you to call those in.

Question-and-Answer Session

Operator

(Operator Instructions) We’ll take our first question from John Difucci from J.P. Morgan.

John Difucci - J.P. Morgan

Mark, as you pointed out, guidance implies license revenue to decline as much as 10%. I realize you’re dealing with a tough macro-environment but if you look even with this quarter, relative to a lot of other software companies that at least you’re showing some growth. I’m just curious here, because as you’ve pointed out in the past and it’s easier to see how the end-market helps someone save money, just wondering is it over? It just seems surprising that growth would disappear in a market that appears to be very underpenetrated which at this point anyway, very little real competition although that, as you pointed out, that will come on over time. It just seems that this quarter, there is obviously uncertainty out there but to show a decline in revenue, I am just surprised to hear you say that.

Paul A. Maritz

This is Paul. Again, the challenge here is visibility. We’re being conservative here. What our contacts with customers tell us is that they themselves are uncertain and we’ve never seen this level of uncertainty before. I think this really is the case that at this point in time, CFOs across the board are trying to preserve cash and keep their expenses as low as possible and to keep as many options open. We’re obviously not immune to them. Mark, do you want to add anything to that?

Mark S. Peek

I would add, John, that if you look at another important point from the fourth quarter, that we added more new VI customers than ever before and this is a trend that continues throughout 2008 so by no means do we believe it’s over. Q1 of 2008 was a difficult time for us for a number of reasons not the least of which is a large number of ELAs that we closed in Q1 of last year and our expectation that ELAs will decline this year so the revenue is a little bit lumpier than Q1.

John Difucci - J.P. Morgan

Just a quick follow-up, Mark. I know that you mentioned Q4, I was just curious, was there any meaningful change in deferred license revenue?

Mark S. Peek

No, there was no meaningful change. It was about flat to the third quarter.

Operator

We’ll take our next question from Katherine Egbert of Jefferies.

Katherine Egbert - Jefferies & Co.

I have a follow-up for what John just asked. If you have ELAs as a percentage of revenue either coming in seasonally in Q1 but you said your transactional revenues were fairly weak in Q4, are you placing an appropriate burden on that transactional business? What gives you confidence that can make up the gap in the ELAs?

Paul A. Maritz

This is Paul. Obviously, we’ve modeled out what we think will be the appropriate balance in Q1 to arrive at the guidance that we’ve got so we’re factoring in what we think we can expect out of both transactional and the ELA business. That’s if we have focus on both and we’re gearing ourselves up as I said to really double our focus on selling our value proposition which remains a fundamentally sound one. We think that if we can keep the ship steady through this quarter and potentially next quarter when things turn around, we should be a big beneficiary.

Mark S. Peek

I would also emphasize that the weakness that we saw in our transactional business was on the very price sensitive segments such as educational institutions and in the entry-level skus of our business.

Katherine Egbert - Jefferies & Co.

You had a large benefit and headwind from acquisitions on the non-GAAP operating margin. It looks like if you’d normalized those, it would have been about 24% of the higher end of guidance. Is that right? Can you give us any sense of what’s sustainable?

Mark S. Peek

On the normalizing, when we provided our guidance in the third quarter call, the currency rates didn’t change that much but on a year-over-year basis, in a comparable period, Q4 versus Q4, we’d be about 24 and change with the impact of the acquisitions that we made. On a go-forward basis, as we come out of this recession and build the platform, as we lead in this business, we’re very optimistic about operating margin expansion but that’s not something we anticipate that we’re going to see in the near future or at all in 2009.

Operator

We’ll take our next question from David Bailey, Goldman Sachs.

David Bailey - Goldman Sachs

Just a quick question on the gross margin on sales. As it continues to go higher, can you talk about the driver of that please?

Mark S. Peek

Sure, there are a couple of factors. One this quarter is our professional services was flat sequentially and that tends to be a lower margin component of our services gross margins. Secondly, we’re benefitting from the maintenance revenue we have been building over time. It grew 57% year-over-year so that annuity is kicking in and increasing our overall services revenue.

David Bailey - Goldman Sachs

If you look at your sales comp plan, I think it’s the first half of the year, what are you trying to emphasize? Is it more new licenses, ELAs, or profitability?

Mark S. Peek

I’m not going to go into the details of our sales comp plan and what we’ve been focused on this first half of the year, is our new business unit structure and our geographic structures so that we have more empowerment of people in the field and to have the focus and the influence they have on the business units.

Paul A. Maritz

I just want to add some additional color to that. Clearly, we continue to have a focus on license revenue being in the channel or through ELAs. We continue to believe that that is very important to focus on for the long-term health of the business. We continue to make that a key objective for ourselves. We are also however trimming our expenses to what we believe will be the right balance between the reality in the marketplace that we face because of the economy in 2009 and the need to really build strategically on these initiatives that we have which we think just have tremendous potential to build one of the great platforms in the industry.

Operator

We’ll take our next question from Heather Blaney, UBS.

Unidentified Analyst - UBS

This is [inaudible] for Heather. Mark, can you talk a little bit about how we should expect the license fees not only beyond Q1 or is it too early to talk about that and secondly, on our European market, what kind of currency benefit would you get in the full year 2009, and should we expect margins to decline on a year-over-year basis?

Mark S. Peek

As we have been saying, it’s very difficult to provide any guidance this quarter and particularly beyond the first quarter. Longer-term, we expect some license revenue seasonality as the economy straightens out but it’s a little early to predict that given the macro that we’re in. With respect to operating margins, there was a lot of currency volatility, as you know during 2008. If currency stayed constant today, we would expect to pick up a point over this entire year. That would be weighted more towards the first half than the second half.

Unidentified Analyst - UBS

Could your margins decline on a year-to-year basis in ’09?

Mark S. Peek

This is the first quarter at VMware where we have had revenue down sequentially so certainly we expect margins to decline sequentially in the first quarter as well. Beyond that, it’s largely going to be the revenue-side that will determine where our margin structure will go.

Operator

We’ll take our next question from Israel Hernandez, Barclays Capital.

Israel Hernandez - Barclays Capital

Can we talk a little bit about the performance of your international businesses? It seems like there is deceleration there. It picked up again over last quarter in terms of the year-over-year growth. Can you just comment on what you’re seeing in the European and Asian theaters and what’s your outlook as you look out for the rest of the year?

Mark S. Peek

Europe, I think, caught the economic cold a couple of months later than what happened in the United States so we certainly saw a bit of weakness in Europe this quarter. Historically, we do fewer Enterprise agreements in Europe than we do in North America so that also has an impact on growth rates internationally. Going forward, again, we’ve factored in demand in all of our geographic theaters for the first quarter and it’s premature to go beyond Q1.

Israel Hernandez - Barclays Capital

In terms of your go-to-market and e-flatline, international is being an area of important growth. Do you feel like you have all of the necessary resources in place or do you feel like adding capacity in those markets?

Paul A. Maritz

The Asia and emerging economies is an area where we are adding resources and we do think that those investments will pay back in a very short time. It should add to our strength in 2009.

Operator

We’ll take our next question from Walter Pritchard, Cowen and Company.

Walter Pritchard - Cowen and Company

Just a technology question around consolidation ratios. I was just wondering if you could provide us any sort of direction or quantity of guidance in terms of what you’ve seen over the course of 2008 as customers have gone into full production and your solutions have matured in many of their environments from a consolidation ratio perspective on your VMR hosts.

Paul A. Maritz

This is Paul. We’re seeing a couple of trends. Obviously if customers get a little bit more comfortable with virtualization, they will begin to move more and more production environments onto virtualization so that the number of loads per servers is going up. As I said, that is one of the current competitive strengths is that we can host more loads than the competition and people see that as an attractive aspect. We’ve seen intel that others are introducing multiple cores for a CPU which further increased the loads per server that people can host on a particular server. We’re aware of these trends. We think it’s actually, although in the short-term, you can say it works against us and people need fewer licenses in terms of having to cloak fewer servers with virtualization. In the long-term, or even in the medium-term, we think it’s a huge beneficiary to us because we can win far more by encouraging customers to go to what we call 100% virtualization, because customers really only get the full benefit of virtualization when they have all of their servers cloaked with a compatible layer of virtualization and where the extended hypervisors are closely cooperating with each other. In the major edition of our software that’s coming up this year, you’ll see us do several things there to further exploit that trend.

Walter Pritchard - Cowen and Company

One follow-up question around the hiring. You said you hired about 100 people organically and about 200 total with acquisitions. Is that case sort of a conservative case and it should expand per quarter in 2009 or is that a good level to kind of think about it in terms of employee adds during 2009 per quarter?

Paul A. Maritz

This is Paul. Obviously, we are going to be watching this carefully on a quarter by quarter basis but you should expect our hiring to slow in the sense that we’ll see fewer acquisitions in the first half of this year and continue to be very careful about any hires that we make.

Operator

We’ll take our next question from Phil Winslow, Credit Suisse.

Phil Winslow - Credit Suisse

Tamar asked a question on operating expenses, we need to think about Q1 and sort of the progression over the course of the year. You got into a pretty significant sort of mid-teens with a potential drop-off in license sales. I just want to get a sense on particularly the sales and marketing line, how much is variable versus fixed because you’ve got expenses flat sequentially. I’m surprised they’re not down sequentially, so I just want to get a sense of that.

Mark S. Peek

Phil, even with our guidance, we’ll have overall 8% revenue growth or so. Of course, the amount of bookings we have in the quarter, only a portion of that is license that will go to the bottom line. Although we expect the variable sales column to go down sequentially, we think about it in terms of essentially flat to the fourth quarter is the right way to think about it. If you think about the 200 people that we added during the quarter, we’ll have a full quarter of their salary on the books in Q1 in addition to additional depreciation expense for the capital that we invested in during Q4.

Operator

We’ll take our next question from Toni Sacconaghi, Sanford Bernstein.

Toni Sacconaghi - Sanford Bernstein

I have a few questions. The first one is can you help us understand linearity in the quarter? I think in mid-November, you reiterated your guidance for the full year of 42%-45% revenue growth all-be it at the low end. You came in at 41.9% despite the fact that you said you benefitted from some seasonal budget shift/flushes at the end of the quarter. Can you help characterize what linearity was like particularly relative to your expectations and normal seasonality?

Mark S. Peek

Sure, Toni, this is Mark. First, in the middle of early November, we indicated that we didn’t see anything that would cause us to back away from the 42%-45%. On last quarter’s call, we cautioned that we thought that it would be very much at the low end. So we see this quarter really coming in where we thought it would come in. That said there was a lot of uncertainty three months ago when we spoke to you last. There was high seasonality as there typically is in the fourth quarter. We closed a lot of our business in the last few weeks of our quarter.

Toni Sacconaghi - Sanford Bernstein

Does your pipeline or backlog as a result given those high closure rates at the end of the quarter, does it result in something that is lower than you typically have as a percentage of next quarter’s revenues?

Paul A. Maritz

This is Paul again. I think it goes back to what we’re seeing is that the guidance we’re giving for the quarter is based upon general feedback about uncertainty that we’re hearing from our customers and through the field from our customers. So I think it’s absolutely honest to say that we have more uncertainty going forward in the past.

Toni Sacconaghi - Sanford Bernstein

Separately, you mentioned the volatility that ELAs can create on a quarter-to-quarter basis. Effectively, you said, you received some benefit on a year-over-year basis from ELAs from the fourth quarter; they were higher than they were a year ago. The converse is expected in the first quarter, you expect your ELA percentage to be lower than it was a year ago. I think a lot of the questions have expressed surprise at the deceleration in your license business. How much of this is explainable by effectively what was a bit of a burst in the ELAs in the fourth quarter and then an anticipated relative slowdown on a year-over-year basis in the first quarter? What might be helpful is if you can help us understand on a year-over-year basis the impact of ELAs on your revenue growth in Q4 and what you’re planning for in Q1.

Mark S. Peek

With respect to ELAs in Q4, the percentage was essentially the same as it was in Q4 of the prior year on a relative basis. It had the same impact that it had in Q4 of 2008. As we look ahead, largely because of what customers are telling us and our visibility forward, we just expect that customers will, to the extent that they are buying, they will buy as you go and not enter into Enterprise agreements. It does have a fairly significant factor in the guidance that we provided.

Toni Sacconaghi - Sanford Bernstein

Should we be thinking, Mark, like 500 basis points or more, or a lower ELA percentage in Q1 ’09 relative to last year?

Mark S. Peek

I really can’t go to that level of detail with you on our guidance. We’re trying to point out if the visibility is unclear for us and we’re planning around the $475 million number.

Operator

We’ll take our next question from Todd Raker of Deutsche Bank.

Todd Raker - Deutsche Bank Securities

Two questions. Just to follow up on the visibility and pipeline issue, can you talk about your impact into your OEM relationships and if you look at Q4, did the OEMs deliver on plan or how did that play out?

Mark S. Peek

As you know, we don’t break out our bookings or revenue by channel. Across the board, the flavor was relatively the same. We had good growth and good demand with our Enterprise commercial customers. Some of them entered into Enterprise agreements through the system vendors. Going forward, we have a healthy relationship and dialog with all of our OEMs and they’re working with us on pipeline as well into Q1 and beyond.

Todd Raker - Deutsche Bank Securities

Just a follow-up. As you look at the server or data center market versus the desktop opportunity, are you seeing the difference in terms of the economic impact on those two markets?

Paul A. Maritz

This is Paul. Obviously, at this point in time, the desktop is a comparatively larger percentage of our revenues than the server. We actually see desktop as being largely upside. The good news is we think 2009 is going to be a year of a lot of activity in that market. A lot of customers are thinking about what they should do strategically and in many ways, it is like the server virtualization market was maybe three or four years ago. So the good news is we think we have a lot of upside there but obviously on a percentage basis, it has to move a lot more to move our overall dial than the server business does.

Operator

Our next question is from Kash Rangan, Merrill Lynch.

Kash Rangan - Merrill Lynch

Just a couple comments and a couple questions. Congrats on getting Tod on board. It also looks like the I4 release looks to have a lot of promising futures, coming up over the year. I wanted to get into the EAs a little bit. It looks like we started doing the EAs in early 2007. We are coming up on a second anniversary of some of these EAs and hopefully the third anniversary on some of these EAs by the end of this year. So you look at EAs and it looks like we are hitting that point of 22%-23% of bookings, how should we think about how growth is going to be driven in the future as you anniversary the first set of EAs. I am also a little bit surprised that 50% of the EAs in the quarter had a desktop component. I’m just wondering if that’s the case, what should be driving license revenue growth in the future if indeed in the near-term, it has appeared to top out at 22%-23% of bookings. Then I have a follow-up question.

Mark S. Peek

I’ll take the first part of the question just around anniversaring of Enterprise agreements. Most of our Enterprise agreements have cap deployments although the licenses are perpetual. What we do is we continue to maintain a relationship with these customers. We have other products, our automation and management products which we deliver to them and we help them with solutions around there, so we have additional opportunities to sell while the Enterprise agreement is still alive. In addition, as the agreements do anniversary, we’ll go back in with our customers, do an assessment and if so, give them their additional needs as well as expect renewals on existing licenses.

Paul A. Maritz

This is Paul. To the second part of your question about the desktop component, as we said, we think this is a leading indicator of interest in the sense that Enterprise is making provisions in their agreements to be able to employ some of the licenses towards desktop virtualization. We think that this is still in its infant phases, there’s still a lot of prototyping, experimentation, proof of concept going on. We expect that to continue during 2009 and we think these opportunities will probably come in 2010. It’s very gratifying because it means that we’re in the pipeline there and they’re looking seriously at our offerings, more than seriously actually, putting money where their mouths are.

Kash Rangan - Merrill Lynch

Paul, just to clarify, I should not look at it as 50% of EAs including a desktop component as a sign of any new item saturation. What we are trying to reassure is that doesn’t jeopardize any growth opportunities in the desktop side of the future.

Paul A. Maritz

Exactly.

Kash Rangan - Merrill Lynch

Mark, back to you on the operating margins. It looks like the maintenance of component revenue streams thanks to the EAs, the bright side is that when it is used as a percent of revenue, you should expect some upward margin pressure. If you are to hold your expenses relatively tight for a flat or down license environment, I’m wondering why shouldn’t the operating margins actually be up although I completely understand how you don’t want to set a high expectation. Conceptually, shouldn’t it be growing in 2009 rather than at 2008 levels?

Mark S. Peek

Kash, certainly, over a longer period of time under those scenarios, operating margins would expand and what I’ve really been addressing is the impact on Q1 since we will be down sequentially on revenue. We’ll largely have a fixed cost base with the exception of our variable sales comp.

Operator

We’ll take our next question from Laura Lederman, William Blair.

Laura Lederman - William Blair

I just want to know on 50% of the ELAs in Q4 including some desktops, was there competition in those desktop deals or were you sort of the solo vendor and they just agreed to use you in desktop? Were those environments competitive and if so, I have a follow-up on competition as well.

Paul A. Maritz

Most of those deals are competitive. The customers are smart. They know that folks other than us have their offerings in the space and a #1 competitor of theirs is Citrix.

Laura Lederman - William Blair

Why did you win against Citrix in most of those deals and secondly, where are you seeing Microsoft today? The IDC numbers show them with a big share. Obviously, none of us really believe those numbers but where are you seeing them? In terms of competition, is it the low end, the middle market, any sense of where they are?

Paul A. Maritz

Let me answer your first question. To the extent that we win over Citrix is because people are desiring a dedicated solution where otherwise each user gets a dedicated virtual machine which offers higher degrees of application compatibility over the shared currency model that Citrix’s current solution uses. We have the highest consolidation ratios, the highest performance, and the highest stability when it comes to running virtual machines in a server environment. It’s largely for that reason that we win. Many of our wins are actually won with parts of Citrix infrastructure in the environment, within the core back-end of virtualization, there is our opportunity.

In terms of where we are seeing Microsoft, we’re still largely seeing them in the hypothetic case, in other words, we see them in large accounts when customers are doing slideware comparisons of our two solutions and in some cases actual bake-offs. So we see them basically where Microsoft has sales presence. Obviously, it is a lot harder to see them in the channel because then you would have one more arm removed there. Even at this point in time, we don’t see major impact yet. Microsoft is a major force in the marketplace and we have to take them really seriously which is why we are pushing forward with the product initiatives that I described earlier and why 2009 will be a year of major product introductions for us. We intend by the time Microsoft brings their offerings to the market in 2010 to be ahead again.

Laura Lederman - William Blair

A quick question. If you look at the Enterprise versus the middle markets, you mentioned the middle markets, the transactional business seemed to be price sensitive in markets like education. General, was the middle market or transactional business weaker due to the economy with the Enterprise or was it just specifically only those verticals? I’m trying to get a sense of the health of transactional middle market business versus Enterprise.

Mark S. Peek

The transactional market has a little less seasonality than the ELA market. Although, we saw primarily the low end being the primary issue where there was some price sensitivity and some demand sensitivity, early in the quarter as a result of high currency fluctuations particularly internationally, the transactional business was slow. It has recovered nicely in the back part of the quarter.

Mike Haase

Operator, we have time for one more question and then Paul has some closing comments. Thank you.

Operator

We’ll take our last question from Brent Thill, Citigroup.

Brent Thill – Citigroup

Can you just characterize the pricing environment, what you’re planning for 2009? Paul, I think you mentioned that Tod was on the line. Correct me if I’m wrong, but I think the COO role is a new role at VMware that had not been filled before. Can you just address where he is going to spend most of his time there, his investment? It would be great to get an overview from him.

Paul A. Maritz

I think in terms of the pricing and Mark can jump in here, we actually saw our ASPs in the fourth quarter strengthen slightly. Looking into 2009, we are thinking strategically, realizing that we will have some price pressure; in particular, we will probably have to remix our functionality. In other words, move features down the waterfall of your skus. Every technology vendor has to do this over time, you can’t stand still. We have planned with that in mind for 2009. Mark, is there any color you wanted to give there as well?

Mark S. Peek

The pricing environment, we did a good job in holding the line on discounting. As Paul mentioned, the ASPs and the transactional business were actually up modestly in the fourth quarter.

Tod Neilsen

I would just like to add, first off, it is great to be here. I’m excited to be part of the VMware team and the opportunity we have in front of us. The COO role is a new one here and the way Paul and I are operating is as two in a box, allowing us to focus and drive things forward. Some of my top initiatives are one, as Paul mentioned, we have gone to a business unit and a geography organizational structure and really working to define the rules of engagement and workflow of how we are going to operate internally to make sure we’re maximizing and getting all that we can out of those investments. Second, is in the product areas. As Paul mentioned, we got a lot of product launches coming out this year and I will be working with the teams on just driving how the launches are going to relate through the channel and our customers and partners and what all of that entails. Third, globalization. There is a ton of opportunity for VMware as we drive more strength in the emerging markets and get out of some of the ways we have been offering and focus more on really being a global company that’s a strong international partner.

Paul A. Maritz

Thanks, everyone. We would just like to add in closing, I have been at VMware 6 months now. When I had first spoke to you back in July, I said one of the key things that had attracted me to VMware was the potential for VMware to become one of the truly important and valuable platforms in our industry. I now firmly believe in that potential heading. I’m seen it from the inside out. We’ve got the talent base, the technology base, the customer base, the partnerships and the strategy. With focus, good old-fashioned hard work, I know that we can achieve that goal and do really amazing things here. Thank you.

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: VMware, Inc. Q4 2008 Earnings Call Transcript
This Transcript
All Transcripts